Jeffrey R. Greene and Jeff Wray
In October 2017, Honeywell announced not one but two divestments representing close to US$7.5 billion in revenues. It planned to execute each via a tax-free spin-off and receive total dividends of US$3 billion at closing. For most companies, a single carve-out would be a major undertaking. For Honeywell, these were just two more transactions in a 15-year journey of prolific portfolio reshaping that included close to 100 acquisitions interspersed with 70 divestments.
The most recent moves resulted from a comprehensive portfolio review process that the new CEO, Darius Adamczyk, described as “objective and fact-based, involving extensive analysis and input from industry experts and participants as well as from our shareowners. The foundation of the announcement was a set of criteria … against which each business was measured.”1 Responding to an analyst’s question about future investments, he went on to say, “So the punchline for me is, we’re going to be very active in the M&A arena. In terms of prioritization, I think now, given these two spins and given … the optimized capital structure, I’m very excited about investing in any of the four [remaining business] platforms.”
Even Daniel Loeb, the prominent shareholder activist who had been agitating for a different path, said through a spokeswoman that he was pleased the board and management chose to conduct a thorough portfolio review and agreed that Honeywell should narrow its business focus. He added that he was confident Adamczyk’s “commitment to continuous portfolio optimization will further improve shareholder value.”2
The Honeywell story demonstrates how applying the capital allocation practices we advocated in Chapter 3 drives shareholder value through proactive portfolio management. That’s also the clear message we hear from business leaders, investors, and academics, and what we observe in the capital markets. In today’s highly uncertain environment, companies cannot afford to be without a well-executed process for deciding which businesses to buy and sell, and when—the essence of portfolio management.
Amid this volatility, CEOs and CFOs should take the offensive in articulating why each business belongs in the portfolio, and lay out clear performance metrics so investors and lenders have sufficient visibility into strategy and operations. When investors understand current and projected ROIC for each business, and see credible plans to improve it, they will be much more willing to support you even when short-term performance lags.
Great uncertainty also puts a premium on a company’s ability to react quickly both to unexpected opportunities—acquiring a suddenly weakened competitor, for instance—and to threats such as loss of profitably due to exchange rate shifts. Rigorous portfolio decision making helps maintain sufficient financial capacity by efficiently pruning noncore and chronically underperforming businesses.
Portfolio management is about strategy, planning, and processes. To assess the strengths and weaknesses in your current approach, consider the following questions:
For many companies, extensive portfolio management tends to be undertaken in reaction to cash needs or market developments. Yet we know that there is now a whole group of external players—analysts, private equity, hedge funds, institutional investors, and the press—who are doing portfolio reviews on your company, whether you want them to or not. We discuss activist shareholders in detail in Chapter 13.
We’ve observed corporate acquisition skills improving steadily over the past decade, but divestment practices have been slower to evolve. Even companies that execute divestments well tell us they rarely sell the right business at the right time. One corporate development officer we know commented that “some businesses are like ice cubes—the longer you hold them the less they’re worth.” Both PE and strategic acquirers, of course, expect bargains when buying from sellers who just want to get rid of an underperforming business that has become a distraction to management, a sore point with the board, or a target for negative analyst commentary.
Systematic portfolio management also identifies potential acquisition and alliance needs proactively. Companies with a solid understanding of the gaps in their business portfolio—and sufficient financial capacity—are better able to react quickly when buying opportunities arise. A complementary leading practice: developing a watch list of desirable acquisition targets and building relationships that bring early indications of when they may become available.
Michael Porter has commented on the benefits of anticipating favorable industry evolution: “[C]reative strategists may be able to spot an industry with a good future before this good future is reflected in the price of acquisition candidates.”3 Applying this observation to divestments, we suggest that forward-thinking management teams should try to anticipate unfavorable industry developments before they are reflected in the value of existing portfolio businesses.
The value creation methods of PE firms have long been held out to public companies as a role model for generating above-market returns. Their approach includes a single-minded focus on cash flow and financial metrics, along with a willingness to sell at any time for the right price. Corporate managers should have the mindset of “flexible ownership” for their businesses—a hybrid approach between PE’s “buy-to-sell” model and the traditional “buy-to-keep” model of public companies.4 Three skills are critical to successfully implementing the flexible ownership strategy:
Shareholders benefit most when companies take a proactive approach and systematically evaluate the hold/fix/sell question for each of their businesses.
Turning portfolio management into a core competency requires a corporate commitment to align incentives, structure, processes, and tools. Getting all of this right helps lead to well-timed divestments, stronger balance sheets, and increased readiness for opportunistic acquisitions—all very big pluses in the current economy.
Though most portfolio management focuses on global business units, there are other useful ways to segment the enterprise. Businesses also can be examined by region. Technology and life sciences firms also consider product lines, platforms, and alliances when evaluating their portfolios. Consumer companies tend to look at a combination of geography and business unit. For example, Nestlé has stayed committed to its confectionery business globally but has decided to divest it in the United States because of the brand footprint and competitive landscape.
