Rise in Carve-outs transaction

• In recent years, divestitures have comprised a majority of M&A transactions as firms are increasingly divesting their non-core assets in order to focus on their core businesses.A Carve-out is list of activities required to complete transfer of a business or assets in a divestiture transaction.Even though both buyers and sellers have joint responsibilities in the Carve-out process, the burden usually is tilted towards the buyer to manage host of complex issues to preserve and maximize the deal value in the transaction.

Why are Carve-outs so complex?

• Integrating divestitures is challenging and complex because only a part of the target company’s assets that are divested needs to be integrated as against the entire company during an acquisition.

• In order to achieve high operating efficiency, most companies have their functions, processes, data and systems integrated in order to support most businesses and operations within the organization. When a specific business unit or asset is divested from the parent business, then these assets needs to be disintermediated out of the highly integrated systems, processes and data.

• In order to successfully complete the Carve-out process, the buyer would require additional support from the seller post transaction. This support and services provided by the seller to the buyer are finalized in TSA – Transaction Services Agreements.

• The assets divested by the seller is non-core and hence neglected by the seller.Seperate historical financial statements of the divested assets may not be made available to the buyer.The divested assets may be deprived of additional investments and would not have a dedicated management in place.

• It is difficult to understand and forecast the stand up and Carve-out costs for both parties.In addition, Carve-outs require additional due diligence, valuation, legal, tax and financial advisory to complete.

• Sellers often cherry pick the best talent available prior to the transaction.This can put the buyer at a disadvantage.The buyer needs to identify the key talent early in the transaction and provide incentives to retain them post transaction.Employees on the other hand would have spent many years with seller and would want to continue with the seller post transaction. They might perceive the divested entity as non-core business and would not want to continue their career with the buyer.

Achieving success in Carve-outs transaction

The following steps needs to be done in order to achieve success in Carve-outs transaction.

Carve-outs step 1 – Define the Scope of the Deal

• The first step is to define the scope of the deal ie. What is included in the deal and what is outside the scope of the deal.
• The buyer needs to determine the operating model components necessary to run the business along with the necessary asset schedules.
• The buyer should undertake a comprehensive due diligence to identify the potential hidden costs including licensing costs and lease costs.

Carve-outs step 2 – Drafting the Transaction Services Agreements

• The buyer needs to draft the TSA by himself instead of relying on the seller.
• The buyer needs to conduct their own independent and research analysis  along with it’s own costing analysis and benchmarking.
• The buyer needs to have a reasonable timeline to build, test, migrate and operate new systems at TSA exit to confirm whether any resources will be required.

Carve-outs step 3 – Clone or Stand alone?

• Clone and Go is the most common strategy used to accelerate the operational independence of the buyer with the newly acquired business.
• In this approach, the seller’s process, system, data, application and policies will be replicated and then using that clone post close.
• In case of performance turnaround and asset repurposing, it is better to adopt a standalone approach because the buyer is looking to rationalize the non core systems and reduce technical debt.
• The decision to clone or standalone depends on the integration approach and the acquisition rationale.

Carve-outs step 4 – Define end state Operating model

• The buyer needs to define the operations by providing an outline of direction and timing of integration at the enterprise, functional and systems/process level along with products/brand/customers and organizational culture.
• The concept of operations should include the acquisition rationale, specific assets or business bought and the integration rationale.
• The integration should be broken down into Short term vs Long term and interim state vs end state to effectively preserve, capture and maximize deal value.
• The integration approach should decide whether the acquired asset needs to function standlaone, absorbed into the buyer business or transformed to a new improved model.

Carve-outs step 5 – Understanding the Buyer and Seller Leadership

• It is critical to gain insights on buyer and seller leadership.The buyer leadership will be responsible for setting the vision, communicating the strategy and motivating the seller staff who may be demoralized.
• The buyer needs to evaluate the relationship between the seller parent entity and the divested entity. The buyer needs to understand the leadership style, decision making and culture at the seller’s parent company and divested entity.
• The relationship between the buyer and seller also needs to be examined. Are they competitors or customers or partners?

Carve-outs step 6 – Apply best practices in Integration

• Although a Carve-out transaction is unique and complex, there is a lot of similarities between a M&A integration and Carve-out deal.
• The deal strategy should guide the integration framework and the buyer should priortise the deal objectives.
• Communication and Change management is critical to mitigate any conflicts due to cultural differences.

Conclusion

• Carve-outs are complex because there is not enough information available to the buyers on divested assets.
• In addition, separation planning and then integrating the divested asset from the seller’s entity to the buyer’s entity requires comprehensive diligence in identifying the hidden costs followed by finalizing on the TSA – Transaction Services Agreement between the buyer and seller.