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Carve-outs – Active portfolio management through the demerger of a business division

Part I – Divestitures in turbulent markets

Carve-out transactions play an increasingly important role in the context of successful structuring of M&A activities, for example, as a preparatory step for spin-offs. Furthermore, demergers of groups also act, among other things, as a major driver for IPOs at the stock exchange. The first part in our series of articles begins by examining the current developments in the M&A market and then discusses the funda-mental economic rationale for carve-outs. A closer analysis of the spin-off and equity carve-out forms of demergers as well as a detailed look at the key success factors for business divestitures in volatile market conditions will then follow in another article.

On the economics of divestitures

The maximisation of shareholder value is largely used as a dominant objective in finance and capital market theories. In (German-speaking) practice, too, for many years now there has been a considerable shift towards aligning with investor interest when making business decisions. In terms of the active management or streamlining of a portfolio, this frequently manifests itself specifically in a functional as well as a legal demerger of a (not necessarily) loss-making business division.

A development can be observed here that draws on the economic rationale of the sum-of-the-parts theory. According to this, ‘activist investors’ attempt to realign diversified industrial conglomerates through restructuring; in such cases, the intention is to realise the ‘break-up value’ as well as to reduce or eliminate the ‘conglomerate discount’. In this connection, the break-up value is understood to be the value creation contributions that would be released through divestitures. The conglomerate discount can be calculated by comparing the company’s market capitalisation with the so-called intrinsic (true) value of the business divisions and it can be eliminated by means of the break-up value. 

The intrinsic value of an enterprise or an asset is derived from its ability to generate cash flows (in the future). In this case, the value of an enterprise is determined on the basis of 

  • an analysis of its fundamentals, 
  • the absolute levels and growth of cash flows as well as 
  • the risk that has to be taken in order to achieve these. 

This is compared with the current market capitalisation, which is defined as the value of all the shares. Here, the stock quote or the share price is generally derived from supply and demand and will thus always depend on the prevailing market sentiment, As a general rule, a – not uncommonly considerable – difference will arise here between the market capitalisation and the intrinsic value of the enterprise.

‘Activist investors’ are investors who initiate transformation processes by challenging the strategic orientation of the respective company; frequently, this is also contrary to the stated intent of the current management. Here, companies that exhibit a value gap – which arises from the difference between the market capitalisation and the intrinsic value – will be classified as being undervalued. 

Achieving objectives through carve-outs 

The primary objectives of a divestiture worth mentioning are: 

  • to focus on the core business, or 
  • to strategically (re-)orient the business portfolio because of changes in the market of the selling company, or 
  • to raise funds in the short term.

Increasing shareholder value – which we mentioned at the beginning – is an aim that is common to all these motives. To this end, a carve-out and a subsequent divestiture could be a sensible course of action if, for example, a business division does not generate the return on capital employed required by the owners or the executive board.

Practical example – One of the biggest M&A transactions in recent years was the carve-out and subsequent sale of the elevator division of Thyssen-Krupp AG to a private equity consortium. 

Such transactions show that individual business divisions are more valuable by themselves, or are more highly rated than can be inferred from an overall perspective; this also means in particular that, in such cases, because of rating aspects the sum of the parts or of the business divisions is usually greater than the value of the overall group. 

Conclusion and Outlook: In a tense economic climate, pursuing divestitures makes it possible not only to generate liquid funds but also to bring about a strategic reorientation of corporate structures. In business practice, carve-outs provide an instrument that is particularly suited to revitalise business divisions in different environments. In a following article, we will take a detailed look at the key success factors for the practical implementation of the particularly relevant forms of demergers, namely, spin-offs and equity carve-outs.

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