Choosing the right divestiture partner

July 2024  |  SPECIAL REPORT: MERGERS & ACQUISITIONS

Financier Worldwide Magazine

July 2024 Issue

Corporations are like living organisms. They never remain totally static and are always reinventing themselves. This is driven by a variety of factors, including changing competitive landscapes, new technologies, evolving customer needs and even changes in corporate leadership. When companies reassess their strategies, there are always winners and losers. Some areas or products will get increased attention and funding, and some will be deemed off-strategy. Off-strategy businesses are not necessarily failures. They simply do not fit the broader vision or direction of the company. Whether it is an acquired business or one that was built from scratch, companies often conclude that the original idea behind how these businesses complement the core is no longer true or was never true to begin with. Divestitures are good and healthy, particularly for rapidly evolving companies. In 2017, Bain studied 2100 public companies and found those engaging in focused divestment outperform inactive companies (those with zero divestments between 2005 and 2015) by about 15 percent over a 10-year period, as measured by total shareholder return. Companies often divest perfectly good businesses that are simply not a good fit.

According to Deloitte, in 2023, there were 1786 divestitures with a total value of $304bn in the US. These divestiture decisions are usually made through organised strategy and portfolio evaluation processes, though sometimes they are made in a one-off decision, particularly for sub-scale assets. And there are a substantial number of smaller divestitures. Deals with values less than $250m accounted for 62.5 percent of deal volume in Q4 2023, according to Deloitte.

The larger the business as a proportion of the parent company, the more arduous the decision will generally be. Divesting a large portion of your business fundamentally changes the strategy and investor perception. It is a seismic choice. Small assets may be less impactful on the parent company, both financially and strategically, and so those decisions are often made quickly. At the smallest end of the size range, companies often consider whether a sale is even worthwhile. Small divestitures are usually the results of a ‘sell or shut down’ analysis. According to Deloitte, in 2024, 60 percent of divestiture survey respondents were strategically evaluating individual portfolio businesses for divestiture potential at least twice a year, compared to 45 percent in 2022.

Occasionally, you see divestitures triggered by an approach from a buyer. While there is theoretically a price at which any company will sell any business unit as a general matter, it is rare for unsolicited offers to trigger a divestiture, unless the asset was already on the chopping block formally or informally. This is because corporations are structured on strong strategic theses and synergies between their different business units. Shedding strategic business units is usually so the price required would be well above anything a buyer would be willing to pay.

Once the decision has been made to sell, the next challenge is how to prepare for sale. There is an art and science to preparing an asset to be divested. The ‘disintegration’ process is usually complex since few business units are kept totally isolated. Once that process is mapped out and underway, companies need to identify natural buyers. For larger assets, an investment bank will usually be retained to help with this process. For smaller assets, it is often done by the internal corporate development team.

Identifying buyers for a divested business is a much more complex process than when a standalone business is sold. The parent company must consider not only maximising price but also several other variables. These include the complexity and distraction of disintegration, the impact on employees, the impact on customers, the impact on brand, legal liabilities and potential ongoing relationships with a divested business, including technology licences or resale relationships. And the smaller the divested asset is, the more these other variables will overshadow sale price.

What are the ideal characteristics of a divestiture partner? The list is long and how each characteristic is weighed will vary based on a variety of factors, including the size of the deal, as well as the strategic nature of its business and the competitive landscape. In almost all divestitures, every one of these is factored in to at least some extent.

A buyer should have ready access to capital as well as the ability, and track record, to close. Letters of intent (LOIs) are non-binding. It is important to recognise that in any negotiation, parties can walk away until the deal is finalised. A broken process is particularly distracting and difficult for a corporate seller. Look for evidence that a buyer has ready access to capital and a long track record of closing deals. One metric to try to identify is the buyer’s conversion rate from LOI to close. This is sometimes hard to find, but a buyer that is heavily committed post-LOI is ideal. One good signal is the buyer’s willingness to spend money on vendors in the deal process. Engaging lawyers and financial and technical due diligence vendors, which is a substantial out-of-pocket cost, is a good signal of a buyer’s level of commitment.

Alignment on how to treat employees and customers is another important variable. This is something worth discussing early in the process to make sure that a buyer is willing to make commitments on things like employee benefits and maintaining quality of customer delivery.

In terms of ongoing transition services, some sellers want to minimise the time and complexity of the transition services agreement (TSA). Others may be willing to have a more extended TSA in exchange for attractive and time margin payments.

Willingness to enter into related commercial agreements is another important factor. A buyer that is willing to commit to non-competition with the seller’s primary market rivals may be preferable. Or it may be important to find a buyer willing to licence back technology or assets being acquired, for the seller’s ongoing use. Maybe the buyer must be willing to let the seller continue to sell its offering, which has the potential to drive very attractive margin revenue back to the seller.

Similarly, a buyer should be flexible in both the structure of the transaction and in the way it is publicised. Some sellers want to characterise the divestiture as more of a joint venture or dictate the narrative and press releases.

A buyer should also have specific experience with a corporate divestiture process. Buyers that are used to buying founder-backed or public businesses or other ‘whole’ standalone businesses, will not be prepared for the complexities of disintegration. They will also not be familiar with the internal dynamics of a corporate divestor, and so may be less flexible or helpful with things needed to complete a divestiture.

Particularly for smaller divestitures, a buyer that can be nimble and will provide the right level of focus and resource to get a deal done quickly and cleanly is best.

Evaluating buyers for these kinds of characteristics can be challenging. Early in the deal process the buyer is wooing a seller and will tend to message very positively. In some cases, the buyer may be transparent, but oftentimes it is either vague or will communicate willingness to accommodate the seller’s needs only to try and renegotiate upon reaching the definitive agreements stage.

It is wise to go deeper in evaluating buyers for all these factors. A seller can use a variety of tools to try to assess a buyer. One is its track record. Has it done a lot of deals? Have there been litigations or other public conflicts involving the buyer? References may be sourced on buyers, particularly if they are repeat buyers, such as a private equity firm or a large organisation. Investment bankers and lawyers are a natural source of reputational checks. So are former counterparties. Asking for more detailed questions will tend to reveal the buyer’s approach. How early in the process do they involve their integration team or discuss the TSA? How willing are they to commit to specific terms in the LOI? Even though LOIs are non-binding, they are at least indicative of a willingness to make commitments.

Particularly in situations where there will be ongoing commercial relationships with the buyer or where buyer behaviour post-closing is an important factor to the seller (employee or customer treatment, for example), this kind of buyer analysis is critical. Sellers are often willing to trade a substantial amount of the purchase price for variables that some buyers are willing to give while some are not.

Choosing the right buyer at the outset can have a huge impact on the success of a divestiture. The smaller the deal, the more likely non-purchase price items will be of primary concern. And it is these non-purchase price items that vary the most between buyers.

In the absence of an investment banker, a seller needs to develop the resources and leverage relationships to carry out buyer due diligence. When engaging an investment banker, it is equally important to make sure they prioritise these variables since they are traditionally both incentivised and trained to maximise only the purchase price.

 

Michael Frankel is the founder and managing partner of Trajectory Capital Partners. He can be contacted by email: michael@trajectorycapital.com.

© Financier Worldwide

BY

Michael Frankel

Trajectory Capital Partners

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