Make things right, or turn left
“A valuation of potential and managerial flexibility in redeveloping divestments”
Amsterdam, March 2005 Ben Wessels Boer
Make things right, or turn left
“A valuation of potential and managerial flexibility in redeveloping divestments”
Amsterdam, 17 March 2005 Author: Ben Wessels Boer
Student Financial Value Management Thesis supervision
Dr. W. Westerman University of Groningen Prof. dr. ir. F.P.J. Kuijpers University of Groningen Drs. H. Hoogduin RA Plain Vanilla Investments N.V.
Mr. drs. A. Ezinga Plain Vanilla Investments N.V.
Contents
Preface... 4
Management Summary ... 5
Chapter 1: Research Framework ... 7
1.1 Plain Vanilla Investments NV ... 7
1.2 Research background ... 7
1.3 Problem definition ... 7
1.4 Theoretical concepts and conceptual model... 9
1.5 Research questions and framework...12
1.6 Measurement and observing methods ...14
1.7 Analysis and reporting...15
Chapter 2: Divestments ...16
2.1 Introduction ...16
2.2 Divestments ...16
2.3 Reasons divestment...17
2.4 Reasons Closure...17
2.5 Consequences cold closure...17
2.6 Disentanglement issues...19
2.7 Conclusion...20
Chapter 3: Potential Divestment ...21
3.1 Introduction ...21
3.2 Horizon 1: Current core business ...21
3.3 Horizon 2: New business and extensions of existing businesses fuelling future growth ...21
3.4 Horizon 3: Options to build future business ...21
3.5 Conclusion...27
Chapter 4: Uncertainty...28
4.1 Introduction ...28
4.2 The uncertainty as a learning option ...28
4.3 Call option with only business development uncertainty...28
4.4 Call option including business development and product/market uncertainty...30
4.5 Conclusion...34
Chapter 5: Financial evaluation of the business opportunities ...35
5.1 Introduction ...35
5.2 Cash flow determinants...35
5.3 Necessary investments to execute business opportunities...37
5.4 Determining the Weighted Average Cots of Capital (WACC) ...38
5.5 How the investor gets his money...40
5.6 Constructing the event tree including present values and required investment ...41
5.7 Conclusion...44
Chapter 6: Flexibilities and Options...45
6.1 Introduction ...45
6.2 Flexibility in general ...45
6.3 Flexibility when redeveloping divestments ...46
6.4 Creating the decision tree and calculating the divestments value ...47
6.5 Conduct sensitivity analysis ...49
6.6 Conclusion...50
Chapter 7: Real Option Analysis ...51
7.1 Introduction ...51
7.2 Real Option Analysis (ROA) ...51
7.3 A simplified comparison of NPV, DTA, and ROA...51
7.4 ROA estimation of the divestments potential value ...54
7.5 Conclusion...58
Chapter 8: Final framework, conclusions and recommendations...59
8.1 Introduction ...59
8.2 The framework: a six step process to estimate the divestment’s potential value ...59
8.3 Added value of the framework ...62
8.4 Recommendations regarding further research...64
Bibliography ...66
Preface
The Faculty of Management and Organization of the University of Groningen requires students to fulfil their graduation project by writing their thesis on a practical problem/challenge within an organization. The thesis lying in front of you has been written during a six months internship at Plain Vanilla Investments N.V. in Amsterdam and Helsinki.
This thesis is about potential, uncertainty and managerial flexibility in redeveloping divestments. The goal is to provide Plain Vanilla Investments N.V. a framework to estimate the potential value of a divestment.
I am extremely grateful I was able to do my graduation project at Plain Vanilla Investments N.V. It was great to experience the entrepreneurial spirit while working for a young and energizing investment company like Plain Vanilla Investments N.V.. It was challenging to combine my graduation project with certain business projects, which were at the same time linked to the subject of my thesis. Our site visits at the chemical plant in Finland and the attendance of various turnaround investment brainstorm meetings gave me the opportunity to observe the process not only from a scientific but also from a practical point of view.
I owe Plain Vanilla Investments and all the people I have worked with a big thank you for a very interesting and enjoyable time. I would like to thank Mrs. Cels, Mr. Binnerts and in special Mr. Hoogduin and Mr. Ezinga of Plain Vanilla Investments N.V. for their helpful insights and guidance during my research process. I would also like to thank Mr. Kuijpers and especially Mr. Westerman from the Faculty of Management and Organization for reading my thesis and their critical reflections. Thereby, I would like to thank Mr. Van der Geest, my house mates at the Paramariboplein and all other friends who made my six months very enjoyable.
Last but not least, a warm and special thank you goes out to my parents and my girlfriend for their help in every respect.
Ben Wessels Boer
Amsterdam, March 2005
Management Summary
Background
Plain Vanilla Investments NV (PVI) is an investment and management company that actively guides its portfolio companies through restructuring and manages these companies in (new) business development. Divestments of large multinationals are one of the targeted acquisition objects for PVI. PVI is especially interested in those divestment cases where closing seems to be the only alternative. PVI acquires these divestments and generates new business opportunities by redeveloping the human resources (know-how and skills), real estate and all other available assets.
