Why Carve out transactions are more complex than a regular M&A transaction?

Introduction

• Many companies are using M&A as a growth strategy to acquire businesses to build products/services that can generate long term market growth.
• In addition, companies have started to reassess their business portfolio to check which of their business are core and non-core to their growth.
• Hence companies prefer to divest business which are no longer going to be core or strategic to their business growth.By unlocking revenues from these non core businesses would allow companies to reinvest these excess capital in strategic investments including M&A.
• Previously companies would wait for their non core business to perform badly by not adding investments to the products or services which they no longer see to be strategic.As a result these business would face loss and when companies no longer can afford to take this loss, they would start looking for a buyer to hive this business.The buyer would aggressively negotiate to buy the distressed asset and as a result the parent company ability to unlock revenues from their non core business is low.
• This is no longer the case now as companies continually assess their portfolio as their long term strategy and prefer to divest business which are growing strong but are no longer aligned to the long term strategy of the company.This decision by the company to divest their non core businesses early allow it to find the right buyer who can grow this non core business further.The parent company can also start to focus on its growth strategy.

Why acquirers should look at Carve outs?

• Most of the acquirers have a dedicated M&A practice that look at target companies which can be acquired.They do not focus on divested businesses from companies which can also be a major source of value creation.By not focusing on carve outs, acquirers stand to lose on major opportunities to create value additions.
• One of the biggest advantages of a carve out for an acquirer is that these assets are available at a much cheaper cost compared to a normal M&A transactions where valuations are at premium.

What are the key focus areas for a buyer in a Carve out?

• Even though buying a divested company is cheaper but the process of a carve out transaction is extremely complex.Hence acquirers need to focus maximum efforts on due diligence to identify hidden costs like separation and transition costs to generate maximum value.

Three important areas focus are:

What is the scope of the Carve out deal?

• The buyer needs to clear identify and come to an agreement with the parent company on what assets would be bought along with processes and what assets the buyer does not have access to.As processes of most companies are tightly integrated, the parent company need to assess the impact of divesting the non core business from its operations.
• In a carve out transaction, the acquirer can buy assets or a business unit as a part of the deal.The reason for the acquirer to buy would be the attractiveness of the divested asset to the acquirer portfolio as well as customer relationships that the divested company has which would be transferred to the buyer.
• The buyer when looking at the value drivers of the carve out deal should also measure the risks and additional costs that needs to be incurred by the buyer post separation to sustain the business operations.
• The divested company would continue to rely on the parent company on certain business operations.Corporate services like HR, Finance and IT would still be provided by the parent company to the divested entity.Post Carve out, the buyer should provide these services to the divested entity.To ensure continuity in the business operations, the acquirer would want the parent company to continue to provide service until a certain time.The parent company would charge a fee to the acquirer to provide such services till a specified time.The scope of the services, duration of these services are offered and the accountability of the party to offer these services within a SLA time frame are drafted in Transition Services Agreement (TSA) between the buyer and seller.

How to value a Carve out transaction?

• The acquirer needs to build a valuation model to arrive at future cash flows of the divested entity along with synergies cash flow as a result of this transaction.
• To build a valuation model, the acquirer needs to have detailed access of the financials of the divested entity.The parent company would not have the detailed and historical financials of the carved out entity as all financials would be consolidated.Even though the parent company would build a pro forma financials for the divested company which would be audited, it would be difficult for the acquirer to build a detailed financial model based on this alone.Further the acquirer would also want to compare the pro forma financial statements with historical financial statements to look at important trends and insights.
• In addition, the parent company would also try to paint a rosy picture of the divested entity by restating its costs.The acquirer should realize that costs allocated by the parent company to the divested entity would be far less than the actual numbers.Post separation, the acquirer cost toward the divested company would be more than twice the costs allocated by the parent company.This is because the parent company might enjoy a good supplier relationships and also due to its size and scale, the costs allocated might be less.

Separation, Transition and Integration

• Once the financial model is built with the valuation, the next step would be to carve out the entity from parent and then integrate with the buyer.This is the most important and complex process which would decide the success and failure of the transaction.
• The process of separating the business operations of the divested entity from the parent company will have an impact on both the parent and divested entity.The parent company needs to decide which of the assets, process, resources and systems needs to be separated from parent company. Since most of the companies use Shared services model for HR, Finance and IT, the parent company needs to separate the data of divested company as well as any systems that are used only by the divested entity. In many companies the sales and marketing data are maintained in a central ERP, hence the parent company needs to build a new accounting and operations system that houses the data of divested company.
• In case of employees, the parent company and the acquirer needs to plan on the employees that will be part of the divested entity.In many cases, the parent company prior to the carve out transaction would Cherry pick the talented employees and transfer them to the parent company and rotate the under performers to the divested entity.The acquirer needs to be cautious and analyse the last 12 months transfer of employees to prevent and regulate such transfers.
• Once the parent company has decided which assets, processes and systems would be separated from parent company, the next step would be to identify the processes where the divested entity is still dependent on parent company for business continuity. The acquirer expect these services to be provided by the buyer during the transition period as per the terms and conditions of Transition Services Agreement.This transition period would give enough time for the buyer to start planning on how to migrate the data from the divested company to the acquirer. The important data that needs to be migrated would the employee payroll and finance process like account Receivables, payables and procurement supply chain information.
• Once the buyer is able to complete the data migration then it will integrate the divested company to one of the business units of the buyer.Generally most of the carve out transactions are integrated tightly with the functional business units and not allowed to function as a stand alone entity.
• The integration strategy followed for a normal M&A deal should be followed here.The integration strategy should be aligned with the value drivers that was envisioned during the deal rationale to capture immediate value.

Conclusion

• Carve out transactions are gaining more popularity recently and offers benefits to both buyer and seller.
• The seller can restructure the business on a regular basis to decide which of the business are no longer strategic to its growth and decide to carve out the business to unlock revenues and increase shareholder returns.
• For the buyer, carve out offers major source of value creation opportunities in acquiring IP or customer relationships of the divested entity at a discounted value. The buyer also do not own all the liabilities as in a normal M&A transaction and would retain liabilities specific to the asset or business bought.