By Chetan Shah – Calder Associates Strategic Growth/ M&A Adviser
The much anticipated demerger of Coles from the ASX listed $56 billion market capitalisation Wesfarmers (ASX:WES) gives me a few thoughts on the subject. A tome could be written on why businesses should demerge from a conglomerate or
a holding company with diversified interests, and another one on how they should go about designing and implementing a demerger.
Here is a teaser on the subject. I welcome feedback from professionals and businesses interested in the subject.
There are Three Key Reasons for Demerger:
Efficient and Independent Management: A conglomerate or holding company structure often degenerates in to a super-boss led management structure who dictates their will upon various business CEOs. In a situation such as this, the various business CEOs depend on the holding company CEO and CFO for their strategic growth, investment outlay, important initiatives and even their job and bonuses. If these CEOs were to become true leaders, they would better report to a Board of Directors and be accountable to a broad range of shareholders as a result of demerger, which will bring in professionalism and better prospects for the individual demerged businesses. No wonder investors prefer board managed single sector businesses rather than conglomerates.
Shareholder Value: A conglomerate is valued for a mix of businesses, which many a time is a strange mix of retail, resources, financial investments and so on. The way institutional investors and even sophisticated individual investors like to allocate funds is dictated by the exposure they wish to take to chosen sectors through different individual companies. A conglomerate confuses investment planning for most investors and it ends up as a defensive investment such that when resources are down, perhaps retail is up and so on. More often than not companies with specific focus, such as retail for example, are valued most efficiently compared to a conglomerate which owns, for example, retail as well as real estate businesses. A business specific fund raising or listing program could lead to such demerger.
Regulatory Diktat: A third reason for a demerger could be regulatory changes that now require a business hitherto run as a business division to be independently owned, supervised and managed. This is more likely in financial services sector that is prone to business conflicts and compromising client interests.
Key Considerations in Structuring and Executing a Demerger:
Project Team Constitution: Most Boards delegate planning and execution of demergers to a team constituting the CFO, investment bankers, accountants and lawyers. It will be a good idea to involve the head of HR and other functional heads depending on how intertwined the demerging business’ people, processes and resources are with the HQ and other businesses.
Clear Understanding of Objectives: The constituents of the demerger team must be on the same page from day one in terms of the essential goals of demerger defined by the Board and the CEO. It is rarely done but I would recommend documenting these goals in 2 or 3 bullet points, so that when the team constituents come with their suggested structures, implementation challenges and suggested solutions, the project manager (usually the CFO assisted by a dedicated demerger project manager) does not end up approving things that compromise these goals. It may be a good idea to share these bullet points with bankers, lawyers, accountants and other external advisers, though it is unlikely they will show much interest!
Vertical Split of the Business: Often a demerger is like splitting a living organism in two. The part being separated is to be kept throbbing through the entire process. Financials are at the heart of a demerger but they constitute less than 100% of the complex set of nerves that keep the business connected to the mother company. The to-be-demerged business would be sharing one or more of real estate, infrastructure, people, processes, services, IT, suppliers (and so on), apart from sources of funds with other businesses still living in the mother company. Separation of the business does not necessarily mean termination of these ongoing relationships; it simply means every shared resource needs to be priced at fair market rates until the newly independent business has a reason to create its own independent business model. So the proposed vertical split needs to be documented in two ways – (1) preparation of proforma financial statements for the separating business, and (2) documentation of non-financial, qualitative aspects of separation relating to HR, IT, marketing, business development and every other element that can be nominated by various functional heads.
Choice of Legal Structure: A business separation can be achieved in two ways: (1) creation of a new company (newco) to house the separating business, such that the newco has the same shareholding as the mother company, which is classically known as demerger; or (2) creation of a new company to house the separating business, such that the newco is owned 100% or majority by the mother company, which is usually referred to as spinning off a business. The former structure suits the intent of an imminent IPO and public listing of the separating business, while the latter accommodates sale of an equity stake in the business to a private equity investor or even a strategic investor, who are not keen on an immediate IPO or listing of the business. In most jurisdictions globally, a classical demerger requires not only a shareholder approval but also some sort of Court or company law regulatory approval, while the spin off may be achieved quicker with shareholder approval without regulatory intervention.
Stakeholder Dialogue: A seasoned CEO and the Board of Directors are unlikely to decide on the move to demerge a business based on the two or three top investment banking teams making convincing presentations to them. Bankers are most likely to focus on enhancing shareholder value and raising capital through demerger, however it for the CEO and the Board to evaluate the potential acceptance of demerger by key stakeholders such as lenders, employees/unions, those regulators who have a say, minority shareholders and sometimes suppliers and customers. Before taking the demerger proposal to shareholders, it would help to spend days or even weeks ‘selling the story’ informally to stakeholders and taking on board their concerns and suggestions. I would include developing a n effective communication/PR strategy for demerger under this head.
Execution and Project Management: Once all the bullets are ticked, it is time to pull the trigger by proposing a Board resolution leading to shareholder approval for the demerger. At this stage every constituent of the project team described above will work methodically to put together the demerger – assemble this complex piece of equipment. Despite every preparation, not everything will go as expected. This is where the collective wisdom and ingenuity of management team and external advisors will be put to test.
Transition: It will be a great idea to create a transition team of key managers who devised and implemented the demerger and the members of the newco management team to oversee the functioning of the newco for 6-12 months. Unfortunately this rarely gets done effectively due to change in power structures and personal equations among business leaders. After all a demerger is not a clock work, it is a process dominated by business rationale, economic ambition and human emotions!