Because closing seems to be the only alternative, the subsidiary can be described as a break- up target. In this case the liquidation value of the divestment is the aggregate of the value that the assets of the firm would command if sold at market prices, net of transaction and legal cost. However, with new business development, there is an opportunity that the potential exceeds the liquidation value. The divested subsidiary may be viewed as a flexible system, in which PVI has to convert an array of inputs into profitable outputs that meet the needs of the market. In contrast to a single projected cash flow, the business strategy is much more like a series of options. Some actions are taken immediately while others are deliberately deferred so that PVI can optimise their choices as circumstances evolve. PVI’s question is how this sequential option should be evaluated. Therefore, the objective of this research is to create a framework for Plain Vanilla to estimate the potential value of a divestment.
Research Question
How can Plain Vanilla estimate the value of a divestment, whereby considering the redevelopment potential, uncertainty and ability to respond to this uncertainty?
Redevelopment potential
Current customer demand must be linked to the skills necessary to satisfy that demand. The synthesis of this segmentation analysis should give a clear sense of the discrete business areas in which the divestment competes or could compete. PVI can use the segmentation to structure the existing business and, for example, the supply and service contracts. Because time-consuming business development is needed, (declining) supply and services contracts are necessary when PVI acquires a subsidiary. These contracts help the new business in covering their fixed expense in the start up phase.
To identify new business opportunities, PVI must research how it can use the segmented capabilities to meet the needs of the market. A match must be made between the current strategic business unit’s strength and the potential industry attractiveness. To identify these potential matches, PVI can use GE/McKinsey matrix as a basic tool. The result is a quantitative measure of industry attractiveness and the business unit’s relative performance in that industry. Based upon the position in the matrix, resource allocations must be made to grow, hold, or neglect (potential) business opportunities. The estimated probability of success of each opportunity, based upon the position in the GE/McKinsey matrix, and the expected pay-off fluctuation in case of new business success determines the projects uncertainty.
Redevelopment uncertainty
Based upon the new business uncertainty different redevelopment scenario’s can be separated.
An event tree must be build to provide an overview of all possible scenario’s of how PVI could develop the divested company. The financial evaluation of each state in the event tree
provides all possible future values at the various points where a decision is needed on how to continue with the project. Herewith PVI must separate two sources of uncertainty.
The first source of uncertainty, business development uncertainty, the success of the new business measured by the number of jobs saved, is diffuse now, but reduced through time by doing research. The business development uncertainty does not get resolved by itself; separate effort and investment are required to learn more about the conditions of the project and reduce the uncertainty. The second source of uncertainty, product/market uncertainty, the expected pay-off in case of new business success, is based on revenues in the chosen attractive market that are known today and become more diffuse through time. The expected pay-off can be measured in terms of each job saved, as is assumed. The number of jobs saved multiplied with the expected pay-off is the total new business revenue in case of new business success
Based upon the actual resolution of the uncertainty over time, PVI can determine the optimal execution of the available options and thus, the correct valuation.
Managerial flexibility: ability to respond to uncertainty
Flexibility (options) must be included by putting the decisions that management may make into the nodes of the event tree. The event tree models the set of values that the divestment may take through time. The decision tree shows the optimal decision, conditional on the state in the event tree. A well built decision tree should give a clear view of optimal option execution. PVI must analyze the event tree on learning, waiting-to-invest, switch, and abandonment and growth option.
The decision tree type analysis (DTA), capturing the choices conferred by managerial flexibility through decision nodes, provides a good estimate of the potential value of the divestment. However, the DTA approach uses the cost of capital for the underlying project without flexibility to value the deferral option. This cost of capital is based upon the beta, and thus, the volatility and expected pay offs of the project without flexibility. With flexibility, the investment has different payouts and therefore different risk than the underlying project. The DTA approach uses an ad hoc discount rate that is incorrect for the riskiness of the cash flows being evaluated. Therefore, a final step must be made: carry out Real Option Analysis (ROA).
Real Option Analysis
With ROA it becomes possible to quantify the value of operating flexibility options and strategic benefits. ROA includes the base case present value without flexibility plus the option (flexibility) value. The ROA calculations are based upon the constructed DTA framework.
Because PVI invests in companies with continuity problems, there is high uncertainty about the future. Therefore, managerial flexibility, the ability to respond to this uncertainty, is valuable and should always be evaluated. A ROA analysis helps to identify and value managerial flexibility. PVI can use ROA as a strategic planning and analysis-thinking framework. It forces PVI to think in future scenarios, and therefore, promotes greater discipline in project management. PVI must evaluate optimal timing decision: whether to exercise, defer or research an option. Futhermore, ROA also helps recognize where PVI may be significantly under-pricing, giving value away or overpaying for flexibility. As such, it can be used in proposal development and as a negotiation strategy support tool when structuring a new acquisition.
Chapter 1: Research Framework
1.1 Plain Vanilla Investments NV
Plain Vanilla Investments NV is an investment and management company that actively guides its portfolio companies through restructuring and manages these companies in (new) business development. Plain Vanilla Investments (PVI) acquires midsized (production) companies in distress that require an active hands-on involvement. In addition, PVI acquires subsidiaries of multinationals that are considered to be non-core, end-of its life cycle or loss making. PVI has the objective to turn these companies into objects that generate healthy returns and/or make attractive acquisition candidates.
1.2 Research background
Divestments of large multinationals are one of the targeted acquisition objects for PVI.
Multinationals can divest a subsidiary either by closing or selling it. PVI is especially interested in those divestment cases where closing seems to be the only alternative. PVI acquires these divestments and generates new business opportunities by redeveloping the human resources (know-how and skills), real estate and all other available assets.
