How to Know If a Spin-Off Will Succeed

Posted at Harvard Business Review

There is little consensus as to whether firms that find themselves spun off from other companies – either as new, standalone companies, or under the stewardship of new parent companies – perform better or worse than they did before. An oft-cited 1992 study found that, on average, the performance of divested units after the spin-off does not improve—and is just as likely to decline—compared with the three years before divestment. But a study from 1999 found that long-run performance of both the former parent company and the divested unit is strongly positive, provided that the spin-off increases the company’s focus. A 2010 meta-analysis detailed many of the different issues that make divestiture so hard to evaluate consistently.

In addition to sheer luck, three categories of factors could explain differences in the performance of divested businesses. The first category is exogenous factors over which the business has little control: the growth of the markets into which it sells; the competitive intensity and thus the average profitability of the industry in which it operates; or the fragmentation of its industry and thus the scope for a growth-by-acquisition approach.

The second category is legacy factors from whose impact the business can only escape slowly. For example, a divested business may inherit assets and capabilities that have been starved of investment by its former parent. Conversely, the business may be an “unpolished diamond” that was neglected by its former management for too long and whose value is just waiting to be unlocked.

The third category is of the most interest because it concerns factors that the divested business’s (new) management and new owners do control: the quality of the business strategy and operational decisions after divestment, as well as the capital made available for follow-on investments.

Based on our 30 years as advisers, on the sell side and the buy side, in close to one hundred divestitures, we find that prospective new owners should ask themselves four questions.

1. Is the business ready to stand on its own feet? After earmarking a business for divestiture, the parent should carefully carve it out to reduce its parental dependence. A detailed roadmap should outline how it will become autonomous in terms of revenues and/or access to central services. A lack thereof may make some staff believe that parent support is still guaranteed, or it might provide some parent staff with justification for continued interference. These preparatory steps are of particular importance for carve-outs that are not full-fledged business units with profit & loss responsibility, such as R&D centers or production units whose only customer is their parent.

The diverging fortunes of two recent spin-offs in the energy industry illustrate how financial markets value autonomy from the parent. Since its spin-off in July 2014, the capitalization of Seventy Seven Energy, the former oilfield services business of Chesapeake Energy, has melted by more than 75%, at least partially reflecting continued dependence on its former parent for about 90% of its revenues. In contrast, the capitalization of NOW, the former commerce unit of National Oilwell Varco, has been much less affected by the recent oil price collapse, which reflects the investor community’s confidence in the spin-off’s ability to prosper on its own.

2. Does the business have a complete, balanced, and cohesive management team? Successful spin-offs tend to have a management team that comprises both insiders and outsiders. The insiders bring a detailed understanding of the company’s assets, capabilities, customers, competitors, and stakeholders. The outsiders provide new blood in support functions such as finance, legal, or administration. It is critical to ensure cultural compatibility between the insiders and the new hires, and to bind them together into a cohesive group with fully aligned objectives. The importance of this factor is corroborated by an academic study suggesting that for a divestiture to be successful, all managers involved must perceive it as a beneficial opportunity instead of an abandonment.

3. Are the management team and owners prepared to abandon business as usual? The management team and owners should realize that the spin-off event is just the beginning of a journey that will be radically different from the past. Only in rare circumstances is “business as usual” a viable value-creating option. Decisive actions are required to tackle the factors that prompted the spin-off in the first place, which in many cases are underperformance and/or a lack of strategic fit leading to chronic underinvestment in the development of the business.

For example, after its spin-off from International Paper, Arizona Chemical drastically changed its market approach from a drive for volume to margin optimization. In parallel, it reduced its fixed costs by restructuring its industrial footprint and overhead structure; increasing sales, marketing, and R&D expenditures in targeted areas; and dramatically reducing working capital.

4. Does the business have an adequate financial structure? The divested business should have the financial resources needed to bridge the transition period to full independence from its former parent, and to implement a strategy that is different from “business as usual.” Obviously the required resources and optimal financial structure depend on the starting quality of its assets (e.g., has its former parent deprived it even from basic maintenance investments?) and the competitive intensity of its industry.

Looking forward, the new owners and the management team should be prepared to embark on a serial investment path. Many of the most impressive divestment growth stories relate to businesses that changed owners in rapid succession: Taminco, a former specialty chemicals subsidiary of pharmaceutical company UCB, changed owner five times in a 10-year period;CABB, a former fine chemicals subsidiary of Clariant, had four successive private equity owners between 2005 and 2014; and Unifrax, a former thermal insulation materials business of BP, changed hands four times between 1996 and 2011.

We are not saying that rapid ownership change is a requirement for business success—quite to the contrary, it is often a corollary. According to the academic literature, so-called secondary buy-outs (SBOs) in many instances are driven by the confluence of two pressures: the seller’s to monetize his investment and the buyer’s to invest committed capital that otherwise he would have to return. Whatever the motives, though, SBOs do enable successive waves of add-on acquisitions to the initial divested business. For example, IMCD, now a global leader in specialty chemicals distribution, made some forty acquisitions and quintupled its revenues since its carve-out from IM twenty years ago, while having been owned by three different private equity investors prior to its IPO in 2014. The challenge for each successive owner is to keep the company’s management team motivated to follow the tempo.

As the above examples also show, Warren Buffett’s famous 1980 saying is not necessarily true in all situations: “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” When it comes to divestitures, bad economics usually get discounted in the transaction price. And while luck plays a much bigger role in explaining business success than managers like to believe, as Daniel Kahneman points out, the examples here clearly demonstrate that you can always give luck a helping hand.

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