There is nothing immutable or fixed about the organisation of a company. It is capable of adapting to changes in corporate strategy, access to financial resources, and market developments and moods, as well as any ambitions of its controlling shareholders. By way of example, the Schneider Electric group of today focused entirely on energy management and automation, and with 100% control of almost all its subsidiaries worldwide, no longer has anything in common with the Schneider of the early 1980s which was active in the steel industry, the nuclear industry, mechanics, textiles, watchmaking, electricity, and construction to name a few. Most importantly, the old Schneider Electric group (at the time heavily in debt) didn't always have control of these companies and was itself controlled via a myriad of holding companies, indirectly owned by the Schneider family.

Generally speaking, investors like simplicity and transparency, which allows for better understanding and easier valuation, whilst simplifying everyone's life and reducing risk (Schneider today). But markets are pragmatic and they can accept complex structures if growth and profitability are present (Alibaba, Liberty Media, Bollore).

A word of caution to our readers: whilst complex structures might solve certain problems or allow for certain opportunities to be seized, they are rarely without additional costs in the form of discounts and undervaluations. Sooner or later, they will have to be reviewed, corrected, and often broken into pieces, especially if the group is listed.

Section 42.1 ORGANISING A DIVERSIFIED COMPANY

The answer to this question depends first of all on the level of sophistication of financial markets. In a debt-ridden economy, financial markets are poorly developed, and it is difficult to finance new activities because equity is scarce. In such economies, it is frequently well-established groups that replace the financial markets; indeed, thanks to their self-financing capabilities, they can finance new activities internally. This can be seen currently in India with Reliance (petrochemicals, media, telecom, health, finance, construction, etc.), in Algeria with Cevital (food processing, supermarkets, electronics and appliances, steel, glass, construction, automotive, services, media) or in Colombia with Argos (cement, insurance, food processing, etc.).

Certain groups from emerging countries resolve the problem of under-sizing and inefficiency in the local equity capital market by going public in Europe or the United States. But this is only possible for the largest and most international companies (such as the Indian Vedanta or the Russian Evraz groups).

When a country moves from a debt-based economy to a financial market economy, the view on diversification of a company's activities changes: lenders are in favour of it because the diversification of a company's activities reduces its specific risk and therefore the lenders' risk.

Equity investors are naturally more sceptical: they know that specific risk is not remunerated (see Section 19.1), reducing it would not be beneficial either, and that there are no financial synergies. Diversification therefore creates value only if the company can use its operational know-how to gain a competitive advantage in a new business, thereby generating synergies. Unfortunately, practice has shown that alongside some brilliant successes – Amazon becoming a web services host (AWS) or Bouygues succeeding in telecoms – there are countless value-destroying failures: Allianz in banking (Dresdner), Murdoch in social networks (MySpace), etc.

If diversification fails, the company will be under pressure to turn the page by selling the division in question (L'Oréal and The Body Shop in 2017). If diversification is successful, the listed company may be perceived as a conglomerate, with the risk of a discount appearing. We see, more often than not, that the market value of a listed conglomerate is lower than the sum of the values of the assets that make it up; the difference represents the conglomerate discount.

The discount generally reflects investors' fears that resources will be poorly allocated. In other words, the group might support ailing divisions beyond what might be reasonable and in which profitability is mediocre or below their cost of capital, and consequently underinvest in the most promising sectors. Moreover, investors are now keen on “pure play” stocks and prefer to diversify their holdings themselves. Finally, there is the problem of head office costs, which absorb part of the value of the conglomerate.

When a discount persists, and to avoid a hostile takeover bid, four solutions are available:

• Convince the market of the synergies the diversified strategy creates.
• Split up the company (demerger by spinning-off an asset, distributing the new shares to existing shareholders of the conglomerate, and listing the new asset¹).
• Piece by piece sale.
• Demonstrate value by listing a portion of the capital of the undervalued division (Qualtics listed by SAP two years after its acquisition and valued at three times the acquisition price).

