The Courage to Break-Up a Company

Generating value for shareholders is a primary raison d’être of performance improvement professionals such as Black Belts. Consequently it is important to see the larger picture of where and how a company can create value. Sometimes, improving the current business structure is like climbing a hill thinking you are heading for the highest point, only to discover that a much taller peak exists nearby, the classic “locally maximized but globally sub-optimal.”

In a recent article in the McKinsey Quarterly titled “Finding the courage to shrink” by Bill Huyett and Tim Koller (August 2011), they write:

It takes courage to break up a company. CEOs and boards of directors often fear that investors will view asset divestitures as admissions of failed strategy—that having certain businesses under the same corporate umbrella never made sense. Many worry that shedding assets will cost a company the benefits of scale, cut into the advantages of analyst coverage, or even damage employee morale. Spin-offs in particular draw scrutiny because they shrink the size of the parent company but, unlike sales, don’t generate cash to reinvest.

We don’t believe these arguments hold up. What’s more, they may lead executives to pass up value-creating opportunities. A fundamental principle of corporate finance holds that a business creates the most value for shareholders and the economy as a whole when it is owned by the best—or, at least, a better—owner. So it makes sense that companies should continually reallocate their resources as circumstances change. Moreover, the benefits of being part of a large company come at a cost; in fact, many spun-off companies can make substantial cuts in overhead costs once they are independent. Investors typically don’t care about a company being too small once it reaches a threshold of about $500 million in market capitalization. And in our experience, executives and employees of spun-off companies often feel liberated and quite happy to be on their own.

So it’s a good sign that there’s been something of a revival in spin-off activity this year. According to Bloomberg, as of August 25, 174 companies had announced spin-offs of all sizes—quickly approaching the previous global record of 230, in 2006. Among the notable deals: Kraft Foods’s spin-off of its North American grocery unit and ConocoPhillips’s spin-offs of its downstream businesses.

A pdf of the full article is found here:  McKinsey-Finding the courage to shrink