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In 2001, Cisco divested a business unit that specialised in switchers, storage networking and SAN products. Andiamo, the new company, was funded with Cisco investment and assets, and staffed by Cisco employees. Cisco even retained 44 per cent ownership in the new entity. All of this was a clear sign of Cisco’s continued interest. So why divest?
Unbundling operations are often seen as a sign of failure, a tool companies employ when they attempt to correct a mistake, readjust business focus or make up for an unsuccessful acquisition. But companies divest units for strategic reasons as well. By retaining a connection with the divested unit, the parent aims to benefit from the dynamism of the new company. Unbundling operations are much more than mere financial and tactical moves; they are a vital element of a company’s corporate strategy toolkit.
What does unbundling mean?
A recent report by the European Commission on 144 companies in European manufacturing and service industries (including Hoechst, Finmeccanica, Deutsche Steinkohle, Ericsson, and Nestle) found that 13 per cent of all new companies created in Europe result from unbundling operations. Yet we still know relatively little about why companies unbundle and what happens when they do.
Unbundling is often understood as what happens when a company disposes of or sells assets, facilities, product lines, subsidiaries, divisions or business units. An unbundling operation is an alteration to a company’s productive portfolio through the disposal or sale of a division, a business unit, a product line or a subsidiary.
Unbundling is discussed in terms of divestments and divestitures. These terms are often used as synonyms, but they are, in fact, distinct strategic options. A divestment is the partial or complete sale or disposal of physical and organisational assets, the closing of facilities and the reduction of the workforce. A divestiture, on the other hand, is the partial or complete sale or disposal of a business unit, product line, subsidiary or division. It is only with a divestiture, and not with a divestment, that the parent organisation creates a new company, able to operate more or less autonomously in the market.
It is important to understand that unbundling operations are more than just financing operations. Their design and implementation affect the success of the parent company and the divested unit, from both a financial and a strategic perspective.
Why do companies unbundle?
Are divestitures merely a reflection of the economic cycle, a means to correct or reverse previous strategic decisions (for example, diversification), or are they a proactive strategic option?
We categorise unbundling operations according to the legal and strategic reasons for the operation. From a legal perspective, it is important to distinguish between voluntary and involuntary divestitures. An involuntary divestiture is a reaction to legal and/or regulatory limitations. For example, in recent years, many public European companies were de-nationalised and had to involuntarily divest part of their operations to comply with European Commission competition regulations.
This was the case, for example, for many national telecommunication companies, such as Spain’s Telefonica, which split up its businesses into different tranches. Nevertheless, a company may voluntarily decide to divest part of its business for strategic, market-related reasons. While voluntary divestiture announcements are typically accompanied by positive movements in the parent company’s stock price, the opposite applies to involuntary divestitures.
From a strategic perspective, companies divest for proactive or corrective reasons. The purpose of proactive divestitures is to restructure the company’s asset portfolio by routinely redesigning, separating, transferring or exiting businesses and operations to adapt to changing market conditions and opportunities.
Corrective divestitures are intended to correct strategic mistakes. They aim to reduce over-diversification, refocus on core businesses, eliminate negative synergies or realign corporate strategy with the company’s identity. For example, Toyoda Automatic Loom Works divested Toyota Motors in 1937 to separate automotive manufacturing from the rest of the corporation in order to maintain a clear corporate identity for market analysts.
These two categories are neither mutually exclusive nor independent of each other. Companies make their strategic and organisational choices taking into account environmental changes, normative limitations and the strategic decisions of other companies. Divestitures may, at the same time, represent an adaptation to regulatory and legal boundaries, a reaction to environmental changes and variations in the sector, and/or a strategy to obtain and retain competitive advantage. Thus, in some cases it is difficult to determine whether an unbundling operation is a corrective or a proactive decision. For example, an involuntary divestiture could also be considered a corrective strategic action, to adjust the corporate strategy to the existing legal constraints.
More than one way to unbundle
The strategic toolkit for unbundling includes various options: sell-offs, spin-offs, carve-outs and buyouts. The divesting mode the parent company chooses, will depend on its objectives. The board of directors initiates an unbundling operation if the performance of the company is declining. Otherwise, the unbundling operation is more likely to be initiated by managers.