There is a very small number of conglomerates that are valued without a discount (Berkshire Hathaway, Amazon) because investors are convinced that they are efficiently managed.

Successful diversification is often a precursor to a change in the group's line of business, even if it means selling the old business (from the electronics engineer Racal to the telecom group Vodafone), or splitting into two independent entities (FiatChrysler and Ferrari, Dow Dupont and Corteva), or even via a sale/merger, such as the pharmaceutical business of L'Oréal, which was merged with Sanofi.

For family companies, the question remains as to where the diversification takes place: at the level of the shareholders or the operating company.

The family shareholders may only diversify their assets if they can increase dividends from the operating company without penalising it (Quandt, Benetton families), or sell part of its shares without jeopardising family control (J. Ratcliffe).

Otherwise, the operating company will have to be diversified like Bouygues (construction, telecoms, television) to allow for both asset diversification and maintaining family control. However, this supposes that the family's control is strong enough to dissuade a hostile takeover bid if a conglomerate discount starts to appear. In our example, Bouygues is protected by its strong internal culture and poisons pills such as TF1 broadcasting rights, or Bouygues Télécom telephone licences.

For some families, diversification is a luxury their already reduced control does not allow (e.g. Volkswagen where the Piëch and Porsche families only control 31.3% of the shares through a 50% owned holding company).

Section 42.2 TO BE OR NOT TO BE LISTED

Whether or not to float a company on the stock exchange is a question that concerns, first and foremost, the shareholders rather than the company. But technically, it is the company that requests a listing on the stock exchange.

When a company is listed, its shareholders' investments become more liquid, but the difference for shareholders between a listed company and a non-listed company is not always that significant. Companies listed on the market gain liquidity at the time of the listing, since a significant part of the equity is floated. But thereafter, for small or medium-sized companies, only a few dozen or hundred shares are usually traded every day, unless the market “falls in love” with the company and a long-term relationship begins.

In addition to real or potential liquidity, a stock market listing gives the minority shareholder a level of protection that no shareholders' agreement can provide. The company must publish certain information; the market also expects a consistent dividend policy. If the majority shareholders sell their stake, the rights of minority shareholders are protected (see Section 45.3).

Conversely, a listing complicates life for the majority shareholder. It is true that liquidity gives them the opportunity to sell some of their shares in the market without losing control of the company. Listing can also allow the majority shareholder to get rid of a bothersome or restless minority shareholder by providing a forum for the minority shareholders to sell their shares in an orderly manner, or if they are simply looking for an exit. But in return, a majority shareholder will no longer be able to ignore financial parameters such as P/E multiples, EPS, dividends per share, etc. (see Chapter 22) when determining strategy. Researchers² have shown that listed companies invest less than unlisted companies and are less responsive to investment opportunities because of the short-sightedness of their shareholders.

Once a majority shareholder has taken the company public, investors will judge the company on its ability to create value and communicate financial information properly. Delisting a company to take it private again is a long drawn-out process (see Section 44.6). So, for management, being listed results in a lot more restrictions in terms of transparency and communication.

For the company, a stock market listing presents several advantages:

• the company becomes widely known to other stakeholders (customers, suppliers, etc.). If the company communicates well, the listing constitutes a superb form of “free” advertising, on an international scale;
• the company can tap the financial markets for additional funding and acquire other companies, using its shares as currency. This constitutes invaluable flexibility for the company;
• the company finds it easier to involve employees in the success of the company, incentivising them through stock options, stock-based bonuses, etc.
• in a group, a parent company can obtain a market value for a subsidiary by listing it (we will then speak of a carve-out) in the hope that the value will be high enough to have a positive impact on the value of the parent company's shares;

Listing on the stock exchange thus increases the company's financial flexibility, but this comes at the price of implementing stringent governance measures and adopting IFRS standards, all of which is costly and difficult to fully assess prior to making a decision.

