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The pros and cons of demergers

Much like its counterpart, merging, a demerger can present its own set of advantages and disadvantages, the latter of which could leave investors out of pocket

Prudential - The pros and cons of demergers
Is splitting ever worth the risk?

The completion of a demerger between insurer Prudential PLC (LON:PRU) and its former UK business M&G PLC (LON:MNG) on Monday marked the end of a 19-month that has cost the group an estimated £355mln.

The immediate aftermath of the split was mostly to be expected, with Prudential shares down 9% at 1,370p in late-afternoon as investors revalued the business, while M&G’s shares were around 221.1p, a touch above their float price of 220p and implying a market cap of £5.7bn.

READ: Prudential shares revalued downwards following split from UK business M&G

This was slightly below forecasts from analysts at Citi, which last week valued M&G at around £6bn.

The bank also pegged M&G with an implied dividend yield of 7.75% against its peers, although only time will tell if these forecasts ring true.

Pursuing a demerger, much like its twin sister, a merger, has its share of advantages and disadvantages, some of which are outlined below.

Greater value

A big draw of demergers in their potential to unlock additional value for shareholders in the firm that is demerged.

Normally, shareholders in a company will be given shares in the two new companies following a demerger, which when combined with the advantages of specialist management and focus on specific business segments can result in greater overall profitability.

This, in turn, causes share prices to rise, with a 2013 research paper showing that share prices increase by around 3.3% in the immediate aftermath of a demerger announcement.

Fixing accountability

A demerger can also fix issues with accountability that may plague a firm with contrasting departments, as a separate entity allows the division to take care of its own financial position without any cross-pollination of cash that may result in a combined business.

It also provides a clearer path to accountability for any failure in the business and avoids management receiving blame for a business failure that they may not have had direct control over.

Tapping the market

Aside from the benefits to shareholders, a demerger also allows a company’s business units to tap the stock market for capital as separate listings rather than having to rely on funding being allocated internally.

A key example is PayPal Holdings Inc (NASDAQ:PYPL), which in 2014 was split off from online auction giant eBay Inc (NASDAQ:EBAY) after the payments business effectively outgrew the support constraints of its parent and instead took its chances with investors on the open market amid a boom in online payment usage.

The decision proved to be a shrewd one, with PayPal’s shares having increased over 190% in the intervening years to US$101.3, while eBay’s share price has increased around 77% to US$39.1.

Smoother operations

One of the key benefits of a demerger is that it allows all areas of a business to be attended by dedicated management boards, rather than a single board of directors having to manage multiple segments of the company.

A demerger can also allow the newly separate companies to appoint specialists to manage specific areas or brands rather than more general directors which would be required for a conglomerate covering multiple areas.

An example is the 2008 demerger of then confectionary and drinks giant Cadbury Schweppes, which decided to split itself in two in order to better focus on both its main chocolate market and, separately, its US drinks business under the new name Dr Pepper Snapple Group.

Potential pitfalls

However, while demergers offer the possibility of payoffs for a company and its shareholders, they can also prove to be more trouble than their worth.

One potential issue is that a demerger can reduce the benefits of economies of scale, when a larger company can produce goods at a cheaper rate than a smaller one.

As a demerger inevitably involves the original company becoming two or more smaller ones, this advantage can be lost, and management is usually less inclined to inform shareholders of the potential loss of synergy before demerging.

A demerger is subject to less scrutiny than a merger and may allow the parent company to offload toxic assets or large debts into the new company without fully informing shareholders of the risks.

The newly divided company can also find itself subject to less favourable borrowing costs if lenders and rating agencies decide its model is riskier after having offloaded a certain business segment.

While the spinning off of PayPal may have been good for the share price, eBay saw itself quickly placed on ‘negative credit watch’ by Standard & Poor’s, with the rating agency citing a reduction in “business diversity” as a new risk to the group following the demerger.

Quick facts: Prudential

Price: 1308 GBX

Market: LSE
Market Cap: £34.01 billion
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