4 steps to create value in private equity carve-outs
It’s increasingly common -- a parent company decides to shed a business that is no longer strategically critical to its core mission. Sensing potential, a private equity firm (PE) sees an undervalued, mismanaged or non-strategic but highly performing asset. They have a plan to buy it, implement their 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 hardly is. There is huge risk to executing a carve-out, says Tom Taylor, principal in the Value Creation practice at EY. “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, principal in EY’s 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 platform acquisitions. Here are four ways to capture a carve-out’s full potential.
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 need to understand the scope of sell side reports,” says Taylor. “For one PE buyer we quickly identified risk in operational areas which were not fully addressed and redefined the deal.”
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 EY.
Clearly defining the deal’s perimeter helps you capture the true asset value and understand 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.
- Source: Bloomberg
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.”
- Tom Taylor, EY
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 during your ownership period to drive value, but you will destroy value if you need to focus on fighting fires," Schooley says.
“On Day One you will have initiatives you want to implement during your ownership period to drive value, but you will destroy value if you need to focus on fighting fires.”
- Greg Schooley, EY
Negotiate detailed TSAs for a smooth exit
Transition service agreements (TSAs) smooth 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 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, where 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 Taylor.
How EY can help
Even PE firms with dedicated operational support resources can benefit from outside help. From IT and HR to tax structures and retirement plans, EY helps PE investors by asking better questions around our clients’ buy side carve outs and discovering the answers to strike the right deals and get their businesses running smoothly from Day One.
Through our capabilities, talent and global network, we can help private equity firms with operational and financial diligence, operational separation, portfolio integration and post-close effectiveness, assisting clients with all aspects of carve-outs and Day One readiness.