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Home / ... / Proactive Divestiture can add Shareholder Value

What are the benefits of a proactive divestment policy? Why should companies regularly consider divestment as part of their strategy? When is it optimal to divest? Many corporates and small to medium sized enterprises (SMEs) underestimate the extent to which a proactive divestment policy can add significant shareholder value.

DIVESTMENT AS PART OF STRATEGY A proactive divestment policy can add significant value to shareholders, whether it be divestment of a business unit or, in the case of a SME, the business as a whole. Conversely, failure to periodically review the option to divest can result in misallocation of resources, missed opportunities and reduced shareholder value over the long term. If the current owner of the business/business unit is no longer the BEST owner, then over time the business will probably under perform. Ultimately this may lead to a depressed value when the business is eventually sold.

Most companies only consider divestment after several years of under performance by the business or when the business stops growing. As a result, the realised exit price is often considerably lower than that which may have been achieved if the sale had been made earlier, resulting in diminished shareholder value.

The optimal time to divest can be difficult to determine, but experience suggests that as businesses mature, their performance tends to decline. This decline in performance can be due to a number of factors, including: -A change in the skills required of management -Lack of focused management time -Lack of future planning as the business begins to generate stable cash flows (complacency); and -Market saturation. As a business moves through the industry life cycle (introduction, growth, maturity, decline) different management expertise is required at each stage in order to extract maximum value from the business. For example, the product development, marketing and sale innovation skills required in the introduction phase are quite different to the cost management and consolidation skills required in the mature phase. Furthermore, as a business grows, the cultural and management style required in the larger organisation will often differ from that of a SME.

A business is also likely to under-perform if insufficient focussed management time is spent on the business, either because the business is no longer part of core strategy or, in the case of an owner /operator, management is distracted by other activities. Divesting the business to a third party provides the simplest and most effective way of overcoming these issues. Accordingly, the option to divest should be regularly reviewed as part of strategy to ensure that shareholder value is not destroyed by retaining the business beyond its optimal date.

DECIDING WHEN TO DIVEST Determining when it is optimal to divest can be difficult and will depend on a number of factors, including:

Opportunity Cost If the capital tied up in the business can be better utilised elsewhere, then the business is a strong contender for divestment. However, the converse of this argument does not necessarily hold. If other investment opportunities are not apparent, and it is determined that it is optimal to divest, a business should still be divested with the sale proceeds returned to shareholders.

Risk Diversification In the case of SMEs, often a substantial portion of the owner's personal wealth is tied up in the business. This concentration of wealth increases the risk of the owner's personal wealth fluctuating significantly depending on the performance of the business. Diversifying this wealth across a number of different investment options will reduce this risk, and may benefit the owner's long term wealth position.

Business Risk The risks facing a business are often underestimated. For example, the recent rise in the value of the euro may have had a damaging impact on export businesses. When assessing the returns generated by a business it is important that owners fully appreciate the associated risks, and do not directly compare the returns to other lower risk investments such as government bonds.

Industry/Company Life Cycle The optimal exit date is not necessarily at the end of a growth phase, where a business is likely to be generating significant cash flows but has little growth prospects (i.e. a ‘cash cow’). Acquirers are often prepared to reflect expected growth or rationalisation benefits in their acquisition price. In fact third parties often see opportunities to increase growth in the business, either through increased sales or margin improvement (profit growth), and may be willing to share some of this value uplift with the current owners to secure ownership of the business.

Windows of Opportunity - Hot Buyers/Hot Sectors At certain times ‘windows of opportunity’ will exist to exit a business at best value and terms. Companies keen to grow by acquisition may be willing to pay high prices to secure new businesses (‘hot buyers’) or certain sectors will be perceived to have greater growth prospects than others which is reflected in company valuations ("hot sectors"). A good example of a recent hot sector is the technology sector in the late 1990s, where company valuations incorporated extremely high growth expectations. Alternatively, one or more investors may have an acquisition strategy based on consolidating and/or rationalising a mature business sector, and be willing to pay a premium based on the incremental value of the business being acquired to their existing business. Capitalising on these windows of opportunity can add significant shareholder value.

Capital Expenditure Capital expenditure can add significant additional risks to a business, either through increasing debt/leverage or additional shareholder funds at risk. When considering major capital expenditure for a business it is important to also consider divestment as an alternative action, as third parties may be able to achieve greater value from the business and be willing to reflect this in the purchase price. For example, if the expenditure relates to production capacity, another company with excess capacity may be able to acquire the business and absorb the extra production requirements into its own resources, thereby eliminating the need for further capital expenditure and increasing the value of the combined businesses accordingly.

Succession Planning Planning for management succession is something that all businesses should do. In the case of SMEs, it is vital that owner-managers have a clear succession plan and divestment of the business should be considered as one option. This may be a trade sale or a sale to the management team (MBO).

CONCLUSION Determining whether it is optimal to retain or divest a business or business unit will depend on a number of factors, and these factors are likely to change over time. Owners, whether individuals or corporate, should ask themselves the following questions: Are you still the best owner of this business? Are you still adding value, or is the business stagnating? Is someone else likely to be in a better position to add value? Therefore, it is important that companies regularly review the option to divest as part of their strategy to ensure that shareholder value is maximised.