How to Prepare for a Breakup Attempt
For decades, corporate growth has often been achieved through acquiring businesses, even if some may have little connection to—or synergy with—the company’s existing business lines and products. A company’s organic growth may also result in business segments with only a loose relationship to each other.
At times, the investment community seems to favor such conglomerates and their diverse revenue streams, viewing such entities as having more durable businesses that are less subject to the vagaries of customers and investors alike. Diversified companies often deliberately seek to deliver more stable performance than pure-play businesses, especially across changing economic cycles.
On the other hand, conglomerates are less likely to be at the top of the valuation and performance tables. In fact, a “sum of the parts” value analysis that activists can readily perform is often higher than the enterprise value by 10 percent or more. This “conglomerate discount” can be the rationale for an activist to call for breaking up a company. This seems to be a more common justification toward the end of a protracted bull market.
Overall, notwithstanding the perceived stability of diversified companies, the investment community often favors pure-play companies over conglomerates predominantly because of the conglomerate discount.
One often-cited theme of the 2022 proxy season is the breakup of conglomerates through spin-offs or divestitures. In some cases, companies have chosen to break themselves up with no discernable outside pressure from investors. For example, Johnson & Johnson announced in November that it is separating its pharmaceutical and health products into separate public companies.
In other instances, activist pressure seems to be the catalyst for proposed breakups. For example, in late October, investor Third Point called for Shell to separate its oil and gas business from its renewables investments.
Activist investors putting forth proxy proposals to split up conglomerates or to change the strategic direction of a company are typically supported by a wealth of research and analysis. The argument for change is often bolstered by the points that conglomerates suffer from excess layers of management, inefficient and duplicative cost structures, opaque disclosures, a lack of focus, and poor valuation against pure-play peers. It can be difficult for management teams to rebuff such claims.
That said, there are several advantages that boards and management teams have that should foster confidence in formulating their responses to an investor. Such responses should be grounded in facts and judged to be in the best interests of the company and its shareholders. These advantages include the following:
Corporate strategy. The board’s role in establishing corporate strategy varies, but at a minimum, board oversight of the strategic plan results in directors having a working understanding of the company’s direction, forward plans, and key performance indicators. A shareholder proposing a breakup or spin-off of one or more businesses may have a good basis for their proposal, but they do not have access to all the information that management and the board have used to develop their strategic plan. Just as importantly, these investors do not have access to the information that management and the board have to decide not to pursue a particular strategy or direction. Directors should assess the investor’s proposal objectively, knowing they likely possess a more informed view of direction and strategy than parties outside the company possibly could have.
Capital allocation. Companies with multiple businesses must allocate and deploy capital and other finite resources to maximize returns. The board’s role in overseeing capital allocation varies widely among companies. Although uncommon, some companies have a board finance committee to oversee capital allocation. Most companies discuss capital allocation with the board in the context of budgets, financial planning and analysis, and medium-term strategy. These factors will inform any response from the company to a shareholder proposal.
A focus on shareholder value. Boards are routinely asked to assess and discuss ideas that may disrupt the status quo. A working knowledge of the value of assets given present market conditions, make-or-buy decisions, assessment of opportunities and opportunity costs, keep-or-sell decisions, dividends, and stock buybacks are within the purview of the board. Many factors bear on these decisions and their trade-offs, but directors who are guided by the best interests of the company and its shareholders should have confidence that such decisions will stand if challenged.
Expert advice. While situations vary, a company facing an outside challenge to its status quo can demonstrate that the board is taking the matter seriously by seeking outside expertise, specifically advisors that can bring a fresh, outside-in perspective to the board. External legal counsel and industry experts can offer objective, dispassionate assessments of the business and work well with management and other advisors to refine a strategy to maximize value for shareholders. As with other important board decisions, getting expert advice demonstrates that the board is taking the matter seriously and is willing to engage with others who may offer differing points of view.
The same principles and practices that foster good corporate governance in less disruptive times will serve the company and its stakeholders well when challenged by an investor or corporate raider.
The views expressed herein are those of the authors and not necessarily the views of FTI Consulting, its management, its subsidiaries, its affiliates, or its other professionals.
Jason Frankl is a senior managing director at FTI Consulting, and he coleads FTI’s Activism and M&A Solutions practice, which works with companies that are preparing for and find themselves the subject of shareholder activism or contested mergers and acquisitions.
Robert J. Kueppers, CPA, is a senior advisor at FTI Consulting.