Here is an excerpt from a classic article featured online by The McKinsey Quarterly, published by McKinsey & Company. Bill Huyett and Tim Koller acknowledge that spinning off businesses can have real advantages in creating value—if  executives understand how. To read the complete article, check out other resources, sign up for email alerts, and obtain subscription information, please click here.

Source: Corporate Finance Practice

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It takes courage to break up a company. CEOs and boards of directors often fear that investors will view asset divestitures as admissions of failed strategy—that having certain businesses under the same corporate umbrella never made sense. Many worry that shedding assets will cost a company the benefits of scale, cut into the advantages of analyst coverage, or even damage employee morale. Spin-offs in particular draw scrutiny because they shrink the size of the parent company but, unlike sales, don’t generate cash to reinvest.

We don’t believe these arguments hold up. What’s more, they may lead executives to pass up value-creating opportunities. A fundamental principle of corporate finance holds that a business creates the most value for shareholders and the economy as a whole when it is owned by the best—or, at least, a better—owner. [Note: See Richard Dobbs, Bill Huyett, and Tim Koller, “Are you still the best owner of your assets?” mckinseyquarterly.com, November 2009.] So it makes sense that companies should continually reallocate their resources as circumstances change. Moreover, the benefits of being part of a large company come at a cost; in fact, many spun-off companies can make substantial cuts in overhead costs once they are independent. Investors typically don’t care about a company being too small once it reaches a threshold of about $500 million in market capitalization. [Note: See Robert S. McNish and Michael W. Palys, “Does scale matter to capital markets?” mckinseyquarterly.com, August 2005.] And in our experience, executives and employees of spun-off companies often feel liberated and quite happy to be on their own.

So it’s a good sign that there’s been something of a revival in spin-off activity this year. According to Bloomberg, as of August 25, 174 companies had announced spin-offs of all sizes—quickly approaching the previous global record of 230, in 2006. Among the notable deals: Kraft Foods’s spin-off of its North American grocery unit and ConocoPhillips’s spin-offs of its downstream businesses.

The trick to executing a spin-off strategy—and to overcoming predictable objections to it—is to understand where the value is created. Markets typically respond favorably to spin-offs, but savvy managers understand that such deals create value not from some mechanical market reaction but from the sharpened strategic vision that comes with restructuring or the tax advantages relative to a sale.

Spin-offs: A brief history

Company breakups through spin-offs date back at least a hundred years. Many of the earliest and best-known ones were mandated by courts to split up monopolies, including the 1911 breakup of Standard Oil into 34 separate companies, as well as the 1984 breakup of AT&T into 8 companies.

After the AT&T breakup, spin-offs became a more common way for companies to change their strategic direction. American Express, for example, spun off Lehman Brothers in 1994, ending its strategy of becoming a financial supermarket. In 1993, as the historical links between chemical and pharmaceutical businesses became less relevant, the British chemical company Imperial Chemical Industries [Note: ICI was subsequently acquired in 2008 by Dutch chemicals conglomerate AkzoNobel.]  (ICI) spun off its pharmaceutical business as Zeneca. [Note: Zeneca later merged with Astra in 1999 to form AstraZeneca.]  Recent spin-offs have reflected similar shifts. In 2008, when the integration of the production and delivery of media content didn’t lead to the anticipated benefits, Time Warner announced that it would spin off its cable television business.

Some of the major conglomerates built in the 1960s and ’70s used spin-offs to break themselves up. ITT, one of the best-known conglomerates of that era, used a double spin-off in 1995 to split itself into three companies, ITT Sheraton (now part of Starwood Hotels and Resorts), Hartford Financial Services, and the remaining industrial businesses, which kept the ITT name. In January 2011, ITT announced that it was further splitting up into three companies: ITT Corporation (industrial process and flow control), Zylem (water and waste water), and ITT Exelis (defense). In an even more extreme example, the company that was Dun & Bradstreet in 1995 has spun out businesses four times (1996, 1998, 1999, and 2000) and now exists as seven different companies.
Understanding the benefits

One common misperception about spin-offs is that they are quick fixes for low valuations. Managers see the typically favorable response that markets have to a spin-off announcement as confirmation that a spin-off itself mechanically illuminates value that investors previously overlooked. But that belief is misleading.

Such assumptions rest errantly on a “sum of the parts” calculation. For each of a company’s businesses, analysts add up an assumed earnings multiple based on the multiples of industry peers. If they find that the sum of the parts is greater than the market value of the company as currently traded, they assume the market hasn’t valued the business properly.

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To read the complete article, check out other resources, sign up for email alerts, and obtain subscription information, please click here.

Bill Huyett is a partner in McKinsey’s Boston office, and Tim Koller is a partner in the New York office.

The authors wish to acknowledge the contributions of Katherine Boas and Mauricio Jaramillo.