Divestments
1 Introduction
Chapter 11 was about buying a business. This chapter is about getting out of one. A divestment is the disposal by an entity of part of itself — a division, a subsidiary, a group of assets — and an exit strategy is the plan by which an owner turns a holding back into cash or into a marketable security.
The two subjects belong together because the same transaction is a divestment on one side and an acquisition on the other, and because the decision to divest is judged by exactly the criterion that justifies an acquisition: does it make the shareholders better off?
Chapter 15 returns to the exit from the acquirer's point of view — how an intended exit is built into the plan for realising the benefits of a transaction. This chapter deals with the routes themselves and how each one works.
This recording predates the 2027 syllabus. It covers the whole chapter — the divestment routes, management buy-outs and going private; carry three things with you.
Demergers and spin-offs: where it says that in a demerger the old company ceases to exist, “which was what happened with HP”, it did not: Hewlett-Packard was renamed HP Inc. and Hewlett Packard Enterprise was separated from it. What matters is in the pitfall box under The divestment routes — in both, the existing shareholders keep the ownership and no cash comes in.
Kraft and Mondelez: the example runs the wrong way round. In 2012 Kraft Foods renamed itself Mondelez International and spun off its North American grocery business as Kraft Foods Group.
Regulation: the Competition Commission it mentions was abolished in 2014; F3 applies no national law (Chapter 11).
2 The divestment routes
Four routes are named in the syllabus material, and the two questions that separate them are always the same: who ends up owning the separated business, and does the seller receive any cash?
Route | What happens | Who ends up owning it | Cash raised? |
Demerger | A group divides into two or more independent companies. | The existing shareholders, who receive shares in each of the separated companies in proportion to their original holding. | No. Nothing is sold; the ownership is simply rearranged. |
Spin-off | Part of a company is put into a new company, whose shares are then distributed to the parent's shareholders. | The existing shareholders, who now hold shares in the parent and in the new company. | No. |
Sell-off | A division, subsidiary or group of assets is sold to a third party. | The buyer. | Yes. The seller receives the consideration; control of that part of the business is lost. |
Unbundling | The group is broken into its component parts so that they can be disposed of separately, usually by a series of sell-offs, on the view that the parts fetch more than the whole. | A series of buyers. | Yes. Where this is done by a predator immediately after a takeover it is called asset stripping. |
Demerger and spin-off are not sharply distinct terms, and the parent does not "cease to exist" in either. The words are used differently by different writers and the boundary between them is a matter of degree — a spin-off usually separates one part out of a continuing parent, while a demerger usually splits a group into pieces of comparable size, often under a new holding company. What an examiner is testing is not the label. It is the two things that actually distinguish these routes from a sell-off: the existing shareholders keep the ownership, and no cash comes in.
A fifth route completes the list, and it is the one that puts a floor under all the others: liquidation — winding the business up, selling the assets piecemeal and distributing the proceeds. It is the worst outcome for the owners, which is why the realisable value of the net assets is treated as the minimum value of a business (Chapter 14).
3 Why divest?
To focus on the core. A management team has finite time and attention, and a business that does not fit the group's strategy consumes both out of proportion to what it contributes.
To react to a change in strategic direction. What was core five years ago may not be core now.
To dispose of unwanted or underperforming assets and stop absorbing the losses of a segment nobody has the time or the appetite to turn round.
To capture reverse synergy where the parts are worth more separately than together — that is, to remove a conglomerate discount. See the illustration below.
To raise cash, most often to repay debt, to restore covenant headroom or to fund investment in the businesses that are being kept.
To remove the co-insurance benefit enjoyed by debtholders. Chapter 11 showed that combining two businesses transfers value from shareholders to lenders. Separating them reverses the transfer.
To meet a regulatory requirement. A divestment is the commonest remedy a competition authority imposes as the price of clearing an acquisition, and regulated industries may require the separation of activities that must not be run together.
As a takeover defence. Selling the part of the business the predator most wants — the "crown jewels" — removes the reason for the bid. Note that under a takeover code this would be frustrating action, so it requires shareholder approval once a bid is on the table (Chapter 11).
Reverse synergy and the conglomerate discount
C is a listed group with three divisions. Its shares have a total market capitalisation of $840 million. An analyst values the divisions separately by applying the price earnings ratios of quoted companies operating in each sector:
Division | Earnings ($m) | Comparator P/E | Value ($m) |
Industrial | 40 | 11 | 440 |
Consumer | 25 | 14 | 350 |
Services | 12 | 16 | 192 |
Sum of the parts | 77 | 982 |
Solution
The parts are worth $982m separately; the group is worth $840m as it stands. The difference of $142 million — about 14% of the sum of the parts — is the conglomerate discount.
