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 an asset. While divesting may refer to the sale of any asset, it is most commonly used in the context of selling a non-core business unit. Divesting can be seen as the 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 process of divesting outlined below is typically managed by professionals working in the Corporate Development department of a corporation.
Once a business unit has been flagged for possible divesting, 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.
Learn more about this process in CFI’s Financial Modeling & Valuation Analyst certification program.
Beyond the divestiture, the company may look to strategy and costs as the two key areas to address moving forward. With a company losing a business unit while gaining a large cash inflow, it will need to decide where and how to budget the money. Some companies may choose to grow its existing business units, while others may choose to 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 this 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 higher or lower than the rate of return of the firm as a whole. This is because of the fact that different lines of business experience different levels of systemic risk, or beta.
Divesting enables a company to reallocate resources into their core areas of expertise that ideally generate higher returns on time and effort. One of the issues with diversification within a company is that managerial dis-economies occur. This means that taking on non-core business activities stretches the scope of managers into areas where they may not have the requisite experience, expertise, or time to invest to make the non-core enterprise successful and adequately profitable.
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 primary area of focus.
Some of the direct costs of divestitures include the transaction and transition costs associated with the decision. This includes bringing in the people, processes, and tools required to execute the divestiture process, which involves things such as managing the legal transfer of assets, valuing the synergies to the buyer, and deciding on retention and severance policies regarding human resources.
Signaling may impose a cost on a company’s decision to divest due to information asymmetry in the capital markets. External investors may not possess sufficient knowledge of the company to make the correct assumptions about its future performance as the result of a managerial decision to initiate a divestiture.
As an example of information asymmetry affecting investor perceptions, consider a case where a company chooses to cut dividend payments to fund positive NPV projects that will increase shareholder value in the future. However, shareholders may view the dividend cut as indicative of a company in financial distress.
In the same way, a firm may choose a divestiture strategy to allocate its resources for optimal use, removing business units that do not generate the required rate of return. But shareholders may mistakenly perceive the divestiture as signaling an urgent need for cash because the company is in trouble. As a result, investors may sell their shares, causing the company’s stock price to fall – further confirming to some investors that the company is in danger of going out of business.
The way to avoid investors getting inaccurate signals regarding a company’s current position and future prospects is to maintain open communications with stockholders regarding any major corporate decisions, such as the decision to make a divestiture. In such an instance, it is in the company’s best interest to clearly communicate to shareholders the reasoning behind the divestiture decision, along with information regarding the benefits that the company plans to reap from the sale of a business unit.
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