8 minute read
In this feature, Corporate Sector Advisory specialist Hai Le highlights three reasons why deconglomeration could accelerate in the current climate and outlines a number of capital structure and financing considerations for corporates considering spinning off or divesting part of their business.
The coronavirus pandemic created a huge upheaval for businesses across the world and many are faced with the need to make major strategic, operational and financial changes to ensure they survive and thrive in the future. A trend we think will accelerate is for corporates to spin-off or divest part of their operations (a ‘de-merger’) in order to unlock hidden value, reset their balance sheet while focusing on what they’re best at, or develop new growth areas in a post-pandemic world.
Conglomeration – the process by which a company acquires businesses with the intention to diversify or become a ‘conglomerate’ – was all the rage back in the 1960s and 70s. Firms sought to expand through mergers & acquisitions (M&A), backed by research that suggested diversifying their businesses should reduce their overall risk profile during difficult periods, achieve better economies of scale, attract more capital and become more efficient in deploying it through internal capital markets.
But the tide began to turn from the 1980s onwards, as research pointed to numerous disadvantages of a conglomerate model. These included information asymmetries between central managers and divisional managers, the high costs of moving in and out of businesses (compared with investors’ ability to do so), and the agency problem which could lead to managerial empire-building. Most infamously, one study estimated that, on average, a conglomerate’s firm value can be 13-15% less than the sum of its parts, implying a significant ‘conglomerate discount’ as a result of diversification1. This marked the rise of the deconglomeration trend.
Differing effects from different perspectives
Any company mulling a de-merger needs to consider the effects on value from different stakeholders’ perspectives, including equity and debt investors.
Equity markets and shareholders are typically supportive of de-merger activity. S&P Capital IQ’s Quantamental research looking at corporate spin-offs and carve-outs between 1989-2015 shows spun-off entities generated long-term outperformance against the broader market2. This is further evidenced in the graph below, where the S&P US spin-off index3 has shown to outperform the wider S&P 500 index by more than 50% in the last 10 years.
Stocks of spun-off companies have outperformed the broader market in the past 10 years
Source: S&P. Note: The S&P US Spin-Off Index consists of companies within the S&P US BMI that have been spun off from a parent company within the last four years and have a float-adjusted market capitalisation of at least $1 billion.
However, credit stakeholders can be less sympathetic. This is mainly because scale and diversification are typically seen as credit-positives, and a de-merger could be considered as a potential trade-off between a weaker business risk profile (smaller scale, less diversified) for a potentially stronger financial risk profile (through the use of proceeds in deleveraging). As a result, a corporate implementing a de-merger needs to carefully consider potential credit implications during its stakeholder management process.
The pandemic could trigger a new wave of deconglomeration. Let’s look more closely at three main reasons why.
1. De-mergers to address stressed capital structures
As of year-end December 2020, corporate leverage – defined as Net Debt / Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) – has reached all-time highs as shown in graph below. Since the Global Financial Crisis in 2008-09, appetite for corporate leverage across Europe and the US has been increasing due to (i) a low interest rate environment and (ii) accommodative debt capital markets, making borrowing cheaper and more accessible while (iii) the rise of alternative investment funds have put additional emphasis on shareholder return generated through financial engineering.
As a result, when the pandemic hit in 2020, many corporates’ capital structures have come under stress, and they resorted to measures such as de-mergers to strengthen their balance sheet and/ or bolster liquidity. This is similar to what we’ve seen in the past: a significant increase in distressed M&A activity in the wake of recessions.
Net financial leverage* for non-financial corporates over time
Source: Factset, NatWest. Note: *Leverage is defined as net debt / EBITDA ratio. The lines show trends in leverage for non-financial corporates measured using weighted average method.
2. Corporates take the opportunity to accelerate business transformation
The pandemic has clearly transformed the business and economic landscape, affecting some sectors more than others. As a case in point, the civil aerospace industry saw a sudden shock of global air travel declining nearly 60% in 2020 after almost five decades of uninterrupted growth (around 7% compound annual growth rate between 1970 and 20194). As a result of the pandemic, the growth outlook for a number of sectors looks very different compared to their pre-pandemic trajectory. As such, corporates may consider accelerating their business transformation plans by pivoting towards new and more sustainable growth areas and away from end markets that look less attractive post-pandemic. At the same time, many corporates also see coronavirus accelerating their environmental, social and governance agenda. A 2020 EY survey of C-suite executives from large corporates found that 62% of corporates stated that the fallout from the crisis will provoke them to reshape their portfolios to cope in a post-pandemic world5. A de-merger is part of management’s tool kit to help implement these portfolio changes.
3. Increasing pressure from shareholder activists
Finally, as shareholder activists have accumulated significant levels of dry powder, we expect them to take advantage of potential opportunities post-pandemic to deploy that capital. After the decade-long bull market, poorly performing companies and management are more exposed in the aftermath of the pandemic and present opportunities for shareholder activists which wouldn’t have appeared otherwise when valuations routinely touched all-time highs. In 2020, after a pause in shareholder activism activity between April and September, activist campaigns rebounded sharply towards the end of the year – European shareholder activism campaign activity finished 2020 roughly 20% higher than the year before6.
We expect M&A, including deconglomeration, to remain a key focus for shareholder activists in a post-pandemic world. A survey of global activists in 2020 suggested that 96% would recommend that a target company carves out or divests from a non-core or underperforming business. By contrast, only 64% were making such recommendations before the crisis5.
European shareholder activism activity
Source: Lazard Annual Review of Shareholder Activism 2019 & 2020.
As highlighted in the first section, whilst shareholders are typically supportive of a de-merger, potential credit implications can be much more nuanced. As such, we believe the financing and capital structure work stream is often separate (from M&A and equity capital markets work streams) and requires significant attention in a spin-off or a carve-out disposal, especially when private equity is a potential buyer: it is not an after-thought.
In contemplating a potential carve-out disposal, there are, first and foremost, considerations on the potential credit impact on the Parent Company (“ParentCo”) from both business and financial risk perspectives. In addition, if potential buyers are private equity, corporates should also be mindful about how the acquisition financing could look, as it would provide an indication of the potential purchase price buyers might be willing to pay. Vendors can also consider other tools at their disposal, such as a lender education process or vendor financing, in order to provide positive momentum on the financing work stream – all of which to go towards ensuring a successful outcome for the carve-out.
Similarly, when considering a potential spin-off, the financing work stream is not only applicable to the ParentCo but also to the entity being spun-off (“SpinCo”) as both must define their new optimal capital structures. A liability management exercise including thoughtful credit investor management may be necessary during the process of structuring and arranging term debt for both the ParentCo and SpinCo. Other financing work streams involve arranging new undrawn credit lines, setting up risk management frameworks as well as managing other stakeholders such as credit rating agencies where necessary.
To learn more about the potential financing and capital structure implications of deconglomeration, get in touch with your NatWest Corporates & Institutions representative or contact the author of this article by clicking here.
1. Diversification’s effect on firm value, Berger & Ofek, 1995
2. Capital Markets Implications of Spinoffs, S&P Quantamental Research, March 2017 (Capital Market Implications Of Spinoffs | S&P Global Market Intelligence)
3. The S&P US Spin-Off Index is designed to measure the performance of companies within the S&P US BMI that have been spun off from a parent company within the last four years and have a float-adjusted market capitalisation of at least USD1bn
4. International Air Transport Association (IATA)
6. Lazard Annual Review of Shareholder Activism, 2019 & 2020