Divestments have become a common phenomenon in the past decade due to changing geopolitical activities and events such as Brexit, the U.S.-China trade war, and the Russian invasion of Ukraine. Before these events, the global economy witnessed massive corporate restructuring activities, be it due to the financial crisis of 2007-08, the various wars in Asia, Middle-East and Africa, the political instability in South East Asia and East Africa, the unification of East and West Germany, or the dissolution of the Soviet Union and Yugoslavia. The multitude of such events over recent decades means that firms have been under constant pressure to structure their operations efficiently and maintain a steady market value.
Divestment is an essential component of corporate restructuring because firms use it as a tool to induce changes in their business portfolio through sell-offs, liquidation, closure, spin-offs, or carve-out. Such events are significant to the shareholders as they directly impact the share price. The share price may either increase because divestments induce changes in the asset allocation strategy such that key resources are directed towards the key business sector, or decrease because divestments may lead to agency conflict and asset depletion. Thus, the literature remains divided on the impact of divestment on shareholder value.
While there are several reasons that potentially explain the divergence in the literature, in our study we argue that institutions such as regulative framework, long-term cultural orientation and corruption have a significant impact on the relationship between divestment and shareholder value. The perception of shareholder protection and shareholder rights differs across countries, cultures, and institutional structures. Institutions provide mechanisms to prevent hostile takeovers such as the obligation to circulate information among the shareholders, or by pressing managers to invite more bidders and encourage an auction. Both mechanisms would result in the shareholders obtaining a higher value, but the degree of their effectiveness depends on the concentration of ownership and corporate control.
A country’s legal system influences the degree of control afforded to the shareholders. In some countries, such as the United States, ownership is dispersed among many shareholders, which gives little control to the shareholders over corporate affairs. On the contrary, ownership in Europe takes the form of block holding where few shareholders own the majority of the shares. Thus, different legal systems offer varying degrees of protection and control to the shareholders.
In our recent study, we contend that among formal institutions, a sound regulatory environment fosters a positive relationship between the shareholders and management. This mitigates agency problems and increases trust between shareholders and management. Therefore, stock market reactions to divestment announcements are expected to be positive. We argue that among informal institutions, divestments are perceived negatively in countries with a long-term cultural orientation. Furthermore, we posit that agency conflicts are more common in countries with high levels of corruption, thereby reducing the efficiency of divestment decision-making. We test our theory by conducting a meta-analysis of 144 primary studies with 202 effect sizes and 90,449 firm-level observations.
Value-enhancing effects of divestments
Value-enhancing effects of divestments can be attributed to multiple reasons. Divestments, in the form of asset sales, help firms raise extra cash. The ability of firms to raise extra cash from divestments serves at least two purposes. First, divestments are commonly used by distressed firms to repay outstanding debts. Firms exit distress when sales proceeds are directed to raise the cash flow over the long-term debt. This is received positively by the shareholders as it indicates that management acknowledges the need for financial restructuring and is willing to reorganise the operations for future growth. Second, non-distressed firms use divestments to fund new projects or reinvest in value-enhancing activities. Stock markets react positively to such events as they demonstrate sound financial planning such that new investments are funded with equity capital rather than external borrowing.
The value-enhancing effect of divestment extends beyond investment in profitable activities. Divestment proceeds, when invested in research and development, help firms grow their knowledge base and develop a competitive advantage over their rivals. Such acts of “creative destruction” are favourable to the shareholders as they ensure steady future returns.
From a strategy standpoint, divestments allow firms to refocus their business operations by reducing peripheral activities, selling fringe assets, and streamlining operations. In addition to raising extra cash through fringe asset sales, refocusing reduces the managerial burden and increases the decision-making efficiency. Thus, managers are able to focus on the core business. This increases shareholder value because of its performance-enhancing effect on other units.
In some cases, divestments influence the trust between shareholders and management. Managers are known to overinvest and overdiversify in the pursuit of self-gain and extend their control over the firm. At a corporate level, such investments jeopardise the credibility of the firm in the market, where external stakeholders tend to separate themselves from the firm. This leads to information asymmetries and a breakdown in the trust of the shareholders. Divestments correct such managerial behaviour by reducing their control over the diversified businesses and returning the investment through asset sales.
