Mark Herndon, Chairman of the M&A Leadership Council shares this part one of a two-part series covering the key requirements for achieving maximum value when divesting a business.
What’s one of the most challenging transaction types to execute well from end to end?
Ask that question to experienced corporate executives or merger, acquisition, and divestiture leaders, and you’ll likely hear a large and loud majority answer – “divestiture!”
Simply stated, divestitures are widely considered one of the most complex and riskiest of all transactions – for both buyers and sellers. As quoted in Strategy+Business, “This type of transaction can often be a make-or-break career decision for CEOs and Boards.”
Especially post-pandemic, an increasing number of companies are likely to face the need to refocus and realign their capital, talent resources, and strategic bandwidth more effectively on those specific products, businesses, and solutions with the best growth and profitability potential. Thus, as part of a dynamic and ongoing strategic portfolio review, more executives will rightly conclude, “we must divest to reinvest capital more strategically and effectively.”
Whether the long-term strategic objectives prompting a divestiture are to harvest cash to pay down debt, fund a share repurchase, acquire new technologies, or accomplish internal transformational or cost optimization initiatives, the complexities and risks of divestitures have indeed tarnished the careers and plans of many a well-intentioned, but ill-prepared executive.
Even for highly experienced acquirers, we find that divestitures require an entirely different level of readiness and experience than most acquisitions for the following reasons:
- The value-curve and lifecycle processes are vastly different from acquisitions. As we often like to say, divestitures are not acquisitions spelled backward. Premium valuation and ready buyers can be won or lost based on the degree of pre-sale analysis, preparation, readiness, and partnering the seller is willing to provide.
- Expect extraordinary complexity in planning and executing the separation of highly comingled corporate shared services, systems, applications, data, and organizations. As a result, most buyers of divested businesses will be highly dependent, at least for a reasonable period, on the seller’s willingness and ability to support a comprehensive separation / stand-up phase via a transition services agreement (TSA).
- The change management stakes and challenges are immense. Employees in divested businesses are often the most at-risk and the most change-resistant. Widespread perceptions of betrayal and loss are prevalent, as are empirically validated concerns of being sold yet again in a subsequent transaction. As a result, we often find the employee mindset in certain divestiture situations strongly resembles something akin to going through the stages of grief.
- Limited internal corporate experience and capabilities. Many acquirers have worked hard over the years to build and sustain a comprehensive and strategic execution capability for acquisitions. Divestitures, however, are often fewer in number and typically not repeated frequently except for compressed periods of strategic repositioning or transformation. As a result, much of the corporate DNA, central nervous system, and muscle tone atrophy between divestitures making it extraordinarily difficult to establish and maintain the procedural, systemic, experiential, leadership, governance, and functional centers of excellence required for consistent results and repeated success.
Four Key Requirements for Divestiture Success.
Based on decades of practical experience and refined over the last 12 years as the M&A Leadership Council has trained thousands of executives from hundreds of companies across all major industry sectors, we believe that focused, internal efforts in these six essential capability and readiness components will help your team plan and execute your next divestiture better, faster, and with more value capture, while avoiding highly disruptive downside risks.
- Master the divestiture process.
Start by carefully examining your company’s existing overall M&A lifecycle or process approach. Document how your organization defines the end-to-end phases, process steps, essential decisions, deliverables, risks, and end-state objectives of a typical buy-side acquisition. As you look at the acquisition process, ask your M&A team or leaders to draw a risk curve across all phases of the M&A lifecycle. Note the specific points along that journey where the risks start, peak, ebb, and ultimately, are essentially mitigated.
Now attempt to do the same exercise, but this time from the seller’s viewpoint contemplating a major divestiture. If your outcome is like most companies’ experience, the risk/value curves for buyer vs. seller will be substantially different.
One common lesson learned by inexperienced divestors is the tendency to underestimate the lead-time, resourcing needs, and sheer volume of planning analysis, documentation, and readiness required. Historically, divestiture prep was heavily transaction-driven with the preponderance of time and effort given to developing a confidential offering memorandum and the anticipated baseline due diligence data required. However, over time, divestors have learned they are more consistently able to realize exit valuations above expectations by ratcheting up their level of pre-sale preparation to accelerate the transaction and support the success of a prospective buyer. These value-creation deliverables often include comprehensive proforma separation plans; operating model maps describing core workflows, decisions, resources and contracts or services provided through the workflow, as along with an actual TSA functional scope that accurately reflects how the business to be divested (“DivestCo”) operates today, and which the seller is willing and able to support.
