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Divestitures and Reasons Why Businesses Divest

Proshare

Tuesday, July 04, 2017 2:35 PM /Greenwich Trust

 

About Divestitures

A divestiture is a corporate restructuring approach that comes from the notion, “bigger is not necessarily better”. It is also sometimes called a “sell-off” or “reverse-acquisition”. It is usually a cash sale of the assets of a (or an entire) subsidiary business unit by a parent company, so as to re-align the core business (or the strategy) of the group of companies.

 

There are several other reasons why businesses carry out divestures, but the underlying motivation remains that the divesting company feels it is better off and more efficient without the subsidiary unit.

 

More specifically, the reasons for divesting include but are not limited to the following: Non-profitability of Existing Business Operations One of the strongest arguments in favour of a divestiture is that the business operation being carried out by the subsidiary unit may no longer be profitable.

 

This could be as a result of erosion of the subsidiary’s market share by more aggressive competitors/new entrants or it might be that the subsidiary now operates at the maturity end of its product-life-cycle, which prevents the company from remaining competitive in the particular industry.

 

When this happens, the parent company may find it more expedient to sell-off the entire subsidiary or scale down its operations, where it still feels strongly about the strategic relevance of the subsidiary’s business to the parent’s (or other subsidiaries) operations.

 

Strategic Misfit

Another common reason for a divestiture is when the subsidiary business is no longer found to be consistent with the overall strategies of the parent company or has become incompatible with the parent’s restructured business functions.

 

This may occur upon the acquisition of a diversified business whereby management decides to get rid of the acquisitions’ unwanted business/product lines. It might even be the case that, the continued existence of the subsidiary, as part of the group, is beginning to cause a market undervaluation of the shares of the combined business.

 

Increased Investment Requirement In a situation where it is becoming increasingly expensive to run the subsidiary’s operations due to challenges that are peculiar to its industry, the parent company may decide to divest from the particular business line.

 

This will be the case where the increased level of investments in Equipment, Research and Development or Man-power required to remain viable in the industry are considered to outweigh the possible future benefits to the group.

 

Regulation-Induced Divestiture

This can happen when large corporate entities are compelled to break up on concerns of anti-trust regulations.

 

It could also be on account of changes in the existing regulatory framework governing a particular industry in which a group company has a subsidiary representation.

 

A typical example of this within the Nigerian Banking industry is the Central Bank of Nigeria’s (CBN) directive for banks to strip-off their non-core banking functions.

 

Other types of Corporate Break-Ups

There are other means or approaches by which parent companies discontinue their interests in subsidiary undertakings, which are slightly different from the mentioned divestiture approach.

 

Some of these are Spin-offs, Equity Carve-outs, Split-Ups and Bust-Ups.

 

Spin-offs: This is the case when the parent company distributes its existing shareholding (via stock dividend) in the subsidiary on a pro-rata basis to its shareholders to turn the subsidiary into a separately identifiable legal entity.

 

Because of the nature of this share distribution mechanism, the spin-off approach is not usually considered by businesses when the motive is to seek additional funds to exploit growth opportunities.

 

Equity Carve-Outs: This method is often used to enhance existing shareholder value. Under this approach, the parent company will sell-off a portion of its stake in the subsidiary company to the public through an Initial Offering (IPO) of its shares.

 

The parent therefore still retains control of the subsidiary company under this method, while having direct access to the funds raised from the public.

 

This is usually done when the parent feels the subsidiary’s business is so lucrative and thereby attracting better valuation independently, when compared to other subsidiaries within the group.

 

Part of the benefits of the approach is the ability to unlock the growth and profit potential of the subsidiary by listing its shares on the exchange and generating cash for further expansion.

 

Having said that, a major downside to this approach is the possibility of having the loyalty of the managers of the carved-out subsidiary torn between the interests of the public shareholders and those of the parent company.

 

Tracking Stock: This happens when an existing publicly listed company issues new shares whose cash flows are tied to the performance of one of its subsidiaries (i.e. the subsidiary being tracked).

 

This involved the issuance of the new shares, just as we have in Spin-offs. However, while the shareholders of the tracking stock have a stake in the group company as a whole, they do not have a direct ownership interest in the subsidiary to which their cash flows are tied.

 

Arguably, some of the apparent benefits of this corporate restructuring approach are that it helps unlock ’hidden’ values of the group company as a whole and serves as currency for any subsequent acquisition the subsidiary parent company might choose in the near term.

 

Split-offs: This, as the name implies, occurs in corporate restructuring arrangements where the parent company offers investors the shares of a subsidiary company to replace its own shares.

 

It is a Tender Offer that comes with a premium so as to stimulate the interest of the parent company’s shareholders in the offer.

 

This means, for the value of each unit of the parent company’s shares given up by the investors, they are given equivalent shares of the subsidiary that are collectively worth much more than the value surrendered.

 

Equity carve-outs sometimes precede split-offs when the motive is to make the shares of the target subsidiary more attractive to the shareholders of the parent company so as to further stimulate their interest in the offer.

 

Conclusion

Until recently, divestitures as a business restructuring decision were viewed as a corporate stigma by a considerable number of equity investors.

 

However, experience has shown that divestitures that occur as a result of well thought-out strategic plans of business managers aids in unlocking the hidden shareholder-value potential of smaller, but better managed corporate entities.

 

Some of the benefits that have been known to occur from this include the leeway it offers management to raise additional capital for a more focused business expansion program, the increased propensity to grow shareholder value from a more streamlined business outfit and its use as a means of paying for the purchase consideration in mergers and acquisition transactions.

 

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