Corporate carve outs and spin offs
December 2018 | TALKINGPOINT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
December 2018 Issue
FW moderates a discussion on corporate carve outs and spin offs between Dan Beanland, Jason Caulfield, Alexis Christofides, Kristina Faddoul, and Justin Hamers at Deloitte LLP.
FW: How would you describe the current environment for corporate carve out and spin off transactions? What activity trends have you seen in the last 12-18 months or so?
Beanland: Overall, we have seen an increase in carve out activity with corporates looking to exit low growth businesses and invest in higher margin and growth segments or fund investment in digital products. Brexit is a double-edged sword. We have seen an increase in activity, particularly in financial services given uncertainty surrounding passporting rights, as well as some accelerated UK processes and increased activity in mainland Europe. In the UK, however, we have seen some instances of a slight pause for reflection as vendors consider commencing a sales process which could conclude during a period of maximum political uncertainty.
Caulfield: Notwithstanding the slight pause in the UK, the M&A market across Europe continued to be robust in the first half of 2018 and current indications point to that continuing into the second half of the year. Corporate divestments have continued to be a major driver of M&A activity. In one of our recent business surveys, 70 percent of respondents said that they expected to make at least one divestment in the next two years. We have also seen activist investors playing an increasingly large role in driving divestments. In Europe, deployed capital has doubled and, according to our research, 37 percent of activist campaigns targeted divestments or growth M&A. Our expectations are for a continuation of these activity levels, driven by an increase in the number of activist campaigns and also the scale of companies targeted. Private equity (PE) is one of the driving forces and is a keen acquirer of carve outs. Global PE-backed M&A is up 48 percent in the first half of this year and there is a record level of ‘dry powder’ to deploy.
Christofides: There is also a general efficiency movement for all mid-to-large corporates, driven by the fear of new entrants and market disruptors, who can do it better, cheaper and are more agile in responding to changing customer needs. This is creating a frenzy for digitalisation, data analytics and automated efficiency and, as a consequence, further M&A activity. From an M&A perspective, this is filtering down to restructuring and rationalisation, to ultimately deliver core services better, resulting in the divestiture of non-core assets and investing or partnering with new entrants and market technologies.
Faddoul: By the end of September 2018, the global market value of M&A had exceeded that of the full 12 months of 2017, climbing above $3 trillion. Like the rest of the world, the Swiss environment for M&A continues to be very strong. Although political and fiscal uncertainty continues in select regions of Europe, the M&A market is buoyed by investments in technology, confidence in growth and is taking bold steps to realise ambitious growth plans. The primary driver, however, remains one of transformation, where companies are looking to drive the growth and innovation agenda and are taking strides into new and tangential areas of business. The rise in divestitures is a result of greater focus on core businesses and an increase in strategic investments, and with funding for these raised through IPOs and sale processes.
“Appetite for large carve outs is mainly coming from financial buyers, which are increasingly educated and experienced in dealing with corporate carve outs.”
FW: What level of appetite are financial and strategic buyers demonstrating for these opportunities in the current market? What steps can companies take to attract acquirers and maximise shareholder value through the sale process?
Beanland: There is still plenty of appetite to acquire, particularly from PE buyers which view carve outs from corporates as a significant opportunity to generate value and also have a record level of ‘dry powder’. The devaluation of sterling means that we are also seeing strong demand from US and Japanese strategic buyers. However, UK and European buyers are more cautious. We would always advise companies to follow a number of key steps. First, they should put themselves in the shoes of the buyer to provide the information needed for them to conclude on the investment opportunity. Is it clear what the business for sale actually is? How complex and risky is the separation? What is the synergy opportunity? Second, they should set the programme up for success. Assign the right people to the right roles and employ tried and tested M&A programme tools and techniques to establish and maintain, to drive momentum and to keep all stakeholders informed. Third, they should maintain a focus on their people, via clear and regular communication; their buy-in and commitment is often critical to effecting a seamless transition to the buyer.