This research is based on one of these cases: the divestment of a subsidiary by a large European chemical multinational. The subsidiary is a site for large batch/ low complexity specialty chemicals production and regional distribution activities. The plant as such performs well, both on quality as on efficiency, but cost efficiency is under pressure due to decreasing sales volumes and overcapacity of the combined multinational plants.
The multinational would like to have an alternative in order to avoid closing and minimize costs and the project hassle. PVI can offer such alternative by taking over the site including all employees at risk and solving the disentanglement issues. The multinational will obtain cash upfront, the employees at risk are offered a perspective and the multinational has no image exposure due to bad publicity.
1.3 Problem definition
The problem for PVI is to estimate the potential value of the divestment. Because closing seems to be the only alternative, the subsidiary can be described as a break-up target. The distress is severe enough to be terminal. In this case the liquidation value of the divestment is the aggregate of the value that the assets of the firm would command if sold at market prices, net of transaction and legal cost (Damodaran, 1994).
However, due to the opportunities of new business development, there is an opportunity that the potential exceeds this liquidation value. The divested subsidiary may be viewed as a flexible system, in which PVI has to convert an array of inputs into profitable outputs that meet the needs of the market. The probability that the value of this flexible system exceeds the value of outstanding debt, determines its value. Therefore, the value of the divestment for PVI can be viewed as a call option on the underlying assets and can be valued as such.
However, the option is not single, but sequential, or ‘compound’; exercising uncovers not an underlying asset but another option (Copeland and Tufano, 2004, p.3). In contrast to a single
projected cash flow, the business strategy is much more like a series of options. Executing a strategy almost always involves making a sequence of major decisions. Some actions are taken immediately while others are deliberately deferred so that PVI can optimise their choices as circumstances evolve (Luehrman, 1998, p. 1). PVI’s question is how this sequential option should be evaluated.
This request for advice needs a clear problem definition. Only this leads to a study that is relevant, achievable and functional. Such a problem definition consists of an objective, research question and restrictions (De Leeuw, 1996). Three questions need to be answered before we start with the framework:
1. What do you want to make for whom (objective)?
2. According to which specifications?
3. Which restrictions apply?
Objective
The objective of this study is stated below:
Create a framework for Plain Vanilla to estimate the potential value of a divestment.
To specify the objective, specifications and restrictions that the framework must meet are formulated and discussed in the next paragraph
Specifications and restrictions
The specifications that the framework has to meet are summarized below and illustrated in exhibit 1.1. These specifications are (3E): Effective towards the objective, Efficient in use and including Experience. The quality of the framework is determined by the way the output meets its specifications; the frameworks suitability for estimating the potential value of a divestment and evaluating this (De Leeuw, 1996).
Problem Definition Situation
SPECIFICATIONS (3E)
1. Effective 2. Efficient 3. Experience
1. Focus on Break-up targets 2. Orientated towards financial evaluation
3. Consistent with models used in practice 4. Evaluate alternatives on the same criteria
RESTRICTIONS
Objective
Framework
The framework must be effective in use:
The effectiveness of the framework is determined by its output. This output must be theoretically correct and relevant (De Leeuw, 1996). The framework is not aimed to be a complete checklist. However, by using the framework in practice, it will be tested and further completed in order to make more realistic estimates of the potential value of divestments.
The framework must be efficient in use:
PVI estimates the potential value of a divestment under time pressure. The utility of the framework depends on the time it takes to estimate the value. Therefore, the framework must be quick in use and not too complex. It should rather focus on headlines than details.
Experience must be included as much as possible:
Including experience and some empirical figures in the framework will increase PVI’s professionalism and ensures reliability. As a result of experience, PVI is able to include all relevant items in the estimated value of a divestment and it may save time. This increases PVI’s effectiveness and the frameworks efficiency.
The restrictions that apply on this study are summarized below.
1. The study focuses on divestments that, without new business development, are break-up targets. This implies that without new business development these divestments will be closed.
2. The framework must be orientated towards financial evaluation.
3. The framework should be consistent with valuation models used in practice. This implies that PVI and their stakeholders can easily understand and interpret the results.
4. Alternative divestment scenarios must be evaluated on the same criteria. Different divestment scenarios need to be compared to make a well-considered decision.
1.4 Theoretical concepts and conceptual model
This paragraph describes the way literature is consulted. This literature is embedded in the conceptual model, which is the backbone of the study. The framework aimed for in the objective will be based on existing theories and models about divestments, strategy, business development and valuation. Furthermore the expertise of the Plain Vanilla team members will be used to develop the framework.
PVI focuses on those divestment cases where closing seems to be the only alternative. In this case, the value of the divestment for the multinational equals the cold closure budget. Cold closure is defined as the immediate and unmanaged shutdown of a line of business. The alternative is redevelopment by PVI. When redeveloping the divestment, PVI has to convert an array of inputs into profitable outputs that meet the needs of the market. As shown in exhibit 1.2, the estimated value of this project depends on the redevelopment potential, the uncertainty in the redevelopment and the ability to respond to this uncertainty. With Real Option Analysis these concepts will be combined in order to estimate the potential value of the divestment.
Exhibit 1.2 Conceptual Model Redevelopment potential divestment
The potential depends on the available know how and assets of the divestment: how easily can these be converted in assets that create a profitable output that meet the needs of the market. To determine this potential the model in exhibit 1.3 will be used as a basic framework.
An analysis of companies with sustainable above-average growth indicates that they manage their business portfolios across the tree horizons of growth. The divestments are break-up targets and not companies with sustainable above-average growth. However, with some adaptations the framework can be used to structure the business opportunities.
