Secrets of a Successful Carve-Out

Winning M&A strategies for buyers and sellers

Carve-out transactions—the divestiture or sale of a division or business unit—have to clear a higher hurdle for success than typical mergers and acquisitions because they are more complex. Yet, carve-outs are worth the extra effort. They can lead to lower premiums and higher gains for buyers, and for sellers they increase the likelihood of successfully closing the deal. Capturing these advantages, however, requires looking beyond the financials to understand the challenges associated with the transition.

Figure 1: The asymmetry between buyer and seller is the reason carve-outs work so well

Even in uncertain times, mergers and acquisitions (M&A) can be a source of value. In particular, carve-out deals, when strategically aligned, can unlock value for sellers and provide buyers with a platform for growth. As demonstrated by ING (online banking), Sara Lee (tea and coffee), Infineon (wireline communications), Dow (styrene manufacturing), and Caterpillar (third-party logistics), carve-outs are not limited to a single sector.

Carve-outs are attractive for a number of reasons. For buyers, they promise greater returns on investment, while eliminating the need to acquire non-strategic assets and business lines in order to obtain the desired assets. Because carve-outs are typically the domain of strategic buyers, there is usually less competition with financial buyers. For sellers, carve-outs are a way to manage activities more effectively.

The asymmetry that exists between the buyer and seller is the reason carve-outs work so well. Their differing needs and motives dovetail nicely, and both get exactly what they want. Strategic fit and value potential are greater for the buyer, while sellers can use the transaction to monetize underperforming assets—focusing resources more strategically on areas that generate higher returns (see figure 1). Although dealing with strategic buyers may limit the seller's ability to generate a competitive bid, it narrows the field to a set of viable buyers, which increases the probability of a successful deal.

More Upside Means More Complexity

No two deals are the same, and every M&A transaction has unique challenges. However, carve-outs present more complexity for buyers and sellers. First, the units in play invariably rely on the parent company for critical business functions that are not part of the sale (for example, information technology, human resources, and supply chains). As such, the buyer in a carve-out typically requires post-deal support from the seller (or vice versa) for a finite period of time under a transition services agreement (TSA). TSAs provide the legal, contractual framework for business continuity until the buyer can integrate the acquisition into its own operations.

Often, the rush to get a deal done overshadows the need to develop a game plan to separate and transition the asset. Without such a plan, both buyers and sellers risk disappointment, unforeseen costs, business disruptions, integration delays, and lost customers, not to mention the additional time taken by senior executives and others to resolve issues that easily could have been addressed earlier on.

The good news is that such unintended consequences can be avoided by managing the transaction and the transition. This means agreeing to guiding principles, clearly defining the destination, and having the right resources at the negotiation table.

Agree on Guiding Principles

When buyers and sellers enter into transition negotiations, each side has different motives (see figure 2). For buyers, business continuity is a top priority, to ensure that critical functions remain in place until separation occurs. Buyers typically want broad service requirements and rigorous key performance indicators (KPIs)—and shrewd negotiators will also try to extract as many free-of-cost services as possible. For sellers, being able to exit the transition period as quickly as possible is of paramount importance. In most cases, the seller is not in the business of providing outsourced services, so will want to refocus quickly on restructuring its remaining core businesses. Further complicating matters, the true costs of providing shared services are often unknown, leading the seller to aim for higher fees and profit margins during negotiations.

Figure 2: In negotiations, buyers and sellers have different motives

Establishing the following guiding principles in the TSA will help prevent problems arising from these different motives:

Define the nature of services and fees. What is written in the TSA will define what is adhered to during the transition. Thus, the nature of the services (such as accounts payable or accounts receivable) and the associated fees must be explicitly defined. Too often services are defined at the functional level (for example, in finance), which can quickly lead to confusion once the deal closes.

Establish the base for cost calculations. Because sellers are not typically in the business of providing the services included in the TSA to third parties, transactional costs are unknown. So the base for calculating fees—including fixed and variable cost elements and cost drivers such as head count, office space, and server utilization—must also be explicit.

Set reasonable timelines. The duration for a given schedule will vary on a case-by-case basis. Sellers and even buyers can be overly optimistic about how quickly and easily separation will occur. Set realistic, rather than aspirational, time frames not only to ensure business continuity, but also to ensure the buyer does not risk its integration and the seller can make appropriate plans for post-sale restructuring.

Use realistic performance standards. Another common mistake during negotiations is to demand (or promise) higher levels of service than have existed historically. Both parties must remember that in most cases, historic service levels are sufficient to sustain the business, and they typically represent a fair balance between costs and true business needs. In situations where past KPIs are not available, the buyer should benchmark services and interview current employees to gauge the appropriate standards.

Define the Destination

A well-crafted TSA is a roadmap that guides both parties from the close of a deal to the separation of operations. However, for any roadmap to be effective, it needs to know the destination. Before the parties can draft a transition plan, several key areas must be addressed and questions answered:

Employees. Which employees are vital to running the businesses long term? Are there critical employees who should be specifically called out in the agreement? Which gaps need to be filled and how long will this take?

Assets. Which assets truly belong with the acquired business, and which should remain with the seller? Where are the gaps?

Services. Which services will the seller have to provide through the transition? Will the buyer have to provide services to the seller? Which employees or assets will support these services?

Financials. Are the business unit's financial statements a true representation of how it would perform as a standalone?

Answering these questions requires an understanding of business practices at deeper levels than what takes place in a typical due diligence process. While tight timelines and pressure make it easy to overlook the details, getting to the end-state requires knowing everything about everything.

Have the Right Resources at the Table

Managing the transition requires both strategic and tactical know-how. Strategic issues have to be addressed—including which services to manage internally, which to outsource, and what is the need for longer-term buyer-seller relationships. Tactical elements must also be worked out to ensure that negotiation of the TSA does not delay the deal. Who is going to gather the requirements and draft the agreement? Are the terms sufficient to avoid business disruptions? Figure 3 offers a to-do list for buyers and sellers.

Figure 3: Buyer and seller teams' "to-do" list for a smooth transition

Getting strategies and tactics to the negotiating table will require additional resources, beginning with the deal team and project management office. It will take effort to balance the interests of the parties and to oversee and coordinate the many cross-functional interactions that might otherwise push the deal into negotiation limbo. Here, an external party with specific industry expertise can help keep the process on track and facilitate a faster close.

Because of non-disclosure and confidentiality requirements, functional managers responsible for providing and receiving relevant services should have defined roles for creating the TSA. As subject matter experts, they are best positioned to align service schedules and objectives. Incorporating their input will also help avoid unwanted surprises during the transition.

Finally, human resources (HR) and finance staff play a key role. Addressing employee matters is always important; however, during a transition additional issues may arise when a workforce is separated administratively but still performs its former function. Imagine the potential confusion: Who is the true employer of record? Who provides direction? Who is liable for grievances and claims? These and other questions should be addressed by HR teams before the transition, while finance teams work through the fee structure to make sure both parties have a clear understanding of fees, costs, and cost drivers.

Carve-Outs Still Make the Cut

Carve-outs will remain an important part of the M&A landscape as companies continue to seek ways to deploy their resources more effectively. Those that not only find the opportunities but also manage the complexities will be well positioned to outperform their competitors.

Authors

Jeff Ward is a partner in the Chicago office.

Andres Mendoza Pena is a principal in the Chicago office.

Rishi Gautam is a consultant in the Toronto office.

Jeffrey Sexstone is a consultant in the Atlanta office.