Splits and divestitures
January 2015 | COVER STORY | CORPORATE RESTRUCTURING
Financier Worldwide Magazine
Splits and divestitures have been part of the fabric of dealmaking for many years. In 2014, the practice of breaking up businesses, particularly in the technology sector, was particularly prevalent. In the latter half of the year, a number of high-profile businesses, including eBay, Hewlett-Packard (HP) and Symantec, all announced plans to split their operations in order to generate higher shareholder value or to respond to shifting market forces. They were not alone; according to data from Spin-Off Research, as many as 60 organisations either split or announced their intention to split their business in 2014.
In a rapidly changing business landscape, dividing a business can be extremely beneficial. It can make a firm sleeker and more agile. It can allow a firm to become more focused and improve its ability to generate growth. HP, for example, intends to split its computer and printing divisions. By becoming two separate and streamlined companies, the organisation will have the fresh start that it desperately needs after stumbling badly of late. Companies in a variety of sectors, but most notably in the energy, industrial, financial services, real estate, media and telecommunications, and consumer and retail spaces, have been particularly active divestors since around 2011.
Yet, although there are many advantages to be gleaned from separating a firm’s business, the process is still fraught with challenges and pitfalls. Companies must take these challenges into consideration before embarking on a split.
Following years of relative inactivity, 2014 was a bumper year for M&A. The majority of the deals were conventional transactions which followed the typical pattern of dealmaking. The bulk of these saw corporate leaders look for ways to expand their business – a tactic facilitated by purchasing profitable and complimentary subsidiaries, and increasing the number of assets under management. This is a highly successful tactic; many companies rely on M&A activity, consolidating within their particular industry to drive growth and generate shareholder value. Size can bring a number of advantages. Not only can large companies benefit from economies of scale, redundant functions at outlying offices can be eliminated or absorbed by corporate headquarters, and diversity can be achieved by amalgamating different kinds of businesses under a corporate umbrella.
Yet a string of poorly-judged M&A transactions can serve to create a bloated and unfocused firm that struggles to flourish in its marketplace. Additionally, without proper management and pre-transaction planning, a merger of similar firms can create a swathe of unnecessary middle managers and staff with positions replicated across the merged business. Units can be neglected or mismanaged due to unfamiliarity with functions and processes at C-suite and management level.
With these challenges in mind, often the most attractive option is to pick apart an overcomplicated and unmanageable corporate structure. Divestitures serve this purpose. While high value M&A transactions have gained headlines over the last 12 months or so, divestitures have also been growing.
Splitting off or divesting parts of a business is an attractive option – even though the concept may fly against the natural inclination of most executives pursuing corporate growth. “Divestitures are driven by a number of factors, united by the view that corporate splits drive increased shareholder value than if the two businesses were to remain together,” says Douglas Cogen, a partner and co-chair of the M&A practice at Fenwick & West LLP. “Improving managerial focus on each business is a key driver, and numerous studies have found that spun-off stocks consistently outperform the wider market, presumably because their management team is able to completely focus on improving operations in the spun company. It is also often the case that one part of the business is growing faster than the other, or is more profitable. In many cases, these are not the same business, so separating them can place the ‘right’ type of investor – growth vs. cash flow – with the right investment.” Indeed, divestitures can help executives to focus predominantly on their core businesses going forward. As the global economy and industry forces shift, capital and management resources can end up in short supply. Divestitures can be a useful strategic response to this issue.
But divestitures may also be forced upon a company, as a necessary consequence of pursuing a large-scale acquisition. “As regulatory authorities continue to vet larger M&A, companies are finding that in order to obtain regulatory approval over certain transactions, they must divest, split or spin off certain assets,” points out Steven Goldberg, a partner and national co-chair of M&A at BakerHostetler. “That makes for an attractive opportunity for buyers, both strategic and private equity.” In this tightly regulated corporate landscape, divestitures have become an important antitrust tool for regulators. Firms may be required to divest aspects of their business in connection with an agreed merger. Antitrust regulators will continue to impose such provisions upon potential acquirers if they feel competition would be harmed by a business combination.
Shareholder activism and value
Shareholder activism is becoming a true force in modern boardrooms. Notable activists such as Carl Icahn and Daniel Loeb have increased pressure on boards in a variety of ways in recent years. Furthermore, since the onset of the financial crisis, smaller shareholders, emboldened by the widespread flaws in corporate governance revealed by the crisis, have begun to speak out. According to Mr Goldberg, many activists hold the opinion that value can be generated by spinning off business units. “The ramping of activist activity is another catalyst for subject companies to potentially split or divest certain assets. The motivation behind activist activity is the belief that certain splits or divestitures will unlock value because the market will value the pieces individually higher than it would the company on an aggregate basis. Companies are generally not ignoring activists, particularly in light of increasing activist initiatives to take control at the board level. If they are not adopting the activist position, they are doing so on an educated basis. Many companies are responding by trying to get ahead of any activist involvement and assessing the value of their business pieces in an unbiased manner, and seeing what moves or shifts in strategy make sense,” says Mr Goldberg.
