Divesting Meaning Strategy Types How Divestiture Works

Divesting Meaning

Companies adopt divestiture as a part of an exit strategy and retain only the profitable divisions. It is also a common practice in government restructuring. This is seen when a government sells off a segment to meet significant capital investmentCapital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more or to mitigate losses.

Key Takeaways

Divesting is a strategic move in corporate restructuring. This is achieved by partially liquidating assets or by selling poorly performing organizational divisions. Business entities resort to divestiture when a specific unit is causing losses. Other reasons involve legal, political, social, and environmental causes potentially forcing a restructuring of a company. There are three ways a company can plan divesting: demerger, sell-offs, and equity carve-out. Divestiture backfires at times resulting in the decline of business sales, market value, and acceptability.

How does Divesting Work?

Divesting is simply a purposeful action that lets a company free up capital invested in certain poorly performing assets or business divisions. Sometimes segments of a firm come under legal pressure or regulation, initiating a divestiture. Subsequently, companies can pour the acquired funds into focused business lines to succeed. Owners often continue to keep such incompetent business units active. Some expect these divisions to perform well in the future; others are unaware of the divestiture process and its advantages. The basic steps involved in divesting are as follows:

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Review of Portfolio: Usually, it involves an assessment of the entire business portfolio. Each business unit’s performance is analyzed. Additionally, a unit’s relevance to the company’s long-term objective is ascertained.Identification of Suitable Buyer: Once a specific business unit is identified as part of the divestiture exercise, a suitable buyer is determined by availing an investment banking firm. OutsourcingOutsourcingOutsourcing refers to contracting out specific business processes to a third-party or specialized service provider, i.e., an individual or company.read more helps in identifying a buyer.De-integration: Consequently, organizations then prepare a de-integration plan and convey the merits of such a divestiture. The purpose and benefits of the divestiture are highlighted. There is an attempt to send a positive message to both internal and external stakeholdersStakeholdersA stakeholder in business refers to anyone, including a person, group, organization, government, or any other entity with a direct or indirect interest in its operations, actions, and outcomes.read more.Executing the Divestiture: Finally, the business unit being sold undergoes valuation. Again, the selected investment banking firm executes this. (It is important to note that the valuation exercise is undertaken to determine if the price derived is at least equal to the opportunity costOpportunity CostThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It’s essentially the cost of the next best alternative that has been forgiven.read more of not selling the business unit). Consequently, the assets are sold off.

Purpose of Divesting Assets

The primary purpose of divesting is to restructure the business investment and finance. The underlying need for restructuringRestructuringRestructuring is defined as actions an organization takes when facing difficulties due to wrong management decisions or changes in demographic conditions. Therefore, tries to align its business with the current profitable trend by a) restructuring its finances by debt issuance/closures, issuance of new equities, selling assets, or b) organizational restructuring, which includes shifting locations, layoffs, etc.read more is discussed below:

Divesting enables businesses to focus on their core operations. The firm once again focuses on the niche where it holds expertise.It is a tool for monetizing assets. Divestiture usually results in a cash inflow.Companies evaluate the performance of all the divisions and divest those divisions whose internal rate of return is below the average or required rate of return.It is often done to improve shareholders’ value. Alternatively, firms are forced into a divestiture by regulatory authorities.Non-alignment with the primary niche also requires divesting of an asset.It keeps a check over the sustained underperformance of business units, denting the organization’s overall profitabilityProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more.The availability of better opportunities compared with the existing business lines also motivates management to divest current business endeavors and set up a new one.

Divesting Strategy

Before divesting, the management should be sure. Before taking such a huge step, other possible alternatives should be reviewed first. Another crucial part is selecting the path, i.e., the type of divesting to go for. It is essential to follow a systematic and structured process. A fair valuation must be executed, ascertaining the assets’ acceptability among buyers. Divestiture is practically a slow process. Patience is another crucial requirement for divestiture; it may take a year or more to crack the deal.

Firms must ensure that divestiture is carried out by a team of skilled executives headed by a professional. Lastly, the customers cannot be overlooked; the management must successfully convey that this strategic decision is for the betterment of the organization and the clients.

Types of Divestitures

Depending on its need and purpose, the three most prominent forms of divesting are given below.

