Corporate Restructuring and Reorganisation

Corporate Restructuring and Reorganisation

Syllabus tag: KASNEB CPA | Advanced Level | CA33 Advanced Financial Management | Topic 7 Corporate Restructuring and Reorganisation

Lesson objectives

By the end of this topic, you will be able to:

• Distinguish the forms of divestment
• Explain the conglomerate discount and how a demerger releases value
• Evaluate a management buyout and its financing
• Evaluate a sale and leaseback
• Describe defences against a hostile takeover

Why this matters

Topic 6 built companies up by acquisition. This topic takes them apart — and the arithmetic often shows that a division is worth more outside the group than inside it.

Forms of divestment

Form	What happens
Sell-off	A division is sold to another company for cash
Spin-off / demerger	Shares in the division are distributed to existing shareholders; no cash changes hands
Management buyout (MBO)	Existing management buys the division
Management buy-in (MBI)	An outside management team buys it
Liquidation	Assets are sold piecemeal and the entity dissolved

Reasons to divest: to raise cash, to exit a non-core activity, to remove a loss-maker, to escape a conglomerate discount, or because a buyer values the business more highly than the group does.

The conglomerate discount

Diversified groups often trade below the sum of their parts. Three reasons are usually offered:

• Analysts cannot value them — a group spanning several industries is hard to compare with anything
• Cross-subsidy — cash from good divisions props up weak ones, which a standalone business could not do
• Investors can diversify themselves, more cheaply than a company can do it for them

A worked illustration. A division earns operating profit of KES 48,000,000 before tax at 30%. Its sector's P/E is 9; the parent group trades on a P/E of 13.

	KES
Post-tax earnings (48m × 0.7)	33,600,000
Value at sector P/E of 9	302,400,000
Value at group P/E of 13	436,800,000

Here the group multiple is higher, so the division is worth more inside the group than out — and a demerger would destroy 134,400,000 of value.

Reverse the multiples and the conclusion reverses with them. Where the group P/E is the lower figure, separating the division releases value. That is the whole logic of a demerger, and it depends entirely on which multiple is higher — a point worth stating rather than assuming demergers always create value.

:::checkpoint A group trades on a P/E of 7 while its main division's sector trades on 12. Compute the effect on that division's value of a demerger, using post-tax earnings of KES 33,600,000, and state what the board should consider. :::

Management buyouts

Management buys the business it already runs, typically with a small equity stake and a great deal of debt.

Why they often succeed: the managers know the business intimately, they now own the upside, and heavy debt imposes discipline — interest must be paid, which concentrates attention on cash.

Why they fail: the debt burden leaves no margin for a downturn, and investment in the longer term is cut to service it.

A typical structure. A division is bought for KES 400,000,000, funded by KES 320,000,000 of debt at 13% and KES 80,000,000 of equity.

Gearing is 80%, and annual interest is KES 41,600,000 — which must be covered by operating cash flow before anything reaches the owners.

If the equity is worth KES 200,000,000 after five years, the annual return to the managers is:

(200 / 80)^(1/5) − 1 = 20.11% a year

The leverage is what produces that return, and it is also what makes the structure fragile. The conflict of interest should be noted too: managers negotiating to buy the business they run have every incentive to depress its apparent value first, which is why an independent valuation is essential.

Sale and leaseback

The company sells an asset — usually property — and leases it back.

Proceeds KES 180,000,000; annual rent KES 24,000,000 for ten years; discount rate 11%:

PV of the rentals = 24,000,000 × 5.8892 = KES 141,341,568

Net benefit = 180,000,000 − 141,341,568 = KES 38,658,432

On these figures the transaction is worthwhile. Note what the arithmetic does not capture: the company loses any future appreciation in the property, loses the asset as security for other borrowing, and commits to a rental it must pay whatever trading conditions are like.

Sale and leaseback is often a sign of financial pressure rather than financial engineering. An examiner will credit a candidate who says so.

Takeover defences

Defence	How it works
Revaluing assets	Shows the offer undervalues the company
Improved forecasts or dividend	Persuades shareholders to hold
White knight	A friendlier bidder is invited in
Poison pill	Rights that make the company unattractive once a bid succeeds
Crown jewels	Selling the assets the bidder most wants
Referral to regulators	Competition grounds

The agency problem runs straight through this list. Directors resisting a takeover may be protecting shareholders from an undervalue — or protecting their own positions. Crown jewels and poison pills in particular can destroy value for the shareholders they claim to defend, and are restricted or prohibited in many jurisdictions for exactly that reason.

The test to apply: would the defence still make sense if the directors kept their jobs either way?

:::checkpoint A board rejects a bid at a 40% premium, citing the company's long-term prospects, and immediately sells its most profitable subsidiary. Analyse whose interests are being served and what the shareholders should ask. :::