Global divestments hit a record 50% of all M&A deals this year as large public companies rushed to tidy up their portfolios and focus on their core businesses. Many businesses including Ebay, Fortune Brands, Thermo Fisher Scientific, Sara Lee, ITT and Marathon Oil have conducted spin offs to focus on their core businesses. On the other hand conglomerates love variety. They thrive on diversification of risk. But there is a price for that diversification. Citigroup Research found that conglomerates in Western Europe and North America were trading at PE ratios 10% lower than more focused peers.
Investopedia states that a conglomerate discount is calculated by adding an estimate of the intrinsic value of each of the subsidiary companies in a conglomerate and subtracting the conglomerate’s market capitalization from that value. Or in plain English the sum of the parts are worth more than the whole.
But in private companies we don’t have a market capitalization. They are not on a stock exchange. Only when they are listed through an IPO, or when a buyer comes along or a venture capitalist, do we get to see value or lack of it! The scary fact is that most private company management teams in their rush to diversify their risk have actually created a mini conglomerate that is either not saleable or that attracts low valuations. It has failed to define and dominate any of its chosen markets.
Peter Lynch the investment guru presumably talking about public companies (but just as relevant for private ones) talks about Diworsification to describe companies diversifying into areas beyond their own competencies.
So the danger for private companies is that the founder is tempted to move sideways into what looks like an interesting area. Two quick examples by way of warning, both nearly killed the company:
- IT recruitment was doing well, running at $25m sales when it started to use large tranches of cash to build a software company. It was going to be a new search engine to allow processing of resumes and matching of candidates and jobs. After many millions of dollars it was spun off as a separate company with its own management but not before it held back the growth of the core business.
- A software productivity tools business dominating a niche software platform was throwing off millions of cash with EBITDA of $3m plus. The founder diverted over $10m of free cash flow into a mainstream Java product where much of the competition offered a free or freemium model. The result was years of losses before it was closed down.
- Private company owners should stand back and conduct a strategic review.Consider the conglomerate discount.
- Are you building a business that is not saleable or at best will attract a significant discount on exit?
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