When the board of directors decides to divest a unit, it is generally because of pressure from stock market analysts. A company may unbundle a high-value unit, when it wishes to “cash in” some capital but still retain links with the unit. This typically happens when the parent’s performance is declining, its leverage is high and a need for external financing arises. In such a case, the parent tends to sell the unit via a public offering, but remains in possession of a substantial part of the equity of the divested (carved-out) company.
When the parent does not need to raise cash, but wishes to redistribute value to its shareholders, it may prefer to divest a less valuable unit by redistributing its shares to the parent’s shareholders (spin-offs). This is often the choice of companies operating in highly changeable and competitive environments, and companies whose units have great variations in R&D expenditure and intangible assets.
Companies undertake a carve-out or a spin-off if they believe that the market is incorrectly valuing the company in its current organisational form (the so-called hubris hypothesis). With a carve-out or a spin-off, parent companies may release information about the existence of positive net-present-value projects in the unit. They expect outside investors to price the new shares high and, therefore, maximise the total equity value of the company (parent plus divested unit). Cisco’s carve-out of its Andiamo business unit is an example of this. Cisco’s main strategic objective was to develop a new line of products to ensure competitiveness.
A parent company may also sell a unit to another company in exchange for cash (sell-off). This happens when the parent does not want to maintain a relationship with the divested unit. Usually, sell-off units have poor operating performance, high leverage or operate in underperforming sectors. Compared with their parent companies, they are low-value assets and operate in different or non-compatible sectors to the parent company’s core interests. This was the case with General Electric and its Insurance Solutions division. The Insurance Solutions division had few connections with the core business of its parent and had been underperforming for years, so at the end of 2005, GE sold it to Swiss Re.
A divestiture can also be initiated by the unit managers. In such a case, managers, with the support of other investors, replace public stockholding of the parent company. These management buy-outs (MBOs) are normally also financed with large debt issues and the involvement of private equity houses. For the unit managers, an MBO is an interesting option when they believe that they can make the unit perform better as an independent company. A parent company, on the other hand, will only agree to sell the unit to its managers when the price managers are willing to pay is higher than its perceived value to the parent.
To summarise, the choice of an unbundling mode depends on three factors: the characteristics of the business unit (Is it worth selling? Does it perform well? Is it related to the parent’s businesses? Is it related to the other parent industries?); the characteristics of the parent company (performance, leverage, need for cash, diversification); and the wider business environment (rate of growth and performance of the industry).
Given the parent company’s need for external finance, the choice between a sell-off or a carve-out depends on whether the parent has something worthwhile to sell. Carve-out units show a better operating performance than their parents, and compared with spun-off units, they tend to be more profitable and grow faster. Spun-off units are more profitable and grow faster than sell-off divisions.
Spin-offs, carve-outs and MBOs may be used by parent companies to design new incentive systems in the divested unit, to boost entrepreneurial spirit and reduce staff turnover. However, this happens only when the decision makers are able to present the divestiture as an opportunity for the unit managers to lead their own company, grow its business and, at the same time, boost their careers – and their performance-related salaries and bonuses. This is why an MBO provides unit managers with the most powerful incentives, since these managers become the owners of the newly created company.
Divestitures are often resisted within companies, because of the stigma that surrounds them. Both the parent company executives who sponsor and support the unit, and the managers of the unit itself tend to be reluctant to let the unit go. However, it is important that company executives consider unbundling as a strategic option for creating value for both the parent and the unit. Their analysis should include assessing whether to divest some “healthy” businesses. Every shrub needs some pruning occasionally, and divestitures should be considered throughout the lifespan of every company.
Unbundling is particularly beneficial when: there is a culture clash between the core and unit businesses; the unit is consuming too much of the parent company’s resources, such as managerial time or capital; synergies between the parent and the unit are decreasing; or there is internal competition for resources, such as capital. The freed resources and the cash gained from the operation could be reinvested in other parent company businesses.
At the same time, the unit may benefit from its former, and sometimes ongoing, relationship with its parent. The parent may provide the divested unit with capital, resources, expertise, and an initial market and status. As a separate entity, the unit may be better off, attracting new investors or customers from the market that were reluctant to deal with the parent organisation. For example, some units unbundled by high-tech companies, such as telecommunications company Motorola, were able to access customers and providers who were competitors of the unit’s parent, pre-divestiture. This way, parent companies are able to retain a stake in interesting businesses considered high risk, allowing them to test markets and promote innovation, while insulating themselves from the risks associated with full ownership.
