9 minute read 5 May 2021
Detail of basket of colored silk

How CFOs can elevate portfolio reviews to drive divestment decisions

Authors
Loren Garruto

EY Global and Americas Corporate Finance Leader

Results-oriented business advisor focused on driving shareholder value. Collaborator, developer of people, avid reader and proud mother.

Rich Mills

EY Global and Americas Sell and Separate Leader

Leader of complex divestitures that help enhance shareholder value and drive more efficient capital allocation. Dedicated husband and father.

Harry St. John Cooper

EY Global Shareholder Activism Senior Advisor

Assisting clients in their strategy and messaging. Agent of change where activist engagement should be embraced, not avoided. Looking to find cooperation, not confrontation. Proud husband and father.

Contributors
9 minute read 5 May 2021

Better portfolio reviews can help the 78% of companies that say they have held onto assets too long when they should have divested them.

In brief
  • Effective portfolio reviews focus on a few key metrics that measure how each business complements the enterprise strategy and contributes to total shareholder return. 
  • After a brief, pandemic-induced hiatus activists are back and plan to recommend carve-outs of non-core or underperforming businesses.

To enhance identification of potential divestments, CEOs are looking for more out of portfolio reviews: 63% say they need to initiate or increase the frequency, and 60% say they need a different approach to these reviews, according to the 2021 EY Global Corporate Divestment Study. CFOs can drive more effective portfolio reviews that help a company execute on its long-term strategy and shift their company away from the 77% that say shortcomings in portfolio or strategic reviews have led to failure in achieving intended divestment results.

Portfolio review can guide CFO divestment decisions - Figure 1

Reviews should be conducted at the level that most closely aligns with potential carve-outs, typically the business unit level. Yet four in five companies review the portfolio, at least in part, at a product line level, which may be an inefficient use of time and resources as few companies measure costs below gross profit or track key balance sheet items at this level (e.g., working capital, shared facilities).

Effective portfolio reviews focus on a few key metrics that measure how each business complements the enterprise strategy and contributes to total shareholder return through a combination of growth and return on invested capital.

Focus on evolving divestment KPIs that can help predict future growth

To focus on long-term growth, CFOs need to use forward-looking measures in tandem with backward-looking KPIs like return on invested capital, a metric that 85% of CFOs already use to regularly monitor their business. These KPIs should be applied to businesses in the portfolio to help identify divestment candidates.

The metrics also need to help with the challenge of forecasting future growth as companies try to determine which pandemic-driven behaviors will remain part of everyday business and which are temporary. Using external data sources, such as vaccination rates, social media mentions, cellphone data and others, may provide useful insight or reveal patterns in fast-moving areas like customer buying patterns or mobility.

Portfolio review can guide CFO divestment decisions - Figure 2

KPIs also should not remain static. If a KPI turns out to not be a predictor of future growth, or if business priorities change, new KPIs should be considered. But only 56% of CFOs say they changed their KPI rankings in the past three years. Similarly, scorecard weightings need to be revised in light of the business’s performance.

Understanding the enterprise strategy and the qualitative and quantitative metrics driving it can be particularly valuable for CFOs, allowing them to move beyond financial planning and reporting to making divestment decisions and otherwise set strategy.

Align compensation with portfolio performance

Management’s compensation can also pose an unforeseen obstacle to decisive portfolio management. It is important to avoid incentivizing the senior team to retain businesses through revenue-based pay and rewards tied to short-term performance that could be adversely affected by divestments.

Instead, overall portfolio performance and long-term value creation should be factored into compensation.

Activists rebound, with ESG on their radar

After a brief, pandemic-induced hiatus during the 2020 proxy season, activists are back: more than 120 campaigns were launched in the first quarter of 2021, according to Activist Insight.

Nearly three-quarters of activists (74%) say the pandemic has affected the way they look at targets. In particular, activists are focusing more on the flexibility of the target companies’ cost base (80%) and ability to adapt to different routes to market (70%).

ESG issues are also now on the radar as areas of leverage to sway shareholder votes toward activists in the event of a proxy fight. However, the traditional activist focus on growing shareholder value still drives most activist campaigns as they seek returns. Overly complex divisional structures (78%), board composition or lack of refresh (70%), and suboptimal allocation of growth capital (63%) were most frequently named as the top factors in identifying new investment opportunities.

Divesting is one way that management can demonstrate that it is looking to maximize shareholder value; 89% of activists note campaigns will recommend carving out non-core or underperforming businesses. Moreover, two-thirds (67%) say they expect a divestment to be announced three to six months after they announce an investment in a company.

