Must-read Wharton Faculty Authors: How to Create Value for a Business by Divesting | Emilie Feldman

How Divestitures Can Actually Create Value

Dan Loney: You’ve written an important book about divestitures. The title is “Divestitures: Creating Value through Strategy, Structure, and Implementation.” Give us the back story on what drove you to do a book on this topic.

Emilie Feldman: This is a topic that has taken a lot of importance in my research over the past 15 years that I’ve been at Wharton. I started studying divestitures when I was a graduate student back in my PhD program. I just recognized that these were understudied in the academic realm, so this spiraled into a bigger research agenda that I continued pursuing throughout grad school, and then when I got to Wharton.

The more I worked on it, the more that I realized that among practitioners, among consultants and bankers and the world at large, divestitures were under-recognized. I decided that the time had come to try to produce a practitioner-oriented book that could speak to these issues and talk about what some of the misconceptions around these transactions might be, as well as some of the realities of what they do and how they work and how they can really help companies in their strategic objectives.

Loney: For the public at large, what do you want to bring to light through this book?

Feldman: I think it’s a very simple but important message. The world focuses on mergers and acquisitions. You read a headline about mergers and acquisitions. It’s splashy. It’s sexy. Synergies, growth, opportunity — all these great, happy things that are associated with these expansionary transactions. And it’s quite the opposite when you read about divestitures. If you even read about these transactions, it’s much more, “Oh, the company is having problems,” or “A business is failing,” or “A merger didn’t work out,” or “Something went wrong.” I think the message of these are not just failures or strategies or transactions to do when something has gone wrong, but rather that divestitures provide real strategic opportunities for companies to focus and realign operations, to reconfigure resources, and to achieve operational and stock market performance improvements. That is really the message for the public at large. And I think that’s a very important message, given the misconception that I started out with.

Loney: What is a divestiture?

Feldman: A divestiture is a transaction that a company can use to remove one of its business units, a subsidiary, a division that it might have as part of its operations. Basically, we’re talking about getting rid of something that’s part of a company’s existing operations. There are various ways that companies can accomplish divestitures. You could sell a business. You could spin it off. You could do other types of transactions. But in broadest terms, a divestiture is the removal of one of those business units.

Loney: Are there ways that seem to be more popular, more attractive than others right now?

Feldman: Popular, yes. Attractive is a trickier question, but I’ll try to answer each of those. By far the most common way that companies will divest is to sell something. I have a business unit that I don’t want anymore or that I’m trying to get rid of, so I sell it to another company, or I sell it to private equity or something like that. Sales actually account for about 95% of all divestiture activity, so it’s far and away the most common.

Spinoffs are the second most common. In a spinoff, a company issues shares in the business unit that it is divesting to its existing shareholder base. So, if you’re a shareholder of the parent company, you automatically will get shares in the spinoff company in the business that’s being divested. It’s not the same thing as a sale, but rather what’s happening is that the spun-off business becomes its own publicly traded company that’s separate and distinct from the parent company that it used to be a part of.

Spinoffs account for about 2% to 3% of all divestiture activities, so much less common than sales, but still the second most common. Then there’s a whole other range of much, much less common divestiture structures, like reverse Morris trusts or joint ventures, equity carve-outs and the like that can be used to accomplish different things. This ties to your question about the attractiveness of these different types of divestiture structures.

What’s really interesting, and I think one of the biggest insights that I got in the course of researching and writing my book, was that each of these transaction types can accomplish very specific financial objectives in terms of generating cash, managing tax burdens, getting an acquirer potentially to pay for synergies, and so on. It’s not to say that one is always more attractive or less attractive than another, but rather to say that these transaction types or these structures need to be used, depending on what it is that the company is trying to accomplish through that transaction.

Loney: Speaking specifically, let’s use spinoffs as the example. What are some of the pros and cons?

Feldman: The biggest one, far and away, is that these can be tax-free transactions under certain circumstances. They are actually a great way for companies to try to manage the tax burden from divestitures, and the easiest way to see that is to contrast them to sales. If you sell a business to another company, you’re getting cash or some kind of consideration, so that’s going to be a taxable transaction. But because in a spinoff there’s no cash that’s being generated; you’re simply issuing shares in that business unit. These can be tax-free transactions, depending on whether you’ve met certain kinds of conditions. That’s a huge advantage of a spinoff relative to a sale.

