U.S. companies working to put their best foot forward in a slow economy seem more interested in unloading business units. U.S. divestitures grew 3% last year and the value of those deals increased 12%, according to Ernst and Young, and 30% of the companies it surveyed last fall said they planned a divestiture over the coming year.
Often in a sluggish economy, companies aim to boost their growth with acquisitions and try to divest to free up capital to make acquisitions, notes Paul Hammes, Americas leader of divestiture advisory services at Ernst & Young, pictured at the left.
Acquisitions can also end up generating divestitures, says Russ Warren, a senior vice president at EdgePoint Capital Advisors in Cleveland, because strategic buyers of good-sized companies can often create more value by divesting parts of the business they don’t need.
Having a strong project management structure in place is critical to success, so that everyone understands what needs to happen to get the deal done, warns Hammes.
Companies also need to be prepared to provide prospective buyers with the information they require. “Certain information needs may be more rigorous right now on the part of particular buyers, just given everything we went through in 2008-2009,” Hammes says. It’s common now for buyers to request audited financial statements for units being sold, “almost regardless of the size of the deal,” he adds
Companies should even be prepared to assist a buyer that doesn’t have a platform for the business the company is selling, he says. “At least being able to demonstrate that you’ve thought through it and you’re ready to deliver it if necessary is critical,” he says.
Financing for deals took a beating during the financial crisis, but consultants say it has freed up a lot since then.
“There was a time in 2009 and early 2010 when the lending ratios were greatly reduced in terms of multiples of EBITDA, but we’re seeing them returning more to normal levels now, if there’s a decent business out there and a market price,” Warren says.
Sometimes sellers work with buyers on financing, he adds. “If a business isn’t very attractive, it may require seller financing. Typically the seller note is not a majority of the transaction, but it may be the thing that bridges the value gap.”
Sellers can also take steps to help make lenders comfortable with the deal, Hammes says. For example, it’s now more common for U.S. companies to provide third-party due diligence reports to buyers, a widespread practice in Europe. The seller hires a Big 4 or regional accounting firm to take an objective look at the business to be divested and write a report.
Another issue when companies decide to sell a division is sorting out how divesting the unit will affect the rest of the business, Warren says. “If it’s a pretty independently operated business that doesn’t share a lot with the rest of the corporation, that’s clear cut and easy. But if it’s a product line and is absorbing the overhead of a business that will remain, then you’ve got a risk.”
For example, he says, a company with $1 million in fixed costs wants to sell a unit that covers half of that overhead. “You’ve got another $500,000 of expense that you have to meet in some way,” Warren says.
Jim Martindale, a managing director at Navint Partners, a consultancy that specializes in business technology and process, says divesting a unit also means figuring out which technology systems and processes that business shares with the parent company. “It often takes a significant amount of time to disentangle,” Martindale says. “It’s complex and often expensive.”
The effort is even more challenging now with the predominance of shared services arrangements, outsourcing agreements and offshoring, Martindale says. “The organization that’s spun out has to be pulled out. New processes have to be developed, new offshore arrangements have to be implemented.”
When it comes to technology, divested business units often continue to use the former parent’s technology systems for 12, 18 or even 24 months under a chargeback or fee arrangement, Martindale says. While 12 or 18 months sounds like a considerable period, he cautions that it’s not that much time, for example, to select a new ERP system, implement it and train staff. “It’s a scramble, those dates come very quickly,” he says.
Companies planning divestitures should do more work upfront to figure out the cost and effort involved in moving the divested unit off the shared technology and setting up independent systems and processes.
“Sometimes, if it’s not well thought out, it becomes a fire drill,” Martindale says. “And if it becomes a fire drill, often short cuts are taken and the new entity doesn’t have the ideal processes and the ideal technology to support it in the long run.”
While divestiture activity has grown, Hammes notes that spin-offs—transactions in which a company divests a unit by granting its shareholders stock in the new entity—have skyrocketed. The number of spin-offs jumped 53% last year, while the value of spin-offs grew 71%, according to E&Y.
But Hammes cautions that spin-offs are even more complicated than divestitures. Companies not only must be sure the divested entity is ready to do business as a standalone, but must do the work of registering the new public entity with the Securities and Exchange Commission. And since spin-offs can qualify as tax-free transactions, companies have to work with the Internal Revenue Service to clear the tax aspects of the deal.