Caulfield: Naturally, carve-out assets present opportunities for value creation as they may have lacked focus and capital. However, for PE, a carve out can be a much greater transaction risk than for a corporate buyer, as PE will have to create a fully standalone business with a hard deadline, versus a merger or tuck-in. Also, often a seller will not have PE in mind and rarely will have undertaken a major carve out, resulting in poor data, financials with lots of allocated central costs, shared services IT and contracts, and two sets of management teams to deal with. As a result, we find that PE buyers in complex carve-out situations, where there is limited clarity on the true standalone EBITDA of the asset, will tend to err on the side of caution and will seek a reduction in purchase price to reflect the risk of significant recurring dis-synergies or one-off costs to make the business standalone. Presenting a robust view of the potential standalone EBITDA and separation costs, along with any detailed plans for the separation and the mitigation of potential dis-synergies, can help acquirers to de-risk the process from their perspective and encourage a more appropriate valuation for the vendor. Ultimately, being experienced in executing carve outs, or having experienced help, is critical to zeroing in on the key issues. Also critical is presenting a credible and robust value creation plan to grow sales and EBITDA in the core business post transaction. In order to be credible enough for buyers to attribute value, a track record and a mobilised delivery programme is key.
Hamers: Appetite for large carve outs is mainly coming from financial buyers, which are increasingly educated and experienced in dealing with corporate carve outs. Furthermore, they are getting better at assessing the risks attached to them and in preparing plans to create value from them. Ensuring the value creation plan for the carve out business is clear, well-articulated and underpinned by strong sell-side documentation helps to get value for these plans, be it through operational cost savings, new business areas or structuring, such as financing or tax opportunities.
Christofides: A smart seller is one that can provide a near standalone business with the thinking and view on the operating model that avoids lengthy transitional services agreements (TSAs) and tackles the risks around people, process, systems and data separation. Too often, sellers wait to find out the nature of the buyer’s intent and are on the back foot from day one. Companies that have developed separation handbooks and migration blueprints detailing how they plan to effect the carve out are attracting acquirers as they have understood their estate and transaction perimeter.
Faddoul: Securing the value of the deal is paramount, and this, very tangibly, means defining a robust perimeter, an early preparation of the financial and operational carve out to reduce uncertainty, and strong delivery teams to execute the separation.
“The rise in divestitures is a result of greater focus on core businesses and an increase in strategic investments.”
FW: Could you highlight any notably successful transactions in recent months?
Beanland: Corporate demergers and IPOs have been particularly popular, with businesses such as Signify – formerly Philips Lighting – and DWS coming to the European markets. Equally, analysts have been very positive about corporate carve outs, such as those from Rolls Royce and Akzo Nobel.
Caulfield: Akzo Nobel’s carve out of its specialty chemicals business was a recent example of a successful carve out and sale to PE. In September, completion was announced for an enterprise value of €10.1bn to Carlyle and GIC, making the deal one of the largest leveraged buyouts in the chemicals sector.
Faddoul: A number of noteworthy, successful divestitures have taken place over the last few months, such as, for example, the Zentiva sale to PE or the carve out of the SIX Group payments business to Worldline.
FW: Could you explain some of the main reasons why companies might consider carving out or spinning off parts of their business?
Beanland: There are a number of reasons for considering a carve out. First, to make funds available for investment, whether to bolster an underperforming core business, for regulatory purposes, or to invest in other assets more aligned to the company’s strategy, for example the sale of downstream fuel distribution assets for investment into exploration. Second, to respond to pressure from shareholders and increasingly vocal activist investors concerned about poor performance. Or, finally, to comply with competition authority directives on market share and to reduce the complexity and risk profile of the group. These are just some examples.
Caulfield: Separations, whether a spin off, carve out or other construct, can create shareholder value when businesses command higher valuations, often when owned and managed in their own right, rather than as part of an enlarged group. Value creation can be driven by a number of factors, including where assessed synergies offset downside risks from any integration and operational improvement initiatives, such as topline acceleration and cash and working capital diagnostics, releasing benefits with further investment not previously realised or funded under previous ownership. It is also worth remembering that having a refocused and energised management team, focusing on a business’s existing core-competencies, can have a marked impact on performance.
Christofides: Carve outs can provide a necessary cash injection to support investment into core services, to return value to shareholders, to provide liquidity and to unfetter the business from expensive, rigid operational processes and systems. Furthermore, carve outs can present a restructuring and cost reduction opportunity for back office functions, such as IT.
Faddoul: There are a number of reasons for companies to engage in separations. The most prevalent reason remains divesting part of a business that is no longer considered core to its strategy, making the company more nimble. Large organisations today may not find the return on investment in far away low-growth areas or in businesses that are sub-scale. A second reason, in this current high sale multiple environment, is that sub-segments of businesses may be able to raise cash to enable reinvestment into innovation and growth.
