More carve-out deals ahead, driven by pandemic
Covid-19 and quarantines may lead to an increase in carve-out deals. The Covid quarantines across the globe led to economic disruption. All sectors of the economy are impacted. Many corporations looking to improve their financial situation will likely look to sell non-core units. To sell non-core divisions requires a carve-out sale. Carve-outs are transactions when a corporation sells a business unit, division, or product line. In these transactions, another firm will buy these carve-out units and then operate them. Typically, in carve-out transactions, the sold unit does not come with back office functions like information technology, finance & accounting, and human resources. Therefore, the buyer of the unit must ramp-up these back-office functions quickly to maintain business continuity.
Since carve-outs require specialized expertise and capabilities, they tend to have fewer possible buyers able to bid on target companies. Carve-outs also tend to come with additional execution risk due because the business does not have its own standalone financial statements.
Carve-outs present some specific challenges that private equity and strategic buyers should evaluate:
1. Carved-out businesses typically do not come with shared back-office functions. Typically, the parent company will keep some of the best resources. Functions like IT, human resources, legal, finance and accounting, supply chain, sales support do not come with the business. Therefore, it is crucial that acquirers conduct detailed diligence to understand which functions are coming or not coming with the transaction. The buyer then determines how to provide those services. These shared services also may not be accounted for adequately in the financial statements. It is very important that the acquirer knows what functions are coming and what needs to be built up on an internal or outsourced basis. Oftentimes, the acquirer can provide some of these shared services on an interim or permanent basis.
2. Carved-out units typically were not operating independently from the parent. Therefore, they typically do not have separate financial statements available. Oftentimes, there are some elements of financials available, but they may include allocations from the parent. It is hard to validate the historical and go-forward earnings for the business. Therefore, it is crucial that the buyer conduct a quality of earnings carve-out audit. There are many firms that are skilled in these carve-out audits. Some sellers will perform their own carve-out audit in advance of the sale to facilitate a transaction.
3. Communication is key. A carve-out is similar to an organ transplant. You are trying to transfer the heart to a new person, but you also need to keep the lungs and liver functioning. It is crucial that the buyer and seller communicate, and over-communicate, the status of the transaction to the stakeholders. It is key to keep the shareholders, debtholders, customers, employees, vendors, and potentially regulators informed.
4. Leveraging experts and advisors. Carve-outs require a special skill set. Some private equity firms focus on carve-outs and have the in-house team of experts to perform the transaction. Some firms are new to carve-outs and need more support. By leveraging advisors, the private equity or corporate buyer can increase the chances for success. There are advisors that can help with the scoping and execution of the carve-out. There are firms which can help with providing the IT services necessary for carving out the business. These firms can host key applications, run IT help desks, and help to redesign corporate back-office and production IT infrastructure. There are other firms that can assist with the challenges of rapidly hiring all of the carved-out employees over global jurisdictions. There are also many accounting and corporate services firms that can help with setting up the legal entities and the statutory accounting to keep in compliance.
5. Understanding and negotiating 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. This allows the business time to build up these capabilities internally or to find outsourced providers. The TSA is an exhibit to the purchase agreement which outlines the menu of services provided to the buyer. The TSA includes the scope of work, the term of the service, and the service costs and any service level requirements.
6. 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 this team develops a detailed checklist of activities that need to occur. This transition team works together from pre-close through transition to effect a smooth transaction. This team meets regularly to work through issues. It is also helpful to have a chief transition officer, who helps to lead the task force. This person serves a cross-functional role. They coordinate all of the resources to complete the carve-out and transition. This person needs to understand the key drivers of carve-out success.
Carve-outs require a lot more coordination, planning, and hands-on execution. This elevates the risk of these transactions but also creates an opportunity for investors. As the recession continues, more firms will likely conduct carve-out acquisitions.