The act of selling off non-core businesses
The act of selling off non-core businesses
Divesting is the act of a company selling off its non-core business unit. It can be seen as a direct opposite of an acquisition. Divesting can create an injection of cash into the company, while also serving the company’s overall corporate strategy. Divestitures are a common advisory mandate in investment banking. Sometimes a divestiture is also referred to as an exit strategy.
Divesting involves several steps, as enumerated below:
The below process will be managed by professionals working the Corporate Development department of a corporation.
Once a business unit’s been flagged for a potential divestiture, a buyer needs to be identified for the deal to proceed. The identification process is crucial because extracting value from the divestiture requires receiving a price that must at least equal the opportunity cost of not selling the business unit.
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Beyond the divestiture, the company may look to strategy and costs as the two key areas to address moving forward. With a company losing its business unit while gaining a large cash inflow, it will need to decide where and how to budget it. Some companies may choose to grow its existing business units or pursue a new line of business altogether. At the same time, there may be leftover costs from the divested unit in the form of backend processes such as IT or other supporting infrastructure that the company would need to sever or integrate moving forward.
A decision to divest a business unit can arise from its underperformance in terms of meeting its required rate of return as shown by its Capital Asset Pricing Model. It means that holding on to the business unit will be detrimental to shareholders as it is essentially holding on to a negative NPV project.
A point to consider is that different business units within a company may report a required rate of return that is high or lower than the rate of return of the firm as a whole. It is because different lines of business experience different levels of systemic risk or beta in other words.
Divestiture allows for a company to reallocate resources into their core areas of expertise that would generate higher returns on time and effort. One of the issues with diversification within a company is that managerial diseconomies occur. This means that taking on non-core business activities would stretch the current scope of managers into areas where they may not have the experience, expertise or time to invest. The potential damage is that there is a greater opportunity cost of reallocating the managers’ focus onto a separate business unit when they could be delivering higher performance in their area of focus.
Some of the direct costs of divestitures would include the transaction and transition costs associated with the decision. This would include bringing in the people, processes, and tools required to execute the divestiture. This could include managing the legal transfer of assets, valuing the synergies to the buyer, deciding on retention and severance policies regarding human resources, etc.
Signaling may impose a cost on a company’s decision to divest due to information asymmetry in the capital markets. Because managers within a company know more than external investors, these investors would make assumptions about its future performance as a result of managerial decisions.
For example, a company may choose to cut dividend payments to fund positive NPV projects that will generate shareholder value. However, shareholders may view this as a company in financial distress and may need to cut dividends to pay off debt obligations.
In the same way, a firm may choose a divestiture strategy to allocate its resources for its best use cases and remove business units that do not generate the required rate of return. However, the shareholder may perceive this as a need to urgently inject cash into the company due to financial distress or perhaps managerial incompetency in competing in that market. As a result, share prices may fall as a result of information asymmetry.
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