Divestitures: Strategies, Mechanics, and Examples

Divestiture Definition: A “divestiture” refers to a company’s strategic decision to sell a specific business unit, division, or asset to another company or spin it off into its own public entity; companies typically do this to streamline operations and attain a higher valuation.

Divestitures can refer to several different types of transactions:

1. Sale to Another Company: The parent company can directly sell a division to another corporation, fully transferring the ownership and operations.
2. Public Spin-Off: The division in question becomes an independent public entity without selling new shares to investors. In this case, the parent company’s shareholders simply receive proportionate shares in the new public entity.
3. Carve-Out via Initial Public Offering (IPO): This involves taking the division public by selling its shares on the stock market. Unlike the public spin-off option, the parent company sells a partial stake in the division through an IPO rather than just listing it as a new public company and distributing the shares proportionally to its shareholders.

Companies that are perceived to be undervalued or misunderstood by the market often undertake divestitures because they believe they might be worth more as separate entities.

For example, let’s say that Conglomerate A, with Divisions B and C, is currently worth an Enterprise Value of $1 billion.

It might believe its valuation is depressed because Division C is growing at ~5% per year, while Division B is growing at ~20% per year.

The market values Conglomerate A based on its blended growth rate, so Division C is effectively “dragging down” the entire entity’s valuation.

Management at Conglomerate A runs the numbers and determines that Division C might be worth $300 million as a separate entity, while Division B might be worth $1.2 billion.

Yes, Division C is worth far less than Conglomerate A, but as separate entities, Divisions B and C would be worth $1.5 billion altogether – up significantly from the current $1.0 billion.

Because of this focus on increased valuations via divestitures, the Sum of the Parts (SOTP) Analysis is critical in evaluating these deals.

We cover divestitures and this SOTP Analysis in detail via a spin-off case study in our Advanced Financial Modeling course.

Files & Resources:

• Sum of the Parts Valuation – Before (XL)
• Sum of the Parts Valuation – After (XL)

Why Do Companies Execute Divestitures?

Companies divest divisions and assets due to both internal and external factors:

1. Valuation Concerns: A business unit may be more valuable outside the company than within it. By divesting, companies can unlock this hidden value, possibly leading to a higher stock price.
2. Need for Cash: Divestitures can be a quick way to raise capital to pay down debt, invest in core operations, or reinvest the proceeds in an expansion or new acquisition.
3. Activist Investors: External stakeholders, especially activist investors, often push for divestitures if they believe that the sale of assets or divisions could increase the company’s stock price. They might argue that a company’s conglomerate nature is “dragging down” its stock price (see above), or that certain divisions could grow more quickly as independent entities.
4. Antitrust Concerns: In certain situations, regulatory bodies might view a company’s operations as anti-competitive (e.g., if it has acquired too many other, similar companies in the same industry, creating a monopoly). Divestitures can address these concerns, facilitating compliance with antitrust laws.
5. Restructuring: Corporations frequently undergo structural changes to adapt to changing markets. Divesting non-core units can be part of a larger restructuring strategy to improve efficiency and boost a company’s ability to service its debt.
6. Strategy Changes: Over time, a company’s strategic priorities evolve. A division that was once important to its mission might no longer align with its long-term vision, which could lead managers to suggest a divestiture.

While divestitures provide many potential benefits, they are difficult to execute correctly and come with risks as well.

For example, one common oversight in divestiture deals is the assumption that a specific division of a large company can operate as a standalone entity without major changes.

The problem is that most divisions depend heavily on the parent company for everything from HR and accounting to IT services.

Therefore, a credible plan to divest a division and turn it into a standalone entity must account for the additional costs and time required to implement these systems for the new entity.

The Mechanics of Divestitures

When a corporation undertakes a divestiture, it’s not as simple as just “selling off” a part of its business; it has to complete an entire financial and operational process to execute the deal.

Here’s a step-by-step breakdown of the normal process:

1. Creation of Separate Financials: The company must prepare standalone financial statements for the division in question before anything else. This involves separating revenues, costs, assets, liabilities, and other financial metrics relevant to the division.
2. Financial Modeling: Detailed financial models are constructed using the separated financial statements. These models help forecast the division’s future cash flows, profits, and other metrics, aiding in valuation.
3. Valuation: Based on the models, the company, usually with the help of investment banks or consultants, will determine the value of the division. In this step, the Sum of the Parts valuation model is essential for estimating what the separated companies might be worth.
4. Deal Value Analysis: Once a ballpark valuation is obtained, the company will analyze the potential deal’s value. This involves considering factors like potential synergies for the buyer and the strategic fit (if it’s a sale to another company); in the case of a spin-off or carve-out, equity market conditions and sentiment around the industry are very important.
5. Marketing and Negotiation: If the divestiture takes the form of a sale to another company, potential buyers will be identified and approached. This stage involves a lot of back-and-forth as both sides negotiate terms, prices, and other deal specifics. In an IPO, the company follows the typical process of filing registration forms, winning regulatory approval, and so on.
6. Finalizing the Transaction: With all terms agreed upon, contracts are drawn up, final regulatory approvals are sought, and the transaction is executed. In an IPO or direct listing of the division, bankers determine the company’s final share price before trading begins.

As an example of step #2 above, here’s the “transaction-adjusted” Income Statement from the SunPower / Maxeon spin-off in our Advanced course:

And here’s an example of the output from the Sum-of-the-Parts valuation:

Why Divestitures Are Important in M&A

Divestitures represent a significant chunk of all M&A activity. Here’s why they’re so important:

1. Volume: A substantial percentage of all M&A deals each year are divestitures. Markets change so quickly now that many companies need to divest assets and change their internal operations consistently.
2. Market Resilience: Even when the overall M&A market faces a downturn, divestitures keep happening. Corporations are always looking to optimize their operations, making divestitures somewhat resistant to broader market trends.
3. Value Creation: From an M&A perspective, divestitures can be valuable acquisition candidates because divisions or specific assets are more likely to be mispriced than entire public companies; savvy acquirers can find bargains by hunting for these deals.

Types of Divestitures and Closely Related Terms

Here are a few types of divestitures and some related terms:

1. Spin-Off: Here, a company sells or transfers assets to create a new, separate public entity. Existing shareholders typically receive shares in this new entity proportional to their stake in the parent company.
2. Split-Up: A variant of the spin-off, a split-up allows shareholders to choose whether to retain their shares in the existing company or exchange them for shares in the newly formed entity.
3. Sell-Off: This is a straightforward transaction where a division or assets are sold to another entity, usually for cash. The usual motive is to raise capital quickly or divest non-core assets for a quick gain.
4. Carve-Out: Closely related to a spin-off, a carve-out involves the parent company taking a division and listing it as an independent entity through an Initial Public Offering (IPO) in which shares in the new entity are sold to new investors. The parent company may still retain a significant ownership stake, but the carved-out unit gains its own public shareholders.

Final Thoughts About Divestitures

Divestitures are strategic maneuvers, enabling companies to refine their strategies, focus on their core competencies, and optimize their operations and valuations.

If you understand divestitures and related analyses, such as the Sum of the Parts (SOTP) valuation, you can gain special insights into companies that might be overvalued or undervalued.

If you use strategies such as merger arbitrage at hedge funds, you can also use news of divestitures to find deals to bet on or against.