The urge to merge is ever-present in the corporate breast. The urge to demerge, however, is weaker and less likely to result in action. One major reason for this contrast in attitudes is almost primitive. Even a modest acquisition or merger adds visibly to management's power: by the same token, a demerger, removing a substantial business from the corporation, subtracts from the managerial might.
For all that, demergers are becoming more prominent as merger and acquisition activity, none too soon, levels off after a stupendous boom. According to John Kelly, head of KPMG's M&A integration unit, 'the number of companies considering separation [is] increasing considerably' in 2001. That, what's more, comes on top of a massive increase over the previous two years.
In 2000, says KPMG, over a quarter of British companies in the Footsie 100 engaged in demergers or disposals. Two years before, only four of the 100 companies got involved in demerger/disposal deals of significance (meaning that they were worth at least 5% of the parent's market capitalisation). The urge to demerge can be found in widely disparate sector. BT in telecomms and Kingfisher in stores have long been publicly exploring the possibilities, while the separation of the Accenture consultancy business from accountants Arthur Andersen was one of the largest-ever (and longest) divorces.
That global deal demonstrates that what's happening in Britain is echoed world-wide. On the Continent, for example, Siemens committed itself to selling assets with a stunning $10 billion in turnover. Some assets which look like suitable cases for treatment will be under-performing, some under-valued, some simply bad fits. But demerger is not the only route, and has disadvantages: it might even be thought to reflect poorly on the abilities of the vendors.
Demerger is a special form of the disposal which becomes necessary when management, for whatever reason, doesn't wish to continue with a viable business. The special aspect of demerging (and of the closely related management buy-out or buy-in) is that the disposed entity continues as a business on its own, pursuing its own destiny. That's why the abilities of the demerging management may come into question - because the board implicitly concedes that its management cannot win the best possible results from the subsidiary.
If the latter triumphs after demerger - as Vodafone did after emerging (or demerging) from Racal - odious comparisons are bound to be made: Vodafone soared to a market worth (now £136 billion) many times that of its erstwhile parent. The directors responsible for this spectacular split can congratulate themselves on their former baby's brilliance. But it's only human to feel at least a twinge of envy when former subordinates soar into the corporate stratosphere.
That twinge can be just as painful with buy-outs. In a poignant case. Cadbury Schweppes sold Premier Brands (including Smash, Marvel and Typhoo) to management in 1986, when the bundle had just lost £2.4 million: two years later, profits of £11.2 million had made the management (led by Paul Judge) into multi-millionaires. Their gain was the Cadbury shareholders' loss - and the experience has been echoed by many buyouts since, with the buyout managers soaring past their vendors in wealth and achievement.
The vendors feel differently when they've made direct disposals through a so-called 'trade sale'. That is standard, everyday corporate practice, a constant swapping of businesses as companies rethink their purposes and define and reinforce their 'cores". If the bought business does better, that merely means, you can argue, that it's found a more appropriate home. While the purchaser of your disposed business may be benefiting mightily, you should be doing likewise with your purchases of other people's cast-offs.
It's a two-way trade. Under Jack Welch, for instance, General Electric has bought businesses on the grand scale, ranging from modest units to record-breakers like RCA and Honeywell. But Welch has also been a heavy seller, even dropping the small appliances that had long been GE's standard bearers.The appliance sale was bitterly opposed and resented by old-line managers who regarded appliances as the sacrosanct heart of the corporation.
The disposal, though, followed naturally from Welch's famous strategic insistence that GE businesses which were not first or second in their markets would be revamped or sold. Strategy is central to any intelligent thinking on disposal, whether by sale or de-merger. The intelligent strategist (the adjective doesn't always apply) is juggling the corporate portfolio to serve strategic aims.
Nokia, for a spectacular example, exited from paper, tyres, metals, electronics (including PCs), cables and TV sets. The bold strategy was to concentrate on a single growth market, mobile phones - which duly rewarded the management with phenomenal success. Strategic considerations are crucial in opting for demerger. Will the strategic ends of the business concerned be better served as an independent, quoted entity than as a subsidiary? Then act: demergers unmake strange bedfellows.
The common objective is to add 'shareholder value', today's Holy Grail of management. Any disposal, including trade sale, will substitute cash and/or securities for assets. The special shareholder benefit of demergers depends on the reaction of the stock market. The classic situation is where the subsidiary is in a highly rated sector (highly rated by the market, that is) and the vendor is unfashionable. Demerger then unlocks the hidden value for shareholders who receive some of the demerged equity.
ICI's shareholders, for instance, were not receiving full value from its pharmaceuticals. Spun off as Zeneca, the demerged pharma company promptly showed its parent a clean pair of heels. After merger with Astra of Sweden, the baby is worth twenty times as much as a becalmed ICI. Becalming is one danger. Shorn of its best growth business, what's left can appear to the stock markets (and others) as an uninteresting rump with no great future.
