7 minute read 9 Dec 2020
Magical shape allotment garden

How private equity investors can be successful with acquiring carve-outs

Authors
Gregory Schooley

EY-Parthenon US Value Creation Leader; Principal, Ernst & Young LLP

Seasoned executive combining operational, M&A and strategy experience. Trusted advisor on critical business decisions. Passionate and proactive who values a healthy debate. Father and traveler.

Andres Saenz

EY Global Vice Chair – Industry Markets

Trusted advisor to leading businesses across industry markets. Ardent student of consumer behavior. Marathoner. Family man.

7 minute read 9 Dec 2020
Related topics Private equity

Carve-out investments generate returns that far exceed the average private equity internal rate of return.

In brief

  • Investments in carved-out entities can be lucrative for PE investors, given lower entry multiples versus other PE buyouts.
  • Such deals result in superior returns, provided investors perform effective due diligence and prepare timely for day one of operations.
  • Our analysis shows that PE investors were able to acquire carve-outs more cheaply than other types of deals during the time period studied.

Over the past several years, private equity (PE) firms have shown considerable interest in pursuing “underinvested” carve-outs from corporate parents. With corporations becoming more active managers of their own portfolios and often under pressure to divest “non-core businesses,” the number of carve-out divestments has been relatively steady at around 400 to 500 deals per year in both Europe and the Americas.

The deal thesis is clear: PE owners can drive more value with these businesses than corporate parents due to greater focus on the business, access to more capital, liberation from stifling corporate cultures and leveraging value creation techniques. That said, those who execute carve-outs also recognize that they can be very risky, costly and complex. Typical challenges that PE investors face include loss of synergies with the parent, difficult separation from corporate back office, loss of key personnel, and customer and supplier disruptions.

So, the pertinent question remains: is the risk-return trade-off that carve-outs represent superior to standard buyouts that offer lower levels of complexity and risk? To answer this, we took a sample of roughly 700 carve-out deals that PE funds have acquired between 2015 to 2019.

Our analysis suggests that not only are carve-out investments lucrative, but they generate returns that far exceed the average PE internal rate of return (IRR) of 14.1% (per Thomson One, average private equity buyout and growth equity IRR for 2010 to 2019). Our analysis of a sample of 12 carve-out deals suggests the average IRR of PE carve-outs is 34%, though a huge variance exists. A minority of carve-outs were challenged, generating negative returns while most delivered IRRs of 30% to 50% or even higher.

Plants in a garden
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1

Chapter 1

How many carve-out acquisitions were completed and where?

Strategic and PE buyers have shown increased interest in corporate carve-outs.

Our analysis focused only on PE performance with carve-outs. We identified more than 96,000 deals valuing approximately $7.2 trillion, which were executed by PE firms over the last eight years (2012 to 2019).

Of total PE deals, carve-outs represented less than 10% of deal volume or about 8,400 over the same period. Interestingly, carve-outs share of total deal volume is relatively stable, ranging from roughly 7% to as high as 10% during this period. Lastly, the Americas and Europe dominate corporate carve-out activity with each region representing roughly 40% to 50% or 400 to 500 deals apiece each year. Asia, Middle East and Africa are much less active carve-out markets.

Total PE deal activity (2012–19)

By region, most carve-outs took place in the Americas and Europe. Within the Americas, the US witnessed the most deals, with the total reaching 3,246 for the period.

PE carve-outs — deal volume by region (2012–19)

By sector, across all years, business products and services (B2B) witnessed the most deals, closely followed by consumer products and services (B2C) and information technology (IT). Within B2B, the commercial services industry experienced the most carve-outs.

PE carve-outs — deal volume by sector (2012–19)
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Chapter 2

Why do PE firms pursue corporate carve-outs?

Analyzing PE buyouts shows that PE investors were able to acquire carve-outs more cheaply than other types of deals.

To assess why PE firms invest in carve-outs, we analyzed 2,875 PE buyouts completed between 2015 to 2019 where each deal had a value greater than or equal to $50 million. We segregated carve-outs from other deal types and analyzed their respective entry-level multiples. This comparison highlighted that PE investors were able to acquire carve-outs more cheaply than other types of deals.

It is relatively cheaper for a PE fund to buy a carved-out entity vs. buying a stand-alone company as shown in the charts below by lower entry-level multiple for PE carve-out deals vs. entry-level multiples of other PE deals.

