After coming off a fairly quiet period, more companies are looking to shed non-core assets, which will likely heat up the M&A market in 2014. Mergers & Acquisitions convened a special roundtable to discuss which companies are selling and who the likely the buyers of the corporate carve-outs will be. KeyBanc Capital Markets sponsored the event and the excerpted discussion that follows provides a range of perspectives on what middle market dealmakers can expect from these companies going forward. Participants included private equity investors, a lawyer and an investment banker. (Watch video interviews with the roundtable participants on our video site and below.)
Participants: Chris Behrens, CCMP Capital Advisors LLC; James Dougherty, Jones Day; Danielle Fugazy, Mergers & Acquisitions (moderator); Robert Landis, The Riverside Company; Paul Schneir, KeyBanc Capital Markets
Danielle Fugazy, Mergers & Acquisitions (moderator): Why haven't carve-outs deals been popular during the past few years? What do you expect going forward?
Paul Schneir, KeyBanc Capital Markets: If you look at carve-out deals coming out of the recession, the level of activity has been fairly consistent. There were around 1,900 divestitures that took place within the U.S. marketplace in 2013. However, the stage is being set for a change in 2014 and 2015. From 2009 to 2012, the carve-out activity was largely a result of corporations worried about their own sustainability and their balance sheets. They were focused on monetizing non core assets to build up cash reserves. Last year, carve-out activity was more a result of boards identifying non-core units for strategic reasons, but there still was a hesitation to complete the deals because the sellers were focused on a loss of profitability and impact to their earnings per share.
2014 and 2015 are setting up for a transition back to divestitures as a strategic weapon used by companies looking to become more fit and focused. Going forward, companies want to focus on where they are world class and if they're not, they are going to look to exit those areas to focus on building on capabilities where they are best in class. Another driver in today's market is shareholder activism, which is motivating corporations to rigorously evaluate what businesses to keep and what businesses to sell. Activists have been increasingly vocal in expressing their opinions to the board. Another factor is share buybacks, which are taking place at a healthy rate. So if a corporation doesn't have an identified target, they are looking to buy back shares as a way of being able to increase their earnings per share. As a result of these dynamics, we're going to see a resurgence of carve-out transactions. It's not going to jump up to pre-recessionary levels, but we should continue to see an increasing portion of M&A activity taking place in the divestiture camp.
Chris Behrens, CCMP Capital Advisors: Shareholder activism is really an interesting phenomenon, which over the last two or three years has been an impetus for a lot of boards and CEOs to think about their portfolio of companies. Five or six years ago private equity or investment bankers would be knocking on the door, talking about shrinking to grow and what parts of your business are growing or not. Now the hedge fund guys are knocking and saying 'hey, have you thought about moving this portfolio this way or that way?' This has allowed boards and the whole investment community to get comfortable with divestitures and trimming portfolios as a way of not just playing offense, but potentially not having to play defense once an activist gets involved.
James Dougherty, Jones Day: Shareholder activism isn't going away. If you look at the amount of money going into activist funds, it's quadrupled over the last decade, and so whether it's volitional or not, boards will continue to evaluate what they really need and sell what they don't. And if you look over the last decade, there were a number of companies that, over time, became conglomerates. They had disparate businesses and industries that didn't necessarily fit. What we are increasingly seeing is the deconglomerization of what was built up over the last decade.
Robert Landis, The Riverside Company: I was talking to a former head of corporate development at Borg Warner (NYSE: BWA) and he was referencing the United Technologies (NYSE: UTX) acquisition of Goodrich last year. He said, 'It's like the python swallowing the pig.' It's almost digested, and now United Technologies, like many large corporations, say 'okay, we've bought this company, what don't we need, what can we sell?' Granted the economy's not moving fast, but there seems to be some mild optimism, so what can we trim here so we have extra cash for other opportunities. We will see this a bit more.
Dougherty: It's interesting you mention that the Goodrich deal. I represented Goodrich in that deal and Goodrich was on United Technologies' acquisition list for 10 years. You would have an analyst meeting every year, and the CEO of United Technologies would literally put up a slide indicating the top three companies he wanted to acquire. Goodrich was on there every year. Even then, United knew that they didn't want all of it, but there was no way to buy the pieces that they really wanted so they were going to write the $18 billion dollar check and take the whole thing and then sell what they don't want.
However, most people in this environment aren't confident enough to do that.
Fugazy: Is it harder for private equity firms to acquire corporate carve-outs than indepdendent companies?
Schneir: Back in 2005, 2006 and 2007, and especially during the recession, carve-outs were marketed much more to strategics, partly because they understand the businesses, the markets they serve, and could get their head around intertwined operations. Historically, carve-outs were tougher for private equity guys to get their arms around. But a lot has changed over the last five to 10 years. Private equity firms are now saying they have the depth of talent and resources to work through complexities and they are ready to go wherever they need to get the right price, opportunity and the right structure.