The lower estimation of the original parent is a corollary of well-found management theory. The theory holds that, as a paradoxical rule, corporate management, by virtue of performing its necessary functions of command and control, exerts an unneeded, heavy and often counter-productive influence over its subsidiaries. The corollary is that heavy-handed central managements can get out of proper touch, not only with the businesses they demerge, but with those left behind.
Nokia, note, was left as a highly concentrated business. A well-conceived demerger aims at the same result. The demerged company ideally operates in a single product or services market, in which all its managers are deeply experienced. In the original state, as managers of a subsidiary, they don't control their own funds, their own investment decisions, their own acquisition strategies - all the ingredients of entrepreneurial success. Instead of thinking and acting like entrepreneurs, they are forced to think and act like corpocrats.
Liberation (the word favoured by guru Tom Peters) breaks the corporate chains and frees the managements to exploit their assets with full vigour, making their own mistakes, but also their own breakthroughs. It's hard to believe that Vodafone would have become so mighty a force in telecomms had it stayed inside Racal: or that Zeneca would have blossomed into one of Europe's major pharmaceutical powers under the aegis of ICI.
Neither demerging management is to blame, though. The problem, as the Racal and ICI boards must have recognised, is intrinsic to corporate structures of the traditional kind. Clayton M.Christensen, a professor at MIT, has spelt out the dilemma in an article in the Harvard Business Review, written with Michael Overdorf. As the authors say, acquisition apart, there are only two ways in which 'managers [can] create a new organisational space' to develop a new business:
1. Start up a new division within the existing organisation
2. Start up a new operation, right outside the existing organisation, and give it real autonomy
Both approaches can work. The conditioning factors are the fit with the existing processes and the fit with the existing values. If both fits are good, you can happily keep the business within the organisation. That won't do if the fit with processes is poor - that is, you need to do important things that are strange to the organization as a whole. You can still keep the business inside, but only if the values fit is good: that is, where the operation improves on your existing business for the benefit of your existing customers.
You risk failure, however, if you keep a 'disruptive' business in-house. By definition it has a poor fit with the existing business values and will almost certainly require new processes, too. But if you spin it off organizationally, with a genuinely heavyweight team in charge (which, the authors warn, is almost invariably the only sensible solution), why stop there? Total spin-off from the parent is the obvious next step.
That being so, demerging must be expected, not only to continue, but to expand in the long term - because more and more business opportunities will be disruptive and discontinuous, going well beyond the existing activities. Current examples are arising in e-commerce. Internet retail banks that strike it rich (if any) will present an obvious challenge to their parents. They will cannibalise the existing bricks-and-mortar trade rather than expand it. Kept within the parent bank, the e-bank may have its wings clipped. Demerged, it will be free to compete in whatever way best suits its own interests.
It doesn't follow, however, that demerging automatically improves, let alone maximises, the performance of the demerged unit. The bifurcation of Courtaulds between textiles and its other interests created no miracles. The sharpest warning possible, however, is the experience of Lucent Technologies. Spun off from the AT&T telecomms colossus, Lucent's manufacturing and research business attracted enormous interest. Its market valuation soared, and so did the reputation of its management. But Lucent was actually heading for a disastrous fall.
As Fortune magazine pithily said about Lucent: 'Think twice about what you promise Wall Street. And don't send a stodgy old company to do a start-up's job'. The shares nearly reached $140: they have been trading lately in single figures, with investors having to absorb shocks like the $6.7 billion of credit extended to customers, and a $679 million overstatement of the year's revenues. The very factor that excited investors - Lucent's position as a telecomms supplier - worked against the company as telecomms cooled off.
That cooling-down, of course, has spread across the whole high-tech sector. Short-term, that's bound to moderate the pace of demerging, simply because the stock market prices on offer are no longer so enticing. Vendors may well realise more from a straight trade sale than from demerger. The former, moreover, is usually less complicated. Demerging involves complex issues of taxation, company law, shareholders' rights, etc., and is not to be undertaken lightly - you have to be prepared for spending (le mot juste) a lot of time with lawyers.
Beyond that temporary issue are deeper problems. There's the risk that your demerger is merely setting the stage for somebody's else's acquisition. Premier Foods' glorious life as an independent was cut short by takeover. The same fate has befallen many demerged firms, including the Courtaulds pair. That may be an unhappy outcome for the business, and still more for the staff. More worrying still, does the vendor have a strategy that will justify keeping the rest of its business together?
Boiled down to its essence, demerger stems from the fact that most multi-business companies are worth less than their parts. This doesn't prove mismanagement, only that the stock market habitually discounts conglomerates. Partial or total break-up therefore offers the prospect of releasing value for shareholders, but at the price of destroying the company. It's not an easy choice - which explains why far more companies dicker and dither about demerger than take the plunge.
