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Failure To Launch

Why Some Spin-Offs Have a Failure to Launch

Why Some Spin-Offs Have a Failure to Launch

Is your spin-off stuck in adolescence and refusing to grow up? It may not be the only one to blame. It's time to stop over-indulging and start offering the tough love your spin-off really needs.

In the film Failure to Launch, actor Matthew McConaughey plays Tripp, a handsome, adventurous, 35-year-old bachelor who still lives at home with his parents. Who can blame him? Mom washes his clothes, makes his bed and vacuums his room. Yet his parents wonder why Tripp won't move out. It is, after all, every parent's wish for their offspring to be self-reliant and successful.

In many ways, Tripp's parents are not so different from parent companies that spin off integral parts of their supply chains—a parts division, maintenance organization or logistics provider, for example—with the hope that the spin-off will flourish and grow business beyond the parent company. In 2006 alone, according to the Mergerstat database, companies worldwide executed almost 10,000 divestitures, and a number of studies show that spin-offs outperform the market. Examining stock performance from 1990 to 2005, researchers at Lehman Brothers found that stocks of spin-off companies earned about 18 percent higher returns than the S&P 500 in the first two years of independence. Stocks of parent companies outperformed the S&P by 14 percent in the year before the spin-off due to investor confidence.1

With all the success stories, it is no surprise that when spin-offs don't flourish, or worse, when they fail, parent companies are left to wonder what went wrong.

After Years of Consolidation, Now It's Deconsolidation

The classic definition of a spin-off is when a parent company separates a division or line of business and distributes ownership to the existing shareholders. For the purposes of this article, we focus primarily on situations where the divisions are sold to another entity but remain active suppliers to the parent company. In other words, our focal point is not American Express's spin-off of Ameriprise Financial or Microsoft's spin-off of Expedia. Rather, we discuss transactions more like GM's spin-off of Allison Transmission or Telia's spin-off of its engineering teams to Flextronics.

What makes these situations unique, and so interesting, is that the spin-off already has an established customer—its former parent. There is nothing inherently wrong with this type of spin-off structure, so how could it not succeed? Before we answer this question, let's discuss why companies make the spin-off decision in the first place. Companies spin off their operations to:

  • Deconsolidate—shed noncore functions to focus on core competencies.
  • Create a more flexible supply chain.
  • Raise funds in the capital markets or via private sale.
  • Unlock shareholder value, which the spin-off can do as an independent entity.
  • Grow faster, which a spin-off can do outside the parent company.Airlines, for example, have difficulty scaling up through M&As but they can spin off their maintenance businesses and let the spin-off do the M&A in its own field. Growth is organic as the spin-off finds customers besides the parent company.
  • Grow in different dimensions from the parent company. Service operations such as call centers can grow far beyond their parent companies, especially if their services are relatively generic.

Sometimes there is a combination of reasons for the spin-off. Caterpillar continues to benefit from the spin-off of its in-house maintenance division, now known as Advanced Technology Services (ATS), in part because the divestiture coincided well with U.S. factories' moves to outsource their maintenance operations to subcontractors. ATS now handles maintenance operations not only for Caterpillar but also for other major manufacturers, including GM, Ford, Toyota and General Electric. Its sales were estimated at $94.5 million in 2006, according to information services provider infoUSA.

Whatever the reason, when a parent company decides that an internal division can or must live on its own, there are inherent problems and risks. When the unit is spun off, its management team is typically built from parent company personnel. The spin-off might maintain office space in the parent company's locations, which often means business as usual. But after a while, the parent is dismayed to find it still generates the vast majority of the spin-off's business. The parent has also found that the spin-off does not provide the best service or price. Other suppliers appear to offer better quality and more advanced technology. Worse yet, the spin-off does not seem hard pressed to change.

A lack of faster, bigger or different growth opportunities for the spin-off can also be a reason for failing to launch properly. Without a mechanism for creating enough value, the spin-off may lose steam once the financing benefits wear off.

In the process of monetizing an asset, the parent company may sign deals that guarantee a revenue stream for both it and the spin-off in the near term but inadvertently support unfavorable terms in the long run. Indeed, over time, a spin-off may fail to achieve the parent company's objectives. Like the charming Tripp, this business has failed to launch. The question is, why?

Developmental psychology presents a subtle parallel perspective on the root causes of failing to launch. It is well known that overindulgent parents give children too much, and provide too soft a structure for their kids to fall back on. Children need a push to go out and achieve their full potential. The same protective, nurturing behavior by parent companies can create dependent spin-offs that also stagnate. The business may not leave the nest because its parent company has made it too easy and overindulged the spin-off.

