Why break-ups can be beneficial

Mr Howe's rationale was that the sprawling nature of conglomerates made them impossible to manage effectively, and that smaller companies with more autonomy and management focus could perform better. Here's an interesting extract from his budget speech of 1980 that seems strangely apt today.

"For many years, the fashion both in government and in industry was to favour mergers and amalgamations. No doubt mergers have brought advantages in some cases, but it is now quite clear that the fashion for industrial elephantism was greatly exaggerated. I believe that there are cases where businesses are grouped together inefficiently under a single company umbrella. They could in practice be run more dynamically and effectively if they could be 'demerged' - I apologise for that word, which has now become part of the jargon – and allowed to pursue their own separate ways under independent management."

Although legislation has moved on since then, the principles of the Income and Corporation Tax Act introduced by Mr Howe still forms the basis of the UK's demerger legislation. In particular, its main tenet allowing companies to demerge businesses without incurring a tax liability for either the parent company or shareholders – remains intact. So, the distribution of shares are exempt from income and capital gains tax as well as stamp duty.

Demergers quantified

Deloitte and Touche conducted a major study, looking at global demergers over a 10-year period from 1998. The results show that parent companies saw an average 23 per cent increase in their share price in the year after the announcement, while the spin-offs gained 15 per cent in the year after coming to market.

That's corroborated by the rigorous research of Mr Kirchmaier, but he adds an extra dimension to the analysis, which suggests that while it's true that demergers can create value, the returns can be maximised by good timing.

The starting point is that, in the year before the announcement of demerger plans, shares in the parent company tend to significantly underperform the market. But in the 100 days before the announcement, most of those losses are recouped. As Mr Kirchmaier says, this: "is hard to explain, as by definition, the market should not have any knowledge of the upcoming event".

But announcement day – day zero – is where things start to get interesting. In the first two days after the announcement, the average return for the parent company is 4.1 per cent, suggesting the market generally greets the prospect of a demerger as good news.

That may be the point at which you decide to bail out of the parent. Mr Kirchmaier has examined the performance of both the parent and the spin off in the three years – or 769 trading days – after the demerger, and found that on average there is virtually no value created in the parent company – that is, the part of the business retaining the core name and holding the bulk of the value – over the period.

It's a different story at the spin-off, though, which over the same period was found to outperform the market by 17.3 per cent. Interestingly, spin-offs tend to show their strongest outperformance in their second year of standalone life – as Mr Kirchmaier points out, it takes a year for firms "to reconfigure themselves in a way so they can exploit the benefits of a more focused organisation". That's good news for any shareholders worried that they may have missed out on the upside from the recent flurry of UK demergers – we'll talk through each in more detail.

Demergers demystified

Demergers – or, in the US lexicon, spin-offs – involve a transfer of ownership of a subsidiary to the company's existing shareholders, who do not have to pay for the shares in the new company which they receive. The spin-off exists as a standalone entity.

An equity carve-out differs from a demerger, in that shares in the new company are not distributed to existing shareholders but instead offered for sale to the wider market through an initial public offering (IPO). Because of this, carve-outs don't enjoy the same tax status as demergers.

A third way that companies can capture value from business that no longer fit in with the corporate structure is through a sell-off, which is often the easiest way for companies to dispose of smaller non-core assets that do not necessarily stand on their own as listed companies. The main problem faced in this approach is whether a buyer can be found who's willing to pay an acceptable price, although at least sell-offs tend to be smaller in size.

Breaking up is never easy

Of course, just as M&A can prove challenging when it comes to integrating new businesses, so demergers can sometime look better in theory than they turn out in practise. Deloitte's study showed that companies that took at least nine months to plan demergers tended to produce returns twice as good as those that attempted a quickie divorce. Fire sales, in other words, are less likely to work, and Mr Kirchmaier says that demergers are a bad option when companies are struggling for survival.

Deloitte also points to evidence that suggests some industries are better at demergers than others. Financial services parent companies on average manage just a 2 per cent return in the year after the announcement, while TMT and manufacturing demergers manage a 29 per cent and 38 per cent rise, respectively. Smaller firms that demerge are also likely to do better, according to Mr Kirchmaier, and so are the parents of those companies – large spin-offs and their parents both tend to underperform in the three years after, by 20 and 29 per cent, respectively. That's partly, but not entirely, because smaller firms are more susceptible to takeovers.