Caulfield: We have also seen in some disposal processes, where businesses have diverse offerings at different stages of the lifecycle – that is growth vs maturity vs decline – the potential acquirers’ focus and demand can be on the high multiple growth offerings and they may opt to not attribute sufficient value to the elements they ultimately are not interested in. In this type of scenario, vendors have been seeking to maximise value by targeting each component of the business at a different type of acquirer, to ensure value is achieved from all components.
“In an environment where demonstrating value, as well as increasing value, are key, buyers and sellers need to be clear and upfront about their expectations.”
FW: What are some of the common challenges and deal breakers that tend to surface during carve out and spin off deals? What steps can buyers and sellers take to resolve or avoid such problems?
Beanland: It is not uncommon for sellers to believe that the separation will be straightforward but businesses are typically integrated via technology and back office support functions and group-wide supplier contracts. These programmes cannot be managed as a ‘side of the desk’ exercise. They require dedicated resources and strong leadership to ensure that stakeholder requirements are met. A structured programme resourced with ‘know how’ using proven tools and techniques ensures focus and control. It is rare that a buyer will be able to accommodate all services that a purchased asset will require in time for day one and therefore a seller is often required to provide TSAs for a period of time, post-close. Sellers typically want to avoid providing these services, particularly as they are unlikely to be service providers themselves. TSAs, therefore, often need to be clearly articulated, with costs carefully considered, service levels agreed that are not onerous and, most importantly, with exit plans defined up front to ensure that an end point is understood and planned for. In terms of the impact on staff, suppliers and customers, these programmes are disruptive and will raise concerns about what the future looks like, so it is critical to ensure that there is a robust communication plan that addresses how and when these important stakeholders will be engaged to ensure a seamless transition. Finally, selling businesses will often leave the seller with costs that need to be swallowed up by the retained business or managed out, such as property costs and group overheads. These costs need to be considered early and plans formulated and executed to mitigate their impact. Competing demands and a smaller resource set are often cited as the reasons why businesses do not deal with these stranded costs in a timely and efficient manner.
Caulfield: First, and perhaps obviously, is the need to clearly understand what you are providing in the transaction perimeter, such as legal entities, staff, contracts, assets, technology, intellectual property, intact processes, costs and so on, as well as what you are not providing and which the parent provides today. The buyer’s and vendor’s views do not always align on these, which can lead to difficulties during implementation of the separation. Second, understandably most of the upfront effort is often focused on getting the deal signed, and as a result the transition is often overlooked and can cause serious disruption. Being ready for day one is essential. Focusing on the day one business critical systems, processes and governance structures will ensure a smooth transition into new ownership, creating a lasting positive first impression with major stakeholders. Third, parties must understand complex costs, such as pension obligations, IT licences, leases and other significant contracts. Without doing so, a buyer may find that costs may have been ‘omitted’ from the income statements which are otherwise required for business as usual. Items such as software licences, insurance and premises or facilities costs may not be transferring with the carved-out business, and you may find yourself having to buy or build additional capabilities, not otherwise reflected in the vendor’s view of EBITDA. From a vendor’s perspective, they may also find that they have significant levels of recurring stranded costs and one-off costs to right-size the retained business, or may find that they’ve signed up to pay for sizeable one-off costs to carve out the divested business.
Hamers: Successful carve outs are often those which have identified potential dis-synergies associated with a business combination. The creation of a cost-mitigation plan for any duplicated activities or personnel, and ultimately how these may be offset, is essential. Well-run processes will focus time and effort up-front, to identify future cost duplication. Dis-synergies often arise in combinations where there is a high degree of integration with the enlarged group, prior to separation. In the short term, post-separation, these dis-synergies are often felt most before any benefits from synergies or operational improvement initiatives have been fully realised, which may take up to 12 to 24 months post-separation. It is also important to avoid scenarios where rushed and ill-conceived separation plans simply result in cutting and lifting roles into new organisations, duplicating personnel costs, or indeed designing aggressive cost-reduction plans, assuming delivery on day one.