Combining these three perspectives helps PVI put traditional value-based management into the broader context of creating new value for the firm (Copeland et al.). The horizons will be used to identify the divestments’ business opportunities. To identify the current value drivers, Scott (1998) is used. Finally, using the basics of the GE/ McKinsey matrix (Collins et al., 1999), these specified value drivers will be linked with a potential market.
Redevelopment Potential Redevelopment
Uncertainty Managerial
Flexibility
Real Option Analysis
Potential Value Divestment
Types of business
Management imperative
Primary focus
Core Business New business and extensions
of existing businesses fuelling future growth
Unlock incremental growth, then manage for value as the business declines
Exercise options, assemble required capabilities, and drive business-building capabilities
Bottom-line performance and profitability
Horizon 1
Creating strategic degrees of freedom
Horizon 2 Destiny shaping decisions
Horizon 3
Creating options for future business
Top-line growth and capital efficiency
Options to build future business
Source options for future growth and test viability of business concepts
Future potential and robustness against scenarios
Redevelopment uncertainty
The uncertainty of the divestments value is determined by success of the business development, described in the second and third horizons of growth. PVI must research how likely the divestments’ new business opportunities are. Futhermore, PVI must estimate the financial consequences of each possible event.
Managerial flexibility: the ability to respond to uncertainty
In the divestment project valuable managerial flexibility is available. The future of the divestment cases depends on the success of the business development. If this business development fails the plant has to be closed, which means that the divestments future is very uncertain. However, PVI will very likely receive new information over time about this uncertainty and there is room for managerial flexibility, which allows PVI to respond appropriately to this new information. In the development of the divestment some actions are taken immediately, while others are deliberately deferred so that PVI can optimise her choices as circumstances evolve. When optimally exercised, all of these options provide flexibility that adds to the value of the project. Senior managers intuitively know that NPV fails to capture these flexibilities and often disregard the results of present value analysis (Copeland and Antikarov, 2001, p.VI). The constructed framework must capture this flexibility value.
Real Option Analysis: valuing potential, uncertainty and managerial flexibility
One option to evaluate the divestment is net present value analysis (NPV). However, NPV is based upon expected future cash flows and discount rates. Given these informational requirements, this approach is easiest to use for assets (companies) whose cash flows are currently positive and can be estimated with some reliability for future periods, and for which a proxy for risk that can be used to obtain discount rates is available (Damodaran, 1994). The more removed a situation is from this idealized setting the more difficult discounted calculation becomes.
Because NPV is based on expected future cash-flows it normally fails to account for value managerial flexibility. To illustrate a typical NPV problem, consider an 8-year project that will cost € 50 million to design and € 300 million to build (Copeland and Antikarov, 2001, p.V). The NPV approach says to figure out the expected cash-flows over 8 years life of the project, to discount them at the weighted average cost of capital, and to subtract out the present value of the required investments. If the resulting NPV investment is negative, the project is not accepted.
Because of the above line of reasoning, the framework will be based on the concepts of Real Option Analysis (ROA). Real options represent the flexibility in decision making that impact financial value typically available in some form, at some point in time, with many strategic business assets (Copeland and Antikarov, 2001).
1.5 Research questions and framework Research question
From the objective and the conceptual model the following research question is formulated:
How can Plain Vanilla estimate the value of a divestment, whereby considering the redevelopment potential, uncertainty and ability to respond to this uncertainty?
An answer to the research question will be formulated based upon the following sub- questions. These sub-questions are based upon the conceptual model. This, finally, results in the achievement of the research goal.
1. What are the unique characteristics of the divestment and deal structure?
2. What is, based on the current value drivers, the divestment potential considering the tree horizons of growth?
3. Which uncertainties affect the divestment value through time?
4. What is the full range of possible values of the divestment during the project’s lifetime?
5. What is, including managerial flexibility, the divestment estimated potential value?
6. What is based upon Real Option Analysis the divestments potential value?
In exhibit 1.4 the research framework is shown. This research framework shows the chapter structure based upon the research sub questions, and how this finally results into an answer to the central research question.
As shown in the research framework, this thesis starts with the unique divestment and deal characteristics. For the establishment of the valuation framework a good understanding of these characteristics is crucial. The framework will be built on these unique characteristics.
The combined divestment and deal characteristics determine the potential value, including managerial flexibility.
Identify potential divestment
The next step is to specify the redevelopment potential. Based on the current value drivers, using the tree horizons of growth, new development opportunities will be identified in chapter 3. The first horizon is the current core business, which is mostly declining. However, in most divestment cases, for some time, the parent company still depends on the services and supply of the subsidiary. For this reason, when buying the divestment, PVI takes over this responsibility, which is described in supply and service contracts. After a supply or service contract ends, PVI can either invest in new business development or abandon the project.
Therefore, these contracts determine the room for managerial flexibility. The second and third are business development horizons. The second horizon described business development opportunities that are extensions of the current declining core business. The third horizon describes opportunities that are not simple extensions of the current business; however they are still based on the current capabilities. Using the basics of the GE/ McKinsey matrix, the current capabilities will be linked with a potential market.
Exhibit 1.4 Research framework Value managerial flexibility
The next steps of the research framework are based on a four-step process for valuing real options developed by Copeland (2001, p. 220).
The first step is to research uncertainty. The uncertainty of the divestments value is determined by success of the business development, described in the second and third horizons of growth. The actual event tree for the project is asymmetric with changes in value occurring when a significant part of the business development success is resolved at certain points of time. As a result, a simple estimation of the project’s volatility in a standard binomial sense cannot be used to generate an event tree. An event tree that reflects the actual resolution of the uncertainty over time must be built (Copeland and Antikarov, 2001, p. 270).