PE entry-level multiple — median EV/EBITDA / PE entry-level multiple — median EV/revenue

We also reviewed purchase price multiples across all industries to understand if the carve-out discount was driven by a handful of industries or was widely observed. The delta in EV-to-EBITDA multiples existed in all industries except for business products and services where the multiples were roughly even with other deal types. In the financial services space, the EV-to-EBITDA multiple of carve-outs was almost half that of other deal types.

PE entry-level multiple — median EV/EBITDA by industry
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3

Chapter 3

Does the carve-out “discount” translate into superior returns for PE investors?

It is relatively cheaper for PE firms to acquire a carved-out entity vs. a typical stand-alone buyout.

A lower purchase price does not necessarily mean superior returns if the acquired companies underperform or they represent higher risk profiles than other companies — you often get what you paid for. The question remains: are non-core businesses sold by corporate parents truly underperforming assets that trade at a discount for a reason or attractive opportunities that generate superior returns for PE investors?

Answering this question is very challenging since obtaining accurate information on most PE deals, carve-out or otherwise, is difficult. We have attempted to build a small but representative sample of carve-outs from which we can draw directional conclusions. To build our carve-out sample, we reviewed 661 carve-outs to identify deals with a single PE firm as an investor. From those deals, 170 transactions were closed by 25 PE firms, as represented in the chart below. We can see that while Platinum Equity led in deal volume by independently investing in a total of 14 companies, Global Infrastructure Partners led in overall deal size.

Of these 170 deals, there were only 6 deals where comparable entry- and exit-level data was available. We also added several other deals that closed prior to 2015 for which we obtained good entry and exit data to expand the sample size. Our resulting sample of 12 carve-outs is small but provides a picture on how well PE investors do on this type of transaction.

Top 25 PE firms — deal size and volume (2015–19)
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4

Chapter 4

Ten success factors for investing in carve-outs

Carve-out deals are complex and carry execution risk that needs to be proactively managed.

Buyers must be cautious and should take the following measures to mitigate execution risk, thereby minimizing probability of losses and, in turn, to maximize returns.

1. Know what’s in vs. out

Developing a clear understanding of the deal perimeter should be the first step in analyzing the carve-outs.

2. Thorough evaluation of stand-alone costs

The buyer must always conduct a detailed assessment of the seller’s costs.

3. Strong leadership and communication

This executive will need to not only make difficult decisions during the separation but, more importantly, garner the organization’s support for these decisions.

4. Shed unnecessary business complexities

Owing to the nature of carve-outs, such entities might come with unnecessary complexities like redundant processes, a bloated operating model and a cost-ineffective infrastructure, which typically arise due to being part of a larger and more complex organization structure.

5. Know your talent

Buyers should devote adequate time during the diligence process to get to know the carve-out’s leadership team that is coming with the deal.

6. Create value as part of the agenda

A robust and complete execution strategy should be designed up front and should not be left for post-close.

7. Understand the one-time costs

Typical areas requiring special focus include technology, financial audit, employee retention and benefit transition, transitional service agreements (TSAs), re-branding, facilities, and various third-party support.

8. Contractually separate the shared agreements

Assigning or re-negotiating such agreements is time consuming and must be initiated promptly to minimize impact on day one operations of the carved-out entity.

9. Adequate diligence to develop a well-structured TSA

The buyer should take utmost caution while drafting these agreements and confirm that they clearly specify the required areas, service qualities, costs and payment terms, governance structure, service levels, duration, and ability to terminate.

10. Plan for the unexpected

It is imperative that buyers understand certain market-facing risks and prepare a hedge to mitigate or best sail through in case any divergence or disruption occurs.

Summary

We analyzed a sample of roughly 700 carve-out deals that PE funds have acquired between 2015 to 2019. This report discusses our findings.

About this article

Authors
Gregory Schooley

EY-Parthenon US Value Creation Leader; Principal, Ernst & Young LLP

Seasoned executive combining operational, M&A and strategy experience. Trusted advisor on critical business decisions. Passionate and proactive who values a healthy debate. Father and traveler.

Andres Saenz

EY Global Vice Chair – Industry Markets

Trusted advisor to leading businesses across industry markets. Ardent student of consumer behavior. Marathoner. Family man.

Related topics Private equity