Behrens (pictured): There's a whole lot of factors around buying a company from a corporate and all the things that you have to do to get it right. Over the last five to 10 years certain private equity firms have gotten more comfortable. They've seen success when they can roll up their sleeves and solve problems for a corporation that needs to get rid of something that maybe doesn't have audited statements, maybe isn't fully separable immediately, and oftentimes needs management, focus and capital to think about more longer-term planning and longer term growth initiatives. It's a fertile ground.
Schneir: When divesting, corporations are getting increasingly smart on hiring the right advisers, both legal and financial, to help them get prepared in advance of a process. In the past companies went to market with internally prepared financials, and many private equity firms shied away. Companies are getting smart about doing carve-out financials, pro forma adjusted, for standalone costs to make it easier for private equity guys to get in and properly evaluate the business and successfully close on the deal. That's part of an evolution that's taking place and, frankly, why private equity has been more successful in acquiring divestitures.
Dougherty: To private equity's credit, they've gotten a lot more sophisticated over the last decade. If you look back at some of the transactions that were done 10 or 15 years ago, the sense that you always got was that it was a lot more about financial modeling, but now almost every private equity shop has strategic partners. Now PE firms have partners who were in the industry for 30 years working with them. So when you layer that on with the ability to look at it from the financial perspective, there's real value and PE has given the strategics a lot more competition over the last decade.
Fugazy: Are there any particular sectors where we will see more carve-outs for sale?
Dougherty: There's clearly a mini resurgence going on in the manufacturing sector and in industrials. If you look at carve-outs in that middle market range, the $50 million to $300 million dollar deals, there's a lot out there that are old line industrial manufacturing types that are going to wind up being heavily pursued.
Behrens: Industries that are growing in the United States are energy and energy infrastructure, so we're excited about both energy and industrial sectors. But when the two are married - that feels like a pretty good dynamic, particularly where manufacturing in the United States has really benefited from lower gas and electricity costs. Additionally, with wage rates being relatively stable, you can make a good case for manufacturing in the U.S.
Schneir: Industrial is probably going to be a significant driver of corporate divestitures because there's greater international competition that's now taking place. If you're not a world leader or in the running for world leadership, then you're looking at divesting and putting your cash where you can be a global leader. It's just too tough to compete as a fourth or fifth player in today's market. And you already see it taking place with some of the big chemical companies where they're raising their hands saying 'we can't make the money or the return on investment that we could previously.' So now they're looking at divesting and refocusing their strategy where they can win.
Fugazy: What impact does the regulatory environment have on carve-outs taking place this year or next?
Schneir: I see it more as a psychological issue than anything else. When you can't get a budget through, and there's dysfunctionality in Washington, investors become more conservative and it changes their appetite for risk and the type of deals they pursue. People are less willing to sell when there is uncertainty in Washington because they're not sure what the business or financing climate will be going to be and they're less willing to make big strategic moves on the acquisition side.
Behrens: When there's uncertainty and when you see institutions like Congress and Washington not able to function, whether you're the CEO or an institutional investor or financing source, you are just less likely to be aggressive. However, it does feel like we have a relatively benign window right now from a macro standpoint. There's still not terribly robust growth, but I think people feel generally good.
Fugazy: What are the challenges of buying a piece of a company out of a larger company?
Landis: Over the past 25 years we have purchased 49 companies from Fortune 500 -type companies in North America and Europe. Our experience is that PE firms tend to have a different focus than publicly traded companies. For PE firms, cash flow, EBITDA, and low capex are very important. For large strategics, P/E multiples and whether an addition is accretive to EPS are important. The focus of the discussion is therefore very different when discussing valuations.
Dougherty: It varies deal by deal, but the interdependentness of the division that you're selling relative to the seller is probably the biggest challenge. Some of these units are almost standalone-ish in that they've got some limited support services, treasury, legal and cash management. Others have their entire IT infrastructure, accounts payable and receivable all together and you have to actually sit there and figure out how you're going to separate that. Then there's the usual things like how do you deal with the pension issue and 401(k)s? Can you segregate and splinter off a piece of it with the people that are going with the sale? We did a deal for Timken about four or five years ago where they sold their needle roller business. It was about a $300 million dollar deal. That business was so integrated that we actually had to build a new $15 million dollar IT system for the buyer in order to allow the business to operate on a standalone basis. Now, that's an extreme example, but these are the issues that come to the forefront.
Fugazy: How are employees impacted when there is a carve-out situation and how do employees impact the deal?
