Defining the appropriate corporate form strategy is perhaps going to be one of the most complex yet pertinent questions facing Indian conglomerates in the next decade. In our previous two articles, we have explored why conglomerates exist and their evolution in the Indian context. This final article in the trilogy focuses on a framework that Indian conglomerates can use to think about their corporate form. There are two assessments or tests that conglomerates need to apply towards their corporate form strategy.
Firstly, conglomerates need to test their conglomerate premium or discount patterns over a period of time. To do this, conglomerates need to compare their historic valuations to the sum of parts (SOP) value of the comparable stand-alone businesses over a period of time — ideally over a complete business and economic cycle. To start off, conglomerates need to compute their total enterprise value as an integrated conglomerate. Towards performing this valuation, they need to estimate (a) the market value of their equity after adjusting for exceptional event based variations, (b) value of debt, (c) minority interest and (d) netting off surplus cash. Let us call this number A — that is, consolidated conglomerate value. Then, conglomerates need to compute the stand alone value of each of their distinct business lines. This may be done through a variety of techniques including use of standalone peer multiples. Additionally, stakes in associate entities and investment assets also need to be valued. While doing this assessment, the valuation of equity stake in businesses whose return profile is similar to fixed income instruments (for example, infra projects, concessions projects etc) needs to be valued carefully. This is because the return profiles of asset and liability sides are fundamentally different. These different stand alone values now need to be totaled — call this B. If A is greater than B then the conglomerate enjoys a conglomerate premium and a conglomerate discount if B is greater than A. This comparison needs to be done for several time periods to see consistent patterns and spot material differences in valuations.
During our work over the years on conglomerate structures, we have observed three typical trends from such analyses: (i) in periods of bearish economy, there are more incidences of conglomerate premiums (A is greater than B) and vice versa, especially in developing economies with market inefficiencies (refer articles 1 and 2) (ii) the findings are often influenced by the mix of investors and quality of investor communication (for example, whether the shareholders of a conglomerate are retail investors vs. FIIs can result in differences in valuation) (iii) the qualitative benefits of corporate deconstruction, for example, ability to attract senior talent, often outweigh small conglomerate premiums. If there is a consistent conglomerate discount observed then there is a case for equity deconstruction, that is, a selective paring of the corporate structure.
Secondly, having established a case for equity deconstruction, conglomerates need to evaluate individual businesses within their portfolio using a framework that we call the “Equity Deconstruction Matrix (EDM)” (refer exhibit, for framework for assessing impact of separation on both residual parent and separated business[es]).
The fundamental premise of this framework is that while answering the question on conglomerate deconstruction it is important to assess the impact on the individual business(es) being separated as well as the residual parent. This framework provides a structured, scientific methodology of examining both sides of this issue. The EDM could also be constructed with clusters of logically adjacent businesses rather than individual businesses as the unit of separation on the X axis. We have seen that such a framework can serve as the basis for a very insightful and objective discussion amongst senior management — at times also involving key shareholders (for example, promoters).
Let us consider the elements of the framework. The candidacy for separation depends on three elements (a) potential to unlock value after separation from a capital market perspective (refer sum-of-parts analysis described earlier), (b) ability of the business(es) to execute specific elements of strategy effectively before / after separation and (c.1) ability of the business(es) and (c.2) residual parent to survive independently after separation. It is critical to avoid an equity structure separation formula that leaves either the residual parent or the individual business(es) weak and vulnerable (unless that is the intent) — especially when there are strong linkages in terms of cash, talent or intellectual property between businesses. Similarly it is important to make sure that the individual business gets adequate level of support from the parent and separation doesn’t jeopardise the mentoring received from parent. This requires the conglomerate centre to take a hard look at management complexities of the individual business and business leadership teams’ capabilities to deliver against fundamental business complexities. Further one needs to assess whether separation allows businesses to execute elements of their strategy better as separate entities than as conglomerates. For example, this requires analysing impact on ability to enter business-unit level joint venture / acquisition opportunities, flexibility of geographic expansion and building a capital structure that is consistent with the individual business’ risk-return profile. These are some of the most complex — sometimes technical — yet pertinent questions which need to be answered adequately for assessing conglomerate structure. Solving for such problems can potentially be a convoluted exercise unless navigated carefully. In such a context, EDM brings a sharp strategic lens which can help the stakeholders identify priority issues and keep the dialogue objective.
In addition to the question of the appropriate corporate structure, is the question of governance model. Answering this question requires assessing several facets such as the role of board, directors, board committees, reporting structures, organisational entities and strategic processes. It is important that the governance model strikes the right balance between autonomy and control, centralisation and decentralisation of decision rights in a way that is aligned with the corporate structure.
Finally, effective corporate communication (internal and external), deft investor relations management and implementing a focused change management program are critical to execution of any corporate form strategy. In our experience, conglomerates that have systematically conducted these assessments find deep insights which are often counter intuitive to long held beliefs and help create and capture value. In the next decade, Indian conglomerates will be under intense scrutiny to show how the conglomerate structure creates value. The sooner they build the corporate form assessments into their strategy development process, the better.
Ashish Iyer is partner and Asia-Pacific leader, strategy practice, BCG and Yashraj Erande is principal, BCG. Views are personal.