The way to do this is to keep the major uncertainties separate and to model their interaction on the project’s value explicitly. Based upon this actual resolution of uncertainty, PVI can determine the optimal execution of the available options and thus, the correct valuation. In chapter 4 this event tree will be built.
Chapter 2: Divestment and deal characteristics Chapter 3: Identify Potential Divestment
Current Core Business
Horizon 1: Supply and Service Contracts
New Business Development
Horizon 2: Extensions
Current Business Horizon 3: Growth Options Build on Current Capabilities Identify managerial flexibility based on
characteristics supply and service contracts (Chapter 3 and 6)
Chapter 5: Compute base case present value without flexibility using DCF valuation model at each node of the event tree
Chapter 4:
Model the new business development uncertainty that affect the present value using an event tree
Chapter 6: Estimate potential value divestment considering managerial flexibility Analyze the event tree and incorporate managerial flexibility to respond to new information.
Flexibility is incorporated into the event trees, which transforms it into a decision trees. Under high uncertainty and managerial flexibility, options value will be substantial.
The flexibility has altered the risk characteristics of the project; therefore, the cost of capital has changed. Real Option Analysis is the solution Chapter 7: Calculate Real Option Value with the risk-neutral probabilities method
The second step is a standard net present value analysis of the project using traditional techniques. In this chapter each state in the event tree will be financially evaluated and thus the full range of possible values for the underlying asset, in this case the divestment, during the project’s lifetime will be figured out.
In the third step flexibility will be included, by putting the decisions that management can make into the nodes of the event tree, to turn it into a decision tree. The event tree models the set of values that the divestment may take through time. The decision tree shows the optimal decision, conditional on the state of nature. At this point we have completed a decision tree analysis (DTA). In a decision tree analysis discount cash flow valuation is combined with a decision tree. In this case the deferral option that allows us to decide later on, after observing the information received during that time, is also considered.
This decision tree type analysis capturing the choices conferred by managerial flexibility through decision nodes is an improvement. However, it is not sufficient simply to estimate future cash flows on future optimal decisions and to continue using a constant risk-adjusted discount rate (Trigeorgis, 1996). The problem with the DTA approach is that one uses the cost of capital for the underlying project without flexibility to value the deferral option. This cost of capital is based upon the beta, and thus, upon the volatility and expected pay offs of the project without flexibility. With flexibility the investment has different payouts and therefore, different risk than the underlying project. The DTA approach uses an ad hoc discount rate that is incorrect for the riskiness of the cash flows being evaluated (Trigeorgis, 1996).
Because of the above, a fourth and final step will be made: carry out Real Option Analysis (ROA). With ROA it becomes possible to quantify the value of operating flexibility options and strategic benefits. ROA includes the base case present value without flexibility plus the option (flexibility) value (Copeland and Antikarov, 2001, p.220). The payoffs in the decision tree will be evaluated using the method of risk-neutral probabilities (Copeland and Antikarov, 2001 p. 222).
1.6 Measurement and observing methods
The answers to the above questions are obtained through use of a multi-method approach (Saunders et al., 2003). The method implies that different types of measurement and observing methods are used. Adapting a multi-method approach gives the researcher the confidence that he addresses the most important issues. Another reason to use a multi-method approach is that it enables triangulation to take place. Triangulation means using different data collection methods within one study in order to ensure that the data represent what the researcher has in mind. For this research it means that a combination of desk research and field research will take place.
Desk Research
As described in the restrictions the framework should be consistent with valuation methods used in practice and alternative divestment possibilities must be evaluated on the same criteria. For this reason it is important that the framework is built on well known scientific literature as described in section 1.4.
Other desk research will include internal interviews with the PVI team members. Companies must review their successes and failures, assess them systematically, and record the lessons in a form that the employees find open and accessible. Or as the philosopher George Santayana said, “Those who cannot remember the past are condemned to repeat it” (Garvin, 1998, p.61).
With the interviews the lessons learned from the past can be included in the framework. These interviews close the cap between practice and literature.
Field Research
In order to get a better conception of the problem to be studied, the researcher will actively participate in the acquisition of a divestment; training on the job approach. To illustrate this, Kurt Lewin (one of the founders of the action research approach) is quoted: “the only valid knowledge arises where the action is” (Van der Zwaan, 1995). By being part of the action, knowledge is transferred on how PVI estimates the value of a divestment. The researcher also learns at which points the knowledge available is not sufficient.
This approach may look similar to the action research approach, but it is not. By using the action research approach, research and action are varied. The action part of this approach is about intervention in an organization in order to change and understand it, followed by evaluation and new changes in order to solve the problem. Participation of the members of the organization is necessary to succeed (Van der Zwaan, 1995).
The training on the job approach is none of this. The only similarity is that both approaches try to get a better conception of the problem field by being as near as possible to the subject of study (inside). Just like the action research approach, the main danger of training on the job is the validation of the outcomes. The outcomes could become too specific and not generally workable. They are internally valid, but externally (in other cases) they may be not.
Exhibit 1.5 Construction of the framework
In exhibit 1.5 the construction of the framework is shown. The divested chemical subsidiary case, combined with desk research, will be used to construct the framework.
1.7 Analysis and reporting
The results of this study will be reported to PVI (the principal of this study) and the University of Groningen, the faculty of Management and Organization. Furthermore a workshop will be organised, in which the PVI team members will estimate the potential value of a divestment, by using the constructed framework, themselves.