Another study by research outfit Macrothink - based in India, where demergers are growing in popularity as large family-owned companies 'de-conglomerate' - reaches similar conclusions. But it adds that sometimes businesses turn to the approach simply because it seems a good short-term solution to pushing up the share price, rather than because there is any genuine business advantage to be gained in making the split. "Investors should differentiate between genuine attempts at value creation and de-mergers undertaken to create hype around stocks. Stay away from dubious companies that want to manipulate prices," it warns.

And sometimes a planned demerger simply doesn't get off the ground at all, resulting in lost management time and focus, as well as the write-off of costs incurred during the preparation – investment bankers, as we all know, don't come cheap.

Shaky foundations

That's exactly what happened to our first unlucky company. In November 2007, Land Securities announced an ambitious plan to split itself into three companies, with its retail and office properties spun into separate Reits - both large enough to have entered the FTSE 100 - and its property management arm, Trillium, becoming a third standalone company. At the time, management said the split was a reflection of the organisational structure under which the business was being run rather than a means of propping up the ailing share price. However, the plan was shelved as the property downturn of 2008 ripped through Land Securities' portfolio – Trillium was sold to Telereal for £750m in January 2009, significantly lower than the £1bn valuation it had hoped to achieve a year earlier.

Egg on its face

Prudential has made all the wrong headlines for its ham-fisted attempts to take over giant Asian insurer AIA. It didn't have much better luck with the carve-out of its internet bank, Egg, nearly 10 years ago. To be fair to the Pru, Egg was a pioneering idea when launched in 1998, and has since grown to become the world's largest pure-play online bank. But the Pru's decision to float the business just two years after launch looks premature with hindsight – some may say flagrantly opportunistic, given the dot-com bubble inflating at the time. Six mostly loss-making years later, and Pru ended up buying back the 21 per cent it didn’t own for £200m, before selling the whole lot to Citigroup for £575m a year later. Far from creating long-term shareholder value, the premature decision to spin off the business and expand into Europe was hugely costly. And, ironically, the failure of the AIA deal means that some analysts have suggested that the Pru is now as vulnerable to a break-up itself.

The attractions of divorce

At the time Geoffrey Howe pushed through this legislation, he was basing his view more on the overriding feeling that conglomeration had run amok than hard statistical proof – in fact, some conglomerates were doing very nicely at the time. And, of course, there was precious little financial evidence to prove that a spin-off would do any better than it would as part of a conglomerate – demergers, after all, had never happened before in the UK, although had been part of the US corporate landscape for some time.

What's more, simple mathematics don't account for the additional value supposedly created by demergers. Theoretically, the value of two demerged businesses should be identical to the previously combined entity, because the cash flows remain the same and there are no financial synergies gained from divestment. In fact, the extra management required to run two businesses should in fact increase overheads.

Since then, the subject has been investigated thoroughly, in the main by Dr Tom Kirchmaier, strategy specialist at Manchester Business School and fellow of the London School of Economics. He's found that very often the sum of the parts is in fact worth more than the whole, because in many cases, managers planning demergers often identify negative synergies in conglomerated businesses.

More often than not, these revolve around the inability to manage the group effectively, either because it has simply become too big or bureaucratic, or because the organisational processes don't suit all units within the group. Demergers can release value because earlier mergers have proved difficult to integrate, and are being offloaded after failing to generate the expected returns, or that mergers have refocused the strategy of the business, rendering other parts of the group surplus to requirements – in the words of lawyers Allen and Overy, "allowing management to rationalise those company division or product areas that do not fit optimally within the larger, evolving corporate structure".

Another, even simpler, explanation is that because the market naturally discounts conglomerate businesses, company management believes that a demerger can achieve a higher aggregate valuation. "Stock analysts can value separated businesses better," said George Budden, a corporate finance partner at accounting giant Deloitte and Touche. Mining group Petropavlovsk, for example, is now talking of a demerger of its iron ore business, Aricom, little more than a year after merging with it, because it does not believe the market is attributing it its full value.