Aug. 4, 2020
Although carve-out transactions – in which a corporation sells a subsidiary or business line – have always been challenging, new economic realities of the coronavirus pandemic are elevating execution risks of the deals and increasing sellers’ desire to complete the transactions. That may result in increased numbers of carve-out acquisitions in an environment where it is simultaneously more difficult to execute an in-person carve-out transition plan.
This article details several steps PE sponsors can take to prepare for certain challenges introduced by carve-out transactions and to increase the likelihood that those transactions are successful. Among other things, the article recommends that PE sponsors take special care when appointing transition task forces to manage the process and that they ensure the carved-out business has adequate back-office functionality from day one.
For more on transaction types and approaches gaining greater prominence during the pandemic, see “Considerations When Using Earn‑Outs to Consummate Secondary Transactions During a Downturn” (Jun. 16, 2020); and “Types of Rescue Capital PE Sponsors Can Pursue to Help Their Portfolio Companies Survive the Pandemic (Part One of Two)” (Jun. 9, 2020).
Carve-out acquisitions occur when a large corporation sells off one of its subsidiaries or business lines. In those transactions, another firm will buy and then operate those carve-out units. Traditionally, in carve-out transactions, the sold unit does not come with back-office functions such as IT; finance and accounting; and HR. Therefore, the buyer of the unit must quickly ramp-up those back-office functions to maintain business continuity.
There are typically several hundred carve-out transactions per year in the U.S. That number may actually increase in 2020, however, due to the effect of the coronavirus pandemic and quarantines. The coronavirus lockdown across the globe has led to massive economic disruption. Almost every sector of the economy has been affected, including sectors that are typically not correlated to recessions, such as healthcare and education. The sheer scope of unemployment, supply-chain disruptions, mandatory store closures and the increasing number of likely bankruptcy filings pose severe challenges.
The economic distress caused by the coronavirus pandemic has caused many businesses to focus on their core revenue-generating operations. In turn, many corporations seeking to improve their financial situations will likely look to divest non-core divisions through carve-out transactions. By selling a non-core division, the parent company can focus on its core business and perhaps exit an unprofitable segment. Accordingly, PE firms that buy distressed units will try to turn around the operations, refinance or merge them to provide more operational scale.
See “Former OCIE Private Funds Examiner Explores Compliance Issues Introduced by the Coronavirus Pandemic and Mitigation Tips (Part Two of Two)” (Apr. 21, 2020); and “Withstanding the Coronavirus Pandemic: Key Person Clauses, Fundraising Disruptions and Deal Flow Issues (Part Two of Three)” (Mar. 31, 2020).
Challenges Posed by Carve‑Out Transactions
Although carve-out transactions can be very profitable M&A transactions, it is much more challenging to acquire a carve-out than to purchase an existing standalone business. Therefore, fewer potential buyers tend to bid on target companies because of the specialized expertise and capabilities the acquisitions require. Also, carve-outs tend to have additional execution risk because the business does not have its own standalone financial statements.
Higher risk and fewer buyers can lead to artificially low sale prices. That allows a savvy buyer to buy low and sell high after it separates the unit and stabilizes the business. To accomplish that, however, PE firms and strategic buyers need to overcome certain of the following unique challenges to turn around the operations, refinance or merge the carved-out business to provide greater operational scale and lead to success.
Valuing Commingled Entities
Carved-out units do not operate on standalone bases from the parent corporations. Therefore, they do not have separate financial statements available. Often, there are some elements of financials available, but those may include allocations from the parent. In addition, it is difficult to validate the historical and go-forward earnings for the subsidiary or business line in question.
In light of those difficulties, it is crucial that a buyer conduct a quality-of-earnings carve-out audit. Many firms are skilled at those carve-out audits. Some sellers will perform their own carve-out audit in advance of a sale to facilitate a transaction. It is crucial that the buyer understand the key assumptions in carve-out audit reports so it is not surprised.
For more on valuations, see “Eye of the Storm: Q2 Valuations of Private Debt and Equity During the Coronavirus Pandemic (Part One of Two)” (Jul. 14, 2020); and “Determining ‘Fair Value’ During a Crisis: Coronavirus’ Impact on Private Debt and Equity Valuations” (May 5, 2020).
Rehabilitating Underperforming UnitsCarve-out units are frequently underperforming business units. They may be “orphans” within large corporations that were not the focus of the parents and thus have weak financial and operating performance. Therefore, it is crucial that the acquirer is able to quickly develop and execute the carve-out and turnaround plan. That plan needs to include a plan to effect an operational revitalization and a cultural refresh.
