By Paula Loop, PwC partner and the leader of PwC’s US Governance Insights Center & Catherine Bromilow, PwC partner in PwC’s US Governance Insights Center
Focussing on growth is a given when it comes to increasing value for a company’s investors. That can mean exploring an acquisition or a strategic alliance. But expanding isn’t the only way to unlock shareholder value.
Some companies have businesses that don’t contribute to core capabilities or fit with their current strategy. Perhaps a previously acquired company wasn’t integrated successfully. Perhaps a business is a drag on earnings because its financial performance lags other businesses. Or a thriving business may have outgrown the parent company and could be more valuable either on its own or as part of another company. By removing nonconforming businesses, a company can create a more focussed portfolio for shareholders.
Shareholder activists also often urge target companies to divest parts of their businesses. In 2016, activist hedge funds had US$176billion in assets under management and publicly targeted 329 public US companies, according to Activist Insight Annual Review 2017. As of July 2017, there were 91 US activist campaigns that called for companies to explore some type of sale process, more than double the number called for in the previous year. See chart below (note, all deals of more than $100billion have been excluded). And with the money that has been flowing into activist hedge funds – at least in the United States – we expect such pressures to continue.
Any potential divestiture should be aligned with a company’s overall strategy and plans to create long-term value. Boards that understand the strategy and how each part of the company does or doesn’t contribute to it will better serve their shareholders.
Divestitures can be challenging. A company must identify the business unit to be separated, decide on the type of separation and either prepare it for sale or develop a standalone entity that will function outside of the parent. A divestiture ultimately is a surgical procedure, with a degree of complexity that demands careful planning and caution.
Boards should discuss with management the goal of any major proposed divestiture. That should include how removing a business unit will allow the company to do something it can’t do today. Once directors are satisfied with the strategic reasons for divesting, they can consider other important questions for the board, including:
- What kind of divestiture should we consider?
- How important is timing?
- How are we handling talent?
- What should our board watch out for after a deal is done?
What kind of divestiture should we consider?
Companies have multiple options for divesting a business unit and may choose to either maintain some type of connection with the divested unit or sever all ties. Depending on the exit structure, the regulatory, tax and financial reporting requirements can vary significantly and usually involve different timetables.
In a carve-out IPO, a company separates a business unit or subsidiary but offers only a minority interest in the new entity to outside investors. The result is two separate legal entities, each with its own financial statements, management team and board of directors. The parent company retains a controlling interest in the new company
A spin-off creates an independent company with its own equity structure, with shares in the new company typically distributed to the parent company’s shareholders. Unlike a carve-out IPO, the parent company doesn’t have a controlling interest and instead holds no equity or possibly a minority stake
A split-off is similar to a spin-off in that it also creates a new entity with its own equity structure and the parent company doesn’t have a controlling interest. The difference is that shareholders can essentially exchange shares in the parent company for shares in the new company. A split-off can have a less dilutive effect than a spin-off on the parent company’s earnings per share
A trade sale typically is the cleanest type of divestiture. A company completely turns over a subsidiary or business unit to another company, a private equity firm or some other buyer. A sale is usually easier and faster to complete than the other types of transactions
A parent company may contribute a portion of its business to form a joint venture (JV), with or without control. This kind of transaction can unlock synergies with a partner and provide access to other assets when other transactions may not be available. For board considerations when management is considering an alliance, see PwC’s paper Building Successful Alliances And Joint Ventures
How important is timing?
Different types of divestitures typically take different lengths of time to complete. That matters if a company needs to separate a business quickly because of broader company concerns or market issues. A sale usually takes the least amount of time – anywhere from a few months to a year. If a company needs to secure capital, reduce expenses or make some other financial or strategic move in the short term, it may be limited to contemplating a sale because other deals would take too long.
“Different types of divestitures typically take different lengths of time to complete. That matters if a company needs to separate a business quickly because of broader company concerns or market issues”
A sale still raises key considerations for the board – notably, how to maximise value for shareholders. Management should tell directors if there’s a specific buyer in mind or if the business unit will be marketed to a wide range of possible buyers. Private equity buyers may have different requirements or conditions than corporate buyers. If the potential buyer is another company, the board should know if it’s in the same industry and be able to share any concerns it might have with management.
Carve-out IPOs, spin-offs, split-offs and JVs take longer to finalise – sometimes more than a year. Forming a new entity involves legal, regulatory and other requirements that simply selling a business to a buyer doesn’t. Without adequate resources, the transaction could become a distraction that affects day-to-day operations – and the board should discuss this with management ahead of time.
Before the company embarks on a divestiture, directors should ensure management has or will hire the right people to handle the heavy lifting. The board also should be confident in management’s plan to keep the rest of the company running effectively and employees engaged in their work.
How are we handling talent?
Depending on the type of divestiture, talent can be a relatively small issue or a more complex concern. In a sale, the business unit’s employees and leaders often stay in their existing roles as the business moves to new ownership. But the divesting company may want to retain certain talent, such as executives with senior leadership potential. Board members should be aware of those conversations and make sure such pursuits don’t jeopardise the transaction. Once the sale is completed, personnel and development issues become matters for the new owner.
