Divestment

Many businesses have operations or even whole subsidiaries that are ‘non-core’ in that they are outside of those areas in which the business’s management believe it has a competitive advantage and which are central to the business’s future plans. This pair of articles discusses why businesses may wish to divest or dispose of non-core subsidiaries, and how to go about it.

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Disposal of an operation is not usually a manger’s first choice but it is sometimes a necessary response to changes in markets and demand, and where these changes have resulted in a poor performing operation, then its divestment can leave the company in a much stronger position.

Why Do Businesses Have Non-core Operations?

Businesses find themselves with non-core operations for a number of reasons including:

As a by-product of acquisition – in some cases a target business will have had subsidiary operations in areas which the acquirer had little or no experience, but which came as part of the package. In some cases the purchaser will have clearly had no interest in these in the first place, in which case they are obviously early candidates for disposal as part of the post acquisition integration process while the new owners seek to concentrate on those activities in which they have a competitive advantage. In others, acquirers sometimes decide to try to integrate these operations into their business on a longer term basis, with varying degrees of success. And of course, expansion and acquisition strategies will change over time, which leads on to…
Historical legacy / market changes – in some cases, as the business moves on and develops, yesterday’s core activity, becomes today’s non-core relic. Does Nokia still make Gumboots, or IBM make mechanical adding machines?

But in some cases, non-core activities have arisen as a result of deliberate attempts at diversification or are the result of opportunistic exploitation of a niche. Development of a widening range of services can be an understandable approach by businesses as provision of a full range of services, the ‘one stop shop’ approach, can be seen as a way of binding customers in, squeezing out competitors and maximising the return from a customer relationship; each of which on the face of it sounds a sensible argument.

The problem with this is that you inevitably begin having to do things that are outside the business’s core competencies which leads to the danger that:

you risk ending up as being a jack of all trades, rather than an absolute master of your own specialism;
poor performance in a non-core area can adversely (and sometimes disproportionately) effect the core relationship; and
distraction from the core business can hand an advantage in this area to your competitors, particularly if you have problems in the non-core areas as this tends to lead to a management focus paradox; you can’t leave these businesses to less able management due to the risks involved, but do you really want to have your best management’s time focused on your worst businesses? Wouldn’t you rather have your best managers focussed on where they will do most good, which is presumably driving forwards your core businesses where you have most competitive advantage?

Finally, the argument that becoming involved in a range of activities diversified the business’s risk is also less heard these days as corporate finance theory now says that investors can buy this diversification anyway in the market, much more efficiently and effectively, by acquiring a diversified portfolio, so why do they need you to do it within your business?

How Do You Make A Disposal Decision?

A disposal is often the final option considered in respect of an unrelated, unprofitable, or unmanageable operation. Even with operations that fit this description, managers may attempt to turn the operation around, by for example increasing investment into it.

But businesses will have limited resources and will therefore seek to put these resources to work where they can generate the best return. So if they can switch their available capital away from areas where profits and prospects are low, to ones where they are high, then they will seek to do so and so a company may sell off a business unit in order to focus their resources on a market it judges to be more profitable, or promising. There are a number of well known tools and portfolio models that can therefore be used to identify potential disposal candidates, ranging from the Boston Consulting Group matrix, where ‘dogs’ will obviously fall into this category, to the GE approach characterised as a desire to exit any sector where GE is not number 1 or 2 in its chosen market.

Leaving aside those businesses which are disposed of because they are actually failing, or because of a clear lack of strategic fit, the range of specific drivers that can lead to a disposal can however include:

Raising cash – in some cases by disposing of businesses which are doing well, for value, so as to generate cash to either reinvest in the rising stars, or to de-gear;
Pressures on management time – as discussed above, when the core business requires focused management, non-core businesses can simply be too much of a distraction and represent a substantial opportunity cost in terms of skilled managers time;
Reducing costs – managing a range of non-core subsidiaries can involve a high level of central overhead, (even dormant companies will have administrative holding costs and so arranging to deal with these can simplify corporate structures and save costs);
Substantial break-up value – taking this to extremes, sometimes the value of the businesses individual assets is worth more than the firm as a whole and a partial (or even a full) disposal program is therefore a way of extracting value;
Over capacity – in a market can lead to a decision to close operating units to reduce this problem;
Regulatory risk- onerous levels of regulation or potential liabilities in an aspect of an operation may lead to a desire to exit on risk management grounds.
Too small a market or market share – the business may decide the market, and its potential growth is too small for them to be competitive in, or bother with;
Investment requirement – A substantial cash requirement to maintain or develop the business often leads to a decision point as the alternative to a business decline in the absence of investment may be to seek a disposal while the operation may still have a value;
Stability – some areas of business may be particularly volatile or risky and so may unduly skew the business’s results;
Clarity – disposing of non-core activities can be used as a signal to the markets as to what the business believes is now core to its success; and finally,
Competition requirements – can result in businesses being forced to make disposals, either after a deal, or as a condition of it going ahead.

