Seperation Planning - How to get more value from Carve-outs

Ramkumar Raja Chidambaram

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5 min read

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Aug 4, 2019

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Introduction

• Companies these days are required to constantly monitor their portfolio of businesses to validate they are operating in high growth markets and if all their businesses are aligned to their growth strategy.
• As market conditions change with disruptions, companies need to constantly work on devising new service offerings to align to the market and customers demand.This will mean that the existing service offerings that were part of the businesses before need not be strategic anymore, hence the demand for these services declines. As companies constantly reallocate their capital and resources to high growing business, businesses that are no longer strategic will receive less attention and importance.A classic case would be an IT service company that has built data centers to manage customers operations finds out that market is moving towards cloud services.Hence the same businesses which brought revenues and market share to the companies are no longer strategic.
• Companies that build their growth strategies and business plans would finalize on the key themes or areas they would focus in order to capture additional market share.Those businesses which are no longer strategic to the company strategy can be divested and sold to another company.This is because the incumbent company is no longer the right owner for this business and cannot help it to grow and add value.Hence it would make sense for both the parent and divested entity to look for a buyer that can help the divested entity grow and add value.
• Divestitures are core part of a company strategy, but many companies do not have the capability and competency in this area.Many companies have built an internal capability in M&A to help it in integrating the acquired business with the company.In case of divestitures, company leave it too late to decide if it wants to divest, thus eroding the divested entity of it's true value.This validates why many companies divest their businesses at a bargain price to either strategic buyers or Private Equity firms.

Importance of Separation planning in Divestitures

• Most companies focus their efforts in identifying a buyer for the divested business before they have decided on the separation planning on how will the divested business be separated from the parent company and move to the buyer.
• Hence parent companies need to decide on the scope of the business that they want to divest, list of services they would provide support for the divested entity post separation.This would be detailed in the Transition services agreement.They also need to provide the list of employees who shall be rebadged as part of this transaction.
• Companies generally come up with packages which includes the assets, services and employees that they would be offering for the buyers.The buyers can decide and customize the package to their benefits.In many cases, buyers would cherry pick a part of assets that they wish to acquire and would not be interested to buy the entire business.The parent company has to be prepared and ready to structure their deals accordingly.
• Once the parent company has taken a decision to divest its business, then it should be ready with a separate financials of the divested business, the operating, sales and administrative costs associated with the divested business and the shared services costs needed for supporting the divested business.Coming up with a detailed financials along with costs structures would help the buyers to understand the true value of the business and also identify risks associated with this business.All these factors would be incorporated into their valuation model for the buyer to decide on the final price for the business.Lack of preparation on the buyer side will result in lower price of the business.
• Buyers of divestitures can be strategic buyers or a Private Equity. If the strategic buyer or a PE firms has operations at the same location as that of the divested business, then the support required for shared services and infrastructure would be minimal and for a short duration.If the buyer does not have a presence where the divested business is located then more support would be required from the seller side.The list of services, the SLA for the services and duration of the support is detailed in the Transition services agreement.Based on the support required, the seller will charge appropriate fees from the buyer for transition support.

Importance of Stranded Costs

• Stranded costs is those costs where the seller needs to bear post separation.These costs are basically the overheads.When the business is divested, the revenues and associated costs of these business are included in the proforma financials.In case of the overheads, when significant part of the business is divested the unit cost of the overheads for the parent company increases.These costs are generally fixed costs like IT systems but in some cases could be also variable costs where post separation, number of resources in overheads functions increase.
• In order to reduce the stranded costs, company generally do a restructuring exercise looking at its costs structures and its management.This gives a perspective for the company on how it is managing its overheads.Basis the restructuring outcome, parent company can decide on a leaner and more cost efficient structure in order to better manage its overheads.

Valuation of Divested business

• Buyers generally value the divested company on EBITDA multiples.Strategic buyers may have synergies added to its final valuations.In order to get a higher purchase price, the parent company positions a leaner business to the buyer which is profitable at the expense of taking more overheads on its balance sheet.

Employee Management during Seperation Planning

• One of the most critical part for a Seperation planning would be to communicate to the employees of the decision to divest.
• A decision to divest would bring high anxiety and concerns to the employees.Hence the parent company needs to have a proper communication plan to motivate the employees by telling them that the parent company is no longer the right owner for the divested business and how employees can have a better career under a new company.
• When the seller shares the list of employees that would be rebadged with the divested business, the buyer would want to have the flexibility to select the best talent available. Parallely, the seller also would want to retain the best talent and can encourage transfers process so that the best players are retained with the seller.The buyer would want to mitigate this risk by asking the seller not to carry out any transfer process.
• A seasoned seller would generally not resort to this activity of retaining the best talent as this can spoil the credibility of the seller in the market place.When the seller would want to divest its business in future, they might not attract the right buyers.

Conclusion

• Divestitures are complex both in terms of how it is structured, valued and separated.A proper Seperation planning is required for the seller to get the right price for its divested business.
• As divestitures are rare in the market place, many companies have not built the internal capability to do efficient separation planning, come up with an adequately Transition services agreement and minimize stranded costs.