How Do Parent Companies Overindulge?

There are several areas in which parent com-panies consistently fail in their discipline.

Rewarding without earning. In these cases, parent companies may guarantee the spin-off a revenue stream or provide incentive bonuses for much longer than is reasonably warranted. The guaranteed revenue or incentives are only loosely tied—at best—to the spin-off's performance.

Staying too close rather than at arm's length. Parent companies may fail to institute clear rules for how their internal procurement staff should deal with the spin-off. Even if rules are put in place, parent companies may not enforce them—sometimes even providing the spin-off with information needed to match the best bid in what should be a competitive bidding process.

Supporting them for too long. Parent companies may provide services or infrastructure to the spin-off at below-market prices or for an excessively long period of time.

In short, the parent company creates conditions for dependence. Overindulgence on the part of the parent company is detrimental for reasons beyond the impact on the spin-off. Lenient parent companies can stir mistrust in the market by consistently letting their spin-offs win or keep business for which they have not competed. Over time, the supply market will catch on that the playing field is not level and eventually stop participating. This is bad for parent and spin-off alike. It prevents the parent company from obtaining best-in-class quality, service and price, and the spin-off from taking the extra steps needed to improve. Why try harder if you, as the offspring, are going to win anyway?

Given their knowledge of the parent company's workings, spin-off suppliers are also more adept at expanding their scope of services to the parent—creating a kind of natural monopoly. The impact is a jumble of services that makes the supplier unnecessarily "strategic" and difficult for the parent to take to market. This needlessly strategic status is perpetuated when the parent and spin-off have interlocking, proprietary IT systems.

Bottom line, if the parent company fails to provide the right preparation or incentives, the spin-off will develop neither the ability nor the desire to improve performance. The spin-off will remain dependent on the parent company and effectively become a vehicle for transferring value from the parent to the offspring through a set of noncompetitive contracts.

To prevent a failure to launch, parent companies must first plan correctly. If that planning is not done and a launch fails, the parent company must be prepared to assess and be involved in fixing the situation. We can illustrate this with an example from the U.S. automotive industry. If ever there has been a pattern of rough parent-child relationships, it is in this industry. Nevertheless, the trend toward deconsolidation is intensifying. In August 2007, an ailing Chrysler announced plans to spin off two divisions: Chrysler Transport, which transfers parts and supplies to the automaker's plants, and Mopar, which manufactures parts for Chrysler, Dodge and Jeep vehicles. Chrysler's news came on the heels of GM's recently announced spin-off of Allison Transmission. As they ready the fledgling companies for independence, both automotive parent companies should heed the lessons of Delphi and Visteon, two other automotive parts suppliers whose missteps as spin-offs in 1999 and 2000, respectively, sent their share prices tumbling and their parents reeling (see figure 1).

One of Delphi's goals for going out on its own was to increase sales to companies other than its parent, GM. When it spun off, more than 75 percent of its sales went to GM. By 2005, the number had dropped, but to a still-substantial 48 percent.2 Visteon's sales to its parent, Ford, were at 62 percent five years after its spin-off.3 Both Delphi and Visteon experienced financial difficulty, stemming largely from legacy issues and a lack of cost restructuring, and neither achieved its intended global ambitions. When Delphi filed for bankruptcy in 2005, GM was responsible for at least part of the billions of dollars in benefits owed to Delphi retirees. The situation could cost GM billions of dollars as it and Delphi reach a settlement with unions, retirees and investors. Meanwhile, GM has well-publicized financial problems of its own.

Planning for a Successful Spin-Off

To avoid a disaster and make these well-intentioned, strategic plays work, companies need to set the stage for the spin-off's success with the following guiding principles.

Honest assessment. Parent companies should take a long, hard look at the spin-off's longer-term market potential. The likely "premium" the parent typically pays a spin-off just starting out must be taken into account in the spin-off's valuation, as that premium is not likely to be available elsewhere.

The right incentives. Spin-offs must be provided the right incentives to perform. Parent companies should be wary of creating fee arrangements. For example, don't get into the "we will pay you X-dollars per year to run our facilities." Instead, tie the fee to a clear, flexible and transparent cost model. In addition, the parent company must create measurable, enforceable service levels and key performance indicators (KPIs) and then hold to them.

No free lunch. When it comes to earning new business, there should never be a free lunch (see sidebar: Tough Love for a Spin-Off). Often, a typical spin-off practice is to guarantee the new supplier (your spin-off) a certain amount of business over a fixed period. Make this no-compete period as short as possible. Any open bidding processes must be truly open. The spin-offs cannot win every time.