Dougherty (pictured): In a lot of these settings you'll have a sales guy who's sitting in a cubicle next to another sales guy and they may be working for different divisions but they're best friends and they've been there for 15 years and that will have an impact. What's important is how you communicate to employees. You have to assure employees that are coming with you that they're not going to wind up getting terminated six months later. It's a very big emotional issue. C-suite folks usually have change of control agreements, and at the end of the day if they get terminated, they've got some economic protection. However, a lot of the people in these corporate divestitures are middle management or sales folks, who don't have those types of protections.
Schneir: There's a staggering number of companies that don't contemplate retention and as you go through a process, anxiety builds and it impacts management's mindset and attitude throughout the process. The people side of it is consistently an issue. You need an internal team with a quarterback that's going to champion the internal communication and retention process.
Fugazy: When you are getting a corporate divestiture ready for sale, what are some of the key things you're trying to get sellers to think about?
Schneir: We try to address timing because inevitably corporations want to go faster. There is an old proverb "fast to market, slow to close." The seller should take a step back and really review diligence information; and look at the linkages between sister businesses and back to the parent. Putting financials aside, it's really identifying those issues and how do you create a business that can operate on a standalone basis, and have financials that are standalone with enough specificity that a buyer can look at the information and validate the true performance associated with it. The seller will benefit by taking that time. Corporations don't necessarily like to have that two or three month delay, but inevitably it saves time and effort on the back end of the transaction. It's all about reducing surprises.
Dougherty: You try to manage the client. I had a $75 million dollar deal where the buyer was a big strategic and there were no anti-trust issues, so we knew once we signed the deal it was going to close in 30 days or less. But our client, the seller, decided that they're only going to tell four people in the company that we're doing the deal. That presented a variety of issues, like how do you set up a data room, how do you show up at the company and explain where why you're there digging through documents, and that comes up more often than you'd think. When you're dealing with companies where a relatively meaningful piece of the business being sold, they want to keep things quiet because they worry about losing customers and suppliers in the event of a leak. They have those issues until they sign up the deal and you're sometimes faced with a situation where you're trying to take shots in the dark and actually orchestrate a sale transaction with very little information and very little inside help.
Landis: There is real value in having an investment banker in the middle. When a buyer comes in and says I need this, I need that, and the seller asks why, then the buyer takes it personally when you raise these questions. You need somebody in the middle to say, 'Here's what we really meant.' Once there's a lack of trust, the deal is less likely to close. It's not because anybody's being disingenuous. They just speak a different language and come from a different culture.
Fugazy: What are some of the issues that will scare you away from doing a carve-out deal?
Landis: We've always been challenged when top management wants to stay with the selling parent company. We understand that they have a loyalty factor, they have credibility, and they know what they're getting. But when existing managers want to stay with the parent, and they say, "We have the other people here, they're really good and they should be given a chance,' it's hard for us to explain to our limiteds why we're going to give somebody a chance as opposed to why we're expecting existing management to continue to perform.
Behrens: What we do is evaluate people and if you're evaluating someone who's going to be the CEO of a standalone business, but yet has always had the benefit and the protection of being part of the large corporate, his scorecard may not be replicable in a new private equity environment, and so that takes a lot of time, a lot of listening and engagement as to all the things that he or she may have wanted to do but didn't get the support for, evaluating if those were effectively the right strategies and platforms, and that's what we spend a lot of our time doing. You'll eventually be able to diligence the financials and the IT system and the pension - that will all come together, but it's the qualitative piece that really takes the time and the judgment.
Schneir: It's tough to really assess management because you're not sure what you're getting, and you may not be sure who's staying or going. The management team's performance may be impacted by the parent company's objectives and motivations or lack of availability to capital. It's not easy to link future performance to past performance when there are conflicting objectives and undercurrents which exist.
Fugazy: Post close, what challenges do the new owners face?
Landis (pictured): What you don't catch in due diligence. There's always something you don't catch. Fraud can still crop up and that's a big worry. Not only do you have to fix it, but then you have to look the seller in the eye and say, 'that's an issue.' Getting the right board, that's important. Oftentimes these companies don't have a board. The CEO was reporting to somebody. Now, we want him on the board. We usually try to get two to three outside board directors mutually agreed between management and ourselves. We need an independent board. That's crucial. That always takes longer than we expect because we want people who are mutually accepting to both sides. We do not want people who are just going to show up and vote with the majority.
Schneir: What about management? How do you guys make an assessment on management? It's a lot more cloudy when it's not a standalone business. We've seen situations where the private equity group or strategic makes a decision six months after closing that this isn't the guy to lead us forward.
Behrens: You're always looking at professional managers and trying to make sure they can become entrepreneurial enough and interestingly we're also looking at entrepreneurs and seeing if they've become professional enough to take their businesses to the next level. So in the case where you've made the decision and the bet that the team has that entrepreneurial spirit as a standalone company, you're always evaluating whether that's the case or not. Which is why I think having a board that has not just different functional and industry areas of expertise but has just seen these transitions occur and become mentors to the management team and the CEO, allows you to get ahead of that phenomenon.
