Private equity funds (“PE funds”) have increasingly embraced carve-out transactions as a strategic maneuver to unleash untapped value within their portfolio companies and generate returns for shareholders. These transactions involve divesting non-core business units from larger enterprises, allowing PE funds to reshape and revitalize their portfolio companies with an eye towards a more profitable exit in the future. In today’s challenging economic climate, PE funds are compelled to evaluate their investments and focus on enhancing the fundamental operations of their portfolio companies.
This article explores the key features of carve-out transactions, highlights the challenges that selling PE funds must anticipate and navigate, and provides insights for improvement and accuracy.
Structuring a carve-out transaction is complex, as it entails separating and disposing of a business integrated within the seller’s operations. Selling PE funds must carefully consider the impact of the sale on the retained business enterprise and plan accordingly. Carve-outs can involve the disposal of subsidiaries, business divisions, or specific assets of the portfolio company. In the public market, carve-outs can take the form of a spin-off transaction accomplished through a statutory plan of arrangement.
In addition to tax considerations, PE funds must analyze the operational complexities associated with disentangling shared business functions such as IT systems, supply chains, and human resources. Developing a comprehensive plan to address these challenges is crucial.
Separation of the Target Business
Carve-outs typically require corporate reorganization to separate the target business before completing the transaction. The selling PE fund collaborates with the buyer to identify which assets, liabilities, and contracts are part of the deal and which ones will remain with the retained business. This task becomes particularly complex when the divested business is intertwined with the operations of the corporate parent. PE funds must gain a thorough understanding of shared services, historical cost allocations, and the costs involved in replacing these services going forward. Despite the challenges posed by negotiating terms while the management team is in sell-side mode, effective coordination between the buyer and the management team during the due diligence process is vital. The purchase agreement should include a “sufficiency of assets” representation to ensure the buyer has recourse if they discover that they did not acquire all the necessary assets for the business. While transitional services agreements can temporarily bridge post-closing gaps, pre-closing preparations may be required to ensure that the divested business is ready to operate independently.
A common approach involves spinning off assets, liabilities, and contracts into a newly formed subsidiary, whose shares are subsequently sold to the buyer. Carve-out buyers often seek a thorough understanding of the separation process, contemplating whether the target business will operate as a standalone entity or integrate into the buyer’s group post-closing. The separation process presents structural complexities, including shared key assets or contracts that require transfer, assignment, replacement, or partial termination prior to or in connection with closing. Some contracts and certain types of assets may necessitate third-party consent for transfer or assignment, which can be time-consuming or result in stranded assets if consent is unattainable.
To ensure an orderly and efficient separation, the parties usually incorporate a reorganization step plan into the definitive transaction documentation, aligning all stakeholders on the process. Effective implementation of the reorganization plan is often a condition precedent to closing the carve-out transaction. The definitive agreement may also include “wrong pocket” provisions to ensure assets inadvertently transferred from either the target or retained business are returned to the appropriate entity after closing.
Availability of financial statements for the target business is critical in pricing a carve-out transaction, just as in any M&A deal. Carve-out financial statements serve as a key aspect of due diligence for the buyer and are essential for the buyer’s capital-raising efforts. However, in some cases, there may be no financial reporting at the target business level, or the consolidated financial information provided by the seller may lack sufficient clarity, particularly where standalone audited or unaudited financial statements are required to secure debt financing. Consequently, preparing suitable financial statements for the target business becomes a significant undertaking for selling PE funds in any carve-out transaction.
Carve-out accounting—as well as determining assets, liabilities, revenues, costs, and expenses attributable to the target business—can be a complicated and time-consuming process, often impacting the transaction timeline.
Pricing the Target Business
Pricing the target in the carve-out transaction requires careful consideration to avoid potential “leakage” due to a number of factors, such as intercompany transfers. Various valuation methods such as discounted cash flow analysis, comparable company analysis, and precedent transactions analysis can be utilized. These methods help establish a fair and reasonable purchase price based on the financial performance, growth prospects, and market dynamics of the target business.
Buyers will look to conduct extensive due diligence to evaluate the financial information provided by the seller, understand intercompany arrangements, and assess the impact on the value of the target business. Negotiations revolve around leakages and potential adjustments to ensure a fair and equitable transaction. Sellers should be prepared for post-closing inquiries to verify compliance with the agreed-upon terms and conditions.
Addressing Employment Matters
Addressing which employees should be transferred to the target in carve-outs can be complex, especially when employees are entangled within the seller’s other business units. Determining which employees will transfer with the divested business, the process of transferring employees, and the treatment of compensation and benefits all require careful planning and analysis. Human resources matters become simpler when the divested business is already operating as a standalone entity with its own employees and subsidiary.
IP and IT Considerations
Carve-outs involving intellectual property (“IP”) assets present challenges in allocating and sharing those assets. Specificity in identifying IP assets and establishing favorable transition services and licensing arrangements can supplement the default allocation standard. Shared IP assets need to be addressed in deal documents, considering the need for one-way licenses or cross-licenses to ensure freedom to operate for both parties. Commercial arrangements for shared IP rights may also be necessary for ongoing dealings between the seller and the divested business.
Data transfer and protection are critical in carve-outs, with careful consideration given to the transfer and sharing of data post-closing. A significant portion of the value of the target business may be tied to data; therefore, the buyer will need to understand what data it requires and how it can ensure it will receive the data. This may include pricing information or customer records, which could include personal information. Compliance with data protection laws, contractual obligations, and cybersecurity concerns should be addressed. Thoroughly reviewing obligations regarding data confidentiality and restrictions on transferring or sharing data is vital. The transaction documents, particularly the transitional services agreement, should establish clear responsibilities for data compliance, remediation of breaches, and liability allocation.
Tax considerations play a significant role in multi-jurisdictional carve-outs, requiring close collaboration with tax advisors to ensure compliance with local tax obligations. Transfer taxes, value-added taxes, and indirect capital gains taxes should be assessed and addressed in the acquisition agreement, as liability for these taxes can vary.
Upon completing a carve-out transaction, the unwinding of internal services such as legal, accounting, procurement, licensing, and human resources from the retained business requires careful planning and execution. The parties often negotiate a post-closing transition phase to facilitate this process. Offering transitional services from the outset can expand the pool of potential buyers and maximize the exit value for selling PE funds. However, providing transitional services may burden the management team of the retained business and require their careful attention.
Finding the right balance between providing transitional services and ensuring operational efficiency in the retained business is crucial. Clear delineation of responsibilities, establishing timelines, and effective communication between the parties are essential for a smooth transition and minimizing disruptions.
At a strategic level, PE funds often turn to carve-out transactions in an effort to focus on the portfolio company’s core assets, boost its value proposition for a subsequent exit, improve operational agility, or to simply raise cash in order to shore up the balance sheet. Historically, we have seen carve-out transactions account for a significant percentage of overall deal activity, and this trend is expected to continue in the face of recent supply chain disruptions and difficult economic conditions. While carve-outs often require careful due diligence, strategic planning, and effective execution, they present PE funds with a viable avenue for growth, value creation, and liquidity.