Many companies are currently taking a hard look at their operations after one of the worst economic downturns in nearly half a century. It should be noted, however, that some companies emerge from a recession stronger and more highly valued than they were before the economy soured. By making strategic choices that sometimes defy conventional wisdom they enhance their competitive strengths and thus gain more power to shape their industries.
One approach to countering the prevailing market turbulence is to maintain a disciplined M&A program that actively allocates capital to acquire new businesses, encourages their growth, and then sloughs them off in a timely fashion. Even in demanding economic conditions successful companies will mobilize the management time and talent needed to identify, execute, and integrate strategic M&A transactions. Conversely, those corporate icons which rely upon their sheer size and momentum to survive rarely create superior shareholder value. This article examines the rationale for one of the more common forms of corporate restructuring – the business unit divestiture, or "spin-off".
In a world of increasingly efficient capital markets, diversified companies can no longer add value simply by providing their operating divisions with access to capital. Instead, they must provide a unique set of corporate skills or competencies to each business unit in their portfolio. These core competencies include factors that drive the performance of existing businesses, such as operations planning and management, financial performance management, or marketing. They may also include those that identify new sources of growth, such as strategic alliances, product/customer strategy, or new product development.
The skills necessary to create value in any single business unit will evolve as a unit progresses to another stage in its life cycle. Because a company's core competencies are relatively static and the skills it needs at each stage of the life cycle are unique and dynamic, few companies excel at managing business units across all stages. When a corporate parent stops adding distinctive value, it is no longer the natural owner of a unit and should consider selling it or spinning it off.
The prospect of selling a business unit will often trigger a vague sense of dread. Executives are sometimes concerned that the sale will seem like a tacit admission of failure or evidence of poor management. In some close-knit corporate cultures, it may even smack of treason.
Such a bias against divestitures serves companies poorly and most CEOs can boost performance by thinking about divestiture more proactively. My experience suggests that the companies that create the most shareholder value are those that actively acquire and divest from their corporate portfolio. Companies that tilted towards acquisition lagged significantly behind those that balanced their acquisitions with divestitures. Companies that pursue active, balanced M&A strategies matched to their core skills have the best chance to thrive in a challenging market.
Disaggregation can also play a prominent role in helping large corporations to deal with challenges such as deregulation, globalization, technological change, and increasing pressure from financial markets.
Nevertheless, decisions to divest are nearly always made in response to pressure, and usually after long delays when problems became so obvious that action was unavoidable. Maybe the divested business is suffering heavy losses, the parent has a suffocating debt burden, or financial analysts have turned negative.
Holding on to a business unit too long also imposes costs – both on the entire corporation and on the unit itself. These costs often far outweigh the benefits of keeping the business and can include:
- Costs to the Corporation. The stability that well-established, profitable businesses provide is a mixed blessing. True, stable businesses can produce cash and help keep earnings smooth and predictable. But they can also dampen a company's impulse to create new, high-growth businesses. Determined business building often springs from a sense of crisis – a clear and pressing need for growth. The sense of comfort that surrounds seemingly stable businesses can temper any sense of urgency, causing a company to stagnate.
- Costs to the Business Unit. Every corporate parent has different skills and resources. Some, like strong venture capital firms, understand how to seed a business, providing important capabilities in such areas as product development, sales and marketing, and alliance creation. Some excel in growing businesses, offering expertise in, for example, operational planning and capital management. Others know how to manage mature businesses, providing assistance in making operations more efficient or helping them to better manage costs. A new corporate parent may be better suited to meeting the challenges of the business unit under consideration.
Furthermore, the operating performance of spin-offs in the years following a divestiture will often see substantial increases in the return on invested capital (ROIC). The new structure makes it possible for a company to offer managers incentives tied to the market performance of the divisions they run. Companies can better indicate to investors, executives, and other employees that performance, ownership, risk, and reward are bound together.
- Costs to the Shareholder. As with acquisitions, a well-timed divesture can contribute to shareholder value, and a poorly timed one can destroy value. Downward adjustments of business valuations by outsiders typically lag behind any decrease in true value of a business as it matures because outsiders have incomplete information. That asymmetry of information can give companies a window of opportunity to sell a business at an attractive price once it becomes evident internally that growth or performance are on the decline.
Alternatively, strategic purchasers for a business unit may offer a significant premium above the unit's intrinsic value due to expected cost or revenue synergies. Where the price offered exceeds the present value of the cash flows anticipated under the current ownership structure, shareholders should strongly consider spinning-off the business unit.
Perhaps the biggest shift in embracing a proactive approach to divestiture is coming to terms with the concept of selling off good, profitable businesses. It is important, therefore, to establish concrete criteria for business analysis and apply them objectively to every unit.
By posing a series of simple questions, senior executives can determine when it might be appropriate to seriously consider a divestiture. For instance:
- Do the parent and subsidiary operate in different industries?
- Is the subsidiary growing much faster or much slower than its parent?
- Do stakeholders (e.g. investors, or financial analysts) seldom consider the subsidiary's future growth or earnings prospects?
- Are high-performing managers or key technical staff being lost to more dynamic competitors, or is there a risk that this might happen?
Where one or more of the above situations exists, and the parent company is no longer in the best position to create the greatest value from its business through skills, systems, or synergies (in other words, it has ceased to be the "natural owner" of the business), a spin-off should be considered.
Once a business unit has been identified as a potential spin-off candidate, management must reflect on various practical considerations – the impact of a spin-off on other business units within the portfolio, tax implications, the availability of buyers, market reaction, payment mix, the use of divestiture proceeds, and dilution of earnings – to develop an appropriate course of action for the future.
Because the stigma surrounding a divestiture is so strong, stakeholders (e.g. employees, board members, or investors) are often resistant to the idea at first. It is critical, therefore, that senior managers rigorously communicate the rationale for each spin-off and why it is essential to the corporation's health. As a company begins to enjoy the results of a more balanced M&A strategy, this stigma should fade, and divestitures should become a natural event in each business unit's life cycle.
The divestiture of a business unit is not an end in itself but rather a means to building a company that can grow and prosper over the long haul. Wise executives divest of businesses in order to create new ones and expand existing ones. All the funds, management time, and support-function capacity that are freed up through a divestiture should be reinvested to enhance shareholder value. In some cases this will mean returning money to shareholders, but more likely than not it will mean investing in attractive new growth opportunities.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.