ESG is becoming part of the activist playbook

While ESG is not yet a prominent factor in identifying target companies, environmental and social considerations are emerging as a more significant prompt for activism as they grow more entwined with long-term value. ESG has become a focus area for boards, with sustainability committees increasingly part of the governance structure. Diversity and inclusion issues are also posing a reputational risk for some companies.

Companies are already restructuring to split themselves into environmentally friendly and unfriendly portions based on their emissions profile and use of coal. Related to diversity, some have begun considering to whom they are selling their businesses and potentially trying to develop a more diverse pool of potential buyers. Some are also taking into account the make-up of senior management and the board when diversifying.

No matter the focus of the campaign, failure to respond may be costly and lead to changes in the management team or board. Executives need to demonstrate that their businesses support long-term value creation. Without strong rationale for a business remaining part of the portfolio, an activist will eventually try to force the separation.

Decide what to divest and take action

Now is a great time to be a seller as buyers, including PE firms with a propensity to acquire corporate carve-outs, are flush with cash in this low-interest-rate environment.

Companies should not wait to act until growth has stalled or for an activist investor to come calling. More than a third of companies (37%) say activist activity in their sector prompted a review of strategic alternatives in the past 12 months.

Even if a divestment decision is more challenging while a business is still healthy, it is far more saleable at this point. And even smaller businesses that do not require much capital investment can still be a management distraction.

There are instances where the cyclical nature of a business unit can entice a company into holding onto it. For example, companies in cyclical industries, such as steel or oil and gas, identify a business as a divestment candidate at the bottom of the cycle, but have held on to see if it can be sold for a higher price when the cycle turns. However, when the business does improve, management may decide not to divest. Then the cycle turns, the process is repeated and the decision to divest is repeatedly postponed.

To break that cycle, CFOs may want to consider recommending strategic alternatives such as: 

  • Staged or stepped exits: Selling a majority interest while maintaining a minority investment can provide the best of both worlds. It removes the business from the balance sheet and brings in new external capital that a non-core holding will not receive under a strategically determined capital allocation plan. At the same time, it provides continued exposure to the business’s upside through the reduced stake retained.
  • Asset-light approach: Companies may take this approach if a business is important to the firm’s operations, but not a core competency. One example is Dow’s sale of its US and Canadian rail infrastructure in July 2020 for about $310m. Notably, the transaction also included a long-term service agreement with the buyer, logistics firm Watco, thereby allowing Dow to maintain the necessary services while removing the rail assets from its portfolio.
  • Joint ventures with strategic partners: This structure may be particularly attractive if the business is an important supplier to the parent company.
Portfolio review can guide CFO divestment decisions - Figure 3

In pursuing a divestment, companies can capture strategic benefits that support future portfolio decisions. More than half (53%) of companies say an improved credit rating and access to capital were strategic benefits in their last major divestment, and 48% say they were able to make clearer capital allocation decisions.

Key takeaways for CFOs

  • Rigorously review the portfolio using a few key metrics related to how each business complements the enterprise strategy and contributes to total shareholder return through a combination of growth and return on invested capital.
  • Take action once it is clear the business should be divested, as the value of a business unit starved for investment can quickly erode.
  • Evaluate strategic alternatives, including an asset-light approach, a staged exit or a joint venture with a strategic partner.
  • Address vulnerabilities across the entire portfolio that could attract unwanted activist attention.

Summary

Portfolios should be reviewed at the business unit level to align with potential carve-out decision-making. Focus on a few key metrics that measure how each business complements the enterprise strategy and contributes to total stakeholder returns. Once the decision is made to divest, companies need to act quickly, or else value can erode and the business may catch unwanted attention from activist investors. Download the 2021 EY Global Corporate Divestment Study (pdf) to learn more.  

 

About this article

Authors
Loren Garruto

EY Global and Americas Corporate Finance Leader

Results-oriented business advisor focused on driving shareholder value. Collaborator, developer of people, avid reader and proud mother.

Rich Mills

EY Global and Americas Sell and Separate Leader

Leader of complex divestitures that help enhance shareholder value and drive more efficient capital allocation. Dedicated husband and father.

Harry St. John Cooper

EY Global Shareholder Activism Senior Advisor

Assisting clients in their strategy and messaging. Agent of change where activist engagement should be embraced, not avoided. Looking to find cooperation, not confrontation. Proud husband and father.

Contributors