Below, we look at what your might want to achieve by way of a disposal and how this effects the way you may want to go about it, as well as the factors that can combine to block a divestment decision.

So it is worth asking yourself whether as part of your business’s strategic planning, do you have a process that reviews your operations to identify core and non-core operations? If so, what is the rational for maintaining the non-core activities and how often is this revisited? Are there dormant companies cluttering up the structure and taking time and cash to maintain? If so, can these be cleared out to save long term costs?

Having discussed how and why businesses may have accumulated subsidiary operations that are now non-core and some of the factors that can lead to a need to divest these, we now need to look at what objectives you may want to secure in achieving a divestment and how these impact on how you will go about divesting a non-core operation as well as factors which can block a disposal.

What Do You Want Out Of A Disposal?

The key outcomes you are looking to achieve from the disposal process will obviously be highly influenced by main reasons for disposal.

In some cases the driver will simply be cash, and the more of it, the faster, the better. But in many situations cash may not actually be the sole, or even a key, consideration and other factors may rank higher such as:

Freeing up management time – to focus on the core areas that are important to the future of the business, in which case speed and certainty of completion may be key criteria. In these cases you will be looking to find parties in whom you can have confidence to act quickly and to see a transaction through to completion.
Maintaining public relations and market image – so as not to damage the core business’s standing, or its customer relationships where the core operation may want maintain ongoing business dealings in respect of its other services. In these cases you will be looking for parties who can be relied upon to act with discretion and who will be a safe pair of hands into which to pass the divested operation so as to provide ongoing services to the customer.
Maintaining employee relations – is a similar issue to that of customers in that the business may want to demonstrate that despite the divestment it is concerned to ensure its employees are looked after appropriately. In these cases you will be looking to see that the other party is intending to take the business forwards with the existing employees.

By way of an example, a US multinational decided that it wanted to focus on its core products which in part involved supplying into the automotive sector with the restructuring to be completed by the year end. However as a legacy of a past acquisition it had a small and poorly performing UK based manufacturing unit, operating in a completely different field in which the parent group had no expertise; but which was supplying key components into its main automotive customers.

The parent therefore needed to speedily exit the business, but in a way that meant that its employees were taken care of, its customers supported (and ideally the performance issues addressed).

The deal was therefore done to dispose of the business to an acquisitive business specialising in manufacturing operations who completed within two weeks over the period leading up to Christmas and proceeded to use their expertise to fix the quality issues that were bedevilling the operation.

How Can You Go About Disposing Of A Non-core Operation?

There are a number of ways that a business can arrange to divest. It can choose to shut, spin off, or sell the relevant operation, and the approach taken tends to depend on the objective sought, the relative size of the transaction in comparison to the parent company and the urgency of the situation.

Shutting – is usually the least favoured option, for PR reasons as it tends to be seen as an admission of failure, for financial reasons as it tends to incur significant costs such as for redundancy payments, and for operational reasons as this process really does absorb management time. It will therefore occur in cases where either the other options are not feasible, or where part of the motivation for closure is to take excess productive capacity out of a marketplace.
Spinning off – where part of the business is allowed to operate as an independent business entity can be used to free up management time back at the core business and can also be used as a stepping stone towards a sale of the now independent entity.
Selling – involves disposing of the relevant operation to another organization through anything from a full corporate finance disposal exercise to the type of swift deal involved in the example above.

What Factors Can Work Against Making A Divestment?

Many potential divestments don’t in fact get this far as a result of management’s perception of the operation. They may for example see current poor performance as a temporary problem as they expect underlying demand to pick up and therefore will look to support a business in difficulties with time and or funding to give it a chance to recover.

Even when management come to accept that a business is failing, there can also be reluctance to divest as this is often felt by management to be a public admission of the fact which can be difficult to face up to for reasons of pride. Again, management may wish to continue to support the business, although the arguments advanced for doing so will centre around the need to preserve confidence in the underlying business and manage its reputation, and not the need to protect managements’ egos.

As with many things in life, it is not enough to take the decision to divest a non core business, you also have to make it happen and implementing the disposal may not be easy.

To get a sale away you first need to find a buyer. If the operation involved is a failing one this can be difficult although there are networks of turnaround equity investors who may be interested, as well as smaller acquirers such as the one in the example above.

Then price and terms have to be negotiated with the purchaser and many transactions fail at this point where the selling management:

have an unrealistic expectation about price;
enter into a disposal process for strategic or non cash objectives, but then lose sight of these in the process of disposal and attempt to turn it into a cash focused process; or
fail to appreciate how the transaction looks from the point of view of the potential purchaser who, for example, may have to take into account a substantial potential TUPE liability in respect of employees acquired with the business.

So, if you have identified non-core operations that should be divested, before going any further make sure you ask yourself, what are the key reasons for this and the important objectives that you will want to achieve in doing so which will drive the choice of method and approach?