At the end of 2001, British
Telecom has created mmo2 by spinning its wireless telephony business off from
its incumbent activities. A few months earlier, Eridania Béghin-Say split
into four companies: Provimi (animal nutrition), Béghin-Say (sugar),
Cerestar (starch) and Cereol (oil). Schneider had thought of spinning off Legrand
to meet Brussels' demands before it disposed of Legrand to financial investors.
Since the early 1960s, diversification has been criticised by financial theory, which has demonstrated that it does not create value, it only reduces a risk, the specific risk, which cannot be remunerated. Today's universally accepted valuation model, the CAPM, is based mainly on the assumption that investors assign no value to diversification that they themselves can obtain, without cost, in their own portfolios.
Not only is no value assigned to diversification, some diversified groups even trade at a discount to their sum of the parts value. There is even a name for this: the conglomerate discount. It is due:
- To the central costs of running the conglomerate,
- To misallocation or perceived misallocation of resources to divisions that are insufficiently profitable over a long stretch of time but are propped up by better-performing divisions, which are thus penalised in their development,
- To the market's difficulty in understanding the group, a difficulty that is heightened by the fact that almost all analysts are specialised by sector and by the increasing number of listed companies, which increases the possible investment choices and makes investors prefer what is simple and clear.
So it is easy to see why companies are increasingly trying to focus on one line of business. They generally do this by selling off businesses that are not part of its core activities. In some cases, the disposal is not desired or possible, in which case groups use a transaction that is simple in principle, but complex in practice - the demerger.
Why and how
A demerger consists in requiring shareholders, or offering them the opportunity, to become direct shareholders of one of its businesses, without having to invest cash. There are two types of transactions, depending on whether it is imposed on shareholders or whether they are given the choice:
When to demerge?
Once a controlling shareholder has seen that the grouping of various businesses within a single group destroys more value than it creates, a controlling shareholder that does not want to change its activity portfolio has no other choice than to enact a demerger. This can also be done when a disposal is almost impossible (if there are no buyers, for example). A demerger can also be the prelude to a break-up, as was done in France, in the case of Eridania Béghin-Say.
A demerger is a complex transaction from a legal and
tax point of view, requiring all assets and liabilities to be allocated to one
business or another. Shared assets and liabilities are generally allocated on
the basis of headcount, shareholders' equity and debt-payment capacity. Once
the assets and liabilities have been identified, they have to be allocated to
the companies that will become the receptacles of the demerged businesses.
This allocation is done on the basis of real value, which potentially raises a problem of capital gains tax. Naturally, this type of transaction requires shareholder approval at an extraordinary general meeting.
As in a share-exchange deal, individual shareholders are usually able to defer capital gains tax.
Because they are so complex and take so long to implement, demergers are rare. Some examples include the demerger of Chargeurs into Chargeurs International (textiles) and Pathé (cinema); Hillsdown Holdings Plc and Terranova Plc; Burton Group Plc and Debenhams; Novartis AG and Ciba Specialty Chemicals Inc; Volvo AB/Swedish Match BV; the split-offs of IXO/Infosources, General Motors/Delphi; Dupont/Conoco; Ford/Associated First Capital; AT&T/Lucent, and others.
Demergers are not panaceas: if one of the demerged
businesses is too small, it will trade at a significant liquidity discount.
Moreover, not all conglomerates are financial failures. Look at General Electric
and Bouygues, for example. In a way, a demerger is the triumph of sloth (on
the part of the investor or the analyst who does not want to make the effort
to understand a complex group) and selfishness (on the part of managers who
no longer want to help finance businesses that are doing less well). But it
is also the triumph of modern financial theory, which questions the practice
grouping businesses together if that does not increase total value.