Over the coming months, we are likely to see more divestitures as companies seek to pre-empt or comply with activist demands. High profile disputes between activist shareholders and boards are not uncommon; in fact, in recent years they have become part of the business paradigm. Increased attention on disharmony between a company’s board and its shareholders has been fuelled by changing communication platforms. Social media and other new technologies have given activists a powerful platform that didn’t exist just a few years ago. As activists continue to agitate and promote their views, businesses are being forced to respond.
Despite the many advantages, splitting a business can be seen as a sign of weakness. Though that may have rung true in the past, attitudes are changing. Today, divestitures are a legitimate means of driving value – ‘shrinking to grow’ as it has been termed – and denote a savvy, agile firm that understands the needs and capabilities of its business. If those needs, and the needs of the company’s employees, are not being met by existing management, it is fair to ask whether they would be better served by a different structure. “In some cases, a divestiture is unwinding a previous acquisition, so some commentators are quick to cite spin-offs or sales as a sign of weakness. But the business landscape evolves, and separating previously linked businesses can unlock value in a number of ways,” notes Mr Cogen. “Executive focus on a single business can drive tremendous value in the years following a spin. A divestiture can also more closely link the cash bonuses and equity incentives of each business’ employees, resulting in improved retention and incentivisation. Another key driver is that in some cases the spun business can access customers that are competitors of the parent, as exemplified by Paypal.”
Although divestitures have been increasing in popularity, they still present firms with a number of challenges that need to be considered. These include identifying non-core or non-performing businesses, fully assessing the unit to be divested, and choosing which method to separate the business, such as a sale to a trade or financial buyer, or an IPO. Pre-closing issues must also be addressed as early as possible. In addition, post-deal transition planning will be required to decide the fate of employees, determine the ownership of key intellectual property, and resolve the separation of software and real estate – particularly if they are heavily embedded across both parts of the business being split. Tax considerations also come to the fore, and this can be complex when the company operates across multiple tax jurisdictions. “It is never too early in the process to start thinking about post-deal transition or back-end adaptation,” says Mr Goldberg. “What transition services is a company going to need as a result of its standalone status? Companies are better served to analyse how integrated their divisions and operations are on a pro forma going forward basis, and appropriately factor that into their structuring and negotiation discussions.”
Without adequate planning, many firms discover that the separation of their business can be more problematic than anticipated, as Mr Cogen explains. “Virtually all companies find that the divestiture process is far more difficult than an acquisition. The preparation and audit of carve-out financials for the separated business can often take a year of steady work. Shared functions, such as sales and marketing, finance and human resources need to be allocated between the businesses. Intellectual property used in both businesses needs to be allocated, often with licences running back to the party not receiving ownership. In many cases, customer and vendor contracts cover both businesses’ product lines. Real estate and capital equipment needs to be allocated. Employees need to be assigned to each business, and it is critical not to see people as ‘winners’ and ‘losers’ in this process. These employees’ equity awards also need to be adjusted for the transaction,” says Mr Cogen. Furthermore, for US companies, structuring transactions between the parent and distributed company to satisfy the various requirements of Section 355 of the Internal Revenue Code to achieve a tax-free distribution is complex, but absolutely critical in most transactions.
For those firms undertaking a divestiture, the chief information officer (CIO) will play an important role. The CIO will need to spearhead the process of unravelling the firm’s technology systems. Undoing the good work that has been done to integrate IT in the first place can be time consuming and challenging. It is, however, necessary.
CIOs will also need to assign IT staff to the right areas of each business. Splitting a multinational corporation is arduous, and the CIO will need to keep the company’s IT staff motivated and focused on the task during this time of upheaval. The CIO will need to manage the expectations of both clients and internal staff. While certain corporate functions may quickly and easily make the transition to a separated corporate structure, the IT department is unlikely to be one of them. The CIO will need to provide continued support to all business departments during the split so that operational processes do not suffer, at the same time as extricating particular units from the network entirely. Managing the costs involved and avoiding inefficiency are other key considerations for CIOs during a divestiture.
Executed properly, divestitures are an attractive, alternative means of generating shareholder value. By removing non-core elements of their businesses, firms are able to right-size their operations and drive growth. Divesting firms can generate additional capital and improve their overall operating performance. Consequently, companies are likely to continue exploring their divestiture options.
Divestitures look set to play an important role corporate finance for the foreseeable future. “I expect to see a further increase in splits and divestitures and resultant M&A activity in 2015, particularly in the media and technology vertical,” says Mr Goldberg. “The combination of media convergence, in distribution, content and resultant technology, on the one hand, and the current regulatory environment, on the other hand, will likely create increased splits or divestitures, resulting in an opportunistic market for buyers, both strategic and private equity sponsors.”
Historically, acquisitions were seen as a positive and progressive strategy while divestitures appeared to highlight a company’s failings and were criticised as a backwards step. Furthermore, corporates demonstrated greater proficiency in the art of pursing and acquiring a business than they did in separating them. Yet a new dawn is breaking. As firms look to exploit any avenue that leads to growth and rising shareholder value, the prospect of ‘shrinking to grow’ is no longer an alien concept. At a time of economic turmoil, divestitures represent the next logical step for many firms. Expect to see many companies follow the lead of HP and others in the future.
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