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Macroeconomic conditions have had a dampening effect on deals — including divestitures, which dropped to near historic lows at one point in the past couple years. Many companies have focused on reducing costs and improving their balance sheets instead of making deals. But an M&A recovery has begun and, in our view, many companies are shying away from an opportunity to recapitalize by delaying, or not even considering, divestitures.
Many executives waiting for interest rates to go down have held deal activity in neutral instead of shifting gears and moving forward. That reluctance to act has resulted in opportunity costs but not improved financing costs. A proactive continuous portfolio monitoring approach, which includes annual portfolio reviews and willingness to consider and complete divestitures, can help create more long-term value in three ways:
- Preventing companies from pouring capital and resources into businesses that are not key to their core
- Investing capital into core businesses with higher value creation potential
- Paying down debt to help create options for growth and capital expenditures, free up cash flow and improve investor confidence
Short-term pain, long-term gain
Due in part to uncertain economic conditions, many organizations have been reluctant to address portfolio imbalances. But uncertainties like these have always existed. In our discussions with clients over many years, we have found that organizations often are unable to justify their slowness to move. Executives tend to be more reluctant to shed an asset than to buy a new one due to a stigma around divestitures that is fueled by inertial forces and executives’ emotions.
A wait-and-see strategy on divestitures can risk eroding value. According to a PwC study, 57% of respondents who tried to fix a business unit said the unit’s value deteriorated or stagnated. Our experience with clients tells a similar story. Companies that delay selling due to a valuation gap often fetch lower proceeds when marketing the business unit a second time. The result is often an erosion of value when taking into consideration the capital infusion made to try to fix the business unit, holding costs and the return on investment (ROI) the seller could have realized with the proceeds. Also, PwC research found that over the years, the market rewards sellers with higher excess returns compared to their respective S&P sector index.
Strategic divestitures can help companies strengthen their balance sheets, reduce debt and enhance liquidity, which can be particularly important during periods of economic uncertainty. And while differences in valuation gaps between sellers and buyers can pose challenges to completing deals, divesting non-core businesses can help companies unlock value and bridge these gaps. By divesting non-core businesses, companies can reallocate capital to more promising areas of their business or invest in growth opportunities that can offer higher returns. Divestitures can also provide companies with the flexibility to adapt to changing market conditions and focus on strategic initiatives that can help drive long-term value creation.
Stay proactive amid uncertainty
The Federal Reserve will continue to adjust interest rates to help address policy goals (keep the economy out of a recession, reduce inflation, etc.) But we believe today’s market is the new norm: Rates are unlikely to return to the ultralow levels that predominated between the Great Recession and the global pandemic.
That doesn’t mean deals can’t get done, and there is a market for quality deals. A generation ago, strong M&A activity occurred for years with similar interest rates to the ones we’re operating in now. In our view, the problem is psychological. Both buyers and sellers should have a mindset shift that reflects the changed economic environment. Put another way: Dealmakers on both sides of negotiations should be more realistic about valuations.
Competition for dealmaking may be around the corner
Private equity (PE) firms have access to a substantial amount of liquidity and typically operate within a defined investment horizon. Current economic conditions could lead PE firms to a phased capital deployment, finding opportunities that meet their deal thesis requirements. This is an opportunity for companies to help streamline their operations and raise capital amid economic uncertainties — and for the carve-out business to grow as a standalone company.
Moving forward
There are several steps companies can take to position themselves to take advantage of opportunities in this environment:
- Conduct timely portfolio reviews. Companies should review their portfolios regularly to make sure all their businesses fit with their long-term strategy. Executives should ask themselves if they are the suitable owner of the assets and keep an open mind on valuations and analyze the costs of holding on to the business — including the amount they will invest before divesting and a potential continuing decline in value. Compare those holding costs to the existing valuation gap when making decisions.
- Employ a value investor mindset. Uncertainty, whether involving potential interest rate changes or regulatory shifts due to elections, will never go away entirely. The better play is to be proactive, continue to foster a proactive portfolio review culture and divest non-core assets as quickly as possible and use the capital generated from the divestiture to invest in other businesses with higher growth and profitability potential.
- Prepare for more thorough diligence. Acquirers now have higher hurdle rates due to the increase in the cost of capital. They’re investing more time and resources into diligence to help improve the chances for a successful deal. Sellers should be ready for a more thorough diligence process than a few years ago.
- Accelerate transformation through divestiture. Divestitures can be a catalyst for organizational transformation and business model reinvention, enabling companies to become more agile and competitive and changing how a company makes money, serves customers or provides new products or services. Companies can face many disruptions, including nearshoring, technological advancements and demographic shifts. Transacting to transform allows executives to address these challenges more quickly than through organic strategies.
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