Chapter 7:
Final framework and recommendations Desk Research
Field research: case divested chemical subsidiary
Chapter 2-6:
Construct framework
Chapter 2: Divestments
2.1 Introduction
This chapter describes the unique divestment and deal characteristics. For the establishment of the valuation framework a good understanding of these characteristics is crucial. The framework will be built on these unique characteristics. The combined divestment and deal characteristics determine the redevelopment potential and the room for managerial flexibility.
When divesting, the parent company has two alternatives: selling or closure. PVI is especially interested in those divestment cases where closing seems to be the only alternative.
In this chapter those divestment cases in which closing seems to be the only alternative will be identified. Therefore, more information about the divestment reasons is necessary. These reasons explain why the parent company wants to divest and what opportunities this creates for a potential buyer.
The consequences of closing for the parent company will be described, in order to determine in which cases PVI can create value for both parties. These consequences include the disentanglement issues and the cold closure budget.
Finally the deal characteristics will be described whereby using the chemical subsidiary as an example.
2.2 Divestments
According to the “Dictionary of Finance and Investment” (Downes, 1997) the definition of divestment or divesture is: “disposition of an asset or investment by outright sale, employee purchase, liquidation and so on”. More in detail Dranikoff et al (2002) state that divestment leads to advantages for the company, namely a general transformation, the improvement of business contents and the development of innovation strategies. In the majority of divestment cases we can observe reinforcement and refreshment of the organisations (Dranikoff, 2002, p.
76-77). Divestment is motivated by any kind of pressure, leading managers through reactive decision making models. By this way we cannot affirm the divestment action as a failure but as a crisis moment that requires an articulated reaction between agents involved (workers, unions, local municipalities, companies).
Divestment and plant shutdowns occur more readily in multi-plant than single-plant companies because managers of the former have a wider scan of investment possibilities.
First, managers of multi-plant companies can easily shift cash flows among branches and subsidiaries. This is one of the greatest advantages of multidivisional companies. A multidivisional company has good information about all of its branches and divisions and therefore can assign cash flows to high yield uses, phasing out, divesting itself of, or closing less profitable operations (Howland, 1998). Second, managers of multi-plant and multidivisional operations have the expertise and staff to carry out a wide ranging search outside the company for more profitable sites or ventures, again phasing out less profitable activities. Therefore, multi-plant companies are especially interesting for PVI. Building a track record in successfully restructuring multinational plants is valuable for PVI, because this will very likely generate follow on projects.
2.3 Reasons divestment
Haynes, Thompson and Wright (2000) studied divestment impacts by an empirical analysis with English companies between 1985 and 1989. According to this study, companies tend to refocus their strategies into divestment options when the environment (economic, social, political, etc) isn’t favourable. Divesting their activities reflects a change of the desired level of diversification where companies are to reply to the new environment circumstances.
Both acquisitions and divestment activity may represent efforts by business companies to adjust to their changing environments. Much M&A activity involves moving from industries with unfavourable outlooks to industries with more favourable opportunities. “Divestures enables selling companies to salvage a portion of their investments by selling to other companies that could exploit the opportunities more effectively”(Weston, Chung and Siu, 1998, p. 232).
In most of the above described divestment cases a company, which is able to exploit the opportunities more effectively, is found. However, these opportunities are not always obvious or, in other cases, the subsidiary cannot be sold because of competitive reasons. In these cases PVI can buy the subsidiary, identify and exploit new opportunities, before selling it to a third party.
The chemical subsidiary is divested because cost efficiency is under pressure due to decreasing sales volumes and overcapacity of the combined multinational plants. This reason can be described as changing strategies or restructuring (see enclosure 3). The local capacity could be perfectly sold to a competitor. However, this is not an option, because the multinational produces the same products elsewhere and will continue to distribute these in the region.
2.4 Reasons Closure
Fothergill and Guy (1990) summarize in sequence of importance the following reasons for closure: structural shift of demand, recession, import penetration, exchange rate, technical change process, pulling out of market, vocational difficulties, other firm specific reasons, international cost differences, operational problems, other plant specific reasons, expansion plans, other industry-wide problems and property difficulties.
In all of the above reasons the subsidiary is running out of business and can be identified as a break-up target. The only option for the parent company seems to be closure. In these cases PVI can create value with new business development and avoid closure. To know how much value PVI can create, the consequences of cold closure have to be researched.
2.5 Consequences cold closure
Closure decisions are amongst the most difficult and painful a company must make (Boddewyn, 1979). It will hurt the employees who will loose their jobs, the local community, which might have to deal with higher unemployment and/ or misses out on taxes, the (local) suppliers who loose a (large) customer and the managers of the facility that is to be divested since closure is closely linked with failure.
Not only the impact on these stakeholders makes closure a difficult decision, also the divesting company faces difficulties. The assets that are to be divested need to be written off.
These write-offs affect the accounting profits of the company, although possible losses can be carried forward to reduce tax expenses in the future. Closure may also be damaging for the image of the divesting firm.
Cold closure is defined as “the immediate und unmanaged shutdown of a (line of) business”
(Offringa, 2001). A cold closure budget is used to estimate the financial impact. It can be used as a benchmark to the alternative; selling to PVI.
The purpose of this thesis is not to determine how one should construct a cold closure budget.