Christofides: From a technology perspective, IT is a real risk and there are often a number of challenges with IT that can be offputting to buyers. Complexity of systems, such as banking, airport and business critical systems, are examples of areas where system failures driven by a complex carve out can seriously impact the customer base. Similarly, the level of integration with the parent business, the age and robustness of the systems and their ability to scale or flex. An old system platform, for example, can present significant concerns around replacement or transformational project risk, high replacement costs that impact the sale price, and an inability to support the business plan. Both parties should be wary not to underestimate programme separation skills, the risk of continuing with project commitments, the resource requirements, costs and focus required.
“Most of the upfront effort is often focused on getting the deal signed, and as a result the transition is often overlooked and can cause serious disruption.”
FW: How important is it for buyers and sellers to establish appropriate protective rights, warranties and indemnities in these types of transactions? What options are available to manage associated risks?
Beanland: Complete knowledge of every potential issue is not possible, so any buyer is likely to seek some protection through the sale and purchase agreement. A seller will make statements that certain facts about the business that they are selling are true – these are warranties. If it is later found that these statements are not true, then the buyer may have a claim for breach of the warranty. An indemnity is a mechanism whereby the seller promises to make good any losses incurred by the buyer if specified events materialise. The seller will look to limit liability for these, either through capping the value of claims or by setting minimum thresholds and time limits. Indemnity is often used when buyers and sellers have very differing views on a potential liability, such as environmental or tax.
Hamers: A well-documented separation memorandum, together with well documented TSAs and ancillary legal agreements, can significantly reduce risk associated with carve outs.
Christofides: It is very important for appropriate protective rights, warranties and indemnities to be established. Ultimately, both buyers and sellers should go in to their transaction relationship with their eyes wide open. In an environment where demonstrating value, as well as increasing value, are key, buyers and sellers need to be clear and upfront about their expectations. Key considerations include a clear sales and purchase agreement, defining what is in the transaction perimeter, such as assets, people, processes and systems, and a well-defined TSA stating what will be provided and what is expected from each party, covering systems support and stability, process support and performance SLAs and commercial and financial commitments.
Faddoul: Protecting yourself, as either a buyer or a seller, remains key in any M&A environment. The use of legal documentation, and of mechanisms like warranties and indemnities, are helpful to bridge some of the risk, but parties should apply ‘operational feasibility’ to the transaction and check in with the business, rather than relying on legal only.
FW: What role can tax liabilities play in making the deal more or less attractive for the parties involved? In your experience, what can companies do to structure a spin off or carve out in a tax-efficient manner?
Beanland: In our experience, tax is often a key value driver in defining the business being sold. For example, which legal entities will be sold? Will it be an asset sale or a share sale? Getting value for accumulated tax losses from any divestment and ensuring pre-sale reorganisations do not crystallise any unexpected tax gains are also hugely important. Finally, considering the tax attributes of the business being divested from the buyer’s perspective is critical.
Hamers: Tax risks often are left behind in the ‘remainco’ as a result of breaking up existing fiscal unities or setting up ‘newcos’ in which businesses of the carve out get transferred as part of the legal separation. Tax efficient carve outs require a careful assessment of existing tax attributes and carve out tax structuring. Sellers need to assess and understand, per buyer, how much value they are willing to pay for certain tax step-ups.
Faddoul: We often see tax teams brought in very early in the deal process, to assess tax implications. As a result of the increasing deal carve out landscape and complexity, in the form of assets and IP transfers, international criteria, long-term agreements and so on, help to unlock substantial gains for both the divesting and the acquiring side of a deal, and to minimise downside. The key aspect here is to make sure experts are involved early on, in order to assess in depth the possible options for tax optimisation that comes with any deal.
“Properly managed, a carve out or demerger represents a very significant opportunity for corporates to drive shareholder value.”
FW: When structuring the deal, what change of ownership considerations need to be made? What kinds of complications can arise when licensing agreements or asset distribution contracts are involved, for example?
Beanland: The considerations are likely to vary, depending upon whether there is a share sale where every element of the business transfers, including employees, contracts, customers, IP, systems, assets and liabilities, or whether there is an asset sale. Change of ownership and consent clauses need to be carefully understood and tightly managed, although transaction confidentiality often means that conversations with third parties are not possible until the deal is announced. It is normally in the interest of all parties to ensure a smooth transition, so although certain customers and suppliers may look to leverage their positions, while this is a time-consuming process, it can usually be managed effectively. Any long-term relationship between the seller and buyer needs to be carefully understood and managed in parallel with the wider deal process, as this is a key value driver and often considered too late in the process.