Now for the warning flags: a stock market listing does not guarantee happy shareholders. If only a small percentage of the shares are traded, or if total market capitalisation is low, i.e. less than €1bn, large institutional investors will not be interested, especially if the company is not included in a benchmark index. Volatility on the shares will be relatively high because the presence of just a few buyers (or sellers) will easily drive up (down) the share price significantly.

Section 42.3 HAVING MINORITY SHAREHOLDERS IN SUBSIDIARIES?

It is simpler for a group to own 100% of the subsidiaries it controls outright. In this case, decisions can be taken without the consultation (or even approval) of a third party, legal formalities are reduced, and the benefits of implementing an effective strategy accrue entirely to the sole shareholder group. Moreover, in this case, the management of liquidity within the group is simplified because the dividend payout is made without “leaks” represented by the dividends paid to minority shareholders; the implementation of intra-group loans does not pose a problem either.

1/ THE REASONS

Nevertheless, a group may sometimes bring in (retain) minority shareholders to the capital of some of its subsidiaries. The motivations for welcoming a financial minority shareholder or carrying out an IPO of a subsidiary are generally different from those for bringing in an industrial partner.

Indeed, the affiliation of subsidiaries to another group can generate industrial, commercial or other synergies; and when the benefits identified go beyond mere financial reasons, the sharing of capital can generate tangible benefits.

But all is not rosy since accepting that a subsidiary opens its capital to a partner or in the financial market can generate risks of conflicts of interest (intra-group or partner transfer pricing, level of risk-taking, remuneration of intellectual property, etc.).

(a) Raising funds

Opening up the capital of a subsidiary can enable the group to raise equity capital in an attractive way, especially when it is difficult to find new equity at the level of the parent company. For example, AB Inbev IPOed its Asian subsidiary Budweiser Brewing Company APAC and got $5bn to pay down debts in 2019. Cooperative or mutualist groups may also list a subsidiary to raise equity capital they would struggle to get otherwise.

Groups can also use it to finance an acquisition without carrying out a capital increase (Schneider and a division of Larsen & Toubro). The buyer can also use a vendor loan to acquire the entire capital, or ask the selling shareholder to retain a share of the capital.

Finally, it is a preferred means of growth for family groups whose controlling shareholder does not have the financial means to achieve its strategic ambitions. The result is an organisation chart similar to that of the Frère group in Belgium:

The game consists of finding minority partners (at the different levels of the structure) during the growth phase; then, once the waterfall of subsidiaries have reached maturity and the cash flows have become more consequent, offer them an exit and close the structures.

(b) Externalise the value of an asset and facilitate external growth

Groups sometimes hold particularly prized assets in their midst, whose valuation multiple may be disproportionate to that of the group as a whole. This high valuation is due to the significant anticipated growth of a given activity.

In such a situation, the group may be undervalued if the size and shape of this attractive subsidiary is not properly understood by investors. The simplest way to revalue the entire group is to sell a share of the crown jewels, thereby externalising the value of this nugget.

Moreover, in such a case, it is value destructive for the group to raise equity at the parent company level to finance the subsidiary's development. This amounts to issuing undervalued shares (those of the parent company) to purchase assets valued at a normal price. It is better to be able to pay in shares of the subsidiary, which is as fairly valued as the target. In 2019, this is what led Volkswagen to open up the capital of its truck subsidiary Traton, in which it retained an 88% stake, to facilitate seizing external growth opportunities (Navistar in 2020).

(c) Sharing significant risk

A controlling shareholder may not want to endanger their group when undertaking an important and risky project. They may then agree to share the profits of the project to relieve themselves of some of the risk. Thus, when the Drahi group expanded into the USA in 2015 by taking over cable operators Cablevision and Suddenlink for $26.8bn, it shared the investment with BC Partner and CPP Investment, which combined held 30% of the capital, before listing it on the stock market in 2017.

