The Role of Divestitures in Profitable Growth
Strategy is as much about what you do not do as it is about what you do, says Harvard’s Michael Porter in his classic Harvard Business Review article, “What is Strategy?”
“Leading companies view divestments as a fundamental part of their capital strategy” concluded Big 4 accounting firm EY in its Global Corporate Divestment Study 2015. EY also found that nearly three quarters of the firms studied are using divestitures to fund growth and two thirds achieved a higher valuation multiple after divestment.
As a company grows and evolves in a changing environment, and as it makes significant acquisitions, some business units no longer fit well or perform well and may be worth more to others, while the divestiture proceeds can be redeployed profitably in the core business. That’s when less is more.
A pruning exercise, or corporate divestiture, can create significant value for shareholders as well as increase opportunity for unit employees and other stakeholders.
The Board and C-Suite executives responsible for a divestiture may need to be as concerned about managing risks and protecting the company’s reputation with key constituencies as they are with purchase price. This article addresses both concerns.
Two keys to creating maximum value with minimum risk when divesting a business unit are: 1) adequate planning and 2) professional execution. These tasks may require specialized resources from outside the company.
The Divestiture Process
The divestiture process begins with reviewing operating results and growth plans, and raising questions about the future role of each business unit.
If a company decides to divest, a divestiture team must be assembled to begin planning the project. When the project is initiated, execution will fall into two types of tasks: managing the unit to be divested and managing the divestiture process itself.
The Divestiture Team
In a large company, the corporate development department often manages the divestiture process, and may engage and oversee an M&A advisory firm to handle most activities. In a smaller company, the chief financial officer typically leads the project, with outside advisors.
A financial executive is often assigned to verify the numbers that will be presented to a buyer, adjust unit financial statements to a pro-forma stand-alone basis and, at closing, “unhook” the unit from the company’s IT systems or arrange transitional services for the buyer.
Raising The Question
Whether part of a periodic review of unit performance or a larger corporate strategic decision, the divestiture process begins with raising The Question: ‘Should this unit be divested?’ - and a number of related questions, such as:
Does this business unit have strategic value in the company’s future?
What are the value drivers for the unit? For example:
Would the unit be more valuable to another owner? What kind of buyer?
What financial effects would divestiture have on the remaining business?
How can any negative effects be prevented or minimized?
The recommendation to divest is usually made by the operating executive above the unit, but the decision is often made by the CEO, after appropriate involvement by other senior executives and the Board of Directors due to sensitivity to the impact of the divestiture on employee morale and strategy.
A decision of a public company to divest may have less emotion than the decision by a private company owner to sell his or her business, but it can be difficult nevertheless. Non-price considerations, like loss of jobs in the local community, risk of shared brand names, and environmental stewardship may be very important to the divesting company’s reputation. In smaller divestitures, price may be overshadowed by these concerns to protect the company’s reputation.
If the decision to divest is made, a second set of questions is raised:
What type of transaction would fetch the highest price and best terms?
Do we want a long-term supply agreement with the unit?
When is the best time to begin the divestiture process for this unit?
How will we manage the unit until it is sold?
How will we execute the divestiture process?
Pre-emptive Due Diligence and Planning
Before contacting buyers, management (with the support of financial and legal advisors, and other consultants) should identify and address potential issues that would concern a buyer. The benefits of thoughtful planning and resolving risks up front include:
A careful review of the unit to be divested should be undertaken. That review should include:
To maximize value and minimize risk, it is important to protect against liability exposure, so the planned due diligence should include:
A virtual data room (VDR) can expedite closing by making the due diligence documents easily available on-line and provide appropriate security and monitoring capabilities. The cost of this service for mid-size transactions has dropped considerably in the last several years.
Managing the Unit Being Divested
Management of the unit being divested focuses on enhancement of its attractiveness and selling price. Focus is on unit profitability. Inventories and receivables are managed aggressively. Capital expenditure requests are reviewed carefully, but not necessarily turned down.
People, too, are important assets, and communicating with employees and key customers – both the message and timing - deserves careful attention. Some companies develop a detailed written ‘announcement plan’. Non-compete agreements, ‘stay’ packages, and other means to secure the cooperation of key unit personnel can be helpful.
Managing the Divestiture Process
The Divestiture Team’s job is to create the most effective form of competition for the unit among motivated, qualified buyers, although not all divestiture candidates are attractive enough to enable an auction.
Most companies offer a unit pretty much ‘as is’. They often are, however, willing to warrant the big items, and take seller notes as part of the consideration when necessary to close.
Finding the best buyer candidates and structuring the transaction creatively are skills necessary for a successful divestiture. There are a number of buyers that specialize in acquiring divested businesses, as well as logical strategic acquirers and private equity firms with interest in the relevant sector.
With the range of possible transaction types cited earlier and considering the size of the unit to be divested, the divestiture team may need specialized resources to handle these tasks effectively. If they are not available in-house, an M&A advisor with relevant divestiture experience can be well worth the cost.
Confidentiality will be a top priority of the Divestiture Team throughout the process. Companies typically have individuals involved in the divestiture process sign a confidentiality agreement.
Providing the right information to buyer candidates is essential in achieving the best price. The value drivers and the unit’s future financial potential under an achievable ‘stretch’ scenario must be communicated in writing and discussed by unit management. DVDs enable a buyer to ‘see’ processes and locations. Sector background is helpful where buyers may not be familiar. Giving potential buyers access to all or part of the VDR can also help move the divestiture process along.
Audited financial statements for the unit strengthen a buyer’s confidence and should be provided whenever practicable. Alternatively, if there are no stand-alone financial statements for the unit, they must be extracted from the records of the larger entity. In the case of a large company selling a small unit, this may be a time-consuming but necessary activity because if the buyer doubts the reliability of the unit’s numbers, it can impede or kill the deal.
A divestiture is an important management activity because it can increase shareholder value. It requires the right people, careful planning, creativity and attention to detail.
© Copyright 2015 Russ Warren and Lori Siwik
Portions of this article first appeared in The Journal of Buyouts & Acquisitions as Practitioner’s Corner by Russ Warren and John Calfee.
[*] The parties should discuss whether the buyer is going to have rights to the seller’s insurance policies. Depending on the type of transaction contemplated between the buyer and seller (asset or stock purchase) and the jurisdictions involved, if the buyer is to have rights to the policies, the parties should discuss the best way to effect an assignment of the policies and specifically address this issue in the Agreement.