Christofides: Key considerations are branding, data management responsibility, real estate leases, commercial customer agreements and supplier agreements. IT suppliers, for example, will charge for change of control, assignation of licenses, regulatory permits and licensing. These areas can have a significant impact on cost, for example the child business may leverage parent group software licence agreements at a high discount, branding changes can impact customer commercials, system changes, product templates and real estate costs. Also, regulatory permits and licensing typically need to be approved before deal completion and sometimes it can take over six months from the deal signing for this to occur.
Faddoul: Complex divestitures often include a mix of asset and share transfers with multiple simultaneous carve outs and migrations. In multinationals, this is made more complex through high levels of integration, as technology has made it much easier for companies to share resources across business units – a surprisingly vast array of supporting functions are provided at the corporate level. These shared assets are often not easily divided, and a key problem to solve will be how to treat them – either the parent or the business being divested will ultimately need to replace the asset, and that can take time and can be expensive. Transitional arrangements are often the solution to this problem, but those arrangements can present issues of economics, such as how much they will cost and how long they will be available. And, in the case of spin offs, they must be compliant with the tax rules.
FW: Looking ahead, do you expect to see more spin offs and carve outs in the M&A market? What underlying drivers are likely to continue or emerge?
Beanland: Overall, we remain bullish about the level of divestment activity we expect to see in the UK and Europe. Acquisitive overseas businesses, historically cheap debt and PE funds with large ‘war chest’, are all driving demand. Equally, increasingly vocal shareholders and corporate boards focused on investing in their core businesses are driving supply. Properly managed, a carve out or demerger represents a very significant opportunity for corporates to drive shareholder value and so, while we may see some short-term ‘noise’ from Brexit, in the medium term we expect activity levels to be strong.
Caulfield: Another driver is the increase in activist campaigns, which were up 6 percent in the first half of 2018, and the scale of market cap targeted, which is up 15 percent to almost $20bn, on average. One of the first places they look at is divisional performance and sum of the parts valuation to determine whether a disposal may add value – disposals are one of the most popular demands made by activists.
Hamers: When things cool off, driven by macroeconomic uncertainty, we will likely see fewer carve outs up to the point that carve outs are a necessity to reduce leverage at those corporates that have been too acquisitive or become too leveraged when interest rates rise again.
Christofides: We are expecting more carve outs and spin offs. Momentum is increasing for continued technology focus and digitalisation, which is disrupting and changing business models. Other challenges in the political and regulatory environment, such as Brexit, GDPR data management, as well as trade sanctions, will likely impact activity.
Dan Beanland is the lead partner with responsibility for divestments within Deloitte’s M&A team. He has over 25 years transaction experience working on some of the largest and most complex business combinations and separations across Europe. His focus is the planning and delivery of complex transaction programmes across multiple industries where he has completed over 75 divestments. He can be contacted on +44 (0)20 7007 1959 or by email: dbeanland@deloitte.co.uk.
Jason Caulfield heads Deloitte’s M&A operations and value creation service teams worldwide. He is a carve out specialist having led some of the largest and most complex divestments globally. He also works with major private equity and corporate clients. He can be contacted on +44 (0)20 7303 4883 or by email: jcaulfield@deloitte.co.uk.
Alexis Christofides is a senior director within Deloitte’s Tech M&A transactions practice based in London. He has over 22 years experience in technology and worked on over 350 deals advising both private equity and corporate clients. He specialises in complex global operational and IT carve outs and FinTech. He can be contacted on +44 (0)20 7303 8499 or by email: achristofides@deloitte.co.uk.
Kristina Keenan Faddoul is a partner in Deloitte AG Switzerland, based in Zurich, with over 18 years of experience in M&A. Ms Faddoul advises multinationals throughout Europe, considering mergers, acquisitions, joint ventures and divestitures, providing specialised integration and separation advisory services. She works primarily with clients in the banking and insurance industry, and has been involved in many of the largest most recent divestitures in Europe. She can be contacted on +41 58 279 7306 or by email: kfaddoul@deloitte.ch.
Justin Hamers is a partner within Deloitte’s transactions practice based in Amsterdam. He has 20 years’ experience of advising both private equity and corporate clients. Mr Hamers supports parties in preparing for and delivering complex (carve out and capital market) transactions. He is a chartered accountant and fellow of the NBA. He can be contacted on +31 (0)6 5151 5372 or by email: jhamers@deloitte.nl.
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