- For maximum seller value, include both “offense and defense” in your pre-sale preparation playbook.
Most acquirers fully appreciate the value of playing defense during the pre-sale preparation phase through a comprehensive sell-side due diligence exercise. While the goals of sell-side due diligence are clear – to de-risk the transaction and to support and accelerate the sale, executives may be unaware of the degree of heavy lifting required at this phase. As a minimum, sellers should prepare the following:
- Financial Statement Considerations. You will need stand-alone and proforma financial statements covering the business to be divested. All assets going with the transaction should be explicitly identified, documented, and reflected in the stand-alone financials. All relevant costs for the target unit must also be included. Finally, any prior audits, audit findings or relevant management letter components about the DivestCo should be provided.
- Intercompany Transactions. Any transactions, services, and contract procurements the DivestCo buy or sells to the ParentCo will need to be identified and documented, along with the prices, terms, and other conditions as well as the operating model governing such transactions. Expect incisive buyer queries about whether these can be continued post-close. If so, for how long and at what price? If not, expect even more pointed queries about the buyer’s likelihood of incurring additional costs, risks, or negativesynergies, and how these might be reflected in the proforma economic model.
- Shared Services Cost Allocations. For any shared services, what costs do or don’t get allocated to the DivestCo? How are these allocations determined? Are allocations booked at a reasonable cost basis for what is provided? And importantly, what cost allocations will go away post-close and the commensurate add-back cost of comparable services?
In our experience, few sellers think adequately about playing offense during the pre-sale process. Therefore they lose out on potential premium value capture. Investment bankers sometimes refer to these as “fix-up / clean-up” activities. Choosing a handful of insightful and well-timed strategic and financial fix-up/clean-up activities can have a meaning valuation impact or at least minimize potential red flags or deal-stop concerns. These often fall into one or more of the categories below:
- Positively impacting the P&L through short-term cost optimization or revenue improvement. For example, what can be done to reduce procurement or materials costs or what sales enhancements can be made to validate product placement opportunities in new or expanded verticals?
- Positively impacting the balance sheet and cash flow statement through cash and capital optimization. For example, how can working capital be reduced by accelerating accounts receivable, reducing, or writing off old inventories, etc.
When considering which initiatives to consider, an important question is always quick to surface. “Since we are selling, how much fix-up/clean-up type of value capture should we attempt to do and within what timeframe?” Working through this question at one recent client contemplating the divestiture of a major business line, we arrived at the following rules of thumb, purpose-fit to their business and operating model.
- The Going-Entity Rule. If reasonably required as a standard business requirement, preventative maintenance for example, keep approximately the same investment level going through the date of sale.
- The 12-Month Rule. If meaningful results could be expected within six to twelve months of commencing the fix-up initiative, it’s a viable candidate for action.
- The Red-Flag Rule. If the issue is bound to raise a red flag during due diligence or negotiations, commence a reasonable fix-up/clean-up initiative even if results are ultimately not likely during the ensuing few months before a sale.
- The Relay Race Rule. Somewhat like the Red-Flag Rule, but also different and more strategic, this client had several longer-term and multi-year portfolio initiatives underway that were important to the go-forward operating model and economics of the DivestCo. Rather than pausing those or “playing out the clock,” it was decided that the seller would double-down on these initiatives and perform additional efforts to accelerate work on select project milestones. In this case the focused readiness and partnering demonstrated by the seller positioned them to pass this important baton more successfully to the buyer and help justify a higher than market valuation.
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Need a deeper dive into divestitures and carve-outs?
Register for our upcoming training, The Art of M&A® for Divestiture & Carve-Out Leaders/ Live-Online, which will be held via Zoom, May 16-18, 2023.
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Mark Herndon, serves as Chairman and CEO of the M&A Leadership Council, and specializes in M&A strategy, due diligence, integration management, enterprise communications and leadership during periods of disruptive change. The M&A Leadership Council is an educational consortium of global professional service firms, experts, and corporate practitioners in the art and science of mergers, acquisitions, divestitures, and joint ventures. Over the past 12 years, the M&A Leadership Council and its partner organizations have trained over 4,500 executives, representing over 800 best-in-class companies from every major industry sector. The M&A Leadership Council actively supports corporate executives and M&A practitioners through a variety of proprietary research initiatives and publications, online and onsite training programs, best practices, and an industry-first certification for corporate M&A practitioners, the Certified M&A Specialist (CMAS®).