A spin-off, or divestment, is a classic example of the shortcomings of finance theory in the real world. Two parties come together to trade a unit of a company. How to value it? There are models (and models). They mainly come down to cash flows, and cash flows are projections based on assumptions. But there are some problems which make the assumptions, and negotiations, very unstable. The key problem is "information assymetry".
The party selling the unit knows a lot more about the operation than due diligence will ever reveal (for example, the selling party knows informally about the intentions of major customers, and how competing technologies that remain in ownership of the seller will impact the spun-off entity). The buying party has their own ideas, perhaps they plan to use the acquisition to fill out a portfolio and therefore compete effectively for some customers of the seller.
Then there is the related problem, which Tim Hartford in his enjoyable book "The Undercover Economist" calls the "lemon problem". Imagine a second-hand car for sale. Some cars are lemons; they are just cursed with an endless stream of problems. My aunt told me about a cursed Volvo. The last straw was the steering lock engaging while negotiating a round-about, but the most uncomfortable problem was the convertible roof not closing just as a Brisbane sub-tropical rainstorm arrived. A factory manager in Germany I know had some terrifying problems with a Mercedes that would lose all electric systems on the Autobahn (no lights, no on-board engine computer so no engine and no power-assisted breaks). After this happened the third time, he swore to never to buy a Mercedes again. (He bought a Volvo).
You don't know if the car you are buying is a lemon. But you should be suspicious ... after all, why would someone sell a decent car? And now the seller of a genuinely good car has a problem: if buyers are convinced that all the cars for sale are lemons, how will he get a good price? Hartford suggests that the way around this is a conditional sale: let the seller confident of the quality of his car offer a warranty or something similar.
Management of the seller won't be keen on this solution when divesting because accounting rules will may enforce the continued consolidation of the sold unit if there is still a good share of risk to the seller. A M&A deal should be a clean deal with a hard date of transfer. Apart from improving management focus on the remaining part of the business, divestments need a clean execution for all kinds of reasons, such as for employees who really need to be commit to their new situation on whatever side of the fence they landed.
So there is no easy solution to the two problems, except for trust and mutual confidence. M&A deals need trust like hot-air balloons need hot-air. It shouldn't be a problem if the deal is genuinely structured as a win/win. After all, employees need to be convinced that the deal makes sense for them. Why? Because they will jump ship or fight to stay with the parent company if they don't like the deal. Of course, if the spin-off sounds too good, the parent company risks losing its best people. Once I was involved in a deal where there the entity being spun-off was part of a site that didn't have a very attractive future with the parent, so the site's management team was very keen to be part of the spin-off, then some dramatic market developments happened, and it seemed more interesting to stay with the parent, but then the dramatic market developments didn't seem so dramatic after all ...
If trust breaks down, it seems to break very quickly. Engineers call this "catastrophic failure": when a house of cards breaks, it usually doesn't break just a little bit. Once one or two assumptions come into question, it's amazing how questionable all the assumptions become.
How to avoid this? I think personal dynamics is really important. A genuine spirit of openess helps, and giving the buyer good access to operational staff is useful, or at least good access to the management team.
Deals where the parties have a track record with each other are much more likely to succeed.
The seller should have really act in good faith at all times (and so should the buyer). A mental experiment is to imagine giving the rationale for the deal at a town-hall meeting of the employees (which will have to happen at some point). I really believe the story they hear should be the story underpinning the deal, although for confidentiality reasons they won't hear if for some time. That's a timing difference, but it shouldn't be a factual difference.
Both sides should be aware that catastrophic failure due to a breakdown of trust is always close. The deal should be the house built on rock, not the house built on sand.| Next > |
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