A demerger that separated the three divisions would, if the market then rated each on its comparator P/E, release up to $142m to the existing shareholders without a single new customer being won. That is reverse synergy: here 5 − 1 = 5.
Two cautions before recommending it:
The $142m is not free. Separation costs money — three boards instead of one, three sets of listing and reporting obligations, systems to be untangled, and the tax consequences below.
Part of the discount may be deserved. If the group really does obtain cheaper borrowing from its combined cash flows, or relieves one division's losses against another's profits, then those benefits are lost on separation and the discount is the price of keeping them.
4 Exit strategies
An exit strategy is how the owner of a holding turns it back into cash. It matters most to an investor who never intended to hold the business permanently — a private-equity fund, a venture capitalist, a founder — and the essential discipline is that the exit is planned when the investment is made, not when the investor wants out. The planned exit shapes everything: the price paid, the gearing used, the length of the hold, and the rights written into the shareholders' agreement.
Exit route | How it works | When it suits |
Trade sale | The whole business is sold to a company already operating in the industry. | The commonest and usually the most valuable exit, because a trade buyer can pay for synergies a financial buyer cannot. Requires a willing buyer with the means to pay. |
Secondary buy-out | The business is sold to another financial investor, who gears it again and repeats the cycle. | Where no trade buyer will pay enough and the business still has clear improvement left in it. Available when debt is cheap and plentiful. |
Flotation (IPO) | The company's shares are listed and sold to public investors, usually in stages. | Suits a large business with a track record and a growth story. Gives the highest profile and often the highest headline valuation, but is slow, costly, sensitive to market conditions, and rarely allows the investor to sell out at once (see Chapter 6). |
Sale to management, or a share buy-back | The management team, or the company itself, buys the investor's shares out of retained cash or new borrowing. | Suits a smaller business with strong cash generation and no obvious external buyer. The price is negotiated rather than set by a market, so the mechanism is normally agreed in advance. |
Liquidation | The assets are sold and the proceeds distributed. | The exit of last resort. It realises the net realisable value of the assets and nothing for the business as a going concern. |
A question that asks you to recommend an exit route is asking you to weigh four things: the price achievable, the speed and certainty of getting the money, whether the investor can sell all of the holding at once, and the effect on the business and its employees — which matters where the seller is a founder or a parent with a continuing relationship.
5 Management buy-outs and buy-ins
What it is | |
Management buy-out (MBO) | The purchase of all or part of a business from its owners by one or more of its existing executive managers. |
Management buy-in (MBI) | The purchase of a business by a management team from outside it, usually assembled by the financial backer, which then takes over the running of the business. |
Buy-in buy-out (BIMBO) | A combination: the team is drawn partly from the existing management and partly from outside specialists introduced by the backer. |
5.1 The parties
The management team making the offer — who usually invest a personally significant amount of their own money, because their backers require them to have something to lose.
The vendor — the parent company, or the owners of an independent business.
The financial backers: banks providing senior debt, a private-equity house or venture capitalist providing the equity and often mezzanine finance, and sometimes government-backed development agencies.
The directors of the company being bought, who have a conflict of interest to manage if they are also members of the buying team.
5.2 The process
The team assesses whether the business can stand alone and prepares a business plan.
The business is valued and an offer price agreed in principle with the vendor.
A finance package is assembled — see below — and the backers conduct due diligence on the plan and the team.
The sale agreement and a shareholders' agreement are negotiated. The second of these sets out the backers' rights and the agreed exit.
Completion, followed by the delivery of the plan and, in due course, the exit.
5.3 Why each side agrees
From the buy-out team's point of view | From the seller's point of view |
Ownership rather than employment — the team runs the business for itself and keeps the value it creates. | It disposes of a business that does not fit the group's strategy, and raises cash. |
Freedom from a parent's constraints, recharges and decision-making. | It disposes of a loss-making segment the directors have neither the time nor the inclination to turn round. |
The chance to save the business, and their own jobs, where closure is the alternative. | A buy-out is often easier to arrange than an open-market sale: the buyer already knows the business, so due diligence is quicker and warranties less contentious. |
A defence against an unwelcome takeover of the parent (Chapter 11). | It avoids redundancy costs, and the industrial action and reputational damage that closure would bring. |
5.4 Why buy-outs create value
Personal motivation. The managers own what they run.
A hands-on approach, with decisions taken by the people who understand the business rather than referred upwards.
Keener operational decisions on pricing, credit control and working capital, because the cash is now the owners' own.
Savings in head-office overhead and group recharges.