Still, a global idea of a cold closure budget is needed to determine when selling to PVI becomes the preferable alternative. According to Offringa (2001) cold closure budgets should merely contain cash items. Exhibit 2.1 shows the cold closure budget that is constructed for the chemical subsidiary.
Cold Closure Budget (euro)
Severance -1,400,000
Retention cost -230,000
Outplacement project and training - 250,000
Salary cost between announcement and effective date (2 months) -700,000
Social security and fringe cost - 500,000
Clean up site -500,000
Relocation production cost -2000,000
Management Cost -500,000
Disentanglement Cost -120,000
Write off assets (N/A) 0
Sell off land & buildings 4,400,000
Total cash side -1,800,000
Exhibit 2.1 Cold closure budget chemical subsidiary
The severance costs are very important in a cold closure budget. With the new business development, PVI avoids these costs. The objective is to save all jobs with the new business development. In the country of the divested subsidiary severance cost are low compared to other European countries. Because PVI saves jobs with new business development, their added value is most in countries with high severance costs. On the other hand high severance costs also increase the risk. When PVI acquires the subsidiary and the business development (partly) fails, PVI also has to pay these high costs. In this case a option to abandon the project and thus, avoiding these costs, could be valuable.
The write offs are not applicable because they are seen as a sunk cost and non-cash. However, they could be of importance since they affect the Profit and Loss statement and thus, taxes; a cash item. Still, this cash item does not affect the decision to sell or close the subsidiary. In both scenarios the consequences are the same. For this reason write offs are not considered in the cold closure budget.
PVI uses the cold closure budget as a benchmark. To buy the site PVI should probably offer more than –1,800,000 euro. PVI can offer this because she expects to create value with new business development.
2.6 Disentanglement issues
Disentanglement issues involve local staff and business processes (production, distribution, sales, finance, HR and IT) that are all included in one (or several related) legal entity. When divesting a subsidiary it has to be made stand-alone or transferred to another entity. Making a subsidiary a stand-alone entity is mostly a complex and time-consuming job. Before acquiring a divestment, PVI has to analyse these disentanglement issues and estimate the costs.
In most divested subsidiaries several business units of the multinational play a role on site.
Not always all business units have to close their local activities. When a subsidiary is closed, these business units have to search for another location. In case PVI acquires the subsidiary, one of the options is to continue these activities on site next to the new business development.
Apart from the business activities that will continue, other business activity (that will be terminated on the long term) will mostly slowly decline. For some time, the parent company still depends on the services and supply of the subsidiary. When buying the divestment, PVI becomes responsible for these services and supply, which is described in contracts. However, with declining business the subsidiary is not able to cover the fixed expense. PVI uses the declining current business as a stepping-stone to attract new business.
Exhibit 2.2 shows the ideal situation when PVI acquires a divestment: the new business start from day 1 and the total turnover increases in time. The supply and service agreements are contracts and can be seen as given. They are described as horizon 1 of the research framework. The business development, horizon 2 and 3 of the research framework, is uncertain.
In almost all the divestments cases that are interesting for PVI, for a limited period, supply and service contacts with the divesting mother company exist. PVI acquires those divestments where closing seems to be the only alternative. For this reason time-consuming business development is needed. Without supply and service contracts, PVI probably cannot cover the fixed expense, and closure becomes the preferable alternative.
In case of the divested chemical subsidiary the local business unit structure is quite complex as many units of the multinational have a foot on site and are facilitated by the subsidiary.
Disentanglement issues involve local staff and business processes (production, distribution, sales, finance, HR and IT) that are all included in one legal entity and several business units of the multinational which play a role on site.
Furthermore, production and distribution contracts that can be used as a stepping-stone for new business development are available. When PVI acquires the site they have the obligation to produce the products of the parent company two years and distribute them for at least five years.
Exhibit 2.2 Ideal situation current business/business development and uncertainty 2.7 Conclusion
When divesting a subsidiary, a parent company has two options: selling or closure. PVI is focussing on those divestments where closing seems to be the only alternative.
Closing seems to be the only alternative when the subsidiary is running out of business, the opportunities are not obvious to other companies or because the subsidiary cannot be sold because of competitive reasons. In these cases PVI can buy the subsidiary, identify and exploit new opportunities.
With this new business development, the multinational is offered an alternative in order to avoid closing and minimize the project hassle. PVI offers this alternative by taking over the site, including all employees at risk, and solving the disentanglement issues. The employees at risk are offered a perspective and the multinational has no image exposure due to bad publicity. Because the PVI approach saves jobs the added value is biggest in countries with high severance costs. On the other hand, high severance costs also increases the project’s risk.
This risk can be covered with an abandonment option.
Because time-consuming business development is needed, (declining) supply and services contracts are necessary when PVI acquires a subsidiary. These contracts help the new business in covering their fixed expense.
It can be concluded that PVI may offer an attractive alternative when closing seems to be the inevitable. However, this alternative only works when new business is generated.
Time Turnover
Business development:
Growth horizon 2 and 3
Current business:
Growth horizon 1
Uncertain Takeover Moment
Given
Chapter 3: Potential Divestment
3.1 Introduction
With the three horizons of growth the full range of possible values for the underlying asset, in this case the divestment, during the project’s lifetime will be estimated. The current value drivers are the basics of the new business opportunities. Based on the current value drivers, new development opportunities will be identified. The first horizon describes the mostly declining core business. The second and third are the business development horizons. The likelihood of success determines the project uncertainty. Combining these three perspectives helps PVI put traditional value-based management into the broader context of creating new value for the firm. In the next paragraphs each horizon will be described separately.
