Split decision

A demerger may seem an adroit tactical play to liberate value and spin off problem entities to shareholders more attuned to their needs, but leading directors warn it can be a rocky road to achieve the right governance.

Company directors and management generally aim to grow their enterprise, but there are times when the best option is to shrink it by demerging parts of the business. While demergers can create significant value for investors, they also come with risks and directors need to be sure of the strategic logic before they decide to make the split.

In order to fulfil their responsibility to maximise shareholder value, boards should be constantly assessing the company’s assets to ensure they are the best owners of the business, says non-executive director of Woolworths Group Holly Kramer MAICD.

There are several reasons for a demerger. They allow management to pursue growth and efficiency measures in a much more focused way than they could as part of a parent company. The demerged entity can often get access to growth capital that it couldn’t previously.

These were factors in Woolworths’ demerger of its Endeavour Group drinks and poker machines business last year. “Investing in that business wasn’t the highest strategic priority for Woolworths, so it was a matter of potentially helping that business find its own access to growth capital,” says Kramer.

The demerger also provided more shareholder optionality, particularly to index funds, which were happy to own a supermarket, but less keen on gaming assets. “It now benefits from having a dedicated board and management team who are focused and experienced,” says Kramer, who is also a director of Endeavour Group, Fonterra and Abacus Property.

As of the end of May, the Woolworths share price was around the same point it was at the demerger a year ago — but the Endeavour share price was up about 20 per cent.

Another option for separating a business is divestment — selling the business to another trade player. This has the potential of delivering better value as trade players are usually willing to pay a premium. Importantly, a demerger is distinct from a divestment. It is an exit to a separately listed business under the same shareholders. The board might settle on this option to give shareholders access to any upside resulting from the process.

One consideration for a demerger over divestment is if it’s likely to be a challenging separation of shared IT systems and supply chains. This was a factor for Woolworths in not wanting to create dis-synergies and it was able to form a strategic partnership with Endeavour to manage these issues. Even so, Kramer says Woolworths took the approach adopted by many parent entities, by running a dual-track process and pursuing a demerger and sale at the same time in case it was offered an “insane price”.

Profitable procedure

Divested entities are often re-rated by the share market with a higher earnings multiple than they were assigned under the umbrella of the parent group. “You’d have different investor groups that might appreciate the value of it more and would rate at a higher multiple,” says Michael Sum, a strategy partner at KPMG.

For instance, Tabcorp’s recently demerged Lotteries and Keno business had predictable recurring revenue like an infrastructure owner, so would appeal to investors such as pension funds. Prior to the demerger, Tabcorp had a market capitalisation of approximately $11.9b and in the days after, Tabcorp and its demerged The Lottery Corporation had a combined market capitalisation of close to $13b.

Research shows this isn’t a one-off. A Goldman Sachs study of 24 ASX 100 demergers in Australia over the past quarter of a century shows significant value creation, particularly for the spun-off entity. In the year after the demerger, about 60 per cent of parent companies outperformed the wider stock market by an average of 3.8 per cent, the 2017 study showed. Spin-offs fared better, with 80 per cent outperforming the market by an average of 18.5 per cent.

One reason is that after breaking up a conglomerate into more focused operations, both parent and spin-off are more likely to become takeover targets. Over half of the companies in the Goldman Sachs study received takeover offers in the years after the demerger. Paint company DuluxGroup, for instance, was taken over by Japanese giant Nippon Paint at a 38 per cent share price premium in 2019, after it was spun out of chemicals company Orica in 2010.

There are no specific legal considerations for company directors contemplating and implementing a demerger, says Rod Halstead, a director in law firm Clayton Utz’s M&A group. However, as with all decisions a board makes, they have to abide by the directors’ duties that they exercise their powers with the appropriate degree of care and skill, and to act in the best interests of the shareholders. In the context of a demerger, this means fully understanding the underlying thesis for a demerger.

“Why is it that this demerger and separating this business from the remaining businesses of the company is going to be in the interest of shareholders and in the interest of that business?” asks Halstead. “The directors of the existing company have a responsibility to ensure that the demerged entity is in the best interests of both businesses and the shareholders of both businesses.”

They need to be fully satisfied with financial modelling for the demerged business and the continuing business of the other, including the level of debt that is going to be left with the parent or passed to the demerged company. They also need to draw on their understanding of the underlying demerger thesis to assess the financial modelling and earnings forecasts. This is all the more important when taking into account the huge expense of a demerger, comprising transaction costs and the cost of separating one operation into two.

Understand the outcome

On day one of the demerger, both companies will have identical share registers, but they will move apart over time, so directors need to understand the profile of the shareholder base. Some investors will only be interested in holding the parent company. “If you leave them with a secondary business, are they immediately going to sell those assets and quit?” asks Halstead. “Will that put pressure on the share price and therefore pressure on the commercial basis for what you’re seeking to achieve?”

Lianne Buck GAICD, a non-executive director of Victorian electricity and gas distributor AusNet Services, says directors need a very clear understanding of parent and demerged entities — which parts will be core and which divested. They need to benchmark both potential businesses relative to peers in the same sectors to be sure that “one plus one equals more than two”.

It’s important that as the demerger process gets underway, the board is very specific about creating management and government structures and accountabilities that align with the strategy for the demerged entity as opposed to the overall group. “It’s not just breaking up what you already have and sending the bits in different places,” she says. “It’s really being very, very clear on the reasons for the demerger and what the strategic benefits are, and then building the organisation and its management around that and what you want to achieve.”

This might, for instance, involve bringing in external management. Along with new management, boards also need to select a new board for the demerged entity, which can often include directors from the parent, particularly if it retains a shareholding. Demergers generally require a 75 per cent vote from shareholders, usually based on the scheme booklet — like a prospectus, but for a demerger. Engaging with the company’s investors early in the process is crucial. Buck says board and management should engage with the market and seek feedback on what the board sees as the values of the different businesses as it goes through the demerger process.

In Australia, shareholders tend to follow the recommendations of the board, but not always, — as shown by the collapse of power company AGL’s plan to demerge its coal assets in late May under pressure from major shareholder Mike Cannon-Brookes.

Risk factors

Boards and management also need to consider the risk of losing customers and employees as they go through the demerger process. Key customers might prefer to deal with larger suppliers and decide not to maintain a relationship with the smaller entity. Likewise, staff such as the CFO might enjoy the kudos of working for a large entity and not want to remain with a smaller one.         

In fact, demergers come with significant operational risk, because two businesses are to become independent where previously they were highly dependent, with shared offices, systems and back-office function.

“That operational effort is hugely under- appreciated and the costs and the timing of that need to be planned extremely thoroughly before announcing the demerger and any form of timeline,” says KPMG’s Sum.

IT can be particularly difficult to untangle, with a business using several hundred systems and applications, which will need to be allocated to one company or another, or duplicated. And the process has a hard stop date, by when the entities need to be separate, so directors need to ensure management is sticking to the demerger timetable, says Sum.

All of this can be hugely distracting for management and the board, particularly as the process can run for as long as 18 months. “One risk is obviously that both companies lose focus during the process, which can sometimes be protracted,” says Kramer. “And you don’t want either the parent company or the demerged entity to lose focus on running the businesses.”

Reputation is another specific risk for directors, she says. “You have a responsibility to set it up so that it is as successful as it can be. Because for a while, you will certainly be judged on the performance of both companies.”