If the spin-off business is not prepared for success on its own, the parent company may opt for an alternate solution—selling the business to a partner that is experienced in the spin-off's industry, for example. Also, the spin-off needs a disciplined, professional management staff. Using former internal staff may not be sufficient. Take Cincinnati Bell's spin-off of its telemarketing and billing software operations after the famous AT&T breakup. The company knew it lacked marketing savvy, so it wisely hired a marketing expert from Procter & Gamble to get its offspring ready to launch. Now known as Convergys, the spin-off has become a global provider of customer management, billing and HR services.

Once solid parameters are set—the parent company is clear about what it is paying for and the spin-off is clear about what is expected—it is time to step back and let the spin-off fly on its own. Successful separations include AT&T's spin-off of Lucent Technologies and Barclays offshoot Edotech Limited. What went right? Lucent had distinct offerings demanded in the broader market, and was never exclusively dependent on AT&T. A year after the launch, roughly 14 percent of Lucent's revenues came from AT&T.4 The rest came from external customers. (Within a few years, however, a struggling Lucent was bought by Alcatel.) When Barclays recognized that its internal statement-printing division could thrive separate from the company, it backed a management buy-out of Edotech, which soon became a leading provider of transactional document processing services. By 2004, Barclays gauged the time ripe and sold Edotech out- right to Astron, a U.K. business process outsourcing group.5

Taking Corrective Measures

Not all spin-offs have happy landings, of course. For those that hesitate to make the jump or have failed to launch altogether, a different approach is needed. If you answer "yes" to all or most of the questions in figure 2, the spin-off supplier is either not ready to launch or has more than likely failed to launch.

Spin-offs that fail to launch require tough love, entailing a comprehensive restructuring of the parent-child relationship. Again, as with the initial spin-off, the parent company must take the lead.

Eliminate the enablers. When the restructuring begins, take an honest look at your interpersonal relationships with the spin-off. Typically, the team leading the restructuring will find people across the parent organization who sympathize with the spin-off and believe it is doing the best it can, despite what the service or cost facts demonstrate. These enablers must be taken out of the process because they serve only to perpetuate the old service model, which is not working. The restructuring team must consist of people familiar with the subject matter but also objective enough to build a healthy, forward-looking relationship.

Get real about costs. The parent company must develop a comprehensive "should-cost" model for the spin-off. Luckily, the original spin-off transaction can provide ample starting ground. The focus should not only be on what the current cost is, but also, and more importantly, on what it should be. A good should-cost analysis will reveal significant improvement opportunities. As a side note, some of the opportunity may come from parents that adjust gold-plated service levels down to silver- or copper-plated.

Demand excellence. The parent company must insist on best-in-market service and quality. To allow sub-par performance from the spin-off creates a vicious cycle. The more the spin-off underperforms, the less it is able to build business beyond the parent, and the more it relies on the parent.

Call their bluff. Spin-offs will typically apply pressure when the parent company demands significant changes. Don't be surprised if you hear, "We'll sue. It will be in all the papers." The fact is most of the spin-off's business is likely tied to the parent company, so it behooves the parties to work together rather than litigate. The parent company needs to call the spin-off's litigation bluff.

Parent and spin-off management must work together to improve the relationship. While it might be uncomfortable, this step sets the stage for a more well-adjusted relationship. Questions to answer include: How can the parent company adjust its service levels to be on par with industry standards? What are reasonable overhead and profit margins? What KPIs will govern the relationship?

Change the locks. Any new agreement should ensure that the spin-off builds its business capabilities and market share beyond the parent company. A company needs to manage risk in its supply chain vigilantly, and business with spin-off suppliers is not exempt. Business must continue, even if the spin-off fails.

The steps to correct a failed launch, while uncomfortable for the parties, are necessary. Like people, parent companies need to recognize the effects of overindulgence and take action to prevent or repair the problems. The result will be a better spin-off story.

 

1 Cited in Shanny Basar, "Spin-Offs Outperform Rest of U.S. Equity Market," Financial News Online U.S., 26 February 2006.
2 Delphi Corporation, United States Securities and Exchange Commission Form 10-K, fiscal years ended 31 December 1999 and 31 December 2005.
3 Visteon Corporation, United States Securities and Exchange Commission Form 10-K, fiscal year ended 31 December 2005.
4 Lucent Technologies Inc., United States Securities and Exchange Commission Form 10-K, fiscal year ended 30 September 1998.
5 "Barclays Bank PLC Sale of Edotech Limited to Astron," www.newsroom.barclays.com, 8 April 2004.

December 2007
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