(d) Reducing the contribution of a subsidiary to the earnings of the group

Without wishing to proceed with an outright sale, a group may decide to reduce its exposure to any one of its assets by selling a fraction of its capital to third parties. Vivendi sold 20% of the capital of UMG in 2019 and 2020, keeping temporarily 80%.

(e) Preparing for a future divestment

Minority shareholders entering the capital, or better still, initiating an IPO as discussed in the previous paragraph, also makes it possible to impose greater management rigour and specific governance requirements intended for listed companies. This can therefore be a first step towards a divestment by the majority shareholder and independence for the subsidiary.

The listing of a 28% stake in AXA Equitable holdings in 2018 was clearly presented by AXA as a first step towards a complete divestment. This plan was pursued in 2019 with several share sales eventually bringing AXA's stake in its former US subsidiary bank to below 10%.

(f) Relying on a partner with industrial knowledge or geographic advantages

Accepting an industrial minority partner requires considering multiple facets of the partnership. The partner may contribute more than just capital; it will generally be selected for its ability to contribute to creating value in the subsidiary by facilitating its integration into the economy, improving relations with local authorities, obtaining market share and driving synergies, for example in distribution. The Richemont group purchased 30% of Kering's eyewear division, which Kering had spent years developing to improve the quality of its Gucci eyewear products. Richemont then gave this division the supply contract for Cartier's eyewear products.

In a number of countries (China, Indonesia, United Arab Emirates, etc.) and sectors, the creation of wholly owned local subsidiaries is not always possible and a local partner is required, even if it is just a nominee shareholder. To develop its fuel cells business in China, Bosch chose to form a JV with Qingling Motors in 2021

When a local stock exchange exists, authorities can be very sensitive to the local subsidiary being listed (Nexans in Morocco, Nestlé in Côte d'Ivoire, etc.).

(g) Having a tool for motivating employees

Traditional motivational tools for employees in general and management in particular are mostly based on share performance (free shares, performance shares, stock options). In a large group, the specific performance of a subsidiary's management may be quite largely diluted in the overall performance of the group (e.g. DWS within Deutsche Bank, its asset management arm). The managers of a fast-growing business may then have the impression that they are not being properly compensated when receiving shares in the parent company.

Section 42.4 JOINT VENTURES

Most technological or industrial alliances take place through joint ventures, often held 50/50, or through joint partnerships that perform services at cost for the benefit of their shareholders. For example, General Electric and Safran created CFM International in 1972 to produce the CFM56 aircraft engine, and have together become the world leaders in the sector.

Several benefits can be identified: economies of scale, complementary experiences, learning, protection from larger competitors, creating a strategic future opportunity.

The shining example of CFM should not mislead our reader. Most joint ventures are sooner or later unwound, because the reasons that justified their creation and pushed groups to join together on an equal footing disappear over the course of time. Dissolution is then the best solution to avoid boardroom paralysis. Either the joint venture is doing well and one of the shareholders will want to take control of it, or it is doing badly and one of the shareholders will want to get out of it (or will at least refuse to bail out the losses and will therefore be gradually diluted). Thus, in 2019, the Stellantis group (Peugeot-Fiat) bought out the shares of its Chinese partner Changan in the joint venture manufacturing and marketing DS in China. Sales were disappointing and the partners no longer had the same outlook on the brand's potential. Preparing for the potential future exit of one partner is key when creating a joint venture. Joint venture agreements often have exit clauses intended to resolve conflicts. Some examples are:

• put and call clauses. These are used in particular if one of the shareholders is likely to be a long-term shareholder (industrial) and the other less long term (financial). The exercise price of the option can either be predetermined, be based on a formula or be determined by an expert independent of the shareholders. The joint venture that Valeo and Siemens created in 2016 foresees a call and a put in 2022, suggesting a potential 100% takeover by Valeo.
• a buy–sell exit provision, also called a Dutch clause or a shotgun clause. For example, shareholder A offers to sell their shares at price X to shareholder B. Either B agrees to buy the shares at price X or, if they refuse, they must offer their stake to A at the same price X.

