In today’s market place, many private-equity firms are focused on investing in “complex situations.” Complex can be interpreted as including high-growth companies with well-performing management teams in need of growth capital where the buyer will perform carefully-executed due diligence. Complex also applies to investments in overlooked, undermanaged and underperforming companies, which might include distressed businesses. Fewer private-equity investors compete for deals in this niche.
A third complex niche-investment area is the “carving-out” of underperforming entities from larger companies. Carve-outs typically involve more complexity than the typical transaction as the business being divested usually relies heavily on the parent company for important, often critical business functions. These functions have to be initiated and activated immediately upon closing of the transaction, and might create issues in valuation as the associated costs of implementation and integration of these critical systems might be uncertain. In addition to business functions, several other categories of assets and “value” are significant in the valuation process: owned and licensed intellectual property (IP), shared customers, vendors, and other relationships that span the larger organization from which the entity is carved-out, transfers of contractual rights and responsibilities, and transfers of certain liabilities.
Why a Carve-out?
The principal reason that is usually stated by a seller in a carve-out transaction is that the business being divested of is not part of the “core business” and that the seller desires to focus on its “core competencies.” In addition to disposing of an unwanted subsidiary that is potentially impacting earnings and market values in a negative manner, carve-outs also raise cash, which can then be used to reinvest in the core business or reallocate capital to new acquisitions in a bid to improve earnings growth. In the current market, sellers benefit from low interest rates and high deal multiples, placing the seller of assets in an attractive position. The sale proceeds can also be used to pay down debt. These days, however, given that debt is not particularly expensive, carve-outs are not generally occurring to pay off debt unless the seller is overleveraged.
Carve-outs can occur for other reasons, such as a business that is pursuing multiple acquisitions. For example, in the 1980s, it was a common practice to use large amounts of debt to finance acquisitions. Then, after making an acquisition, acquirers would sell off subsidiaries to raise cash to pay down and/or service the debt. The method certainly made sense if the sum of the parts was greater than the whole. When it was not, deals were unsuccessful and a number of bankruptcies resulted.
When investors accumulate companies in a particular “space,” such as when pursuing a roll-up strategy, some of the acquired businesses have parts that are non-core. Divestitures of the resulting non-core assets can reduce the transaction price, enabling an acquirer to be more aggressive in pricing. Doing so benefits the seller and also boosts the acquirer’s return on investment because the net amount invested is reduced. In other cases, combinations of companies can result in regulators directing divestitures to cure potential anti-competitive behavior.
In an overleveraged or turnaround situation where insufficient capital is available, an owner is usually being forced to make difficult decisions on where to invest scarce cash. A carve-out can then serve two needs: It can generate cash while at the same time alleviating capital investment demands across the entire organization.
Why Acquire a Carved-Out Entity?
The analyses that buyers undertake in deciding to pursue a carve-out acquisition are very similar to a seller’s decision to divest. Where a seller determines that a subsidiary or division is not core to the business and does not meet the required rate of return on capital, strategic fit and value potential are greater for the buyer. A buyer likely has a business with which to combine the carve-out target or believes that it can improve the business sufficiently to provide an attractive rate of return. This can include cases where a buyer might have greater financial resources that will enable the carved-out entity to capitalize on available organic growth or acquisition opportunities[ES1] .
Valuation
Many companies carve out a subsidiary not because it is doing well and is not strategic, but because it is a burden. A carve out for that reason will not lead to an enhanced valuation, especially if a carved-out subsidiary was ignored and deprived of capital investment, or had trouble when it was a part of the parent and is lacking in an established track record for growing revenues and profits. In addition, a poor track record of earnings may have leaked into the market place where customer support might have weakened and/or trade credit might be initially difficult to obtain on a standalone basis.
From the seller’s perspective, preparedness is key to a successful carve-out. Most buyers will expect audited financial statements of the carved-out business. Valuations will be highest where the seller can deliver a credible standalone financial model and transition plan, with clear visibility as to how the business ultimately will be separated from the parent. The model and plan should assess all shared operations and perform a clean “surgery” of any shared costs, such as administrative expenses and research and development (R&D) expenses, as applicable. Any other shared costs between the target and other divisions of the seller should also be reviewed. Then, it should normalize earnings for costs in excess of market value, such as rent and use of corporate jets. This plan is often not well prepared, and buyers should scrutinize all discretionary expenses and determine if each cost item is truly needed to support ongoing operations.