Talent decisions are typically more complicated with carve-out IPOs, spin-offs, split-offs and JVs. Because parent company shareholders typically still have some level of investment in the new entity, boards should have a stronger interest in decisions about employees and leaders.
The board should ask management if the managers of the business unit being separated are willing and able to lead an independent company. If not, directors should discuss how new talent will be brought in.
Talent migration is complex, particularly for employees working outside the separating business unit, such as finance or IT. People attached to the divested business can expect to be affected. The transaction also could pull employees from these enterprise functions. Management needs to be strategic about who stays and who goes.
“With the right understanding and planning, companies that are considering a divestiture in a dynamic market can achieve strategic goals and ultimately deliver greater value for their shareholders”
Employees in these functions may question management’s decision to shift their employment to the new entity and some could choose to leave for jobs elsewhere. To retain them, management may need to offer compensation, career development opportunities and other incentives, such as stay bonuses. Management will also have to address deferred compensation for the individuals who are going to the new entity. The parent company board should ensure that leaders are equipped to communicate the rationale behind talent decisions.
Understanding at the start of the process where talent gaps will exist – both in the parent and separating companies – provides for more time to plan for the necessary incremental hiring from outside the companies. A divestiture also can affect employees and managers who aren’t directly involved in the transaction. The board should confirm that management is keeping the entire company in mind and has a comprehensive communications plan for the entire deal cycle.
For example, in some deals the selling company signs a transition service agreement (TSA) to provide certain services and support for a certain period after the deal closes. A seller with a TSA may need to maintain the resources to provide essential services in areas, such as finance and accounting, human resources (HR), legal, information technology (IT) and procurement. In some cases the TSAs may last more than a year.
What should our board watch out for after a deal is done?
A successful divestiture means going beyond executing the details of the transaction and taking the necessary legal steps to separate a business from the company. It requires putting both companies on the right trajectory for profitability and growth in the years following the deal.
This means striking the right balance when it comes to changes post-deal. If the new entity and parent company make only slight adjustments in strategy and operations, they run the risk of simply being smaller versions of the formerly combined company, with stranded costs and few, if any, new advantages. But if the two entities go to the other extreme and make drastic shifts, it could make the divestiture process even more complex and overwhelm the companies. The board can help by engaging management on the divestiture plan and, if it’s not a full sale, ensuring that it will leave both companies in competitive market positions.
One short-term challenge for the new entity after the transaction closes is the cost of establishing and managing processes and personnel that had been covered by the parent company. Those costs could be high, especially in the early months. The board should make sure there’s a cost-mitigation plan in place before the split.
The board also can help shareholders in the carve-out IPO, spin-off, split-off or JV understand how those added costs ultimately will be offset over time. Directors should understand how the divestiture may create opportunities for long-term value in both companies.
A divestiture can impact the original company, especially groups that support the enterprise. Large divestitures can leave the remaining company with more personnel than needed in some areas (e.g. HR, legal, IT). The board should discuss with management if the company will need to restructure to stop paying for services that are no longer needed once the TSA term is over.
The board should also discuss with management whether the divestiture process could make the company vulnerable to competitors. With highly visible and/or complex separations, other companies could see an opportunity to disrupt customer relationships and grab market share. Management should explain to the board how the company will provide business as usual for customers.
Done right, a divestiture can maximise shareholder value for all companies involved. The board of directors can play an important role in providing guidance at different stages of these complex transactions. With the right understanding and planning, companies that are considering a divestiture in a dynamic market can achieve strategic goals and ultimately deliver greater value for their shareholders.
For deeper insights into the board’s role in divestitures, read PwC’s full publication When A Piece Of Company No Longer Fits: What Boards Should Know.
About the Authors:
Paula Loop is the leader of PwC’s Governance Insights Center, which strives to strengthen the connection between directors, executive teams and investors by helping them navigate the evolving governance landscape. With more than 20 years of experience at PwC, Paula brings extensive knowledge in governance, technical accounting, and SEC and financial reporting matters to organisations. Paula is a well known speaker on a variety of governance topics. She has also been quoted in publications such as the Wall Street Journal, Financial Times, Forbes and CNBC. In 2017 NACD Directorship magazine named her for the third consecutive year as one of the 100 most influential people in corporate governance in the United States. Paula is a Certified Public Accountant (licensed in New York) and is a graduate of the University of California at Berkeley with a B.S. in Business Administration.
Catherine Bromilow is a partner in PwC’s Governance Insights Center, which strives to strengthen the connection between directors, executive teams and investors by helping them navigate the evolving governance landscape. With more than 19 years of experience at PwC, Catherine has focused solely on corporate governance. Earlier in her career, she worked in internal audit at a major financial institution. Catherine has authored and contributed to many PwC governance publications, including the new Risk Oversight Series, Governance for Companies Going Public — What Works Best and Director-shareholder engagement: the new imperatives. NACD Directorship magazine in 2017 named her for the eleventh consecutive year as one of the 100 most influential people in corporate governance in the United States.