This article is written by Alyan Virani pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.

Introduction

Divestment is the scrapping of the business or a company’s assets through either exchange, closure, sale or bankruptcy. The disposal can either be partial or full and can occur depending on the cause of the decision the management took to opt to sell or liquidate the resources of the business. Divestment is also known as a divestiture, and as the name suggests, it is the opposite of investment. It is usually done when that asset is not living up to the expectations. There are several cases wherein a company may be forced to sell its assets due to legal or regulatory action. Companies also look at a divestment strategy to satisfy other goals which can include financial, social or political. Some examples of divestitures include selling intellectual property rights, mergers or acquisitions (corporate) and court-ordered divestments. For example, Mr Raj had previously invested  Rs. 4,00,000 in MNZ Ltd. for the last few years for 1000 shares in the company. Now, he plans on selling his shares to Mr Rushabh.

Here Mr Raj is disinvesting in MNZ Ltd. It is pertinent to note that generally, disinvestment is a term used in the cases of Public Sector Undertakings (PSUs). When the government sells its shares in PSUs (Companies where the government has more than 51% ownership) to Private entities, it is called disinvestment.

What are the types of divestment?

Spin-off

It is basically creating a subsidiary with the exact proportion of shares as the main company. In simpler terms, a spin-off takes place when a company creates a subsidiary. The holding in both the subsidiary and the main company is in the same proportion. A spin-off is usually carried out when the company wishes to take different decisions, distinct approaches and payment structure; and additionally wants to give an extra push to a product.

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Example: Let’s assume a company, Afio Ltd, has several lines of businesses like manufacturing: 

  • Cosmetic products
  • Athleisure wear
  • Duffle bags 
  • Footwear 

One day the company realises that its athleisure wear segment is doing significantly well but since the company’s primary segment is footwear, it is not able to focus on the athleisure segment. This is when Afio Ltd decided to spin off the athleisure company on its own with an independent management team, CEO, resources etc. The shareholders of Afio Ltd become shareholders of the athleisure company. The newly formed athleisure company becomes a publicly-traded company with its own business units and products. 

Split-up

In a split-up, a number of subsidies and a parent company are created from the main company. In this particular process of splitting up of the main company, the company essentially forms a holding company (which has no physical operations but only financial assets) and this holding company, in turn, holds the shares of the subsidiary companies. The shareholding could be different in each company.

A split up is basically carried out when a company is into myriad businesses, and the management proficiencies to run these vast number of activities cannot be managed altogether by the core management, hence a company is then split up into smaller and more number subsidiaries. There is no intrusion from the people who are not in charge of the management or have no rights in the operations making decisions of each subsidiary. This is the most appropriate tool to divide the wealth of a family.

Example-  The announcement by United Technologies on November 26, 2018, to split-up into three separate companies: United Technologies, Otis Elevator Company, and Carrier. While the United Technologies name will remain the same for one of the three companies, the new company (UTC) will be an entirely new entity from its original parent (UTX). 

Split-off

This means separating a business vertical and selling it to a potential buyer. This type of setting is very identical to that of a business transfer. In the entire process of split off, the selected vertical of a company is separated into a different and new company; and then sold to the interested third party.

A split-off is mostly carried out when the company wishes to exit from the business of a  certain product line or physical location. 

Example- One notable example is the split-off of Synchrony Financial (SYF) from its parent General Electric (GE) on November 17, 2015. Synchrony Financial was a wholly-owned subsidiary of General Electric, but then it was eventually decided to separate its financial business from its core industrial business. 

Equity carve-out

In equity carve-out, the holding company lowers its holding in a subsidiary company to a minuscule fraction and rather than showing it as a subsidiary it is shown as just another additional investment. All the income generated from such an investment is counted as investment income.

Equity carve-out takes place when a holding company has a substantial shareholding in a subsidiary, it has to compulsorily report the consolidated income and also perform a lot of compliance activity. By becoming the minority shareholder of the company, the statutory and regulatory risk of the subsidiary is automatically eliminated. 

Example- The most relevant examples of equity carve-out would be GlaxoSmithKline selling its consumer healthcare business, including its health food drinks portfolio, to Hindustan Unilever, and L&T’s exit from its electrical and automation business via a sale to Schneider Electric.

