Technology companies are divesting to keep up with the innovation cycle

Tech executives continue to increase strategic portfolio reviews and the most innovative companies are making bold decisions to shape their future.

Technology companies face an urgent need to optimize capital and revisit their platforms, and divestment is a critical part of that process. Firms can use divestments to streamline portfolios weighed down by business units that are no longer accretive to the top-line or are no longer at the core of the company’s long-term strategic plan.

According to the EY Global Corporate Divestment Study, EY analysis shows that the volume of global technology divestments over US$100m decreased 33% from 2017 to 2018. However, the decrease in activity is more muted when you look at mega-divestments (larger than US$1b), which dropped to 11 deals, down slightly from the 12 mega-divestments in 2017. While divestments were down in 2018, we expect divestments to pick up in 2019 with 82% of our polled tech respondents indicating they plan to initiate a divestment within the next two years. We believe this is good news as companies that do not engage in continuous portfolio pruning will be less prepared to lead as a wave of new innovative technology reshapes the technology sector.

Under pressure to prepare

Interest rates were on an upward trajectory in 2018 – the Fed raised rates four times in 2018 and there was uncertainty around where rates were headed in the current year until the Fed recently announced it was projecting no interest rate hikes in 2019. However, with future interest rate increases still on the table in 2020 and beyond, tech companies remain under pressure to proactively manage capital and potentially make divestments to pay down historically high levels of debt and streamline product portfolios. Pressure is also coming from activist investors seeking to push some companies to divest assets to reinvigorate company growth and unlock value for shareholders.

The good news is that hunger for tech assets is growing, which means more competition among buyers and, in turn, higher multiples realized for strong assets. Corporate buyers within the sector are snapping up assets to build on their core capabilities and revitalize legacy portfolios, while private equity buyers, which acquired 22% of technology divestments in 2018, are also a significant factor.

As a consequence of competition, tech valuations remain high and continue to influence divestment decisions: the proportion of executives who expect rising multiples to have an increased impact over the next three years is now at 65%, up from 55% a year earlier. Of the 50 largest transactions done by PE firms and strategic acquirers, PE firms paid 5x trailing 12-month sales while strategic acquirers paid 6.3x trailing 12 months sales, up from the 3.8x and 4.9x multiples paid in 2017 by PE firms and strategic acquirers, respectively. (Source: 451 Research.)

While the tech sector is becoming increasingly sophisticated in its divestments strategies, many businesses are coming unstuck when it comes to executing deals – often because they lack a detailed understanding of their own assets (see Dive deep and analyze below). Technology companies are wired to grow, and many technology companies have grown quickly through M&A. Businesses facing slowing growth, or even technological obsolescence, are now ripe for divestments.

Many are already taking action: 67% say their divestment plans have been prompted by the need to exit non-core businesses so they can acquire assets elsewhere – with 24% citing this, as well as investor pressure, as their main reason to divest. A decline in the growth potential of existing assets is still a divestment driver, but now only cited by 55% of tech respondents, down from 77% last year. However, as companies prepare assets for sale, they need to fully understand the importance of making data-driven decisions. A solid understanding and analysis of the operational data at hand will help sellers maximize success during a divestment process.

Dive deep and analyze

When a company prepares an asset for sale, the value proposition needs to be clear and supported by reliable data that tells a compelling story for buyers. However, we found that data quality is a major stumbling block: many companies continue to use outdated data sets to measure business performance.

Despite most technology companies generating operational data on a grand scale, getting a hold of specific data to support the sale process is still cited as a top divestment challenge by 22% of tech respondents, up from 18% in last year’s study. Companies need to take initiative and invest in tools and refresh legacy systems to allow for data extraction and analysis. Additionally, companies need to instill a culture that incentivizes and promotes detailed data analysis during routine portfolio reviews and the general operations of the business – not just during a divestment or M&A process.

We often find that success can hinge on being able to extract and analyze data at a transactional level (i.e., invoice level database). The right analytics tools, coupled with granular data, often allow sellers to understand customer cohort trends, customer retention, cross-sell opportunities, and profitability. Understanding these metrics allows sellers to craft a cogent story for buyers and answer critically important questions from buyers.

A tighter focus on data and reporting can help companies avoid potentially damaging pitfalls. For example, what would happen if a business believed it was streamlining its portfolio by divesting an unprofitable and non-core business segment, but it had in fact over-allocated costs and under-allocated revenues?

This isn’t just a hypothetical question. In one instance, a seller’s data and related assumptions were found to under-report the profitability of the business. The sale was halted and the divestment of a strong business was stopped before it was too late.

How did this profitable business unit end up on the block in the first place? A lack of reliable data tied to soft assumptions – the company was unable to accurately assess the business unit as a stand-alone entity because it was a legacy acquisition and not typically monitored on a stand-alone basis. The seller erroneously over-allocated shared costs, resulting in artificially depressed margins for the business unit. In short, a business can easily stumble by moving too quickly and not taking the necessary time to thoroughly analyze internal data and assumptions.

Conclusion

Technological advancement will require tech companies to proactively keep up with the cycle of innovation. Divestments of non-core or lower-growth legacy businesses are integral to business transformation, but many tech companies struggle to identify and execute divestments successfully. A lack of preparation for a divestment not only creates headaches for both the seller and buyer, it can result in lost value for all parties involved. While all transactions carry an element of execution risk, risk can be minimized – and the opportunities amplified – with a thorough data-driven understanding of the assets to be divested.