Difficult economic and
industry conditions have depressed operating results for many firms. This has
stimulated changes in corporate strategy and structure. Fusion based mergers
and acquisitions are a means to implement such changes. They are based on the
premise of 1+1=3, largely through synergy based improvements. The other side of
the merger coin is the less well know fission-based de-mergers approach where 2-1=3. The focus of this post is on voluntary as opposed to imposed de-mergers
due to financial distress or bankruptcy issues.
De-merger activity, like its merger related cousin, runs in
waves. Currently, the wave is in an upswing. For example:
1)
Smithfield: the friendly acquisition to a Chinese
firm is challenged by an activist shareholder claiming a de-merger of the
vertically integrated pork producer would create one-third to two-thirds value
increase over the acquisition alternative.
2)
Sony: activist investor Daniel Loeb is seeking a
15-20% equity carve-out (partial public offering) of Sony’s entertainment
division to unlock value and fund the turnaround of its lagging electronics
unit.
3)
Media Industry: McGraw-Hill split of its
publishing and ratings units and the Fox spinoff of its print from electronic
media just to name a few.
De-mergers, unlike mergers have a surprisingly positive
value impact. Despite this, it is not something that comes naturally to most
managers. It is seen more as a mark of failure-shrinking versus growing- than
as a natural process in portfolio management reflecting changes in market
conditions and the firm’s life cycle. Consequently, most firms engage in
de-mergers only after being prodded by activist or frustrated shareholders
signaling their displeasure with disappointing performance. Also, de-mergers
appear to be more about financial engineering than value creation. This is
partly true as de-mergers are about releasing trapped value inherent in
multi-divisional diversified firms than creating something new.
Typically, such firms suffer from a conglomerate discount, which
reflects the difference between the values of the separate individual business
units on a standalone basis in a conglomerate from the market value of the
parent. This difference is in effect a negative synergy or management as an
off- balance- sheet- liability. The negative synergy can result from increased
overhead expenses, capital misallocation, cross subsidies, and suboptimal
incentives. These suggest that the current parent is not the best owner of the
division.
The major de-merger methods include among others:
1)
Divestment: usually taxable sale to a third
party. An example is McGraw-Hill’s sale of Business Week to Bloomberg. Getting
an acceptable price depends on finding a natural buyer (best owner). As Warren
Buffett notes, divestment is not Gin Rummy where discard your worst cards. As
you are unlikely to get much for losers. Rather, it is about selling good businesses
to someone who pays more to you than the assets are worth to you as a continuing
operation.
2)
Spinoff: frequently a tax free distribution of
subsidiary shares to the parent shareholders - similar to a stock dividend. They
continue to own the same operations, but in a separate form. It can be faster
and more assured than a divestment - especially, when no natural buyer can be
identified. Can be both leveraged and un-levered. In a leveraged spin-off, the
subsidiary borrows to fund a special dividend to the parent before the spin.
3)
Split-off: related to a spinoff, whereby parent
shares are exchanged for direct ownership in a subsidiary.
4)
Equity Carve-out: portion (typically 15-20%) of
a subsidiary’s shares are sold to the public as a partial public offering.
Carve-outs, like spin-offs, can be either leveraged or un-levered.
5)
Tracking Stock: separate classes of parent stock
whose dividends depend on the performance of an individual subsidiary.
The relative merits of each method vary are beyond the scope
the scope of this post. Nonetheless, it illustrates some of the many ways to
unlock trapped value in underperforming diversified firms. The key is to
recognize that subsidiaries come with different “sell-by” dates. Management
needs to watch and act on these dates as part of it on-going portfolio
management process.
J
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