The discipline of debt. A heavily geared business has to generate cash to survive, which concentrates management on cash rather than on reported profit.
5.5 The finance package
A buy-out is normally financed in layers, each accepting more risk than the one above it and requiring a higher return in exchange.
Layer | Provided by | Features |
Senior debt | Clearing and commercial banks. | Ranks first, secured on the assets, and the cheapest layer. Carries a margin over a benchmark reference rate and tight covenants — typically on gearing, interest cover and cash flow — which are tested frequently in the early years. |
Mezzanine finance | Specialist lenders and the equity backer. | Ranks behind senior debt and ahead of equity. Priced well above senior debt, and often carries a warrant or conversion right so that the lender shares in the upside. |
Equity | The management team and the private-equity or venture-capital backer. | Ranks last and carries the whole residual risk. The backer will usually hold preference shares as well as ordinary shares, so that it recovers its money before the managers share in anything. |
The equity ratchet. Backers commonly agree that the management team's share of the equity increases if the business hits agreed targets, and shrinks if it does not. It is the mechanism by which the backer keeps the team's incentives pointed at the plan — and it is one of the terms the team should negotiate hardest.
5.6 The problems
Inexperience. The team has run a division, not a company. Nobody above them now deals with treasury, tax, financing or the board. The more complete the team's experience, the easier the finance is to raise.
Raising the money, and then repaying it. A highly geared business has little margin for error, and a covenant breach hands control to the lenders.
Loss of the parent's services — payroll, human resources, information systems, legal and treasury support — which now have to be bought in or built.
Loss of economies of scale, purchasing power and group tax relief.
Tax and legal complexity, both in structuring the transaction and in operating afterwards as a standalone entity.
Motivation of the employees who are not part of the buy-out, and the risk of losing key staff during the uncertainty.
Commitments made by the previous owner to employees, customers and suppliers, which the new owners inherit.
6 Acquisition by private equity and venture capital
Buy-out teams are rarely the whole story. Behind most of them stands a professional investor whose business is buying companies, improving them and selling them again. Two kinds are named in the syllabus, and they are not the same thing.
The two investors
A private equity house raises a fund from institutional investors — pension funds, insurers, endowments — and uses it to acquire whole, established companies, usually with a large amount of debt. It holds each for a few years, improves it, and exits. Where the acquisition is financed principally by borrowing secured on the target's own assets and cash flows, it is a leveraged buy-out (LBO).
A venture capitalist invests in young businesses that have a product or an idea but no track record. The stake is often a minority one, the risk is that the business fails altogether, and the investor expects most of a portfolio to disappoint and a small number of successes to pay for it all.
Private equity | Venture capital | |
Typical target | Mature, cash-generative, often a division of a larger group or a listed company being taken private. | Early-stage or high-growth: seed, start-up, early-stage and expansion (development) capital. |
Stake taken | Normally all of the equity, or enough for outright control. | Often a minority stake, with control secured through the shareholders' agreement rather than through votes. |
Use of debt | Central. Debt magnifies the return on the equity invested. | Little or none. A business with no reliable cash flow cannot service debt. |
Where the return comes from | Repaying debt out of the target's cash flow, improving operating performance, and any increase in the exit multiple. | Growth in the value of the business itself. |
Holding period | Typically three to seven years. | Typically three to ten years, and less predictable. |
Return required | High, and it is expected from nearly every investment. | Very high on the winners, because most of the portfolio will not return its cost. |
Usual exit | Trade sale, secondary buy-out or flotation. | Trade sale or flotation. |
What the investor will want, whichever it is, and these are the terms a management team or a selling board should expect to negotiate:
A seat on the board and detailed, frequent information rights.
Preference shares or loan notes as well as ordinary shares, so that the investor's capital is repaid before the ordinary shareholders receive anything.
Consent rights over major decisions — further borrowing, acquisitions, capital expenditure above a limit, changes to the business plan, and the appointment of senior executives.
Drag-along and tag-along rights, so that a majority can compel a minority to sell into an exit, and a minority can insist on being included in one.
An agreed exit, usually with a target date, and a mechanism for forcing a sale or a flotation if the investor's money has not been returned by then.
Where a private-equity return comes from
A private-equity fund acquires the whole of the equity of D for $200 million, funded by $60 million of its own money and $140 million of borrowing. Over the next five years D's cash flows repay $50 million of that borrowing. At the end of year 5 the fund sells D to a trade buyer for an enterprise value of $310 million.
Solution
At acquisition ($m) | At exit ($m) | |
Enterprise value | 200 | 310 |
Less: debt | (140) | (90) |
Equity | 60 | 220 |
The fund turned $60m into $220m — a money multiple of 3.7 times over five years, which is an internal rate of return of about 30% a year ($220m ÷ $60m = 3.667; 3.667^(1/5) − 1 = 0.297).