Fugazy: Is there anything specific that corporate divestitures need to help grow?
Landis: They need a good IT system. If you can't figure out what's happening, you can't fix it. We do a significant assessment up front before we buy the company: What are the IT issues? What are the reporting issues? How are they tracking in inventory? How are they tracking shipments? Do they have an ERP system that marries up the financial operations?
Behrens: Whether it's a carve-out or not, you try to underwrite the same business and strategic plan with management before you close the deal and establish KPIs and other ways to measure success along the way, and some of those KPIs may be the same ones that the corporate parent had. We often find that the CEO and the executives have a whole set of other ways that they want either themselves to be evaluated or their people to be evaluated and so we're open to that. And again, classic private equity would also marry not just annual compensation, but longer-term compensation to hitting those goals. So that part usually has a way of bringing people together and getting people to buy in on a not just, say, a 100-day plan, but longer-term goals and key success factors.
Fugazy: Are there any best practices when you're looking at buyers that are coming into a potential corporate divestiture situation?
Dougherty: As a general rule, from the sell side you're really looking for people that can come in, that are organized and know the drill; they're sophisticated and they can move quickly and understand the issues. So the best practice is to have a team that come in ready to go, moves quickly, understand the issues and cuts to the deal points that really matters.
Schneir: It comes down to minutia in every deal. There's just a lot more of it in corporate divestitures, especially messy ones. I think the people who know what really matters versus what is minutia are the folks that get it done, and get it done without wild delays. I think some groups also are just better at working through the challenges. In every transaction you're going to have issues, probably more in divestitures than other deals. The ability for private equity or strategics to be able to come up with a solution... we see this issue, here's our workaround.... those are frankly, the better guys for us to deal with and they're the better guys at getting deals done on time and with fewer headaches.
Behrens: There's no real substitute for experience in these things, from the financial perspective and the operating perspective. In marrying those two allows you to decide if a certain issue is a mountain or a speed bump. Anybody can come up with the 40 things that we've discovered in diligence and how are we going to deal with it, but if you have someone who has both years of experience doing this and understands in this industry it's not considered that critical to lose, for example, naming right after three years or this distribution channel after five years or whatever it may be, we can all live with that. You're trying to execute not just a transaction, but you're trying to allow a corporate seller to execute on probably what it told its board six or 12 or 18 months ago what it's going to go ahead and do, and that reputation of being able to solve problems for a corporate seller builds on itself, and that's the virtual cycle if you start getting these things done well.
Fugazy: What role do legacy issues in terms of unions and pension plans play?
Landis: How is the union relationship? If it's contentious, then you look to see when the next union contract comes up for renewal. If it's one year after you bought the company, that's a big risk factor. If they've just negotiated that contract and there have been no issues and it seems to be a very good relationship, that's a positive.
Dougherty: You have to look at these issues in buckets starting with pension and retiree medical. The second bucket is the union situation. The union issues usually work themselves out by doing your diligence and figuring out what the situation is and the history there. On the pension and retiree medical, so many public companies are moving away from that regime anyhow because it's just inordinately expensive, and the private equity folks typically are not going to set up a pension, and they're not going to assume retiree medical. So that just becomes a negotiation on the cost of those benefits, but the seller is almost universally going to wind up retaining that. Then the third bucket is the 401(k) and the other benefits, the medical, the dental, and then the comp, and when dealing with this third bucket, I think the private equity folks have a tremendous amount of flexibility because a lot of these middle managers and even the senior managers of the division, if they're in a larger public company, their opportunity for really creating personal wealth is relatively limited. They have an opportunity based on performance metrics over the long term to improve their compensation under a private equity structure. So from a management perspective, many of the management teams we work with that are going to a private equity buyer are ecstatic because of the opportunities to grow the business and be rewarded for success.
Behrens: During the process of the sale, both the seller and the eventual buyer don't want to give the company's employee base a whole lot of reason to sit around and talk about what's going to happen. You want to communicate. You want to be constructive in terms of answering questions and things like comp and option plans and health care. We would typically gauge from the senior team what's worked in the past and try to live along those lines and try to minimize the water cooler talk and the concern that things are going to turn 180 degrees. It's an interesting time in the health care industry because benefits and employer plans on everybody's mind as to what's going to be changing, and so that kind of opens up a series of questions and opportunities for private equity. For example, without potentially the legacy issues that a corporate acquirer may have, private equity can tailor and be flexible in creating or adopting healthcare plans.
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Corrected February 12, 2014 at 4:37PM: 3198462271001