PE funds always have in mind current valuations for their portfolio companies, but rarely do corporations objectively value each business. Doing so regularly is a best practice. It forces each unit’s leaders to be explicit about how they plan to deliver shareholder value over time, and to develop a point of view on scenarios for how their industry may evolve, particularly given the current economic outlook.
Having up-to-date threshold values allows management to quickly respond to unsolicited acquisition interest in all or part of the company. Without a current valuation in hand, hostile bidders can have a head start in persuading investors that their offer is superior to the status quo.
Employing a common valuation model across the company also helps promote a shared view of value creation. In world-class corporate development groups, standard valuation models are utilized in acquisition processes, but often these models aren’t applied to portfolio management. As debt and equity capital costs change, companies should rethink the discount rate assumptions embedded in their DCF calculations, which makes the need for institutionalized valuation methods and processes all the more pressing. We explored these challenges in Chapter 2.
As part of preparing stand-alone valuations, managers should be especially careful to quantify shared costs and benefits among business units and with the parent. Any potential divestment analysis should anticipate negative synergies—such as lower volumes under corporate purchasing agreements—and include a remediation plan for stranded costs.
As we’ve discussed, leading portfolio managers regularly assess the gaps in their business and scan the market for acquisition candidates that could fill those gaps. Conversely, a business that fits well strategically and generates healthy returns may be a divestment candidate if someone else is willing to pay more than it’s worth to the current owner. It may be one of the few players in an industry segment that has suddenly become very desirable to potential acquirers willing to pay an above-market premium for access. Managers should be on the lookout for buyers that have unique synergies. Keeping track of market valuations for similar public businesses provides a benchmark for your portfolio companies.
The strategy group also needs to be alert to pending industry developments—new entrants, regulatory changes, demographic shifts, and technological breakthroughs—that could put a business unit at a disadvantage. Early warnings allow management to proactively decide whether divesting is the best response.
The best analytical tools and high-quality information won’t yield the right portfolio moves if decision making is flawed. In designing the process, senior management should allocate clear roles and responsibilities to business units and corporate staff. Some companies reserve for corporate staff any divestment decisions, with the business units submitting detailed plans for addressing underperforming businesses.
Another design concern is whether and where to build dedicated resources. In order for portfolio management to be a core competency, some people may need to work on it full-time. This is analogous to the corporate development function embodying the company’s core institutional knowledge on M&A execution.
In the absence of a compelling explanation for how all your businesses fit within the same enterprise and where the corporate parent adds value, the whole will be worth less than the sum of its parts to investors. See Chapter 2. This conglomerate discount is well documented in academic literature. Though there are perfectly good reasons for conglomerates to exist, they are frequently overwhelmed by the costs of maintaining a multibusiness firm.
Thinking through your “conglomerate rationale” requires an honest appraisal of why sometimes disparate businesses belong together, and a readiness to act if pieces no longer fit. Are there operational synergies such as shared plants, technologies, and distribution channels? Does the corporate parent possess unique skills such as personnel development, capital allocation, or performance management that can be leveraged across its portfolio? In emerging economies, conglomerates can sometimes provide access to capital and talent that may be more efficient and effective than relying on external markets locally.
However, there is sufficient empirical and anecdotal evidence to make investors skeptical of a conglomerate premium in most situations. For example, individual businesses often need their own capital structure, tax planning, and shareholder base. Where a business is in its life cycle—start-up, growth, maturity, decline—dictates the kinds of management skills needed. Rarely is the same corporate team able to add optimal value at each stage for each business.
The value-creating effects of divestments, including spin-offs, have been confirmed by numerous academic studies, and increasingly reflected in activists’ critiques in recent years:5
The more focused a business, the easier it is to align compensation with shareholder value. And in public companies those managers get clearer feedback from the capital markets—an outside-in approach to performance management.
“I love stranded costs.” That’s the way a Fortune 200 CFO put it when implementing a recent divestment. What he meant was that the carve-out transaction highlighted cost-cutting potential in the parent company. A process that strives for accurate cost allocations across a corporate portfolio will naturally challenge the need for certain expenditures and activities.
A well-run carve-out routinely uncovers substantial cost reduction opportunities in the business being divested. In one situation, the annual benefit amounted to more than 25% of the business’s reported EBITDA. Management was able to implement some cuts and sufficiently document the others so the final sales price reflected their value to the buyer.
Given such outcomes, should CFOs simulate a carve-out of each business unit as a way to surface possible cost rationalization opportunities? Certainly once a systematic portfolio management process is in place, very little incremental effort would be required to do so. In some cases, however, information systems would need to be revamped to provide adequately detailed cost data. One indication this idea is catching on: the growing number of companies reorganizing so they can report detailed business unit results and provide more transparency to investors.