Where did the $160m of gain come from? Two sources, and only one of them is about running the business better:
Source | $m |
Increase in the enterprise value (200 → 310) | 110 |
Debt repaid out of the business's own cash flows (140 → 90) | 50 |
Gain to the equity holder | 160 |
And the same gearing works in reverse. If D had been sold for $180m instead of $310m, the equity would have been worth 180 − 90 = $90m: a multiple of 1.5 times and an IRR of about 8% for five years of risk. At an exit value of $95m the equity would be worth $5m — a loss of more than 90% on an enterprise value that had fallen by only half. This is why private equity buys businesses with predictable cash flows, and why a venture capitalist, whose targets have none, does not gear them at all.
7 Taxation implications
As with an acquisition, tax rarely decides whether to divest, but it very often decides the structure — and it can decide whether the transaction is worth doing at all. No national tax law is examinable; the reasoning is.
Selling shares or selling the trade and assets. The buyer normally prefers to buy the assets, so as to leave the liabilities behind and obtain a fresh tax base cost; the seller normally prefers to sell the shares, so that only one gain arises and it arises in the hands of the shareholders. The Chapter 11 table sets out the trade-off in full — it reads the same way from the other side of the table.
Relief for the gain on a substantial shareholding. Many jurisdictions exempt, wholly or partly, the gain a company makes on selling a substantial shareholding in a trading subsidiary. Where such a relief exists, a share sale can be very much cheaper than an asset sale — which is why the structure is negotiated, and usually reflected in the price.
Degrouping charges. Assets moved between group companies are commonly transferred without a tax charge. If the company holding them then leaves the group, a charge can crystallise on the assets it takes with it. Group reorganisations carried out shortly before a sale are exactly where this bites.
Loss of group relief. After the disposal, losses can no longer be surrendered between the divested business and the rest of the group, in either direction. Both sides lose the flexibility; the effect on the group's overall tax charge should be part of the appraisal.
Demergers and spin-offs are usually structured to be tax-neutral, so that the shareholders are not taxed on receiving shares in the separated company — but the relief normally depends on strict statutory conditions, including that the demerger is for genuine commercial reasons and not to facilitate a sale. A cash sell-off has no such relief: the gain is taxed.
Stamp and transfer taxes are payable on the transfer of shares in most jurisdictions, and are normally borne by the buyer.
8 Going private
Going private — also called a public-to-private transaction — is the purchase of all of a listed company's shares by a small group of investors, after which the company is de-listed. The buyer is very often a management team backed by a private-equity house, which makes it a buy-out and a de-listing at the same time.
Benefits | Drawbacks |
The direct costs of a listing are saved: fees, registrars, and the cost of preparing and auditing the information a listing requires. | The company loses access to the public equity market as a source of new finance. |
The indirect costs are saved too — management time spent on investor relations, and the pressure to manage for the next set of published results rather than for the long term. | The remaining shares are illiquid. There is no market price and no easy way for a shareholder to sell. |
A hostile takeover becomes effectively impossible, because there are no shares in public hands to buy. | Minority shareholders who do not want to sell may be compulsorily bought out, and will argue about the price. |
With a small number of shareholders, most of whom are also directors, the agency problem largely disappears: the owners and the managers are the same people. | Where the transaction is financed by borrowing, the company emerges highly geared and carries the financial risk that goes with it. |
A divestment separates part of a business from its owner. In a demerger or spin-off the existing shareholders keep the ownership and no cash is raised; in a sell-off or an unbundling the business is sold and cash comes in. Companies divest to focus on the core, to raise cash, to satisfy a regulator, to reverse the co-insurance gain their lenders received on an earlier combination, and to capture reverse synergy where a conglomerate discount means the parts are worth more than the whole.
An exit strategy — trade sale, secondary buy-out, flotation, sale to management or liquidation — is chosen when the investment is made, not when the investor wants out. Management buy-outs and buy-ins are financed in layers of senior debt, mezzanine and equity, and succeed on the motivation of owner-managers and fail on inexperience, gearing and the loss of what the parent used to provide.
Private equity buys whole mature companies with heavy borrowing and earns its return from repaying that debt out of the target's cash flow as much as from improving the business; venture capital takes minority stakes in young companies, uses no debt, and relies on a few successes to carry a portfolio. Both take board seats, preference capital, consent rights and an agreed exit. Tax shapes every structure, and going private trades the cost and pressure of a listing for illiquidity and, usually, gearing.
9 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Divestments
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