Breakups aren’t just fodder for celebrity-gossip websites. Separations are back in the business pages, as large conglomerates in healthcare, consumer electronics, logistics, and other sectors announce their intentions to spin off business units or explore avenues for doing so.
Despite all the new ink being spilled on this trend, in many ways it’s just another chapter in the long-running story about diversification strategies: a company matures, prompting executives to look outside the core business for ways to grow. (A logistics company acquires a software company. A pharmaceutical company enters the consumer-health market.) As revenues increase, so do costs and complexity. Some operational and other synergies may materialize—but eventually executives and boards realize how difficult it is to add value to businesses that have little or no direct connection to the company’s core business.
The realization may come when a business unit’s performance is lagging behind that of its peers with no clear path to catch up. Or a review of the company’s portfolio may reveal that some business units’ cost structures are not comparable with peers. Or executives may recognize that the company lacks sufficient management capabilities to grow all the businesses in its portfolio.
When these signals appear, companies acknowledge that they are no longer the best owner of an asset, and spin-offs ensue—especially in an environment like the one we’re experiencing now, when business models are being tested by a crisis and new strategies are needed, market valuations are high, and financial engineers are hard at work (exhibit).
There are fundamental reasons why we’re seeing more large companies pursuing spin-offs—specifically, because such deals can help to improve the operating model, management focus and strategy, and capital management for both the parent company and the divested business unit.
A group structure often imposes operating requirements on all the business units in a company’s portfolio. A pharmaceutical and medical-device conglomerate, for instance, may require all business units to use a centralized compliance and regulatory process or common inventory-management and sales-reporting systems. But different drug and device divisions have different needs, so the teams managing these common compliance, procurement, and sales functions would likely struggle to cater to each unit’s unique circumstances and priorities. Indeed, when companies’ portfolios mix high-margin, high-growth businesses with lower-margin, mature businesses, there can be a clear operating-model mismatch.
A breakup would allow for a more tailored operating model. Consider the case of a global consumer company that owned both a high-margin branded business along with a lower-margin, nonbranded-commodity business: there were clear synergies in distribution and supply-chain processes. But razor-thin margins in the highly competitive consumer-packaged-goods industry meant that the nonbranded-commodity business required a much leaner cost structure and a more focused operating model than the consumer company had. By selling off the nonbranded-commodity business to a better owner, the global consumer company was able to streamline its operating model and pursue growth in its branded business.
A group structure can make it difficult for executives to determine how to balance investments in high-risk, high-reward opportunities (or, “the most exciting initiatives”) versus low-risk, low-reward ones.
Management focus and strategy
Experience shows that senior leaders in conglomerates tend to overinvest attention and organizational resources in high-growth parts of their business and underinvest in lower-growth or more mature parts of the organization. The opposite can happen, too. Senior leaders may be overly focused on the success or failure of the biggest business unit and less so on overall growth. The result is often uneven development of businesses within the portfolio. Mature organizations fall further and further behind peers and struggle to find the resources to maintain or recapture their leadership positions, even when they represent most of the company’s total revenues. Even if management is appropriately tending to all parts of the business, analysts and investors with limited time to evaluate companies may struggle to understand what’s driving growth in disparate parts of a diversified business.
At one technology services provider that also owned and developed its own software, senior management struggled with resource-allocation decisions and at times missed out on some of the biggest trends in the industry—particularly in moving the provider’s software to a cloud infrastructure. It was only after divesting its services business that the company was able to position itself as a player in the market for software as a service.
The best-performing conglomerates do well not because they are diversified but because they are truly the best owners of the businesses within their portfolio.
A group structure can also make it more difficult for executives to determine how to balance investments in high-risk, high-reward opportunities (or, as they are known in most companies, “the most exciting initiatives”) versus low-risk, low-reward ones. Moreover, some executives are reluctant to raise capital for discrete business units—in the case of an acquisition, for instance—when they feel like their share price doesn’t fairly reflect the full value of the organization.
Divesting noncore business units can help address these concerns. For instance, if a technology company spins out a legacy infrastructure business unit as a pure-play stand-alone company, it may be easier for the infrastructure business to raise capital for an acquisition and pursue market consolidation—without having to compete for funding with all the other businesses within the technology company.
Executives frequently comment that a “sum of all parts” valuation, versus applying peer multiples to each business in a portfolio, doesn’t fairly reflect the full value of their business. That is because individual business units tend to perform less well than pure-play companies. In the case of the technology company, then, the separation of the legacy infrastructure business would eliminate this noise and, theoretically, would ensure that each business within the technology company’s portfolio is valued at a fair multiple.
For conglomerates that acknowledge their flaws and that are seeking improvements in operations, management focus, and capital, breaking up doesn’t need to be so hard to do.
In perfectly rational capital markets, the value from a spin-off would come primarily from the operating-model efficiencies it enables and the management attention that it frees up. Capital markets aren’t completely rational, though, and as we noted, many businesses struggle with allocation decisions. Additionally, there is at least a perceived multiples discount on companies with diverse business lines, perhaps because investors would prefer to make their own diversification decisions rather than rely on management. As a result, companies pursuing spin-offs often include all three sources of value creation when announcing their plans.
It’s true that some technology companies are, so far, still following a bigger-is-better approach. But for most others, the days of the diversified conglomerate are receding.
Our own research and experience suggest two things: first, the best-performing conglomerates do well not because they are diversified but because they are truly the best owners of the businesses within their portfolio. And second, for conglomerates that acknowledge their flaws and that are seeking improvements in the three areas cited earlier (operations, management focus, and capital), breaking up doesn’t need to be so hard to do—as long as executives systematically consider the growth strategies, operations, talent, and cultural changes the parent company and divested business unit will require for a win–win scenario.