Back in May 2018, I asked if Private Equity (PE)’s future lay in its past in terms of its established ability to carve-out and turnaround non-core businesses. Well, it’s certainly been a busy few years – but what happens next? In this week’s blog, I want to re-examine the outlook for PE carve-outs and share our experiences of how to maximise value in this more testing part of the cycle.
Means, motive, opportunity…
Since I last blogged about the potential for PE carve-outs, we’ve seen means, motive and opportunity align in a most extraordinary way. PE dry powder rose steadily to surpass US$1.5t, according to Preqin. PE’s deal motivation remained strong, with the opportunity presented by carve-outs to reshape and build value proving increasingly attractive in a low-growth world.
Meanwhile, opportunities also remained plentiful as companies took a more proactive and strategic approach to divestments in response to increasing investor and activist demands for greater corporate clarity and their own need to invest in new growth markets and technology. A high level of corporate M&A activity also continued to create the need for further divestments, as companies paid down debt and met regulatory demands.
Will the stars continue to align?
Most of this still holds true. Although, as we start 2020, there are signs that the stars aren’t so perfectly aligned.
PE fundraising certainly continues apace, but the number of funds closing has fallen. Protracted political uncertainties haven’t seriously dampened M&A activity. Indeed, a slowing global economy – combined with a need to invest to meet the challenge of technological disruption and sector convergence – has increased the need for companies to optimise their use of capital. EY’s 2019 Divestment Study shows that 84% of companies are looking to divest in the next two years. But increased market uncertainty and buyer scrutiny contributed to a dip in PE deal activity mid-2019.
Companies have also become more astute in the way they approach divestments, continuing to use dual-track process and undertaking parallel carve-outs alongside internal break-ups to maximise value. Transactions have become more complex and lengthier. Trade and PE buyers are now equally credible in vendor eyes – but the flip side to this is increased competition and higher prices.
Thus, whilst PE’s appetite for carve-outs remains high, greater competition, economic headwinds and deal complexity will require PE buyers to work smarter and harder to make the same returns.
How can buyers maximise value?
Carve-out deals, whilst potentially rewarding, are inherently hard to transact. As businesses become more complex in their processes and technologies, so do carve-outs. The over-arching lesson from our recent experience is that they are often much riskier and complex than many buyers or indeed sellers realise.
Typically, the deal will involve imperfect data, pro-forma financials with an abundance of hidden costs and co-dependencies that will all need to be resolved before the carved-out entity can stand alone. These complexities make every deal unique, but there are common themes and five lessons we’d like to share:
A lack of understanding around interdependencies causes 56% of divestments to be delayed or derailed.
EY Global Divestment Survey
- The early days: from the outside in
Never underestimate the importance of early preparation and the insight available from internal and external networks. We’d recommend speaking to the business’s management team, if possible, to understand their knowledge and motivation. This process will have benefits throughout the transaction. In the initial stages it will help to save on time and fees, increase buyer credibility and potentially make it easier to move towards deal-exclusivity. It can also prevent the seller employing unnecessary solutions and provide an early understanding of the knowledge and expertise that is staying with the business – a fundamental value driver.
- Diligence: integration is key
The nature of carve-outs means that most will operate pre-deal with blurred financial and operational lines. Nonetheless, the buyer needs a clear picture of the complete deal perimeter and the buyer/seller obligations for two fundamental reasons. It firstly helps buyers assess the true asset value, and secondly helps them to understand what functions need to be transitioned and re-built by the carved-out operation. More specifically, to develop their valuation models, buyers need to understand what assets (including people) and liabilities are in and out; any standalone, hidden, recurring or one-off costs; and the everyday costs of running the business.
Buyers also need to understand operational entanglements and co-dependencies in areas such as IT services, personnel, facilities and contracts. In addition, what will remain in the standalone entity and what will be required for any Transitional Service Agreement (TSA) to ensure the entity will be operational on Day One.
It’s vital that both financial and operational due diligence are integrated to provide a holistic picture of the business. The diligence process will need to validate and assess complex and potentially hidden issues that will cross operational and financial boundaries, such as software licenses, leases and redundancies. It’s also important to gauge the potential upside from areas such as tax impacts and to be ready to leverage synergies quickly.
- Signing: define and flex
To maintain stability and preserve value, it’s crucial that the Sale and Purchase Agreement (SPA) establishes a common foundation and critical path early in the deal process. But, buyers should also allow flexibility to influence or even change the blueprint and separation plans post-signing. It’s important to closely define the TSA agreement, including agreed service levels, performance reporting, pricing and penalties – whilst again also retaining flexibility in the pre- and post-deal period.
Creating a flexible TSA structure that allows the buyer to pay for, and exit services separately, will allow it to turn off services it no longer needs, whilst at the same time maintaining a longer transition for longer-lead time functions, such as IT. Buyers should clearly start planning how they will exit the TSA early in the process; but at the same time they shouldn’t underestimate the possibility that they may need to add services and gain additional help from the seller.
- Signing to close: creating alignment
Time is of the essence in this stage, as the buyer and seller prepare for a smooth transition. Introducing joint governance early, with a commitment in the SPA, will help to ensure visibility and alignment between the buyer’s and seller’s plans for the deal to remain on its critical path. The buyer needs to make sure it has a project team in place ready for Day One with the TSA signed off and agreed protocols in place with the seller to address any initial problems.
- Post-closing: hit the ground running
As with any deal, it pays to prepare early and to engage a trusted project team to focus on the most important aspects of your business in the first weeks of operation. The most important thing is to hit the ground running on Day One – with the focus shifting later to operational improvements, once the business is stable.
Above all, throughout this process, buyers and sellers shouldn’t underestimate the importance of detail and clarity – but also flexibility. Presenting a clear and detailed perimeter will maximise value for the seller and create a clear path to separation for the buyer, avoiding a protracted deal process and the expense of stranded costs. But carve-outs are a complex art and buyers need to be prepared for the unexpected, pre and post-deal.