It’s been almost a month without a single major company announcing that it is winding up its business as a public company. Kellogg, GSK, Johnson and Johnson, General Electricand IBM everyone has recently made such announcements. While it is too early to predict the effectiveness of any newly announced deal, this intensified focus on separations raises some critical questions about the value generated from a spin-off. What do these companies hope to achieve? What challenges will they face? How do they create shareholder value given these challenges?
We analyzed more than 350 public spin-offs valued at more than $1 billion between 2000 and 2020. The most unexpected thing we learned was that 50% of the companies that sought a separation failed to create any new shareholder value two years later, and 25% destroyed a significant amount of shareholder value in the process. This is despite their stated intentions to create value through greater management focus, increased growth opportunities, targeted capital allocation, and investment profiles that fit a more specific base of investor.
The evidence is overwhelming. Among the companies in our study, the average spin-off delivered as little as a 5% increase in combined market cap two years after the spin-off. The scope of the show is important. Firms in the bottom quartile have completed separations that are in fact damaged amount to as much as 50% of the combined market cap.
At the same time, while most companies saw little for their efforts, top-quartile separations performed exceptionally well, with a 75% higher combined market cap two years after separation. Consider the experience of the industrial company Arconic, which changed to Howmet Aerospace in April 2020. Fifteen months ago the combined market cap of the two companies increased by more than 150%. Or consider Baxter’s spin-off of Baxalta in 2015, where the combined market cap rose 30% in the year before Shire acquired Baxalta.
The huge disparity in performance between winners and losers led us to focus our research on what the top companies were doing that resulted in such spectacular outperformance—as well as the mistakes that step that keeps other companies away.
What we see is that many companies destroy their separations from the beginning with the wrong premise. They believe that just moving a business is enough to achieve a higher multiple, and they define success in the short view as getting to the first day as fast as possible. In fact, investors know that there are sometimes significant dis-synergies and one-time costs from the separation. They want to see that the profit and loss (P&L) shape, operating model, and growth trajectory of one or both entities are good enough to recover costs and different enough from past performance to ensure a higher multiple.
Some companies already run separate operations, without shared functions and systems, and can be broken up easily and quickly. Most companies, however, face high levels of involvement in support functions and even operations. Layoffs can last several months to several years and often include service agreements of varying duration. In addition, complex regulatory and legal requirements make the process more complex.
Why do top-quartile separations give more value?
Top-quartile companies focus on what matters most. They start with a clear point of view of what the forward equity story and P&Ls need to be, design the future organization to make that happen, and then build separation and transformation plans. The best divorces have a strong point of looking into these things before they go public with their separation.
More than anything else, it’s a well-crafted separation thesis that helps them focus and provides a road map to value creation. In our study, we found that the existence of a clear and strong separation thesis is the biggest difference between top-quartile and bottom-quartile separations.
In the best situations, the thesis serves as the primary input to the board’s decision to part ways. It explains how strategic and financial benefits outweigh one-time costs, dis-synergies, stranded costs, and distraction from the base business.
There are four parts to the separation thesis: equity story, target financials, asset perimeter, and program design. Let’s look at each other.
The heart of the separation thesis, the equity thesis articulates the value each company would create as a standalone entity, including its growth trajectory and margin profile, compared to its new competitive set. It also provides an opportunity to reset which metrics are important in the future. A well-defined equity story sets the ambition (eg, annual growth of x%, EBITDA profile of y%) and lays the groundwork to achieve it (eg, expansion into specific categories/geographies, cutting costs in specific functions to enable reinvestment in specific areas).
Consider the case of a new manufacturing company that uses its internal equity story to set clear post-spin-off revenue growth and EBITDA targets for one and four years. year. These are each supported by specific activities so that the company can reach its targets. The company then prioritizes projects according to high-value activities. These projects run alongside the separation program to deliver the necessary changes to the business on day one.
Setting a financial goal involves asking two questions:
- What are the standalone business financials now after dis-synergies are added?
- What will our P&L look like in three years?
Once these two questions are answered, the top-quartile separations assess the gap, define the set of initiatives needed to close the gap, and then determine which initiatives should be implemented in the spin-off, which may fly in the spin-off, and which must be executed after the spin-off. When the health care company Baxter separated Baxalta, its biopharma business, the separation program focused on establishing the right cost structure for each business early on. Baxter set sales, general, and administrative efficiency targets, while Baxalta increased R&D and sales and marketing as a percentage of revenue. Baxalta traded at a significant premium after the split, and Baxter saw an increase in share price and free cash flow.
The asset perimeter is the detailed boundary of the business to be separated. It is important to draw this boundary across several major categories: people, property, systems, and IP/contracts. Drawing the asset perimeter early allows critical linkages to be identified. It also creates a picture of where dis-synergies are likely and where critical decisions are needed between signing and closing. It is common for the asset perimeter to gradually increase over time as the new company’s P&Ls take shape.
Kraft and Mondelēz set the precedent for this in 2011. Despite activist pressure for a clean division of grocery and snacking businesses around the world, the company designed an asset perimeter with a regional focus. North America was divided into grocery and snacks, and everything outside of North America went into snacks. This makes the separation less expensive, reduces dis-synergies, enables the separation to take place in just one year, and ensures no de-scaling in small markets.
Once the other three elements are defined, a team can begin to identify how the separation thesis affects the separation transaction itself.
What timeline is needed to implement the separation and make some meaningful changes to each business? What are the critical decisions around asset perimeters and extractions that require senior leadership bandwidth? What is the ongoing relationship between entities that post spin-off transfer service agreements and commercial agreements, for example? What methods will they take to mitigate corporate/stranded costs? Answering each of these questions will provide critical inputs to the process and structure of the transaction.
The separation thesis becomes the answer key to questions about how a spin-off should create value and how to plan the actual separation process. This helps focus senior leaders on decisions that drive the greatest value and highlights the operational implications for both companies. Understanding the extent of P&L changes and the level of complexity around the asset perimeter enables the company to set a realistic timeline on day one.
Ultimately, the separation thesis creates an exciting picture of the future of each standalone business – one that inspires employees and shareholders at a time that would otherwise fall prey to confusion, dissatisfaction, and frustration. results.