Divestiture Definition, how does it work, reasons, types & benefits

Divestiture

Businesses and companies hope to succeed in their business. But what if the new business units don’t deliver the expected results, there should be a contingency plan of getting rid of that unit. That’s what the divestiture strategy is all about. Today, we’ll discuss divestiture, its types, and reasons with examples;

 What is Divestiture?

Divesting is the act of a company selling off an asset. While divesting may refer to the sale of any asset, it is most commonly used in the context of selling a non-core business unit. Divesting can be seen as the direct opposite of an acquisition.

 Divesting can create an injection of cash into the company, while also serving the company’s overall corporate strategy.  Divestitures are a common advisory mandate in investment banking.  Sometimes a divestiture is also referred to as an exit strategy.

 In other words, we can say that divestiture means selling a company’s assets so that you could manage its portfolio. When companies and businesses expand their operations, then they come up with several lines and categories that they have to shut down to focus on their core profitable business. Many conglomerates usually come up with such issues.

 The divestiture allows companies to cut down their cost and expenses, repays their debt, smoothen business operations, and provides them sufficient funds to reinvest into other ventures. It improves the share value of the company’s stock.

How Does Business Divestiture Work?

Your company launched a product/service that hasn’t generated sufficient profit that you were expecting it. You invested some capital in the marketing and promotional campaigns to target and attract more customers, instead of finishing it. You realized that investing more capital was a bad idea and it isn’t working anymore.

 It’s important to mention here the concept of sunk cost. People usually think it’s logical to invest more resources on a project that isn’t working, and they’re right to some extent.

 But the concept of divestiture is completely different. It means you get rid of the product line or category completely. It means you aren’t going to waste money on the product that isn’t selling and getting rid of the inventory that isn’t moving.

 Business divestiture isn’t a random decision and the management should consider it out of desperation. Rather it’s a part of business financial planning.

Reasons to Consider for a Divestiture

Businesses and companies follow the divestiture strategies for the following reasons and they’re as follows;

 Regulations

Antitrust legal issues compel businesses to divestiture. For instance, the US Justice Department found Bell System guilty of monopoly in 1982. The government ordered the company to divestiture the conglomerate, many small companies came into existence including AT&T.

 Low Performance

When certain departments and units of the company aren’t performing well, then the management follows the divestiture strategy and eliminates those departments.

 Unlocking Values

Sometimes companies follow the divestiture strategy to split into two or more companies based on the values. It usually happens at the liquidation stage.

Strengthening Balance Sheet

When the management decides to strengthen the company’s balance sheet and it requires them to pay off the debts.

Earning & Profitability

Often companies follow the divestiture strategy to earn profit and they use the same profit to stabilize their bottom line unit.

 Defocused to the Core

Some divisions are out of the focus of the company’s core identity and values, and the management decides to divest those divisions to focus on the primary line.

 Raising Capital

Companies and businesses also follow the divestiture strategy to raise capital, especially when they’re facing financial difficulties.

 Bankruptcy

Companies find themselves on the verge of bankruptcy when they’re facing the financial and operational problem, and following the divestiture strategy is a part of business planning.

 Types of Divestiture

Some of the main types of divestiture are as follows;

 Spin-Offs

Spin-offs in the process of separating a part of the company and making it the company’s subsidiary unit by selling its shares to the investors. It creates value for the shareholder, but it doesn’t generate cash. Spin-offs is the exit plan of larger organizations.

 Splits-offs

Splits offs is like a spin-off because it results in the creation of another entity that isn’t under the influence and control of the parent company. But the difference is that the shareholders have a choice whether to buy the shares or not.

 Equity Carve-outs

Equity carve-outs is when a parent company sells one of its parts that aren’t following its core operations. The company sells its shares through an initial public offering (IPO), and it creates new shareholders. The parent company has some level of influence in the subsidiary company in the carve-out. It’s the most complicated type of divestiture.

 Trade Sale

A trade sale is when a company sells its subsidiary company to another company. it’s the simplest and easiest type of divestiture.

Consideration before You Divesting here are some of the following points you should consider before implementing the divestiture strategy;

 Future Probability

You should consider and answer this question whether divestiture is temporary or permanent. If you’re trying to solve a temporary solution by divesture, then a particular unit or division would go away permanently. It’s not the best way to solve temporary problems with long-term impacts. Therefore, you should have one eye on the future before applying divestiture.

 Profitability

You should perform the profitability ratio analysis of the particular division or the product line that you’re planning to divest. The gross profit margin and sale volume comparison of the business/product divisions is very good profitability measuring tool. If the profit margin is higher, then it would be better for the company.

 Product Lifecycle

A product goes through various stages during its product lifecycle. It starts from the introductory, growing phase, and maturity to the declining stage. However, the best time to finish a product/division when it has reached its maturity or the declining stage.

 Break-even Analysis

You should perform a break-even analysis of the location, asset, or product that you’re planning to divest. However, the break-even analysis means that your initial investment and profitability are equal. If your product or division is closer to the break-even analysis point, then you should wait a bit longer.

 Assets

You should carefully study the assets in your balance sheet. If your assets are easily liquefiable or the current asset, then you could easily sell them.

 Benefits of Divesting

1. Required Rate of Return

The decision to divest a business unit can arise from its underperformance in terms of meeting its required rate of return as shown by its Capital Asset Pricing Model. This means that holding on to the business unit will be detrimental to shareholders, as this is essentially holding on to a negative NPV project.

 A point to consider is that different business units within a company may report a required rate of return that is higher or lower than the rate of return of the firm as a whole. This is because of the fact that different lines of business experience different levels of systemic risk, or beta.

2. Systemic Risk Formula

 Strategic Focus

Divesting enables a company to reallocate resources into their core areas of expertise that ideally generate higher returns on time and effort. One of the issues with diversification within a company is that managerial dis-economies occur. This means that taking on non-core business activities stretches the scope of managers into areas where they may not have the requisite experience, expertise, or time to invest to make the non-core enterprise successful and adequately profitable.

 The potential damage is that there is a greater opportunity cost of reallocating the managers’ focus onto a separate business unit when they could be delivered higher performance in their primary area of focus.

 3. Costs of Divestitures

Direct Costs

Some of the direct costs of divestitures include the transaction and transition costs associated with the decision. This includes bringing in the people, processes, and tools required to execute the divestiture process, which involves things such as managing the legal transfer of assets, valuing the synergies to the buyer, and deciding on retention and severance policies regarding human resources.

4. Signaling

Signaling may impose a cost on a company’s decision to divest due to information asymmetry in the capital markets. External investors may not possess sufficient knowledge of the company to make the correct assumptions about its future performance as the result of a managerial decision to initiate a divestiture.

 As an example of information asymmetry affecting investor perceptions, consider the case where a company chooses to cut dividend payments to fund positive NPV projects that will increase shareholder value in the future. However, shareholders may view the dividend cut as indicative of a company in financial distress. 

Divestiture Examples

As we know that divestiture could take many forms, the most obvious form is to sell your company’s divisions to improve the financial position. A Canadian media and information multination company, Thomson Reuters divested its science and intellectual property divisions in 2016. The goal was to decrease the leverage in the balance sheet.

 Onex and Baring Private Equity bought the division for 3.55 billion dollars. However, the division booked sale value in 2015 was 1.01 billion dollars. Approximately 80% of the divisions’ sale was recurring, and it made the division very attractive to the private equity firms. The divesture of the division was only one-quarter of Thomson Reuters’ entire business, and it never represented the company’s whole valuation.