One of the biggest disadvantages of spinoffs is the potential for conflicts between the parent company that’s doing the divestiture and the business that’s being spun off. The reason is that, in most cases, the parent company will direct the process of going through that spinoff, so a lot of times the spinoff company doesn’t have much, if any, involvement in terms of how it’s being set up.

Oftentimes when things go wrong after the spinoff, that is used as a basis for saying, “Well, I didn’t have a say in this.” That’s where the conflicts really start to come up between these types of companies. That would be a big disadvantage of spinoffs relative to a sale. You can go through each of these transaction types and explain what are the advantages, what are the disadvantages relative to each other. My book goes through and lays out these considerations. But it’s a really fascinating strategy in and of itself to say, “We have to think very carefully about what are the objectives that the specific way that we’re going to do the divestiture can accomplish?” And then match accordingly.

I really hope that one of the effects of my book is to help mitigate a little bit of the storytelling that goes on around these transactions. For example, a lot of times what I’ll hear when I’m talking to companies is, “Oh, I don’t want to do a divestiture because if I divest this business, I’m going to have a huge tax bill.” That might be true if you’re selling it, but have you thought about these other modes of divestiture, spinoffs, and perhaps others, as a way of maybe not having a huge tax burden when you’re doing this divestiture? I think that there is a lot more element of choice than managers realize when it comes to undertaking these transactions. I hope my book starts to correct some of those ideas.

Why Companies Are Underutilizing Divestitures

Loney: In talking with companies, have you seen that there is maybe not a high level of understanding as to the potential options?

Feldman: Oh, very often. There are many sophisticated companies, and I think that’s definitely true. But I think divestitures are just so understudied and underutilized. For example, my book shows that companies do three to four M&As for every one divestiture that they do per year. And then 70% of the S&P 500 never divests in any given year.

I think the familiarity, sort of the muscle memory, if you will, of divestitures is underdeveloped relative to M&A. So, a lot of times, the options that are available just don’t come as readily or aren’t as readily recognized as they might be on the M&A side.

Loney: But when you think about where a company is at a particular moment and where they would like to go, a lot of the discussion ends up around value and performance, correct?

Feldman: Correct, yes. I think that’s another really important aspect. We’ve been talking about structure in terms of how companies can do divestitures, but what you’re talking about is the strategy element. That is: Why would we even think about doing these transactions in the first place? What are they going to help us accomplish? How might they help us to improve our operating performance or perhaps share price stock market performance?

The first part of my book goes through these different strategic objectives that divestitures can help companies achieve, and why they might be valuable under these different circumstances.

Loney: Are there specific examples you’ve seen where that component of focusing on performance or corporate value has played out?

Feldman: I think we’re seeing it very intensively right now. For example, one of the big strategic reasons why companies should and often do think about divesting is to improve corporate focus. This is the focus, if I may, of Chapter 2 of my book. What I talk about there is that you have a company that has a number of different business units, and perhaps you are having difficulty allocating resources to one of those areas. Perhaps the number of different businesses that you have is confusing to external constituents like securities analysts or investors. Perhaps there are issues of resource allocation, and so on and so forth. There are lots of different reasons why focus might be desirable.

What my research shows is that when companies do these focus-improving divestitures, we do end up seeing these performance improvements that we’ve been talking about. GE is a great example. GE, after a huge wave of kind of slimming down, basically did the final blow in terms of breaking apart health care, aviation, and environmental services. They broke those three apart, allowing each of them to stand on their own two feet and have their own corporate focus.

Johnson & Johnson is another great example. Or Kellogg’s from last summer is a third great example. Cereal has a very different growth trajectory and profit margins than snacks. And plant-based foods are very uncertain, depending on where consumer tastes go, so it’s sort of hard to say. How do you keep those businesses in the same portfolio? The idea of separating and allowing each of them to be independent is a key motivation for those three kinds of transactions.

Loney: It also seems like we’re seeing more consideration on these potential divestitures because of the regulatory side.