Section 42.5 BEING IN THE MINORITY

Although the vocation of a group is not to be a minority shareholder, there are nevertheless several situations where groups hold minority interests. There are several possible reasons for this:

• the group wants to gain a foothold in a new activity, and starts by taking a minority stake in a company, even if it later takes control once the business model is refined. This is what groups are doing today with digital start-ups (Facebook in Unacademy, Daimler in ChargePoint, etc.);
• the group wants to “lock in” an asset by taking a stake in a company it wants to eventually take control of (Vivendi in Lagardère, eyeing its Hachette subsidiary). It consequently gets a foot in the door;
• a legal provision prohibiting in certain sectors of activity holding more than a certain percentage (49% for a television channel in France, for example); Certain countries (such as Algeria or Indonesia) do not allow a foreign group to be a majority owner of a local company;
• the relative value of the contributions when setting up a joint venture did not allow the group to obtain at least 50%. Thus Diageo holds 34% of the spirits subsidiary Moët Hennessy alongside LVMH at 66%;
• to seal a strategic or operational partnership between groups through the acquisition or exchange of minority shareholdings in order to give it greater weight. For example, since 2018, Tencent has owned 5% of Ubisoft, whose products it distributes in China;
• because it is the remnant of a business being divested. Thus L'Oréal owns 9.2% of Sanofi, which is the successor to its 100% ownership of Synthélabo, which has been reduced over time by mergers and sales;
• because a minority can lead to or determine the control of a group with a very fragmented shareholder base (Mediobanca in Generali) or in the case of a limited partnership (for example, for certain specialist real estate companies, the status of general manager offers a varying degree of control).

From a financial point of view, these minority shareholdings are seldom properly valued. When they are below the equity method threshold (a priori 20%, see Section 6.1), they may be completely forgotten by investors, especially if they do not pay dividends, if their historical cost price is low, or if their strategy is not explained clearly to investors.

The equity method of consolidation is not the holy grail, since the share of profit or loss accounted for by the equity method is not included in EBITDA, nor EBIT or free cash flow, which are aggregates frequently used for valuation purposes (Chapter 31) and in the analysis of indebtedness (Chapter 12). This is in addition to the acquisition of the shareholding reducing the company's liquidity. Hence the deterioration in value if analysts do not do their job properly. To avoid this problem, it is in the company's best interest to include the profits accounted for using the equity method in the operating profit as permitted by IFRS.

Our reader will note the asymmetry with the situation where the company disposes of a minority interest in one of its subsidiaries. Operating income and EBITDA are unchanged, but the company's net debt has been reduced thanks to the cash received, which has a positive impact on the value of the company and its financial situation for those who run their calculations too quickly.

In any case, the value of a minority shareholding will be better protected if a shareholders' agreement is signed with the majority shareholder and if the minority company is represented on the board.

Section 42.6 THE FINANCIAL STRUCTURE WITHIN THE GROUP

In arranging financing, the CFO must first determine where to situate the net debt within the group, and then which entities will use external financing and which entities will be financed by intra-group loans. These are two separate decisions because a group entity that indebts itself may well have zero net debt if it then lends to other group entities.

With regard to positioning the net debt, it is a good principle of financial management and internal governance to ensure that the surplus cash of subsidiaries systematically flows back to the parent company at least once a year. In this way, it can allocate financial resources between the different units in the best interests of the group, create or acquire new ones, and avoid the formation of internal baronies (based on the principle that the one who has the money has the power). It is therefore not advisable to locate the net debt within the parent company, leading to a poor parent and rich children.

The choice of the internal financing structure will depend on various parameters:

• Tax aspects that consist of four main variables: the tax rate on profits in the country where they are generated, the tax cost of paying dividends (taxes and withholding taxes) in that country, the tax cost of collecting dividends in the receiving country, and finally the social acceptability of possibly having structures in countries considered as tax havens. Thus, for an American group, until 2017, it was expensive to repatriate dividends from countries where the corporate tax rate was lower than the federal rate of 35%, because it had to pay an additional tax to the Treasury for the difference. This is why Apple's subsidiary in Ireland (official corporate tax rate of 12.5%) was so cash-rich and Apple Inc. so indebted! Several countries have put into place tax measures to limit intra-group indebtedness of subsidiaries (earning stripping rules in the US, thin capitalisation rules in the UK).

