This week’s blog comes from Fredrik Bürger, who leads EY’s Private Equity Value Creation service offering across EMEA.
Will this be the year Private Equity goes back to its roots? Buying and turning around unloved corporate divisions is an important part of PE’s heritage – and, I think, a bigger part of its future. In this week’s Capital Agenda blog I’ll explore how the stars have aligned to create a potentially golden period for carve-outs and discuss how PE firms can create the most value from this opportunity.
The stars align
Why do I think we’re about to see an increase in carve-outs? Quite simply it’s the alignment of means, motive and opportunity.
The Means: record dry powder
In 2017, the aggregate capital raised by buyout fund managers reached a 10-year high of $282b, according to Prequin, with over half (54%) of the capital raised by 15 mega funds. This has been followed by the most successful start to a year this side of the financial crisis, with a total of $54bn raised in Q1 2018. European buyout fund managers are leading the way, accounting for 62% of all buyout capital raised this year – although North America and Asia look set to play catch-up.
All of which leaves the industry with an estimated record $631b of dry powder to deploy.
The Motive: securing returns
How and where should funds deploy this cash? Asset pricing concerns aren’t new to this cycle, but growing economic and market anxiety has made them more pertinent. As we discussed a few weeks back, the global economy, whilst not going backwards, is losing momentum in the UK and the Eurozone. It will be much harder in these circumstances to match the high returns of the cycle so far.
It’s a view shared across the industry. At the end of 2017, half of LPs surveyed by Prequin stated that sourcing attractive investment opportunities was more difficult than 12 months ago. PE firms will need to go deeper to find value and carve-outs often offer a unique opportunity to shape a business – often beyond that found in typical platform acquisitions.
The Opportunity: increasing corporate divestments
Which brings us to opportunity, because EY’s latest research suggests that there has scarcely been a better time for private equity to look for carve-out opportunities. In EY’s latest Global Divestment Survey, 90% of European companies said they plan to divest within the next two years – up from 51% in the 2017 study.
Why are so many companies ready to divest? High asset prices are obviously an incentive to sell, but most companies have deeper motives. Over three-quarters of respondents said that their divestments were directly influenced by the evolving technological landscape – a big increase from 50% in 2017.
Companies understand that they need to optimise their capital to keep up in the digital race. That could mean be selling non-core assets in order to buy or build capabilities. It could also include the sale of an asset where they simply don’t have the expertise, capital or scale to take it to the next level.
This is where PE comes in.
What about competition?
PE won’t be alone in looking at these assets. They’ll be joined by corporate buyers, who will usually also have a synergy-driven valuation advantage. But, PE can offer speed and the ability to act (in most cases) without the delaying involvement of competition or anti-trust authorities. It’s interesting to note that in our latest Global Capital Confidence Barometer, 30% of respondents said that expected the main theme of M&A in the next 12 months to be the ‘return of private equity as a major acquirer of assets’ and most expect private equity to be a major competitor in the deal market.
All of which suggests that it’s time for PE firms to brush-up on their carve-out skills. Turning around and achieving value from an undervalued, mismanaged or non-strategic asset may sound simple on paper; but it’s usually much riskier in reality. All deals are different, but five areas in particular warrant focus:
- Deal perimeter
The very nature of carve-outs means that most will be operating pre-deal with blurred financial and operational lines. Clearly defining the deal’s perimeter helps buyers capture the true asset value and understand what functions need to be built by the carved-out operation. Buyers need to know which legal entities, IT services, personnel, facilities and contracts are included – and what they’ll need to put in place for day 1.
Related to the first point, buyers need to understand what support and expertise is coming into the carved-out business and what’s staying with the parent. Some vital knowledge and relationships could be staying behind, so it’s vital to map who knows what and who.Parent and buyer also need a clear understanding of who will be communicating restructuring messages to staff & unions.
- Hidden costs and value
Buyers need to assess complex costs, such as software licenses, leases, severance and hidden HR expenses to make sure everything is included in any margin estimates. IT costs are especially important to plan for in carve-outs because existing systems often don’t come with the deal and replacements are expensive and time-consuming to implement.On the other hand, it’s also important to gauge the potential upside from areas like unexplored synergies and be ready to leverage this quickly. There may also be the potential to re-energise management and the workforce.
- The Day One plan
As with any deal, it pays to prepare early – during the diligence phase if possible – and to engage a trusted team to focus on the most important aspects of your business. It’s vital to hit the ground running and set a positive tone in the first few weeks to bolster staff, suppliers and customers.
- Transition service agreements (TSAs)
These smooth the separation of a carved-out operation and help hold things together until new systems and infrastructure are in place. TSAs need to specify clearly who gets paid what for which services and for how long. Services, like IT, may need to be in place for a long period of time.It pays to pay for services separately so that the company can turn off the activities and associated costs when appropriate.