6 minute read 10 Apr 2019
ring polishing

Four steps to create value in private equity carve-outs

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US Americas

Multidisciplinary professional services organization

6 minute read 10 Apr 2019

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When done right, a carve-out offers unique opportunities to drive profitability in a way you don’t have with typical acquisitions.

It’s increasingly common: a parent company decides to shed a business that is no longer strategically critical. Sensing untapped potential, a private equity (PE) firm sees an undervalued, mismanaged or non-strategic but potentially high-value asset. The firm has a plan to buy it, implement a value creation playbook and then exit years later with substantial growth at a higher multiple.

We’re talking about carve-outs. The playbook described above sounds simple — but it isn’t. There is huge risk to executing a carve-out, says Nish Shah, a Senior Manager in the Value Creation practice at Ernst & Young LLP. “You typically deal with imperfect data, pro forma financials with lots of allocated costs, two management teams, personnel and intermingled services with the parent and subsidiaries.” And everything needs to be ironed out before Day One of the deal.

“To say carve-outs are risky and complex is an understatement,” says Greg Schooley, Leader of the Value Creation practice. Every carve-out comes with unique wrinkles, whether subtle or substantial, and issues often surface without warning.

When done right, though, a carve-out offers unique opportunities to shape the business in a way you don’t have with typical acquisitions. Here are four ways to capture a carve-out’s full potential.

To say carve-outs are risky and complex is an understatement.
Greg Schooley
Principal, Value Creation, Ernst & Young LLP

1. Fully understand the perimeter of the deal

To properly value the asset and determine how to best separate it from its parent, you need to understand everything you’re getting — and not getting. For example, which accounts, legal entities, IT services, personnel and facilities are included. Are contracts still intact with customers and vendors? Will you need to communicate with unions before reorganizing staff? The questions go on and on, and you need answers to them all.

“You must understand the scope of assets, contracts, liabilities, employees — everything included in the deal,” says Shah. “For one PE buyer, we quickly identified ongoing expenses in operational areas which were not fully addressed and reflected in the estimated standalone financials.”

Carved-out companies often lose all kinds of support, from treasury and audit to finance and IT, which the parent company had provided previously. “In the case of one PE firm looking to acquire a consumer products business, we found operations, tax, HR and financial dependencies that could have disrupted their ability to stand-up as a business on Day One,” says Paul Fuhrman, principal at Ernst & Young LLP.

Clearly defining the deal’s perimeter is critical when evaluating the true asset value of the carve-out and understanding what functions need to be built by the carved-out operation.

In the last 10 years, private equity firms have undertaken 463 carve-out deals worth US$68.5 billion, according to Bloomberg.

2. Find the hidden costs and value

Buyers need to assess complex costs, such as software licenses, leases, severance and hidden HR expenses. IT costs are especially important to plan for in carve-outs because existing systems often don’t come with the deal. “You may find that you have to build or buy your own system, or move to the cloud,” says Fuhrman.

Often the target’s income statement prepared by the seller omits important items that affect the target’s profitability. Schooley recalls a recent deal in which “several large costs were somehow ‘forgotten’ in the target’s income statement and they inflated the target’s EBITDA. These costs included some rather large items, like business insurance and the lease expense of the offices, as well as other smaller and more obscure costs. We needed to thoroughly review all activities and then validate that those costs were present in the P&L.”

PE firms should look across their businesses to seek value. “In the case of an international PE client who was integrating a carve-out as a portfolio add-on, we were able to identify cost synergies by integrating the manufacturing networks of the two businesses,” Schooley says.

Don’t underestimate the value in re-energizing and inspiring the company’s workforce to improve morale and productivity. And if reorganizing the management team is part of the playbook, buyers need to understand where the carve-out’s institutional knowledge lies and take steps to preserve it.

You typically deal with imperfect data, pro forma financials with lots of allocated costs, two management teams, personnel and intermingled services with the parent and subsidiaries.
Nish Shah
Senior Manager, Value Creation, Ernst & Young LLP

3. Get ready for Day One

After the transaction comes the transition. Buyers should prepare for it early, even during diligence. Once the deal is signed, the buyer should get a project management office operating quickly, run by a trusted team with a clear sense of purpose and policies.

Focus on the most important aspects of your business first, such as IT services and order-to-cash processes, which may have lead times of nine months or longer. Don’t delay. Day One is your chance to get the business off to a great start. Your customers will be watching. Competitors will be, too.

On Day One, you will have initiatives you want to implement to drive value. But wise buyers focus on executing a smooth stand-up of the business before launching improvement initiatives. You will end up destroying value if you need to focus on fighting fires resulting from a rocky Day and Month One.
Greg Schooley
Principal, Value Creation, Ernst & Young LLP

4. Negotiate detailed TSAs for a smooth exit

Transition service agreements (TSAs) smooth out 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.

They should cover such nitty-gritty matters such as whether value-added tax (VAT) incurred by the seller or buyer is recoverable and who absorbs the cost. In negotiating a TSA, buyers should do their own diligence, rather than relying on the seller to control the agreement.

Keep in mind that some transition services will be required for a longer duration, particularly IT-related activities, while others can be transitioned to the carved-out entity more quickly. That means “it is critical to price the services separately so that the company can turn off the activities and associated costs when appropriate versus paying a lump sum every month for services that the company no longer needs,” says Shah.

Summary

In a carve-out, you need to understand everything you’re getting — and not getting — and you should assess complex costs, such as software licenses, leases, severance and hidden HR expenses. Transition service agreements can also be a help as you aim to hit the ground running on Day One.

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US Americas

Multidisciplinary professional services organization