Our findings are supportive of the aforementioned arguments. In our study, we found that divestments result in a strong positive stock market reaction as measured by cumulative abnormal stock returns around the divestment announcement. This suggests that stock markets are generally supportive of divestments as any corporate restructuring activity is an indication of resource re-allocation and strategic change. Thus, our finding helps resolve the debate on whether divestments increase or decrease firm value by showing that divestments elicit a positive response from the stock market.
Regulations
Regulations are important to divestments because they provide mechanisms to monitor corporate governance and maximise shareholder protection. Regulations ensure that corporate strategies are implemented effectively without external challenges. They offer shareholder protection by ensuring that all shareholders have equal voting rights. These include the right to call extraordinary shareholder meetings as well as legal guarantees to challenge management decisions. When shareholders have limited power, managers may pursue self-interests by divesting high-value units to allocate excessive remuneration or make unwanted investments to strengthen their control over the firm. Regulatory bodies in some countries monitor such value-destroying activities by regulating the number of investments that could be legally made by the firms. Such regulations obligate managers to keep their focus on the core operations of the firm and ensure that the divestment proceeds are invested in value-enhancing activities.
Our analysis shows that divestments carried in a stable regulatory environment are associated with a strong positive stock market reaction. We attribute this finding to the following two reasons. First, the protection offered to the shareholders by external regulations is reflected by their capability to control antitakeover behaviour and fraudulent transactions. When divesting a business unit, an aspect that may reduce its value is the failure of the management to reveal the transaction price and payment method. There is more scope for hostile takeovers and fraudulent transactions when the price and payment method are not disclosed. Disclosure regulations impose legal responsibilities on firms to disclose their financial reports to public shareholders, and to not provide fraudulent or falsified information. Disclosure fines are imposed on firms that fail to meet the disclosure criteria.
Second, some divestments are executed without having a strategic plan. Such divestments are intended to temporarily inflate the cash flow and falsify a healthy financial image of the firm. This is harmful to the shareholders as it pressurises present and future returns and reduces the external credibility of the firm. Regulatory bodies help minimise this risk by pressurising the management to conduct external audits instead of self-certifying the financial results. Shareholders may also use the regulatory provisions and challenge the divestment decision through their voting rights.
National cultural orientation
National cultural orientation is the dimension of culture concerned with the way people perceive and value time. It is the extent to which a nation’s culture shapes its people to adopt a present versus future-oriented view. Short-term orientation (STO) implies a present-oriented view where individuals are likely to favour short-term commitments, whereas long-term orientation (LTO) implies a future-oriented view where individuals are likely to favour long-term commitments. This feature of national culture is an important determinant of trust and mutual dependency between the management and shareholders to achieve common goals. Through its capacity to foster trust and mutual dependency, cultural orientation influences shareholders’ perception of divestment.
In an STO culture, the preference is towards current performance over future growth, and shareholders prefer immediate returns over an uncertain pay-off in the future. Therefore, the decision of divesting assets to improve current performance is received positively in an STO culture. Shareholders also react positively to divestments because they are likely to receive higher dividends from divestment proceeds. In contrast, firms in a LTO culture are averse to uncertainty and are likely to keep an unprofitable business afloat with the hope that the financial performance gradually improves in future. Further, dividend pay-out is low in an LTO culture because individuals are willing to trade present consumption for future earnings. Managers in such countries are likely to pay lower dividends in the short term as the emphasis is on safeguarding future interests. Divestment announcements in such countries will generate higher abnormal returns only if the management focuses on reinvesting the proceeds in growth opportunities. Therefore, theoretically, stock market reactions to divestment announcements should be positive in STO countries, and negative in LTO countries.
Our theoretical assumptions were supported by the analysis. We found a significant negative stock market reaction to divestment announcements in LTO countries, which justifies our argument that individuals in long-term-oriented cultures are more risk-averse and prefer steady long-term returns over short-term gains. This finding also highlights the nature of the principal-agent relationship, which is future-orientated in LTO countries, where firms emphasise investing in long-term projects and where divestment is likely to be perceived as an asset-depleting activity.
Corruption
The term “corruption” refers to a wide range of human behaviour, attitudes, approaches, or social contexts that are illegally used to obtain illicit benefits. Corruption in government offices is defined as the misuse of a bureaucrat’s or an elected official’s power for personal gain. Power abuse can include breaking the rules, selling government property, nepotism, or improperly influencing public policy. While corruption is a major concern in business organisations, it takes a different form when compared to corruption in government organisations. Shareholders elect the board of directors to oversee the daily operations of publicly traded companies. Given the inherent structure of publicly held organisations, the agents (elected directors or managers) have access to more information than shareholders. The shareholders, however, exercise control over the board and management through their shares and voting rights.
