Sustainably Successful Spinoffs Need a Strategy

The spinoff scene has seen major action recently. Prominent examples abound. General Electric divested its formerly strong financial services business. Hewlett-Packard separated its PC/printer unit from its service unit. Nokia sold off its cell phone and maps businesses. German utility E.ON spun off its conventional power generation and energy trading business. Yet many recent spinoffs have delivered mixed results. What’s more, spinoff volumes were down considerably in 2016. What’s going on—and how can executives boost the chances that a demerger will create long-term value?

The impulse behind spinoffs often comes from investors. Since the global financial crisis, investors have increasingly looked for new value creation levers—in such forms as improved business portfolio logic and greater value provided by the corporate center.

Thus, in a BCG study, roughly 80% of participating investors said that they favor aggressive divestment strategies. (See "Investors Brace for a Decline in Valuation Multiples," BCG article, April 2014.) In an earlier study, that number was just 50%. Clearly, investors want management teams to sharpen their focus. Trends in the current stock market and financing environment have reinforced this emphasis. Relatively attractive valuations, driven by low financing costs, sweeten the odds that a divestiture will deliver high financial returns.

Companies looking to divest parts of their business have three options: a direct sale, an initial public offering, or a spinoff, in which shares of the new company are distributed among the current investors. As a rule, capital markets reward spinoffs more than the other two options. A global M&A study by BCG showed that, in the long run, spinoffs generate excess stock returns of 2.6%, on average, between announcement and execution. Thus they considerably outperform direct sales and IPOs—even though they generate no direct income and generally take longer to execute than either a sale or an IPO. (See Don't Miss the Exit: Creating Shareholder Value Through Divestitures, BCG report, September 2014.)

However, short-term returns should be only one factor in decisions about whether to divest. Executives must also understand that over the long term, focused companies are not necessarily more successful than diversified ones. BCG analyses have shown that the so-called conglomerate discount—the lower valuation of groups in the capital market compared with the sum of their parts—is less than it was in the past. Some conglomerates even realize a diversification premium—especially in times of crisis. (See The Power of Diversified Companies During Crises, BCG report, January 2012.)

So how can executives ink demerger deals that generate long-term value? They need to craft and communicate a coherent underlying strategy. And that means weighing three critical considerations:

• Portfolio Logic. Articulating a clear portfolio logic increases a firm’s value beyond the sum of its parts. That logic could include synergy effects, which are a central motivation for keeping multiple activities housed in a single company. If synergies are low or do not materialize as expected, divestment may make good business sense.
• Parenting Strategy. Executives should ask themselves whether the corporate center’s capabilities still fulfill the needs of the individual businesses. A demerger can create value if the needs of each business are highly diverse or if a fast-growing division requires new capabilities that the center cannot provide. Nokia's sale of its maps business to German car makers was driven by the rationale that the latter would make much better owners. Car makers needed their own maps solution for their autonomous-driving activities and wanted to gain independence from the offerings of Apple and Google.
• Portfolio Balance. If a business is damaging the overall portfolio in the long run by tying up excessive resources and management attention, divesting it can be the right choice. On the other hand, as discussed above, diversification benefits can add a premium to a group's value. Balanced portfolios ensure long-term value creation beyond short-term profit considerations. General Electric, for example, divested its financial services business to simplify the portfolio and focus it on the company's core capabilities in premier industrial businesses.

Executives who decide to split up a company with only short-term capital market considerations in mind may be suffering from myopia. As a result, they risk inking demerger deals that deliver disappointing results. Those who carefully think through their strategic intent in initiating a spinoff stand the best chance of achieving vital advantages—including a sharper competitive edge for their overall group and the creation of value that endures. In short, they make the whole more successful than the sum of its parts—not just for today but also for tomorrow. (See "Creating Superior Value Through Spinoffs," BCG article, February 2016.)