Unlocking value: Approaching stranded costs in M&A
Missteps during a disposal can seriously impact the retained business and attract unwanted attention from activist investors. One impact is an erosion in operating profit margins, which in some cases can be material. In many cases this is due to selling, general and administrative (SG&A) costs going up relative to revenue, driven by poor management of stranded costs.
Stranded costs can be found in many areas of a business and can be mitigated by the parent company if they plan for it pre-deal, en route to a simplified business. So, what leads to these stranded costs, where are they typically found, and how can you approach a disposal to mitigate them from the offset?
The disposal dichotomy
For many companies globally, divestments are on the rise, with some portfolios still bent out of shape by many of the macro factors seen in recent years as well as COVID, the inflation shock and Net Zero.1 However, when it comes to performing divestments, a degree of rustiness risks sellers leaking value. Recently, activist investors have also been returning to markets, deploying their preference to simplify businesses via divestments as a route to returns.
The current economic climate remains volatile. CFOs recently reported significant rises in operating costs and a focus on cost reduction, so profitability remains a top priority over the next 12 months with a continued focus on building up cash and controlling costs.2
To achieve these goals, companies may choose to divest part of their existing business. This could either be a promising growth area of the business that attracts a high valuation but isn’t part of the strategy, or an under-performing or non-core subsidiary that is cost intensive. Either way, divestments have historically been seen as a great way to re-focus a company.
While a divestment may raise cash in the short-term, it is often at the expense of overall profitability. Most companies experience a decrease in their EBITDA margin 12 months post-divestment, that takes an average of nearly three years to recover. Disposing of the non-core business – at least temporarily – can harm the retained core.
A different approach is needed
Divestments should be seen not just as an opportunity to release capital, but also – critically – to simplify and focus the remaining business. Indeed, often this simplification is an activist investor’s larger objective: to give clarity to markets on the core business and cut away unnecessary complexity and cost. Businesses can do more, not just to mitigate the profitability loss, but to rejuvenate the business.
Delving deeper, not only is there a decrease in EBITDA, but we also see increases in SG&A costs post-divestment. For those companies who experience a drop in profitability 12 months post-divestment, a majority also experience a relative increase in SG&A costs. Again, the median increase in SG&A for these companies is significant at 1.7 percentage points on average, with three in five companies taking four years or longer to recover. Stranded costs left unaddressed are a major contributor to these.
Avoiding stranded costs - Key areas to focus on
Stranded costs arise after a deal in several places and can be material, particularly if the divestment was part of a fully integrated operating model. To mitigate this, successful businesses need to address questions in six key areas:
Summary
A full assessment of stranded costs can lead more quickly to improved profitability, showing where to focus. If, at the outset, a disposal is framed as a means to an end – a simplified and more efficient parent that investors can readily understand and clearly value – then the planning process will more naturally identify and address stranded cost risks. It will also ensure they are dealt with promptly once they are no longer needed by the parent or to serve TSAs to the disposed business.
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