3.2 Horizon 1: Current core business
Horizon 1 includes current core business, which generally account for the greatest part of current profits and cash flow (Copeland et al., p.95). As shown in exhibit 2.2 the current core business of the divestments is declining and will be terminated in the near future. Incremental growth of the current core activities is not likely. For this reason the focus is to manage for value as the business declines. The declining core business is described in the supply and service contracts.
The first horizon is also the basic of the managerial flexibility. The time you receive with the distributions and production contracts can be seen as the “time to expire of the option’. A longer time to expiration will allow us to learn more about the uncertainty and therefore it will increase option (deal) value.
When PVI acquires the chemical subsidiary they have the obligation to produce the products of the parent company 2 years and distribute them for at least 5 years. This gives PVI 2 years to redevelop the production activities and 5 years to redevelop the distribution activities.
3.3 Horizon 2: New business and extensions of existing businesses fuelling future growth Within this horizon the growth is closely related to the current core business that is declining.
These extensions may be forbidden by the divesting parent company due to competitive reasons. However, when available and allowed, these growth options are easiest to exercise.
At extensions of the current business, most likely all required assets and capabilities are available.
In case of the chemical subsidiary growth options in horizon 2 are not available. Extensions of the current core business are forbidden by the divesting parent company. For this reason the new business development has to be found within growth horizon 3.
3.4 Horizon 3: Options to build future business
This horizon describes business options that are not just simple extensions of the current core business. However, these growth options are build on the current capabilities. In order to structure these options the current capabilities will be segmented first. To segment these current capabilities and to identify the strategic business units, the nature of the customer demand has to be linked with the skills necessary to satisfy that demand first (Scott, 1998).
In paragraph 3.4.1 the business portfolio of potential redevelopment opportunities will be identified. A business portfolio is the collection of strategic business units. A Strategic Business Unit (SBU) can be defined as a business producing a product or service to meet distinct customer demand and requiring distinct competencies to satisfy those demands (Scott, 1998, p.9).
The optimal business portfolio is one that fits perfectly to the company’s strengths and helps to exploit the most attractive industries or markets. In paragraph 3.4.2 will be researched, based upon the GE/McKinsey matrix, how the current strategic business unit’s strengths can be used to generate profitable outputs that meet the needs of the market.
Exhibit 3.1 Identify and specify business units’ strengths and match with attractive market 3.4.1 Clustering current demand and skills
First the current customer demand has to be researched. Unless a company understands the motivations of customer demand, it will not be able to sell what it makes effectively. In most cases, customers will more or less have a standard list of purchase criteria, which tend to include: price, quality, performance characteristics of the product or service, speed of delivery, after sales support, and brand appeal/endorsement (Scott, 1998, p.14). In addition there will be a number of criteria, which are unique to the industry of the divestment. By simply asking the customers, these criteria can be identified.
The next stage is to rank the purchase criteria in terms of their importance to the customer.
Once ranked this should expose quite clearly the difference in nature of what a customer expects from one product or service versus another. These differences will exist because the customers are either fundamentally different or because they are buying for quite distinct reasons (Scott, 1998, p.15).
The chemical subsidiary only delivers to the divesting multinational. However, two types of customer groups can be separated based upon their purchase criteria. The first customer group is the multinational for which the subsidiary produces large batch/ low complexity specialty chemicals. The main purchase criteria of this client group are price and quality. The second customer group is the multinational for which the subsidiary distributes all products to its regional clients. The main purchase criteria of this client group are speed of delivery, after- sales support and price.
To segment a company based on competencies it is necessary to understand the value chain.
Step 2-3: Interrelated process Step 2: Identify potential attractive
market Match specified business
units strengths with identified attractive market
(§3.4.2) Step 3: Specify business units’
strengths in identified attractive market
Step 1: Identify strategic business units (§3.4.1)
Current Demand
Skills to satisfy demand
For the purposes of segmentation the areas of the value chain in which the company has to be outstanding to succeed in each customer segment must be identified (Scott, 1998). In the divested chemical subsidiary case, a quick purview of the value chain (exhibit 3.2) clearly shows that the critical competencies to compete in both customers markets differ. This almost certainly means that the two markets should be serviced by separate strategic business units.
Exhibit 3.2 Illustrative hierarchy of competencies necessary to different chemical segments (following Scott, 1998, p. 18)
The synthesis of the segmentation analysis based on both customer needs and competencies should give a clear sense of the discrete business areas in which the divestment competes. If the competencies necessary to meet different customer’s demands appear similar then the segments can be grouped into a single strategic business unit (Scott, 1998, p.19).
In exhibit 3.3 the divestment is clustered in two strategic business units. The segmentation analysis gives the foundation from which to understand the basis of value creation in each segment. Furthermore the segmentation can be used to structure the (declining) supply and service contracts, and to indicate in which segments new business has to be generated.
Exhibit 3.3 Illustrative clustering of the chemical subsidiary business activities into strategic business units based upon competencies and purchase criteria (following Scott, 1998, p. 20
Quality Price Speed of delivery After-sales support Performance charasteristics Brand appeal/endorsement
Marketing Sales and Service Distribution
Core production process
Purchasing and supplier process
Competencies
Purchase criteria Core
Production Process Purchasing
and Supplier Process Human Resource Management
Information Technology
Finance
Innovation Government
Relations Sales and Services Marketing Distribution
Supporting, non critical, tasks
Critical for competing in distribution segment Critical for competing in production segment