Introducing Administrative Functions
Carved-out businesses do not come with shared back-office functions. The parent company will keep some of the best resources, such as IT; HR; legal; finance and accounting; supply chain; and sales support. Therefore, it is crucial that acquirers conduct detailed diligence to understand which functions are included with the transaction and which need to be added post-closing.
In addition, the shared services also may not be accounted for adequately in the financial statements. It is very important that the acquirer knows which functions are included and what needs to be developed on an internal or outsourced basis. That diligence is challenging for the buyer, however, because the seller is incentivized to not disclose all of the necessary dependencies on the parent. The seller typically wants to have as little ongoing interaction and responsibilities for the carve-out unit post-sale as possible.
To overcome those issues, the acquirer can often provide some of the following shared services on an interim or permanent basis as the carved-out business transitions to operating as a standalone entity.
In a carve-out acquisition, only some staff transfer to the buyer. In that situation, buyers need to quickly assess and set up the pro forma organizational chart for the business. New employment contracts and offer letters need to be provided, and healthcare benefits need to promptly be set up.
It is also important for PE sponsors to keep in mind that the carved-out entities may have morale problems among their workers due to the uncertainty of transactions and multi-year periods of underperformance. In addition, teams may also have some significant gaps in key functions, and there may be differentials in employee benefits and titles that need to be managed to properly calibrate employee expectations.
See “How Compliance and HR Can Work Together” (Jun. 2, 2020).
In a carve-out transaction, it is crucial to maintain IT continuity and to transition key information to the carved-out entity so it can maintain and upgrade its software systems. IT can be very complex and can have dependencies on the corporate parent, which can be hard to identify during diligence.
Within IT, a lot of “blocking and tackling” needs to occur, including:
- transferring phone and internet lines;
- analyzing and renegotiating software and cloud licensing agreements;
- scrubbing parent information from computers;
- rerouting email addresses; and
- copying and separating information between the buyer and seller.
During the coronavirus pandemic, the increased use of work-from-home policies has led to a heightened risk of security breaches. Often, corporate IT security personnel use shared corporate resources, which do not transfer with the carved-out entity. That poses the issue of having a limited security team during the dynamic period of the carve-out and the increased number of IT threats, which is a dangerous combination that can lead to denial of service attacks, phishing attacks and ransomware. It can be helpful to hire a firm to conduct a cybersecurity audit in advance of a transaction, as that can help identify vulnerabilities and facilitate a clear execution plan.
In a carve-out, the buyer needs to quickly set up a new financial system to track financial transactions to keep the business running and in compliance. As applicable, those changes also need to be promptly communicated to customers and vendors. Setting up a new financial system is very challenging because the company needs to track transactions on the original system while migrating to a new system – all with a team that is new to the business.
The financial tasks are particularly important because the PE sponsor will be demanding regular updates on the status of the business. If the new business has taken on leverage to finance the transaction, the financial sponsor will have even less patience.
A company’s supply chain is another crucial behind-the-scenes function despite sometimes not being a focus during due diligence. The issue is that the carved-out entity frequently is leveraging the supply chain and shipping infrastructure of the parent, which can inhibit the new entity’s operations if it loses access to functions such as warehousing, freight and logistics. Also, there are economies of scale provided by the parent that the smaller, carved-out unit cannot immediately achieve. The failure to establish an efficient supply chain can lead to excess inventory, customer shipping mistakes and cost overruns.
Sales is the lifeblood of the company, making it crucial to maintain and expand profitable sales. The problem, however, is that sometimes salespeople are supported by shared infrastructure with the parent company, and some business development leads come from other parts of the parent company.
In light of that issue, the buyer needs to be focused on preserving and incentivizing the sales team to transition to the carved-out entity. Buyers should also try to work with sellers to develop processes and programs to continue the sharing of some sales leads in the near and long-term.
With that said, it is worth noting that sales support staff is another area where the seller may retain top performers while simultaneously offloading underperforming personnel to the buyer of the carve-out.
Research and Development
Teams working on research and development (R&D) and product management need to continue innovating, which makes it crucial that they understand the new product roadmaps and corporate strategy of the carved-out business. To that end, they need to understand how the separation from the parent affects new product features. For example, if a software product links to the previous parent, they may need to remove those connections or find alternative providers. It is worth highlighting, however, that R&D is usually a very shared function, so it may be hard to clearly segment which people are tied to which business units.
Marketing and Customer Support
During the carve-out, customers will be very interested in the fate of the business. Marketing can be very useful to proactively prepare press releases, collateral updates and webinars to explain the transaction. The marketing team will often need to quickly change the branding, business cards and other corporate design elements from the old business. They may also need to swap signage and update text on websites.
