Introduction

In the fast-paced world of Indian business, companies are looking for ways to improve the value they provide to their shareholders. One of the most effective and overlooked ways is to utilize a demerger, when a company splits into two or more independent companies. This isn't just changing names on the paper, as a demerger creates value, improves efficiency, and gives investors more choice. This article explains how a demerger works, its forms, strategies, and why it matters to you as an investor in India.

What is a demerger?

A demerger is best defined as the corporate equivalent of splitting up your family business so each can create value and prosper independently. A demerger essentially divides a company's various units into multiple stand-alone businesses, each with its own management, financials, and stock listing. Demergers have gained traction in India, where the motivation to demerge can be said to be a better and clearer corporate focus and improved returns to shareholders.

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Demergers can take several forms, such as:

• Spin-off

Shareholders receive proportional stock in the newly created company. They retain the value of the parent company.

• Carve-out

A parent sells a portion of a subsidiary through an IPO, which creates a publicly listed company.

• Split off

Shareholders exchange their shares in the parent company for shares in the new company, thus changing their investment allocation. Indian behemoths, for example, companies like Vedanta, use demergers to declutter their operations, reflecting demergers' usefulness today.

• Divestitures

A divestiture is when a company or organisation partially or completely removes assets, divisions, or operations through selling, transferring, closing, or filing for bankruptcy. Most often, it reflects a decision by company leadership to exit an area of business that was no longer suitable for the organisation's core strengths or strategic intent.

How Demergers Create Value

A Demerger is not just a split; it is to create stronger, more focused businesses. Here are the ways they create value for Indian companies and investors:

• Sharper Strategic Focus

When a conglomerate owns multiple businesses, such as telecom and retail, the company may struggle with allocating resources across each business, leading to a challenge for each and confusion about its distinct vision. A demerger allows for each business's vision to be carried out. For example, when Reliance Industries demerged Jio Financial Services in 2023, Jio Financial Services could now focus on innovative thinking in the fintech space, while Reliance Industries could hone its focus on its energy and retail operations. This was successful, driving clarity in the operations of both companies and potentially making them more appealing to investors who may prefer a more particular company instead of being part of a conglomerate with many businesses.

• Higher Market Value

Another potential benefit of a demerger is unlocking the full market value of the demerged entities. Conglomerates commonly face a “conglomerate discount”, i.e., where the market cannot fully value the underlying business, or businesses, because of the complexity of having so much involved in one entity that makes it a conglomerate. Demergers can create “pure play” companies that are easier to value and for which higher valuations can potentially accrue.

• Empowered Investors

Demerger leaves decisions to the shareholders. Rather than represent a single stock tied to a collection of businesses, shareholders will have every opportunity to pick which company they want to invest in. An investor identifying as risk-averse may favour a business's stable and cash-generating side. In contrast, an individual identifying as a growth investor may favour the high-risk subsidiary. This will increase the level of satisfaction for investors and allow for a much wider participation in the capital markets.

• Greater Efficiency with Capital

In a conglomerate, business units compete for capital. Each side often requires funding simultaneously and may not produce optimal investment decisions. Post-demerger, each company will adopt its own capital management strategy, and there will be no internal feud for financial capital or strategy when determining whether to raise debt for equity, issue new equity, or reinvest profits.

The Flip Side: Risks to Watch

Demerger of businesses can be highly effective. However, there can be so much to take into consideration. Investors in India should practice proper due diligence before proceeding:

• Costly: There can be legal, regulatory and administrative costs. These costs can be significant, although they may outweigh the advantages for smaller companies.

• Tax Implications: Demergers will require consideration of the costs paid on taxes by the company or shareholders based on the structure. Tax liabilities may diminish net gains.

• Loss of Shared Expense Advantage: Conglomerates share working resources such as supply chains or branding. Each entity is missing out on expenses. The loss of these shared expenses will diminish profits as warranted

• Price Volatility of new shares: Once companies are considered, then becoming newly listed companies and almost by definition smaller companies, they may experience price swings since the stocks will experience the volatility typical of investment in a sentiment-driven environment.

Conclusion

Demerger is an entirely new paradigm in India’s corporate playbook, which has a huge impact on breaking large conglomerates into focused, value-maximising business segments. Demerger values abound, as demergers enable lower-cost strategies, enhanced valuations, and investor choice, which are multiplied to create wealth.

With Indian companies like Reliance and Vedanta taking the lead, Demergers will reshape the landscape with potential opportunities unlocking value using a new investment strategy of outstanding potential.

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