Don Sull's blog

In my last post, I argued that turbulent markets demand portfolio agility–an organization’s capacity to reallocate cash, people, and other resources from stagnant or declining businesses into promising opportunities, and do so in a timely manner. Effective portfolio agility consists of both investment and disinvestment. Unfortunately, most companies are better at getting into new businesses than they are at getting out of declining subsidiaries or ones that no longer fit as the corporate strategy evolves. Firms can rarely avoid disinvestment forever, but they often delay the inevitable for far too long. These delays consume scarce resources, and starve promising initiatives of the cash they need to succeed.

Research has shown that companies regularly divest businesses to re-balance their portfolio. In a study of 9,276 deals completed by 86 of the Fortune 100 firms in the 1990s, Belen Villalonga and Anita McGahan report that the median number of divestitures was 17 for firms they studied. Divestitures were almost as common as major acquisitions–the median for firms in their sample was 19 completed acquisitions over the same time period.

In another study of 1,305 firms from 59 industries between 1990–1999, Harold Mulherin and Audra Boone find that 17% of the firms in their sample engaged in major divestitures during the 1990s, while 26% conducted large acquisitions (and 4% did both).  They also report significant differences in divestiture activity across industry, with widespread divestiture in the diversified chemical (67% of firms in that industry divested), telecommunications (48%), and integrated petroleum (48%), while other industries, including cosmetics, securities brokerage, and grocery stores reported no major divestitures.

The large, public firms analyzed in these studies clearly rely on divestment to free up resources. These corporations, however, often delay sales beyond the economically optimal point, destroying value in the process. In their influential book Mergers, Sell-offs, and Economic Efficiency, David Ravenscraft and Frederic Scherer find that divested business units underperformed for seven years on average before their parent firm finally spun them off.  Tim Koller and his colleagues at McKinsey studied fifty large divestitures announced by  public firms between 1998 and 2001, and found that only one-third were spun out in a timely manner once the unit’s performance began to decline. In two-thirds of the cases, the selling company allowed the business to suffer prolonged under-performance, and in many cases divested only under mounting pressure from shareholders.

Outright sale is not the only way to pull resources out of a business–managers can also close a unit down or milk it for cash. Firms often delay these disinvestment as well. Several years ago, I analyzed how the US tire industry responded to the introduction of radial tires. The new tires lasted twice as long as the technology they replaced, and their rapid adoption rendered approximately one-half of the 57 North American tire factories obsolete. In this study, I found that the tire manufacturers did indeed shutter approximately half of the industry’s productive capacity, closing 29 plants between 1975 and 1987. The average closed plant was shut 3.2 years after first suffering negative cash flows, and lost $47 million cumulatively in those three years. Three plants lost over $100 million each. Only five of the 29 plants were closed in the same year that their cash flow fell below zero.

Delaying exit reduces the resources available to invest in promising opportunities in several ways:

• Sustained negative cash flow can quickly add up to material value destruction. In the tire industry, total pre-tax cumulative losses for all 29 plants totaled $1,374 million. To give some sense of magnitude, this loss represented 45% of the market capitalization ($3.1 billion) of the public tire companies in the sample in 1974.  These losses deprived managers of the financial wherewithal to invest in other promising businesses in their portfolios.
  
• The longer managers delay selling a deteriorating business unit, the lower the price they can expect to receive. While other publishing companies hoped for the best as digital technology took off, Thomson Corporation, which owned over 100 newspapers in the North America and the UK in the 1980s, began selling off its papers by in the mid 1990s. Thomson used the proceeds to invest in digital information companies including West Publishing and Reuters.
• Business units in perpetual crisis absorb a great deal of attention and emotional energy as top executives spend inordinate time trying to fix a business that, in the end, may have no place in the portfolio. The CEO will often appoint  extremely promising managers, who then burn out trying to fix the unfixable. This executive attention, energy, and talent could be more productively deployed on building new businesses instead.