What Are the Reasons Divestiture Occurs?

What Are the Reasons Divestitures Occur?

In finance, divestment or divestiture is defined as disposing of an asset through sale, exchange, or closure. A divestiture is an important means of creating value for companies in the mergers, acquisitions, and the consolidation process. For example, a merger might create redundant operations and businesses. Through divestiture, the company can improve operational efficiency and reduce costs. However, there are many reasons why companies engage in divestitures, and not all of them have a positive impact on the company.

Key Takeaways

• In finance, divestiture is the process of disposing of an asset through a sale, exchange, or closure.
• A divestiture is an important means of creating value for companies in the mergers, acquisitions, and the consolidation process.
• Through divestiture, a company can eliminate redundancies, improve operational efficiency, and reduce costs.
• Reasons why companies divest part of their business include bankruptcy, restructuring, to raise cash, or reduce debt.

Understanding the Reasons for Divestitures

Companies that divest a portion of their business might do so by selling a subsidiary or a separate business that operates under the parent company. Divestitures are common with large publicly-traded corporations since they typically have more business units and are more likely to engage in acquisitions of companies outside their industry. Acquisitions involve the purchase of a company or a specific business unit.

Although there are numerous reasons why companies divest assets or part of their company, below are some of the more common scenarios in which companies engage in divestitures.

Bankruptcy

Companies often undergo bankruptcy due to their operating and financial problems, and divestiture is almost always part of this process. The divestiture can help the company reduce costs, improve cash flow, and emerge from bankruptcy as a healthier company. For example, General Motors filed for bankruptcy in 2009 and closed at least 11 unwanted factories. It divested some of its unprofitable brands, such as Saturn and Hummer, as part of its reorganization plan.

Raise Cash

Another common reason for divestiture is to raise cash. This is especially important for companies experiencing operating and financial difficulties. For example, Sears Holdings, a consumer retail company, struggled with declining sales and negative cash flows. In 2014, as part of its survival plan, the company announced a divestiture of its real estate holdings to raise funds to continue reorganizing its retail business. However, Sears, which also owns Kmart, has struggled since emerging from bankruptcy in 2019 even after closing hundreds of its stores and using the cash from its divestitures to pay down some of its debt.

Non-Core Businesses

Companies may divest businesses that are not part of their core operations so that they can focus on their primary lines of business. In 1989 Union Carbide, a well-known manufacturer of industrial chemicals and plastics decided to spin off its non-core consumer group business so it could focus more on its core business matters.

In 2020, WeWork Corporation, which provides office sharing spaces for rental, faced financial struggles. As a result, the management team announced divestitures of its non-core businesses, including its content marketing and software businesses.

Earnings

Companies often divest to improve their bottom-line stability. Earnings are synonymous with net income or profit. In 2006 Philips, a Dutch diversified technology company decided to divest its chip subsidiary, NXP Semiconductors. The primary reason for selling NXP was a high volatility and unpredictability of earnings for the chip business, which was hurting Philips’ stock value.

Strengthen the Balance Sheet

When the executive management of a company states that they’re taking measures to strengthen the company’s balance sheet, it typically means that they want to pay down debt.

For example, in 2020, General Electric Corporation (GE) announced the completion of the divesture of its BioPharma division in which GE received approximately $20 billion in cash. According to the press release, the GE chair and CEO H. Lawrence Culp Jr. stated that the sale helped to “de-risk our balance sheet and continue to solidify our financial position.”

Unlock Value

A firm often breaks up into two or more companies to unlock value believed to be greater for separate entities than that of a consolidated company. This is especially important during liquidation. For example, investors are willing to pay much more for different parts of the company separately, such as real estate, equipment, trademarks, patents and other parts, than to buy one single company.

Underperformance

Companies often divest parts of their business that are not performing up to their expectations. These divestitures can involve eliminating subsidiaries or divisions that are underperforming.

A notable example of such a divestiture was done by Target, a large consumer retailer. Target’s stores in Canada did not perform well due to Canadian customers’ lackluster demand. In 2015, Target decided to exit its Canadian line of business by shutting down its stores or selling them to interested parties.

Regulations

Divestitures sometimes happen for regulatory reasons such as antitrust concerns by regulators. A prominent example of divestiture required by the regulatory authorities involved Bell Systems in 1982. Due to Bell’s monopoly position in the telecommunication industry, the U.S. government ordered the company’s breakup, creating many smaller companies, including AT&T.

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