The seller can improve valuations by articulating how to reduce the risks that are related to the separation and how to add value in the separated business. Buyer considerations should include interlinkages in manufacturing, R&D, branding, distribution channels, sales and marketing personnel, shared customers, back office (accounting and collections, administrative/human resources), logistics and distribution.
If an existing operating business is acquiring the target, the buyer will identify potential savings that could be generated from synergies that will be established among the businesses. A simple example would be that the combined businesses might not need another controller. Another more valuable consideration might be that purchasing can be centralized between the buyer and the target entity — not only are overall administrative costs reduced, but the combined entity’s total expenditure is larger, providing greater leverage for negotiating reductions in cost. The buyer should identify multiple scenarios to reduce costs, thereby raising the likelihood for a successful investment.
Other Valuation Considerations
Where an operating business is being divided, carve-outs can be problematic. It should be very clear what employees, assets, and contracts transfer with the business and what remains with the seller. This can be rather complicated, in particular when certain assets are used in both the seller’s businesses and in the carved-out business, and employees work for both the seller and the carved-out business. Problems can arise where a buying party will want to ensure that the carved-out business has sufficient assets, employees and IP to run its business; a selling party will want to ensure the opposite.
The allocation of owned and licensed IP is one of the most difficult issues in carve-out transactions. Sometimes owned IP is shared by the seller and the business being divested of, and the parties must decide who will continue to own the IP and who will be left with “only” a license to the IP. A seller will sometimes try to retain ownership of IP, not because it actually needs it in its own businesses, but it desires to own the IP as a defensive tool, or because the seller is concerned that the IP could ultimately end up in a competitor’s hands when the divested business is sold in later transactions.
As in any mergers and acquisition transaction, a change of ownership might trigger change of ownership clauses in certain contracts, including licensing agreements. Carving up licensed IP raises difficult issues in that many such licenses (e.g., desktop software licensed under an enterprise-level license or enterprise-level software used for financial reporting) do not permit the licenses to be divided up between two unaffiliated entities. Licensing of shared trade names, trademarks and service marks can also create issues. Such names and marks might represent a key part of the value for certain products and services.
Carve-out transactions often involve transfers of liabilities from entities that stay behind to entities that are being divested, and vice versa. Quantification and allocation of contingent liabilities can be a potential obstacle to any carve-out. Indemnities are helpful in addressing these concerns but are limited by the indemnitor’s credit profile.
In divestiture transactions involving a buyer in the financial-services industry (also called “financial buyers”), buyers require a number of important ancillary agreements, which are not often needed in the context of the sale of a standalone business. For example, most carve-outs involving a financial buyer require some kind of “transition services agreement” under which the seller agrees to provide certain support services to the buyer for a period of time after the closing — generally a year or less — while the buyer gets the new business up and running on its own.
Under some transition services agreements, the buyer also agrees to provide certain services back to the seller for a period of time while the seller fills in a business “hole” resulting from the sale. Many carve-outs with financial buyers also have commercial agreements between the buyer and the seller for the provision of goods or services over a time frame longer than that of a typical transition services agreements.
Conclusion
Carve-outs are potentially attractive opportunities for both a buyer and seller. The seller benefits by extracting and redeploying capital into more attractive opportunities. However, carve-outs are complex transactions, not only in execution but also in valuing the multi-faceted aspects of the transaction. As a result, the pool of financial buyers such as private-equity firms can be limited as many firms are not willing to undertake the complexities and risks that are associated with completing a carve-out transaction. For experienced buyers willing to dig in and better understand these complexities and risks, this can result in an opportunity to buy assets at attractive valuations relative to where they would trade on a standalone basis. Sellers who understand this can enhance valuations by being prepared, creating credible financial models and transition plans, articulating how to reduce the risks related to the separation and helping buyers with how to add value in the separated business.
[ES1]Make sure that you have a version of the chart that is the resolution needed for newsletters. May want to insert “See Figure 1” at the end of this paragraph in case the chart has to be moved in layout.