Why aren’t more companies taking a systematic approach to portfolio management? As with many business problems, there are multiple causes, and almost everyone shares some responsibility for suboptimal performance.
Successful managers advance their careers by building and sometimes by turning around businesses. Gaining recognition is usually easier when you run a large group. As long as the primary financial metrics that drive executive compensation and promotion are revenue growth and earnings per share, operating managers will be reluctant to seriously consider selling off portions of their portfolio.
What’s more, divesting is often perceived as admitting a mistake. It’s rare to see a corporate executive celebrated for a well-executed divestment. And when a sale happens, the group leader does not get to keep the proceeds to reinvest in other businesses. Instead, the funds revert to headquarters’ control.
The uncomfortable reality is that a solid portfolio management process relies in part on judgment and information from managers and staff whose jobs may be affected negatively by a possible divestment.
In contrast to PE-held portfolios, large conglomerates don’t have the resources to provide the equivalent of a hands-on, independent board for each business that stays in touch with the environment, closely monitors industry developments, and makes quick changes. Unlike corporations, PE companies do not typically worry about interbusiness synergies that might complicate divestment decisions.
How to use the proceeds from a possible divestment is a question that sometimes prevents managers from executing the transaction in a timely fashion. The redeployment decision—reinvest, acquire, pay debt, build cash balances, repurchase stock—should be considered separately from the analysis of whether the business still fits in your portfolio.
Boards need to balance their priorities to ensure they also provide proper stewardship of the corporate portfolio. There have been waves of urgent topics for directors in recent years: risk management after the enactment of Sarbanes-Oxley, financial system crises and instability, cyberattacks, and disruption from technology-savvy new entrants. Opportunity costs to shareholders from ineffective portfolio management can be less visible and more difficult to measure than the effects of many of these challenges.
In many companies, the board encourages senior management to rigorously review the entire business portfolio only after major inflection points, such as the arrival of a new CEO or a transformative acquisition. Rarely do executives—who are closest to the market—have an ongoing mandate to make fundamental portfolio changes in response to evolving market conditions.
One CEO—definitely in the minority—has made clear that his public company is “always for sale, either one share at a time or all at once.” This may be the right approach to maximizing shareholder value, but can be unsettling for employees who think their business unit may be sold at any moment even if it’s performing well.
How can boards and CEOs overcome these barriers and implement an excellent portfolio management process? First, the performance measurement system has to encourage your people to think and act like investors. Financial metrics that focus on earning returns in excess of the cost of capital will help embed a shareholder value mindset throughout the organization. Managers need to understand that capital will be allocated not to the largest business units, but to those with the highest risk-adjusted returns and best strategic fit. This approach rewards timely, well-executed acquisitions and divestments, and penalizes leaders that hold on too long to underperformers.
Once a business is identified as a divestment candidate, companies face the challenge of motivating the unit’s management to execute a transaction that will maximize value for the parent. Such motivation is especially important when the business must first be restructured or when the divestment process may take a year or longer. However, current line employees rarely have the mindset or the tool kit to do a short-term turnaround and then execute a divestment like a PE firm would. One valuable approach is to maintain a small team with these capabilities that can parachute in to help with special circumstances.
A separate but related challenge is to have compensation and career planning policies in place that recognize that those doing the turnaround may not stay with the business—or even the company—after the transaction closes. Similar to owning equity in a PE company, the team could be rewarded based on net proceeds. Beyond financial incentives, these managers might be retained by offering them new roles that provide further career development opportunities.
Paying attention to employees’ anxieties helps build a culture that celebrates divestments as a necessary part of creating shareholder value. Compensation in the form of performance and “stay” bonuses plays a role, but qualitative actions are equally powerful. Leading practice companies work hard to explain the transaction’s benefits to the people who will be most affected. Employees need to understand how their business will become a core focus of its new owners, and that will present personal growth opportunities. Each deal also builds (or detracts from) the seller’s reputation with its remaining employees. When planning for each divestment, senior management needs to ask itself: “What can we do to positively engage our people in promoting and executing this transaction?”
The board is in a unique position to provide objective perspectives on portfolio decisions. The directors’ annual strategy off-site meeting provides an excellent opportunity to examine the financial performance and strategic fit of each portfolio business. Even the largest companies can benefit from asking themselves: “What if we were acquired by a PE consortium whose sole criterion was maximizing shareholder value?” Using the off-site meeting to think through the full spectrum of possibilities for realigning the portfolio and adjusting financial policy (capital structure, dividends, and share repurchases) will help management fully prepare for today’s challenges—including activist shareholders.
CEOs and CFOs can no longer afford to tie up resources in suboptimal uses. Better to employ rigorous, repeatable portfolio management processes to liberate that capital and improve financial flexibility. Tomorrow’s corporate winners will be those with active and effective portfolio management processes in place to counter threats and quickly capture investment opportunities.