What Is a Divestment and How Does It Work

A divestiture takes place when a company sells an asset such as a subsidiary company, service, piece of property or product line. Divestitures allow companies to generate cash flow, eliminate a business segment (product line or subsidiary) that doesn’t fit their main objective, lower debt, and increase shareholder value.

Divestitures are part of the M&A world, but they often do not get the attention that traditional mergers and acquisitions do. However splitting companies including their technology and services they can be just as involved and complex.

While divestitures can raise challenges, require exceptional portfolio management, and spark fear in some sellers, they also yield powerful results when carried out properly.?

In fact,?Forbes?magazine cited a report by Bain and Company which examined 2,100 public companies; the study found that?

“companies focused on divestment outperform inactive companies by about 15% over a 10-year period.”

The results were even more impressive when companies had robust M&A practices.

Major Reasons for Divestitures or why Companies Divest

Divestitures should be thought of as an integral part of a company’s ongoing M&A strategy. Generating value is equally possible by divesting as it is through acquiring.

And just as the decision to acquire can be motivated by several different factors, so too can the decision to divest.

Knowing when to let go of a business is important for generating value. Assets are always better sold at the top of the economic cycle rather than the bottom.

Similarly, a parent company that decides to divest an asset when they don’t need to, rather than we they do, is likely to achieve more in the transaction. In general terms, the reasons to divest tend to fall under one of the following:

1. Not part of core-business

This is the most commonly cited reason among managers for divesting of assets, at least in part because it’s the best reason to divest: Essentially, the parent company is moving in a different direction and the asset is no longer a fit with its corporate strategy.

2. The need to generate additional funds

The need to generate additional funds - and avoid the need to sell shareholder equity or issue debt - is a common reason for divesting.

There is an obvious overlap between this reason and reason 1 if the additional funds are required to make an acquisition.

3. Lack of internal talent for business

This is one of the less obvious reasons for divesting a business, but the global talent shortage hints that it may become more popular in the coming years.

This is more common in service lines, where a lack of human capital may impinge on the company’s ability to continue providing the service, forcing them to divest the business unit in question.

4. Opportunistic approach for asset from third party

Another common reason for divesting an asset is because an attractive offer is received from a third party - usually another company from the same industry, or a private equity company.

The fact that the asset wasn’t being marketed for sale should put the selling company in a better position during negotiations and typically leads to a higher selling multiple.?

5. Regulatory environment or tax structure

The specific regulations around a certain industry or product category may mean that the company decides that a divestiture is the best decision.

This can be seen where an industry is placed in a higher tax band, or becomes a ‘strategic (read: protected) national industry’, changing its value for the parent company.

Examples of Divestitures

Over the past decade, the major trend in divestments has been asset managers, private equity companies and sovereign wealth funds divesting fossil fuel assets.

This wave of divestitures has been driven by the requirement for funds to meet the increasingly demanding requirements of their shareholders around ESG metrics.

For each of the reasons given for divestitures above, we now look at some examples of divestitures below:

1. Not part of core-business

Invariably, managers will say that a divestiture is because the asset in question is not part of its core business (i.e. it’s a non-core asset).

Typically, these assets are located in markets which have become less of a strategic focus for the company. A recent example is provided by GE’s decision to divest its share of Baker Hughes, the oil field services company.

2. The need to generate additional funds

As mentioned above, the divestiture of ‘non-core assets’ often translates into a need to generate additional funds, most often because of the debt pile created by acquisition sprees.

Currently, companies such as Aryzta in food, Tata Power in energy and Takeda in pharmaceuticals are looking to divest of non-core assets, readily admitting in each case that?the motive behind the divestments is to reduce their debt.

3. Lack of internal talent for business

Some industries become unfashionable with younger generations over time, meaning businesses in those industries aren’t easily passed from generation to generation.

This amounts to a talent shortage which forces owners to divest.

The example of publicly-listed British funeral services firm, Dignity PLC, which has been able to acquire hundreds of funeral parlours and crematoriums in the UK, often family-run businesses, is a case in point.

4. Opportunistic approach for asset from third party

Iconic assets, including brands and real estate, often attract vanity purchases. That is to say, the buyer is looking to acquire for ego-related reasons rather than strategic ones.

This is common in property portfolios with iconic buildings. In 2008,?90%?of the New York’s Chrysler building was divested for?$800 million?- extremely over-valued, even by New York’s inflated prices. But it did allow for a huge value generating divestment for its then owner.

P.S.?- In 2019, the building sold for?$150 million.

5. Regulatory environment or tax structure

Some of the consequences of the ongoing US-China trade feud can be seen in mergers and acquisitions - and specifically, forced divestments.

A recently created organ, the Committee on Foreign Investments in the U.S., has already forced several Chinese investors to divest of their U.S.-based assets. It’s probable that these actions will be met by similar reactions on the China side and we can expect to see divestitures by U.S. investors in China in the relatively near future.