#1 – Equity Carve-Out

In this kind of divestiture, the company releases initial public offeringsInitial Public OfferingsAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more (IPOs) to initiate the partial sale of its business sectors, subsidiariesSubsidiariesA subsidiary company is controlled by another company, better known as a parent or holding company. The control is exerted through ownership of more than 50% of the voting stock of the subsidiary. Subsidiaries are either set up or acquired by the controlling company.read more, or divisions. However, the parent organization is the major shareholder and holds complete control over the divested business unit.

#2 – Sell-Offs

The organization can sell out one or more business divisions, subsidiaries, or units. The reason behind such a decision can be a failure of a particular segment, the underperformance of a subsidiary, non-alignment with core functions, or excessive capital requirement.

#3 – Demerger

Splitting up a business unit is another method. When splitting up, the organization parts into two or more new independent corporations and the parent company’s identity dissolves. Alternatively, a spin-offSpin-offA spinoff, also known as starburst or spinout, refers to an operational strategy where a company separates its subsidiary to form a new independent entity.read more method can be followed. In a spin-off, the business entityBusiness EntityA business entity is one that conducts business in accordance with the laws of the country. It can be a private company, a public company, a limited or unlimited partnership, a statutory corporation, a holding company, a subsidiary company, and so on.read more subdivides into multiple subsidiaries, but the parent companyParent CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary’s directions and policies.read more persists in its operations.

Examples of Divestiture

Let us understand divestiture through an example. Assume that a Swiss Corporation operates in three business divisions,’ namely clothing, automobile, and real estate. The company has an internal rate of return of 13%, 8%, and 15%, respectively, from its three divisions. Swiss Corporation has a required rate of returnRequired Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rateread more of 12%. In such a case, by divesting its automobile division, an 8% internal rate will be generated, and the company will be able to utilize the proceeds towards more profitable divisions. Ultimately this will result in a higher rate of return for the business as a whole.

Further, consider this real-world example reported by the Guardian. In 2017, Harvard University decided to divest its direct capital investmentCapital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more worth $42 billion in fossil fuels.

Harvard management took this massive step under the sustained pressure of alumni, students, and faculty. Ultimately it was a move towards an investment portfolioInvestment PortfolioPortfolio investments are investments made in a group of assets (equity, debt, mutual funds, derivatives or even bitcoins) instead of a single asset with the objective of earning returns that are proportional to the investor’s risk profile.read more comprising green economy products.

Advantages and Disadvantages

Divesting can be a turning point for companies. It is a source of funds from non-business operations. But this, in turn, facilitates corporate expansion, focusing on core niches. Additionally, it is an opportunity to unload debtsDebtsDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more. Moreover, restructuring helps a company eliminate failing divisions. The freed-up funds are invested into profitable ventures. Ultimately, divestiture results in a higher return for the shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company’s total shares.read more.

Despite various benefits, divestiture has certain limitations. In the absence of proper disclosure of such a strategy, the investors can presume it to be an adverse sign of poor corporate health and withdraw their funds from the company. Even clients and vendorsVendorsA vendor refers to an individual or an entity that sells products and services to businesses or consumers. It receives payments in exchange for making items available to end-users. They constitute an integral part of the supply chain management for providing raw materials to manufacturers and finished goods to customers.read more can lose trust over a disinvesting organization and could shift to a competitor. Further, divestiture is a cost-intensive process where the company has to pay for various transition and transaction costs, including the fees for professional experts, employee severance paysEmployee Severance PaysSeverance pay is paid to employees removed or terminated from the employment of the company. It is generally paid to employees who are being let go due to job elimination or downsizing rather than the reasons for voluntary termination of employment.read more, and asset transfer charges.

Divestment vs. Disinvestment

Divestment is nothing but the strategy of selling off some of the business divisions, assets, and investments to acquire funds. In this case, restructuring of the business entity takes place while its functioning is not affected.

With disinvestment, the company faces a reduction in its capital assets due to a loss. Alternatively, a company deliberately sells assets like buildings and equipment to pay off its lenders and shareholders caused by business failure or shutdown. Here, the organization is not in a state to reinvestReinvestReinvestment is the process of investing the returns received from investment in dividends, interests, or cash rewards to purchase additional shares and reinvesting the gains. Investors do not opt for cash benefits as they are reinvesting their profits in their portfolio.read more the funds.