Carved-out businesses often lack separate legal entities, as the businesses or product lines are sometimes under the parents’ legal structures. That can pose problems because the new operations will need to quickly create legal entities to operate.
In addition, important vendor and customer contracts may also need to be transferred into the name of the new entity. Therefore, it is crucial to conduct detailed contract reviews and to understand change-of-control provisions so the new company can continue to operate, serve customers and obtain key services from vendors.
See our three-part series: “How Fund Managers Can Control Legal Costs and Negotiate Outside Counsel Fees” (Mar. 10, 2020); “Ways to Approach the Process of – and Key Criteria to Consider When – Selecting Outside Legal Counsel” (Mar. 17, 2020); and “Advice for Allocating Legal Tasks Between In‑House Attorneys, Outside Counsel, Consultants and Other Vendors” (Mar. 24, 2020).
Tips for a Successful Carve‑Out Acquisition
There are several activities that can help improve buyers’ chances of successfully carving-out a business entity.
A carve-out is similar to an organ transplant. In that type of operation, the surgeon attempts to transfer a new heart to a person, while keeping the person’s lungs and liver functioning. Continuing that analogy, in a carve-out, it is crucial that the buyer and seller communicate – even over-communicate – the status of the transaction to the stakeholders. It is also necessary to keep the shareholders, debtholders, customers, employees, vendors and any applicable regulators informed.
All M&A transactions are tense, but carve-outs are even more so. Carve-outs do not have the stability and safety net of the parent, and all the parties need to understand the situation and key success factors.
See “The Dos and Don’ts of Investor Calls That Investment Managers Must Consider” (Jun. 16, 2020).
Leverage Experts and Advisors
Carve-out transactions require a special skill set. Some PE firms focus on carve-outs and have in-house teams of experts to perform the transactions, while other firms are new to carve-outs and need additional support. By leveraging advisors, a PE or strategic buyer can elevate the chances for success.
Advisors can assist with a broad range of elements of a carve-out transaction, including with the scoping and execution of the acquisition. In addition, some firms can help provide IT services necessary for carving out a business such as hosting key applications; running an IT help desk; and helping redesign the back office and production IT infrastructure.
Other advisory firms can assist with the challenges of rapidly hiring all of the carved-out employees across global jurisdictions. There are also many accounting and corporate services firms that can help with setting up the legal entities, as well as with navigating the statutory accounting to keep processing orders in a compliant manner.
Understand and Negotiate the TSA
A key part of carve-outs is that the seller of the business usually offers to provide some of the shared services for a period of time, which affords the carved-out business time to build up its internal capabilities or to find outsourced providers. The transition services agreement (TSA) is an exhibit to the purchase agreement that outlines the menu of services provided to the buyer. The TSA includes the scope of work, the term of the service, the prices of the services and any service-level requirements.
Preparing and negotiating TSAs are very specialized diligence tasks with which very few corporate executives have experience. Also, negotiation of the TSA is often left until the end of a deal, when fatigue may be setting in. Therefore, it is crucial that a lot of attention is paid to the detailed TSA terms. A well-structured and negotiated TSA can be the difference between a successful, harmonious carve-out and an unsuccessful, litigious experience.
Create a Transition Task Force
The transition task force is composed of team members from IT, finance, HR, legal, sales and operations from both the buyer and the seller. During the pre-close period, that team should develop a detailed checklist of activities that need to occur. The transition team works together from pre-close through transition to produce a smooth transaction. The team typically meets regularly – perhaps two or three times per week – to work through issues.
In addition, it is helpful to have a chief transition officer (CTO) to lead the task force. That person serves an important cross-functional role of working for the buyer while also serving as the go- to person to coordinate all the resources to complete the carve-out and transition. The individual appointed as CTO needs to be able to understand the key drivers of carve-out success, as well as to be very organized, disciplined and pragmatic.
In carve-out transactions, solutions need to be developed quickly to handle short-term crises. Over time, longer term and more scalable solutions can be deployed. The CTO needs the clout in both organizations to obtain results in a timely manner to accomplish both those short- and long-term objectives.
Clearly, carve-out acquisitions of subsidiaries or business units require significantly more coordination, planning and hands-on execution than traditional M&A deals involving standalone companies. Those needs can elevate the risk of the transactions, but they also create opportunities for investors willing to put in the effort. As the coronavirus pandemic and resulting economic recession continue, more firms will likely pursue carve-out acquisitions to stabilize their businesses. Therefore, PE sponsors that plan effectively and dedicate adequate internal and external resources to the smooth execution of carve-out transactions can greatly increase their chances of success.
Pradeep Khurana is a managing director of ContinuServe – a global business process outsourcing firm, which helps corporations and PE firms with their IT, finance and carve-out needs.
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