Divestitures: Overlooked Aspect of Active Portfolio Management
Annual strategic planning is a fundamental management process for public and private companies. The refreshed plan documents describe corporate aspirations for growth and diversification typically over a multi-year planning horizon. Growth is created by either investing in core businesses or by completing business combinations through acquisitions, joint ventures, and alliances. While not always covered in annual plans, divestitures also play an important role in realizing a company’s strategic ambitions. That is because by shedding businesses that no longer fit strategically, a company can recapture underperforming capital. These funds can be plowed back into the core business or be used for strategic acquisitions that will drive future growth.
Updating a strategic plan does not necessarily mean a company will be managed strategically, particularly if the process does not include a detailed portfolio assessment. For industrial companies, this entails reviewing current, past, and projected performance of each business line within the portfolio. Performance should be assessed along multiple dimensions, including cash flow return on capital employed and changes in capital employed. A strategic business line, on average and over time, should deliver positive spreads in cash flow returns as compared with the parent company’s cost of capital. Moreover, the business line should generally realize growth in their capital employed because of their attractive cash returns. In strategic parlance, such business lines are the “star” performers in the portfolio. On the other hand, a company may also have business lines in its portfolio that are performance laggards. These businesses could be generating negative spreads relative to the cost of capital. An assessment might even uncover a pattern of investing additional capital in laggard businesses, essentially the company may be throwing good money after bad.
Strategic-managed companies make dispassionate portfolio assessments a fundamental part of the annual planning process. Active portfolio management enables a company to make Informed decisions about where to divest non-core or consistently underperforming business lines or related assets like underutilized manufacturing plants. Just as important, these assessments spotlight where to prioritize new capital investment -specifically in business lines likely to generate profitable growth. Notably, divestments should not be limited to performance laggards. Even if a business line generates positive cash flow, it may still be a candidate for a carve-out from the portfolio. For example, if a business line is worth more to another company than the current owner believes it is worth to retain, divesting that business and reinvesting the capital recovered in doing so can create significant economic value.
In practice, a company may find it difficult to divest non-strategic business lines even when they conclude doing so would be beneficial. Public companies, for example, must be careful about divesting non-core businesses if doing so would leave too much cash on the balance sheet without ready opportunities for reinvestment. In some cases, divesting business lines promoted earlier as “growth opportunities” can tarnish management credibility with investors. Such divestments could impact market capitalization unless the associated financial communications are managed carefully with the investment community. Even with private companies, divesting legacy business lines can be gut-wrenching decisions especially during stable economic times and when founders remain active in management. It is often hard to let go of business lines that are familiar even if they well past their prime.
Notwithstanding strategic management considerations, the ongoing health crisis has reduced revenues and profits for many industrial companies. In this environment, marginal business lines struggle. Consequently, the downturn provides strong incentive for companies to assess their business lines thoroughly and face up to hard decisions about portfolio realignment. Still, some companies may feel uncertainty favors inertia over action. The general reason is concern about price realization. A seller might believe waiting until next year or the year after to divest a business will provide time for exiting at higher valuations than can be realized in the current downturn. Unfortunately, inertia exposes a company to the risk of even lower valuations in the future. A major reason is the fundamental change taking place in the competitive landscape and business models across many industry sectors. In the face of such change, strategic advantage lies with those companies that have the wisdom to know what the right thing is to do now and have the virtue to do it. Non-core businesses may be worth no more, and possibly less, to the seller in the future.
The bias for action does not diminish the complexity of being smart about how to divest business lines. Difficulty in predicting future revenues and profits in the current environment creates uncertainty for dealmakers in valuing divestments with DCF calculations and financial pricing multipliers. Certainly, earn-out provisions and other deal-structuring mechanisms can be used to help address these uncertainties but are more complex transactions to negotiate and manage. These transactions need to address explicitly the means for addressing future disputes about earn-out achievement and calculations. Moreover, face-to-face meetings, site visits and normal due diligence activities are also difficult at best while the health crisis drags on.
Still, as we have seen over the past six months, transactions are getting done despite the challenges. Making good deals will continue to require flexibility and creativity on the part of both buyers and sellers. This reality underscores that deal-making, more than ever, is as much an “art” as it is a “science”.
CEO CDI Global