What are Demergers: Its Pros and Cons

Mergers and acquisitions are often used by conglomerates to create value. However, in some cases, demergers have also been effectively used. While the workings of mergers and acquisitions are well known to many people, demerger is still considered somewhat of a mystery.

In this article, we will have a closer look at what a demerger is and how it can be effectively used to generate value.

What is a Demerger?

A demerger can be defined as the transfer of a company’s business undertakings to another company. The source company, i.e., the company whose undertakings are being transferred is called the demerged company. The other company is often known as the resulting company.

Demergers can be of more than one type. Some examples are given below:

• In some cases, a division or a line of business of a conglomerate company ends up becoming a separate entity. This type of demerger is called a spinoff.

  For instance, company A used to operate in two lines of business viz. logistics and hospitality. If company A decides to separate all its logistics business in a separate entity, it would be called a spinoff. It needs to be noticed that both companies would exist as separate legal entities. Hence, A would still exist, and a new company B would also come into existence. The parent company would not be dissolved as a result of this separation of concerns.

• In other cases, a conglomerate may want to split its businesses into separate companies. This is called a split.

  For instance, if company A decides to create two new companies B and C to hive off its hospitality and logistics business respectively, such an arrangement would be called a split. It needs to be noticed that company A would not continue to exist in this case.

• In other cases, company A may want to sell off its logistics business to an external party. Hence, it may sell some portion of its equity stake in a subsidiary company to a third party or to a strategic investor. This type of transaction is called an equity carve out. There are two things to be noticed about this transaction.

  Firstly, spin-offs and splits do not constitute a sale to an external party. Hence, an equity carve-out results in the infusion of cash whereas spinoffs and splits do not.

  Secondly, in this case, A remains the same legal entity. The carved out unit B becomes part of another company i.e. it does not remain an independent unit under the aegis of the parent company.

Advantages of a Demerger

Some of the most obvious advantages of demerger have been listed below.

• Focus on Core Competency: Conglomerate companies are known for not have focused business operations. These companies try to manage a lot of diverse operations which require different competencies. In several cases, these companies lose to competitors who have a single-minded focus on any one particular line of business. The modern business environment is more about specialization. Generalists do not survive for very long. It is for this reason that it is important that companies need to focus on their core competencies. This reasoning has led many conglomerates to streamline their operations and demerger has been a major tool used during the process.

• Management Accountability: When companies are split off, the management of each company has its own balance sheet. As a result, it is not possible for certain entities in the group to live as parasites off the earnings of other entities. The management of each company becomes accountable for its own financial results. Also, management tends to have more control over their operations. They have the right to make their own investments and even raise funds from the market on their own account.

• Increase in Market Capitalization: In many cases, demergers are used to create stock market value. Investors have more visibility over the operations and cash flow of a firm that has been spun off. This enables them to make better investing decisions. Investors are willing to pay a premium for this better information. As a result, spinning off units to form separate legal entities does result in increased market capitalization for the group as a whole.

How Demergers Actually Work

In order to conduct a demerger, the following steps need to be followed:

• The value of all the assets related to the resulting company needs to be found out and listed

• The value of all the liabilities related to the resulting company also needs to be found out and listed

• These values are then transferred out of the balance sheet of the demerged company and into the newly created balance sheet of the resulting company. The transfer of these assets and liabilities takes place at their current written down value in the balance sheet of the parent company.

• In very few cases, a premium may be paid to the demerged company. However, such practices are heavily scrutinized by the tax authorities. This is because there have been past instances where demergers have been strategically used to evade taxes.

To sum it up, demergers are an effective corporate strategy. They can be used to unlock value as well as to streamline the operations of a firm.