Reasons for divestment 

There are several reasons for divestment or why a company may make the decision to sell an asset, business unit or the entire company. The first reason is to sell off redundant business units wherein the company decides to sell a part of their core operations if they are not performing. This will allow the company to focus more on the units that are profitable and performing well. The next reason why a company may take this decision is to generate funds. The company can do this by selling a business unit for cash which could act as a source of income without a binding financial obligation. 

The next reason is to increase resale value. If the sum of a company’s individual asset liquidation value is greater than the market value of its combined assets, this suggests that the company would gain more by liquidating the assets compared to if they hold it. In addition, a company may face financial problems and instead of shutting down or declaring bankruptcy, they might choose to sell a business unit to ensure business survival. Lastly, a company may comply with the law if the court requires the sale of a business to improve market competition. 

Strategies for divestment

There are several strategies for divestment which are minority divestment, majority divestment, strategic divestment and complete divestment or privatization. The first one is minority divestment. In this strategy, the government wants to retain managerial control over a company by having a majority stake which suggests that the government has a stake equal to or more than 51%. Since public sector companies serve the citizens, the government needs to have control or influence over the companies policies to serve the interests of the general public. The government usually auctions the minority stake to potential investors or announces an offer for sale which allows the public to participate. 

The next strategy is majority divestment. In this strategy, the government gives up the majority stake it holds in a government company. After the divestment, the government is left with a minority stake in the company. Strategic grounds and government policies affect this decision. Usually, majority divestments are done to favour the other public sector companies. An example of this would be Chennai Petroleum Corporation Limited who is a group company of Indian Oil Corporation after the divestment by the government. This leads to operational efficiency. 

Another strategy is strategic divestment in which the government sells off a PSU to a private entity. The reason for this is to transfer ownership of a non-performing organization to private players to reduce the financial burden on the government balance sheet. Transferring it to the private players would increase efficiency due to competition. 

The last strategy is complete divestment or privatization. As the name suggests, 100% of the government stake in a PSU is sold to a private entity. This results in complete ownership and control for the buyer. 

Process of demerger

Demerger refers to a corporate reorganization in which a business is broken down. This can be either to function on their own or to be liquidated. In simple terms, demerge is a separation of one or more units to form a new company. 

Section 232 of Chapter XV of Companies Act 2013 deals with mergers and amalgamation including demergers.

However, demergers have a long process and contain several steps. The first step is the preparation of the scheme of arrangement. This is the most crucial document in this process by which the company binds all the related stakeholders on the terms of the demerger. This document would deal with aspects like the share swap ratio, details of the transfer of debt, transfer of employees, liabilities, assets and much more. The scheme of arrangement can be proposed by either the directors of the company or the liquidator of the company. This would have to be accepted by all the shareholders, creditors, employees and all the other related stakeholders. 

The next step in the process is the application in court. This can be completed by making an application to the High Court and through orders issued by a judge. To start the demerger process, an application must be filed in form 33 along with the affidavits of the promoters and several other documents. The documents to be submitted include:

  • Extract of Board Resolution approving the scheme
  • List of shareholders and creditors
  • Explanatory statements, and replacement or substitute, draft notice of meeting
  • Scheme of arrangement
  • Memorandum and Articles of Association of the company
  • Latest audited balance sheets

Next, a notice must be sent to the interested parties by the individuals who are authorized 21 days before the date of the meeting along with the scheme of arrangement and proxy forms. This notice would be published through form 38 through newspapers. 

Moreover, a meeting should be held according to the court guidelines. The outcome of the meeting should be recorded along with the votes, either for the motion or against it. The chairperson must also submit a report in form 39 within the time approved by the court.

Lastly, a petition has to be submitted to the court in order to authorize the demerger. It has to be sanctioned by at least 75% of the members to file an appeal. Once the court has heard all the objections, it checks the applicability of the scheme submitted and eventually issues an order. The court would then pass an order which approves the demerger in the same newspaper in which the notice of the meeting was advertised. 

Conclusion

Divestment is essentially a more labour-intensive process as compared to acquiring a new entity. On one hand, business acquisitions do take a considerable amount of time and effort, whereas, on the other, divestment comes with stringent time constraints.

It is solely due to the extensive planning that is required and the timely execution of the divestment from the seller before the transaction comes to an end. It also mandates the seller to handle the marketing and selling of the divested entity parallelly. Finally, companies may take into account the concept of divestment for a number of reasons such as alternative investments, exiting a competitive market or even generate funds. 

References 

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