The Dutch conglomerate Philips has a strong spin-off policy. It has a specific centre, called the Technology Incubator, which develops new business ideas, identifies the most promising opportunities and assists the unit managers in transforming these ideas into new businesses, allowing them to separate when they achieve profitability. The formation of business structures around promising ideas allows faster take-up by customers and attracts funding from venture capitalists.
The result is that sometimes divested units outperform their parents. This was the case with Toyoda Automatic Loom Works (parent) and Toyota Motors (spin-off). Toyoda Automatic Loom Works initially supported Toyota Motors. But the spun-off division grew larger than its parent and started serving and supporting it.
Who is in charge?
The most frequent instigators of an unbundling operation are: changes in ownership; high levels of ownership concentration (caused by blockholders or institutional investors); and movements in top management. Board members, and specifically executive directors, tend to become involved in the operation only when managerial strategic controls are perceived to be weak and/or where the top management team is heterogeneous.
In all cases, the active participation of unit managers in the divesting process is essential for the success of the divestiture. The unit manager plays numerous vital roles in the divestiture, as information supplier, implementer of secondary decisions, protector of the morale and productivity of the unit’s staff, host of potential purchasers on unit visits, and, finally, a potential buyer. As a result, they are responsible for all aspects of the procedure from due diligence to implementation of the unbundling operation.
In addition, the unit manager’s co-operation and transparent communication has a positive influence on employees’ perceptions of the procedural fairness of the divestiture. This is particularly important when undertaking divisional redesign or staff downsizing. In the case of the latter, employees only see the resulting changes and layoffs as fair where they consider them to be necessary for corporate survival. Once again, the unit manager’s involvement is essential for the success of the divestiture – in influencing staff reaction to redundancy announcements and creating post-divestiture employee loyalty and trust in the organisation.
Nevertheless, external investors may perceive the role of management in unbundling operations in a negative way. This is particularly so in MBOs, where conflict of information and interests often arise. External investors may believe that unit managers are pursuing their own interests and that the divestiture may require specialised information unavailable to such managers. Even in these circumstances, however, unit managers often know more about a company’s investment opportunities than external investors do.
Market reactions and beyond
Normally, when a company announces that it is going to unbundle, its share value jumps. Investors often believe that factors such as less diversification, wealth redistribution between stakeholders and efficiency will ultimately improve share value. However, in some cases, unbundling will have a negative impact on a company’s market performance or no impact at all. This usually happens with involuntary unbundling announcements, which tend to incur negative price movements in the parent company’s shares.
For voluntary divestitures, on the other hand, negative reactions at market level seem to depend on the information conveyed with the unbundling announcement and its credibility. The announcement may lack credibility, for example, if the company has not preceded it with preparatory organisational changes. Similarly, investors and analysts will be sceptical if they believe that the operation will have no impact on the company’s future, or that public knowledge of the divestiture is already reflected in the company’s stock price.
Research on European spin-offs undertaken by the European Commission reveals that companies originating from unbundling enjoy higher growth rates and reduced failure rates than traditional start-ups. This is unsurprising, since corporate spin-offs benefit from greater business experience and better access to development capital and markets than other newly incorporated companies. Unbundled units are also found to be an important source of job creation in Europe.
Unbundling should not only be on the agenda of managers and consultants but also policymakers. At corporate strategy level, we recommend regular evaluations of how different business units add value to the corporation. This will enable managers to decide early if, what, when and how to divest.
We stress that more attention needs to be given to the process of unbundling. Managers must go beyond considerations of immediate effect and evaluate the long-term benefits of such operations for both the divesting parent company and the divested unit. Unbundling may initially have a negative effect on the share price of both companies. However in the long term, this may be outweighed by an improvement to the companies’ strategic positions and economic performance.
On a policymaker level, governments need to recognise the value-creating role of divestitures by providing companies with a supportive regulatory framework, and facilitating benchmarking and the exchange of best practices in unbundling.
Johanna Mair is an assistant professor at IESE Business School in Barcelona. Her research centres on the strategy of companies that operate in multiple lines of business and in the role of managers in formulating and implementing strategy.
Caterina Moschieri is a PhD candidate at IESE Business School. Her research centres on corporate strategy, including unbundling operations, organisational change and innovation.