  This will allow cash to accumulate in subsidiaries, thus imposing some form of internal financial structure on the CFO.

• Legal constraints: These can, particularly currency exchange constraints, handicap the upward flow of liquidity from subsidiaries, forcing the development of wealthy subsidiaries within a group. As an example, even though no law or regulation stops the outflow of capital in China, the financial system (banks in particular) does so when asked by the government. Local subsidiaries are therefore obliged to keep their cash or invest it locally. Thus, since it is generally easier to send interest and loan repayments upwards than dividends, in a constrained legal environment internal debt is preferred.
• The geography of the assets: if the assets are to be used as collateral for financing (see Section 39.1), the debt capacity will naturally depend on the legal ownership of the assets. The group will then indebt its operating subsidiaries (or possibly the holding companies holding listed securities, if any).
• The motivation of local management: adopting LBO logic, the group's management may wish its subsidiaries to be in debt as a matter of principle in order to create a “healthy pressure” for their management to generate cash flows at least sufficient to service the debt. This motivation will be all the more important as the debt will be owed to third parties. It is always possible to make arrangements with the parent company in the event of a default on an inter-company loan, but it is more complicated to do so with one's bankers.
• The presence of minority shareholders: it is often simpler to finance subsidiaries in which there are minority shareholders with external debt. Indeed, intra-group financing by debt in proportion to ownership percentages is complicated to implement, while financing solely by the majority shareholder raises the question of the interest rate to be charged in the context of normal governance.

The simplicity of a group's financial structure generally goes hand in hand with its maturity. Most large groups are financed almost exclusively by bond debt issued by the parent company (Section 39.1), which then finances its subsidiaries through intra-group loans. Bond investors prefer to lend to the highest level of the group, which has access to all the cash flows, since they do not, at least for investment grade issuances, have any security on its assets.

Conversely, SMEs that use bank financing are more likely to use the assets of subsidiaries (receivables, inventories or even real estate assets) to secure lenders and thus obtain more attractive terms: factoring, securitisation of receivables and inventory, leasing of fixed assets.

The quality of the signature also plays an important role in the choices made by the CFO. The more financially sound the group is, the less it needs to secure its financing with assets, allowing the financing to be carried out at the level of the parent company. This makes steering easier for the central finance department.

The more financially strained groups use all available means to obtain financing and therefore use their liquid assets, generally located in the subsidiaries, as much as possible. Although this will make it more complex to monitor financing, the financial directors of subsidiaries have broader and often more motivating roles. At this level, an important and structural decision is whether or not to place non-recourse (on the group's cash flows) financing with subsidiaries.

If third party indebtedness at the subsidiary level is high, lenders at the parent company level will see a specific risk that the rating agencies will also take into account. The subsidiaries' lenders will have direct access to the assets in the event of liquidation whilst the parent company's lenders will be naturally subordinated. They will only be able to recover a share of the value of these assets after the subsidiaries' lenders have fully recovered their debts. This is structural subordination that worsens rapidly as the risk of bankruptcy increases.

But the CFO's job does not stop there. Once they have conceived and set up this financial structure within the group, they will have to bring it to life. This means supplementing it with intra-group loans to supply units that do not have sufficient external financing. But also to determine the desirable and achievable dividend payouts from a financial, legal and tax point of view. The intra-group financial structure will live and evolve in line with the subsidiaries' cash flow generation and the upwards flow of dividend payments.

Section 42.7 THE LEGAL STRUCTURE WITHIN THE GROUP

SUMMARY

QUESTIONS

EXERCISE

ANSWERS

BIBLIOGRAPHY