By Simon Wells, for Forbes Business Council.
View the article on Forbes.
Corporate carve-outs are a type of merger and acquisition (M&A) that involve the sale of a specific division, business unit or collection of assets that are no longer deemed core to a company.
They are considered to be complex as they involve the separation of a business that may not be functionally or structurally stand alone within a wider corporate setting while still maintaining “business as usual.”
They often come with tight timescales and high one-off costs to deliver, and as such, are high-risk endeavors, especially when compared to traditional M&As.
But while both costly and complex, I’ve found that a well-executed carve-out can offer a significant return on investment for a buyer. This is because a considerable portion of value is created during the separation process itself. If delivered poorly, however, investors face a costly recovery process that significantly diminishes the expected value of a deal.
As the head of an organization that supports corporate M&A activity, both pre- and post-deal execution, here are six key steps to de-risking your corporate carve-out.
1. Ensure stakeholder alignment pre-deal closure.
Whether buy-side or sell-side, understanding expectations across the deal team is key to determining transaction success. Expected outcomes can be formed based on limited carve-out experience and may need realignment during the negotiation process.
This is especially true if the buyer is private equity, for the engagement is typically in the form of an investor as opposed to an operator (i.e., a trade business) with pre-existing infrastructure to onboard services immediately post-completion.
It is important all parties are aware of the effort and timescales required to deliver a successful separation ahead of deal closure. This will avoid gaps in transitional support and unexpected costs to both parties. Special attention must be paid to any condition precedents to facilitate sale completion and ensure enough time is agreed by both parties to deliver.
2. Target gaps in transitional services agreements (TSA).
An essential element of any carve-out is a well-negotiated TSA. This legally binding agreement allows the newly acquired entity to continue receiving critical back-office services from the seller such as HR, payroll and IT for a defined period after the deal is completed. This allows the buyer time to stand up services in a controlled way.
The scope and duration of the TSA must be negotiated accurately to avoid gaps in support or unexpected costs post-completion. It should replicate current service levels and include a “reference period” to bring all services provided by the seller prior to the acquisition into scope as a catch-all measure.
As the newly acquired entity reaches a level of maturity, reliance on the seller starts to diminish. It is important to ensure the TSA provides the ability to scale down services to avoid operational inefficiencies and unwanted duplicative costs.
3. Forecast cash flow fluctuations and dissynergies.
Carve-outs can be capital-intensive endeavors with significant one-off costs to deliver a standalone business. If no pre-existing infrastructure is present to onboard onto, it is important to factor the cost of standing-up services into the short-term cash flow forecasts to avoid periods of financial uncertainty.
Therefore, I think it is critical for the separation team to closely align with the finance function to profile expected periods of increased capital spend, areas of duplication, dissynergies and adverse economies of scale.
This will allow the separation team to factor in any preventative measures to preserve cash flow, such as negotiating extended payment terms with suppliers or temporarily increasing financial controls.
4. Reduce risk exposure in commercial agreements.
During the separation, the newly acquired entity will move away from the systems and services provided by the seller and enter into new standalone agreements with third parties.
It’s common for the buyer to set up services in advance of deal completion due to the seller being unable to provide coverage under a TSA. This is often at the buyer’s risk. Negotiating commercial protections into supplier agreements, such as abort clauses, will ensure the contracting entity (which may be outside of the transaction perimeter) is not left on the hook for longer-term financial liabilities should the transaction scope change or fail to materialize.
Other helpful protections include liquidated damages for suppliers working under time-based deliverables that may result in financial penalties from the seller and reducing the liabilities for TSA extensions if separation milestones are not met.
5. Remain data-compliant.
As part of the separation process, sensitive data must be shared between key members of the deal team. In the case where services are required to be stood up prior to completion, personally identifiable information (PII) may also need to be accessible to the buyer. Remaining compliant is vital to the success of the transaction.
Data processing agreements (DPA) should be put in place to ensure there is a legal definition of who owns the data, how and when the data is transferred and the location of its storage during the separation process. For some PII data, consent may need to be provided by the affected individuals prior to transfer.
Data compliance rules differ by jurisdiction. Involving subject matter experts early on can help ensure that these considerations are accounted for within the DPA. This proactive approach reduces the risk of non-compliance or legal challenges during the separation and ensures the deal team is on top of their obligations as part of the transfer.
6. Determine standalone compliance reporting requirements.
Prior to closure, I believe it’s crucial for the buyer to determine if the standalone entity meets any government or regulatory body thresholds for mandatory reporting, particularly around ESG (environmental, social and governance) and HSE (health, safety and environment).
As part of a larger corporate structure, reporting on data for items such as gender pay and carbon emissions may have previously been managed by the seller under a centralized compliance function. Additional backfill hires or specific supplier relationships may need to be factored into the separation budget from the point of deal closure.