Carve outs drive M&A dealflow in the chemical industry

July 2022  |  SPECIAL REPORT: MERGERS & ACQUISITIONS

Financier Worldwide Magazine

July 2022 Issue

The chemical industry is a busy M&A marketplace. The coronavirus (COVID-19) pandemic shock was followed by a catch-up effect that continues to this day. Russian aggression against Ukraine has led to even more activity. Gas is one of the most essential commodities to the sector; cost increases and potential shortages are serious issues and need to be dealt with immediately. It cannot be denied that the industry has been hit by events since 24 February: companies are undergoing a massive transition process, rendering them more vulnerable to external effects.

In this context, the transformation of energy supply and rising focus on environmental, social and governance (ESG) factors have led to adjustments to existing business models and the development of new ones. Active portfolio management and the increasing sale of non-core activities are leading to a high level of M&A activity – increasingly in the form of carve-out transactions.

Favourable market conditions with a high number of interested parties and plenty of liquidity (especially among private equity (PE) investors) in the market are accelerating the trend. This trend also accelerated during the COVID-19 crisis and the subsequent phase of economic recovery, with companies now increasingly thinking about strategies to restructure their work and production processes, and to set up their portfolios in a sustainable and robust manner.

Carve outs are complex portfolio adjustments

It is the large number of issues to be considered which makes a carve out a complex undertaking. Various stakeholders need to be involved, especially management, employees, suppliers and customers of the carve-out business. In addition, a typical carve-out transaction is very ‘asset heavy’, so that a large number of operating assets and properties are affected, which have to be separated or divided up.

In addition, business areas often grown organically over a long period of time, so that the dependencies on, and interdependencies with, other business areas are correspondingly large: permits have been issued for several plants en bloc or there are shared supply or customer relationships, so that standalone operation of the carve-out business is not easy to establish. For this reason, transitional service agreements (TSAs) are often implemented. Under these agreements, the parent company must still provide services to the carve-out business for a certain period of time. Finally, historical environmental liabilities and legacy issues must be taken into account.

No carve out is like the other

There is no set routine when carving out a business. This type of transaction features different variants, such as a public carve out, sale to a PE investor or an asset deal (e.g., the sale of chemical parks).

Public carve out. A public carve out refers to the sale of one or more business units, often as part of an initial public offering (IPO) on a stock exchange. The business unit to be sold is initially spun off. At this point, the parent company still holds all the shares. The next step is the IPO of the new company created by the spin off. In the initial years after the IPO, the parent company continues to retain a significant stake – often for tax reasons on the one hand, and to ensure stability of the carve-out business on the other. Two examples are the carve outs of Lanxess and Covestro from the Bayer Group.

The goal of maximising shareholder value by creating an independent company with its own objectives, independent of the parent company, appears achievable in many cases. Most carve-out companies outperform comparable indices. In this respect, capital markets often value the individual companies more highly than the sum of these units in a conglomerate. In addition to the general carve-out issues that require legal independence, the complexity of public carve outs is increased by the capital market requirements of an IPO (including the preparation of a corresponding prospectus).

Sale to PE investors. In recent years, PE investors have played a prominent role in M&A transactions in the chemical industry (which have often been structured as carve-out transactions). In particular, target companies from the specialty chemicals sector have been the focus of attention due to their high margins. Active portfolio management by strategics led to the carve out of businesses that were profitable but that could not develop as well as capital-intensive businesses in a group with a different focus. From a transaction perspective, the advantage of selling to PE buyers is that antitrust approval procedures (merger control) are often – although not always – much simpler and faster than with strategic competitors, which means that transaction certainty and speed may be higher.

On the sell-side, it should be noted that PE companies typically aim to distribute the purchase price received to their investors in the short term and to avoid subsequent liability from the transaction, so that as a rule hardly any representations and warranties are issued. Warranty & indemnity (W&I) insurance (which may also be referred to as representation & warranty insurance) is regularly used in these company sales. In particular, warranties and indemnities from the purchase agreement are insured, so that the risk of a breach of warranties and indemnities are shifted to the insurer.

Carve outs as asset deals. If the available time frame of the transaction permits, an internal separation of the carve-out business can be carried out in advance. This can be done by means of singular succession (asset deal) or a spin-off in accordance with transformation law (universal succession). In the case of an asset deal in particular, the principle of clarity must be observed, which requires that the respective assets are clearly recorded and listed. The respective contracts must also be transferred, which generally requires the consent of the respective contractual partner. In this respect, the carve out in the context of an asset deal requires particularly detailed documentation.

In the case of a spin off under transformation law, the assets can be described in a more general, determinable form. The consent of the contractual partners is also not required, as the contracts are transferred by operation of law. However, in the case of a spin off under transformation law, it should be noted that there is a five-year subsequent liability for the liabilities of the carved-out business (or 10 years if the liabilities relate to company pension plans) in several European jurisdictions, such as Germany. If the carved-out business is limited to one location, the advantages of structuring the carve out as an asset deal often outweigh the disadvantages, for example in the case of the carve out of a chemical park.

Conclusion: no carve out without prudent preparation

Without doubt, the conflict in Ukraine has accelerated carve-out transactions. Companies are increasingly trying to optimise their portfolios, in 2022 with the tailwind of economies starting to recover from the COVID-19 shock. Now, time pressure is adding momentum to the development. Nevertheless, carve outs require thorough advance planning. The legal and factual requirements are complex.

Potential investors require meaningful financial information. At the same time, the business unit to be spun off does not yet exist. The legal situation must be thoroughly analysed, with regard to permits, employees, contracts, real estate and assets, and the carve out must be carefully structured accordingly. In addition, required TSAs must be prepared in good time. A deal maker who follows these steps will be efficient and successful, despite challenging circumstances.

 

Carlos Robles y Zepf is a partner at Mayer Brown. He can be contacted on +49 (69) 7941 1022 or by email: crobles@mayerbrown.com.

© Financier Worldwide

BY

Carlos Robles y Zepf

Mayer Brown

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