A multifaceted concept marked by pragmatism and rationalisation
Carve-outs are not conventional M&A transactions but consist, on the contrary, in complex strategic operations, often high-stakes as they might destroy value for both the seller and the asset to be disposed and need to be considered over a longer period of time (i.e., generally between 12 and 24 months).
The current environment, characterized by the determination of economic players to reduce their debt which results in particular from the cost and stricter conditions applied to obtain bank financing, has accelerated a trend towards cleaning up companies’ balance sheets and refocusing on their most profitable and/or core business activities, which represent bargains for private equity funds which have of substantial resources.
Despite its complexity and the associated risks, carve-outs should not be excluded from the outset of discussions in the context of a restructuring project, as its effects may be utterly positive: on one hand, it enables the seller to be better valued and obtain liquidity allowing the buyer, on the other hand, to create value by exploiting differently the assets transferred.
A complex and high-stakes transaction at a crossroads
As a genuine transformation operation with high human and financial stakes, a carve-out is first and foremost a response to the strategic objectives the seller intends to pursue: accelerating the development of strategic activities, rethinking its operating model, accessing more capital, etc.
Carve outs, highly technical in nature, are further based on modelling the financial balances and regulatory ratios. This model will endure along the discussions between the seller and the buyer, in order to reflect the allocation of the overall value between its elements.
Lastly, the seller has to identify all the legal, employment, competition law or regulatory constraints that may have an impact on the completion of the contemplated transaction, in order to adjust the timeline. Depending on the legal form chosen, the tax implications (particularly in terms of tax consolidation, transfer pricing or the holding period oh shares) may vary significantly and shall be subject of a specific prior analysis.
Proteiformity and agility
Once the objectives of the contemplated transaction have been clearly identified, carve-outs reveal its multi-dimensional aspect by adjusting to the practical requirements.
Depending on the issues identified and the willingness of the buyer to take over all the assets of the target disposed, carve-outs come in various legal forms, from the purchase of shares (implying the takeover of all the company’s assets) or business assets, to the demerger of shares or assets, in particular via partial contribution of assets (long considered to be the most effective type of carve-outs), contribution in kind or sheer sale of assets for cash (without any liabilities).
The protean nature of carve-outs is illustrated as much by its form as by its meaning, which depends on the legal and operational constraints, and can thus consist in the divestment of an asset that is the subject of carve-outs in order to house it in another structure, or in the divestment of other assets that the seller wishes to retain, in order to house them in another structure.
A complex operation to be anticipated upstream and controlled downstream
Understanding the target’s business positioning and value chain is key to the success of carve-outs, result of careful and rigorous planning. Each step shall be anticipated and apprehended as part of a wider process, since the complexity of carve-outs lies essentially in controlling its effects and impacts.
This preliminary identification and evaluation phase are crucial, as it aims to make the target as standalone as possible, by identifying the operational complexities, any conditions precedent and the associated costs at the time of the effective legal separation (i.e. breakdown between stranded, standalone or one-off costs).
Key preparation work
It is therefore essential that an upstream work supporting the creation of value is initiated and conducted by the seller and carried out by the buyer in order to set up, on one hand, an ad hoc diagnosis (the buyer may in particular require pro forma accounts and/or a business plan) and, on the other hand, a risk mapping.
This phase allows to identify the key issues relating to (i) relations between the seller and the target, including supporting functions as well as decision-making process and operational functions, (ii) the full range of costs associated with carve-outs, which require to be taken into consideration in context of assessing of the transaction, particularly in terms of EBITDA and working capital (i.e., normative, transitional, standalone), and (iii) the action plan to anticipate and implement the transaction as a whole, which will differ depending on whether the target is envisaged to be totally independent or integrated into an existing organisation. This work will be even more essential if it takes place in an international context.
These fundamental steps are designed to determine the value of the target in the context of the contemplated transaction. This value will then be reviewed and updated in the lights of potential synergies, financing requirements and the buyer’s intentions.
As part of a proactive approach, which should be emphasised to the buyer at the appropriate time, the seller may also offer solutions to any difficulties identified in the course of this upstream work, in order to manage any consequences on the price.
In this respect, certain aspects are essential in the context of a carve-outs projects, in particular (i) accounting study of the financial statements and, more broadly, the financial analysis of the target being sold, since the financial statements obviously have a direct impact on the valuation of the contemplated transaction, (ii) issues relating to the target’s legal and human resources (i.e. identification and transfer of contractual commitments and any related constraints) and consideration of employment issues: employees, welfare benefits, employee representative bodies, automatic transfer of employment contracts in the case of the transfer of an entire branch of the business, (iii) appropriate distribution of the target’s intellectual property rights and, more broadly, of the technology used (including the migration of information systems) and (iv) any relocation of the target that could disrupt the continuity of its business. It should be noted that as the purchase prices are mainly negotiated on a cash-free, debt-free basis, it will probably be necessary to review for the target’s cash to be repatriated before closing.
Three principles will guide carve-outs process to help its completion: anticipate key issues, communicate in order to raise awareness and secure the support and cohesion of the target’s various internal (i.e., employees) and external (i.e., suppliers, customers) collaborators, and plan the timeline and subsequent actions required, in particular in connection with employees’ representatives (particularly in the case of shared activities within groups) or with any application for approval and/or authorisation that may be necessary, in order to have an overall view of the contemplated operation and to run it as smoothly as possible.
Essential anticipation of the consequences of collaboration between the seller and the buyer downstream
Carve-outs differ from traditional M&A transactions in that they usually require the seller and the buyer to collaborate well beyond closing. In order to avoid any unpleasant surprises at a later stage, it is essential to identify who liable, depending on the legal regime governing the contemplated transaction.
Sometimes neglected although it should be taken in account from the outset as one of the key elements of the contemplated operation, it is key, during carve-outs, to draft and negotiate carefully transition service agreements (TSAs), allowing the target to be as standalone as possible in order to anticipate the “day after”. This agreement enables a smooth transition, which is sometimes essential, through the provision of resources by the seller during a transition period and requires close collaboration between the seller and the buyer in order to identify the essential or useful support services to be provided by the seller, as well as the related duration and price.
In this context, it may also be appropriate, depending on the features of the contemplated transaction, to arrange, at an early stage in the contemplated transaction, for the appointment of an interim management team, external in nature but already well integrated among the target’s employees, in order to carry out, objectively and downstream of the closing, carve-out operations, in accordance with the terms and conditions of the TSA entered into.
Given the current economic and financial circumstances, carve-outs are all the more interesting from the point of view of distressed M&As because they enable the strategic takeover of a declining business after the seller rigorously review for asses the target’s financial solidity, insofar as the seller may be held liable if it fails to conduct the required verifications or take additional precautions (such as opening an ad hoc mandate or conciliation procedure).
The opportunities will therefore be all the greater as some companies have a solid customer and supplier base but only suffer from a lack of short-term cash flow due to the current strained economic climate.
No one will deny that the success or failure of carve-outs may only be assessed after several years further to its completion. However, a duly anticipated and regularly monitored carveout, controlled through the implementation of a tailored action plan and effective day-to-day coordination between management and consultants, is a guarantee of success that will reassure all parties involved in the operation. Carve-outs, even though complex, have certainly not said their last word.