Agency conflicts arise because of information asymmetry and power imbalance. Prior literature suggests that management tends to conceal information from shareholders to promote their personal interests. Information asymmetry creates the following two problems. First, the shareholders of an organisation cannot determine whether the management is performing the tasks for which they are compensated. Second, the shareholders cannot determine if the management is efficient in safeguarding shareholder interests. Both these issues indicate a breakdown in trust between the shareholders and management, which may lead to opportunistic behaviour from the managers. Opportunistic behaviour is perceived as self-serving. Therefore, managers may conceal information, mislead, or deceive the shareholders to increase their personal profits.
Agency conflicts may also arise due to (1) the tendency of managers to hold on to underperforming asserts, (2) their decision to sell assets for personal gain, or (3) poor governance. Managers may hold on to underperforming assets to protect their self-interests because a divestment decision is perceived as an indication of an inappropriate investment decision. Conversely, divestment allows managers to eliminate personal pressure and increase their personal gains. A corrupt environment exacerbates agency conflicts by necessitating more cash flow for managers to make unofficial payments. Evidence suggests that the incentive to extract personal gains is lower in countries with low corruption and better investor protection. In contrast, the level of cash holdings is higher in countries with high corruption and poor investor protection. Consequently, shareholders are likely to compel managers to pay dividends to prevent them from hoarding cash. Moreover, external corruption has a negative impact on managerial efficiency. Therefore, a corrupt environment contributes to the deterioration of the manager-shareholder relationship. Since information asymmetry, agency conflict, and poor governance influence pay-out policies, we presume a negative stock market reaction to a divestment announcement in the presence of external corruption.
Our analysis, however, shows that the presence of external corruption strengthens the agency-principal relationship, and divestment decisions are likely to be made in the best interests of the shareholders. This is because the presence of corruption increases the pressure on management to practice effective governance. In a competitive market, firms that practise effective governance are valued highly and the stock markets generally react favourably to their divestment announcements.
Implications
Through our research, we sought answers to an important question in the corporate governance and strategic management literature: How do stock markets react to divestment announcements? To find answers to this question, we delved deep into the literature using meta-analytical techniques. We were able to identify that: (1) stock markets, in general, react positively to divestment announcements; (2) the relationship is positive and significant when the regulatory environment is stable; (3) the relationship is negative in LTO cultures; and (4) the relationship is positive in presence of external corruption.
In demonstrating that divestments are received positively by shareholders, our study assists managers in overcoming decision-making uncertainty and aligning their interests with those of the shareholders. This is further expected to be fruitful in overcoming agency conflicts. Although not a litmus test, this study provides a decision-making spectrum regarding the mode of exit. Based on our findings, we recommend the following sequence for selecting the appropriate divestment mode to assist managers with divestment decision-making: (1) Mergers and acquisitions, (2) Equity carve-outs, (3) Sell-offs, and (4) Spin-offs.
Our results concerning cultural orientation are self-explanatory, as shareholders in countries with an LTO culture are more likely to value future gains over current returns or dividend payments. Rather, they are willing to reinvest the proceeds in future value-enhancing goals. This is an important contextual factor that managers should consider when building shareholder trust. Our findings indicate to policymakers that sound regulations benefit shareholders in that they promote effective governance, thereby building trust between an organisation’s shareholders and management.
Finally, our finding that shareholders react positively to divestments in presence of external corruption provides an impetus for academics and policymakers. This finding, which is based on the meta-analysis of 90,449 firm-level observations from 144 primary studies between 1983 and 2022, is vital in resolving the ongoing debate on the role of corruption either as a “wheel greaser” or a “wheel sander.” Thus, going forward, it may be worthwhile to reconsider the pessimistic view of the public sector, and rethink and reevaluate the role of corruption in the modern economy. For policymakers, the implication is straightforward – if the government adopts a “grabbing hand” approach, the management and shareholders unite internally for more effective governance.
Pratik Arte is an Assistant Professor of International Business at Newcastle Business School
Sami Vähämaa is a Professor of Accounting and Finance at the University of Vaasa
This post was adapted from their recent paper, “The Impact of Formal and Informal Institutions on Stock Market Reactions to Divestment Announcements: A Meta-Analysis,” available on SSRN.
