Demergers are a common corporate action that can create value for investors and traders alike. Find out the different ways a company can divest its assets through spin offs, split offs and carve outs.
What is a demerger?
A demerger is a restructuring strategy in which one company separates part of its business into a new entity by transferring business and assets. Ultimately, the two will operate as independent companies. The term demerger can also cover a segment of a larger company being sold or liquidated.
Why do companies demerge?
Companies demerge brands or business units for a number of reasons, mainly to:
- Expand into new markets – operating in different regions and markets can make a balance sheet complicated. Dividing up a business can create clarity on each entity’s core activities
- Raise capital – splitting up a large business can give investors a clearer idea of cash flow and operations, making them more willing to pay a premium for the separate businesses
- Streamline business operations – it’s a good strategy to separate out business segments that are underperforming and causing the overall performance to decline
- Prevent an acquisition – dividing up a business can fend off hostile takeover bids
- Manage regulations – if a section of a business operates in a highly regulated market, they might demerge this part to ensure the rest of the company isn’t restricted
How do demergers impact share prices?
Typically, news of a demerger will have an immediate positive impact on a company’s share price as it looks as though management is taking positive steps toward making operations clearer and more efficient.
After the deal is complete, the share price of the parent company is likely to fall as the equity is split up. This volatility could continue for some time for both the new and old stock. Research by Macquarie Group suggests that the new entity could underperform for a period of about six months while it finds its footing.
For buy and hold investors, the volatility shouldn’t be cause for concern, but it will be important to assess the cash flows of both entities going forward before making any decisions. And for traders, the volatility around demergers can create exciting opportunities for going long and short on the share prices of both companies.
Learn about the differences between trading and investing in shares.
How to demerge a company
There are a few different ways a company can demerge certain assets or divisions, namely:
- Spin offs
- Carve outs
- Split offs
These three processes are often all described as spin offs, as that’s the most common type of demerger. But there are some key differences between each process that can influence a company’s decision. Let’s take a look at each way to demerge a company in more detail.
What is a spin-off company?
A spin-off company is created when the parent company distributes shares of the new subsidiary to existing shareholders – usually in the form of a special dividend. After the spin-off, there are two distinct entities with their own management.
The newly formed company will retain the same assets, intellectual property and staff as it had under the parent company.
The parent company receives no cash in the spin-off but retains an equity stake in the new company. After the demerger, existing shareholders will own two shares of separate companies in the place of just one.
Examples of spin offs include:
Why spin off a company?
Companies spin off subsidiaries and divisions that are expected to be worth more as independent businesses than as just one part of a larger firm.
Under a spin off, a company can choose to relinquish 100% of its shares in the subsidiary, but most will spin off the 80% required to satisfy regulations around the process – retaining a 20% stake.
This brings us to the next major benefit for companies. Spin offs can be more tax efficient for both the company and shareholders. However, this is contingent on the parent company relinquishing at least 80% of its voting and non-voting shares.
What is a carve out?
A carve out is the process of a parent company selling shares in its subsidiary to the public through an initial public offering. This creates a new set of shareholders and equity for the company.
Carve outs often don’t happen in isolation. They can mark the first step toward a company performing a full spin off or split off from the parent.
However, in order for the spin off to take place later, a company can’t sell too many shares at its IPO. As we’ve seen earlier, in order for a spin off to be tax efficient, they have to sell 80% of its shares. If the firm has already sold more than 20% in the carve out, but want to retain some equity, it’s unlikely they’ll be able to do both.
Why carve out a company?
Companies choose to carve out a subsidiary if they want to receive a cash inflow from a new pool of investors, rather than their existing shareholder base. The parent company still retains an equity stake in the business, but often gives up a lot more control than in a spin off.
For example, while a spin-off company usually has directors from the parent company sitting on its board, a carved-out firm might have no involvement from the previous management.
Carve outs are a more common solution for when the area of the business being demerged is a ‘problem’ area. It means the parent company can capitalise on the business by selling shares but doesn’t have as much involvement in operations or obligations going forward.
What is a split off?
A split-off company is similar to a spin-off company, in that the parent company will offer shares to existing shareholders, but there’s a catch: they have to choose. A shareholder can either continue holding shares in the parent company, or exchange some (or all) of their holding for shares in the new company.
Why split off a company?
A company would split off a unit for the same reasons it would perform a spin off: to boost shareholder value. The only difference is the method of distributing the new shares.
A split off can be thought of as more like a stock buyback. The parent company wants to get back its equity from shareholders by offering them shares in a new company in exchange. They usually give a premium to shareholders to encourage them into the offer, meaning the new shares will be worth more than their old ones.
A split off is often a follow-on step after a carve out, as the listing of the new company on a stock exchange provides a clear indication of how the new stock’s price measures up to the parent company’s – giving investors an idea of which company’s shares they want to own.
How to trade stocks with City Index
Whether you’re looking to trade shares in a parent company or a newly demerged firm, you can take your position with City Index. We offer thousands of international stocks for you to choose from.
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- Open a City Index account, or log in if you’re already a customer
- Search for the company you want in our award-winning platform
- Choose your position and size, and your stop and limit levels
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