Feldman: Very much, yes. Regulatory regimes have changed very significantly. For example, right now we’re in an era of much more robust antitrust enforcement. Of course, antitrust in competition is a huge motivation for divestitures. When companies do certain M&As, a lot of times they’ll be required to divest certain businesses as part of those transactions to try to mitigate anticompetitive or potentially anticompetitive effects that might result from their M&A transactions. I imagine that we’ll see a lot more activity in terms of trying to mandate divestitures from a regulatory perspective along that dimension.

Another area is national security. CFIUS (Committee on Foreign Investment in the U.S.) is another reason why companies will often be required to divest certain assets in response to managing national security interests, And I think this point is an important one because it helps to distinguish between pure strategy motivations, like we’re doing a divestiture to achieve a particular strategy, versus being required to do a divestiture perhaps as part of something else that’s going on, maybe from a regulatory perspective. I think it’s interesting to distinguish between those two aspects.

How to Develop a Successful Divestment Strategy and Create Value

Loney: What do companies have to look at when they’re considering a divestiture, to make sure that the process goes smoothly?

Feldman: Implementation with any kind of corporate transaction is tricky, right? I think this is probably the biggest pitfall that we see with mergers and acquisitions, and equally so, perhaps, when it comes to divestitures. The devil is in the details of managing implementation. When it comes to divestitures, there’s a lot of detail in the book about the different things that companies need to pay attention to. But if I had to highlight three, I would say the first would be to try to be very clear about managing shared resources and shared liabilities that need to be divided between the divesting company and the divested business.

It’s easy, for example, if you have something that’s very clearly applicable to the divested business. It just goes with the divested business after the divestiture. Unfortunately, the reality in many companies is that it’s not that simple. A lot of times there are shared resources, there are shared people, shared expenses, shared functions like human resources that are hard to disentangle. I would say don’t underestimate the process of disentangling shared resources and shared liabilities and expenses, and manage those carefully when it comes to divestiture implementation. That’s one pitfall to watch out for.

The second would be managing cost structures. On average, when companies divest, what you end up seeing is that their sales decline by about 25%. So, the average divestiture reduces a company’s sales by about a quarter. You would think that the cost structure of those companies should decline after these transactions, but what’s really interesting is that they don’t, and quite the opposite. The cost structure of the divesting company, after these transactions, increases by about 20%. That is problematic because divestitures need to be used as an opportunity to cut the extraneous things. But if companies are increasing their cost structure, that’s the wrong direction.

So, the second lesson that I would offer is to be sure to manage costs carefully when going through these transactions, because a lot of times you will end up with a bigger cost structure than you need or want after these transactions if you’re not careful about it.

The third thing I would say is use divestitures as an opportunity to reconfigure. I think this is often underutilized. Ask, “What do we want to do differently after this transaction? What do we not want to invest in? What do we want to invest in that can help grow our business beyond its existing boundaries?” Use that transaction as a catalyst or an opportunity to reposition the organization to go in that different strategic direction.

Loney: When a divestiture occurs, how frequently do we see now that a company is looking at a specific segment line in comparison to the larger company as a whole?

Feldman: With divestitures, I’m talking more about segments as opposed to the company as a whole. But you’re right that companies can sell the entire entity to another organization, and that does happen. We tend to see the full-scale types of sales in situations of perhaps distress or opportunities that need to be taken by a different owner. Private equity is a great example. I think that’s an interesting distinction between the more kind of corporate divestitures that the book is focused on, versus these full-scale sales of companies.

Loney: What would you like the reader to take away from your book?

Feldman: I was talking before about that underutilization. I quoted those statistics about how infrequently divestitures are utilized in comparison to their expansionary counterpart, mergers, and acquisitions. So, here’s the killer statistic for me. If there is one takeaway, this is what it would be. If you look at the performance implications of divestitures versus mergers and acquisitions, we see that the divestitures outperform the M&As by two to three times in terms of their shareholder value. And that difference persists for up to 36 months after the completion of these transactions.

That’s the pathology. We don’t do these transactions, even though they actually create more value for companies than the transactions that we are focusing on. We’re doing the wrong thing pretty much when it comes to maximizing shareholder value and improving performance, so divestitures need to enter the conversation. Divestitures need to be as much a part of that conversation as mergers and acquisitions are, because clearly, they are a lever that companies can pull to create outside shareholder returns for their companies.