Creating value in private equity carve-outs
August 2018 | TALKINGPOINT | PRIVATE EQUITY
Financier Worldwide Magazine
August 2018 Issue
FW moderates a discussion on creating value in private equity carve-outs between Mark Bunker, Jason Caulfield, Mo Habbas, Jan Rattay and Jason Spencer at Deloitte LLP.
FW: To what extent have you seen a rising level of activity involving carve-outs sold to private equity (PE) firms? What are your expectations for such activity over the months ahead?
Caulfield: The M&A market has continued to be robust in the first half of 2018 and current indications point to that continuing into the second half of the year. Private equity is one of the driving forces. Global private equity-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. Corporate divestments have continued to be a major driver of M&A activity. In our recent business survey, 70 percent of respondents said that they expected to make at least one divestment in the next two years. Activist investors are also 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.
Rattay: M&A volumes are very high at the moment. There has been an increasing volume of large-scale divestments from major corporates with PE actively participating in these processes as serious bidders. A number of large-cap PE firms have demonstrated a track record in value creation of carved-out business and are using these blueprints to help identify additional upsides to help them win deals. With more corporates looking to optimise their portfolios and the rise in activist shareholders pushing for value realisation of underperforming or misaligned business units or divisions, there looks to be a steady stream of carve-outs in the months ahead.
“Deliverability of the carve-out and managing dis-synergy separation risks are also key considerations.”
FW: What opportunities do carve-outs offer to savvy PE firms, from a value-creation perspective?
Bunker: At face value, corporate carve-outs are attractive for private equity for a number of reasons. These include, among others, the value creation opportunity that could be associated with reversing the ‘corporate unloved-child syndrome’ and resetting the strategy of the business as an independent company to drive earnings growth. In the first instance, private equity is generally focused on assessing whether the business to be carved out has a product or service that is a strong proposition relative to competitors, operates in a compelling growth market, and has a capable management team in place. Thereafter, attention quickly turns to assessing the carve-out opportunity for accelerating revenue growth and cost optimisation under a new capital structure with a management equity plan in place. Deliverability of the carve-out and managing dis-synergy separation risks are also key considerations. Ultimately, in a carve-out situation, a private equity investor needs be comfortable that value can be created by separation and the business can be operationally standalone from day-one.
Rattay: Carve-outs are often opportunities for a new PE owner to ‘reset’ the cost structures for the business they are acquiring, taking away group-driven operating and reporting structures and adopting these on a standalone, fit-for-purpose basis. They are also situations where the performance of underinvested businesses can be put on an accelerated development track with the right investments. Finally, carve-outs often serve as platforms for the new PE owners to consolidate platforms through a buy-and-build strategy.
Caulfield: Naturally, the carve-out asset presents opportunities for value creation as it may have lacked focus and capital. However, for PE, a carve-out is 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 private equity 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. Being experienced in executing carve-outs, or having experienced help, is critical to zeroing in on the key issues and not getting distracted from the opportunity to create value after getting through the main separation activities.
“Getting clarity on the assets being divested as part of the deal and clear financials which allow lenders to assess the performance of the divested business are both key.”
FW: In terms of sourcing attractive targets, what considerations are PE players making when assessing a potential carve-out for acquisition?
Rattay: PE firms need to have a strong belief in the commercial proposition of the carved-out business – without this, the deal will not fly for them. Once this has been grounded, PE firms are looking for a clear and deliverable separation plan to transition the carve-out business to a fully standalone operation. Flexibility from the vendor on transitional service agreements (TSAs) in terms of scope is also an attractive transaction consideration. In summary, the more standalone the business is and the more robust a commercial plan the carved-out business can demonstrate, the more attractive it will be for PE.
Caulfield: We see that a number of the larger, sector-agnostic PE firms invest in businesses which, while looking dissimilar from an industry perspective, may be facing similar challenges. One common theme is IT separation, where there is often ambiguity in the activity and cost required to stand up the carved-out entity’s IT function and in turn what that means for costs going forward on a standalone basis. As such, this has become an area where several PE firms have built up strong in-house expertise, further supplemented by external advisers.
Spencer: Historically, PE has looked to complete the carve-out almost entirely prior to actively pursuing accelerated revenue growth and cost optimisation. This is traditionally due to complex operational or technology-centric separation programmes running under sometimes extreme deadlines limiting opportunities for initial business-wide transformation. This usually delays value creation and ultimately puts the target on a long, sometimes distracting path of business change. PE players are now more than aware of this and are looking at minimising the business impact of carve-outs and, more importantly, to business areas where incremental revenue growth can be focused on alongside a separation programme. Technology is typically the key driver behind this different approach. For example, technology platforms and environments that can leverage cloud services to quickly transition systems and departments, potentially limiting business impact, are now key buying considerations. Investments in customer-facing technologies to expand channels or geographic presence while separating allow much quicker value creation to be realised.
“The investment thesis will be premised on an opportunity to drive value from the target asset.”
FW: What challenges is a PE firm likely to encounter when trying to unlock the full potential of a carved-out business? What strategies are they deploying to overcome these issues?
Caulfield: There are four main challenges. First, and perhaps obviously, is the need to clearly understand what you are getting in the transaction perimeter – such as legal entities, staff, contracts, assets, technology, intact processes, costs, and so on – and what you are not getting which the parent provides today. Also important is understanding what sell-side preparations have been carried out and the extent of any external diligence conducted – and crucially, the key operational risks flagged as part of diligence. In carving out businesses, core support services including treasury, IT, finance, and so on, are left behind in the process – interruption in these processes can often impact day one business operations. Second, the transition post-transaction 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, understand complex costs such as pension obligations, IT licences, leases and other significant contracts. Without doing so, you may find costs have been ‘omitted’ from the income statement 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. Finally, carefully consider the use and content of TSAs to ensure seamless business continuation post-transaction, until you have established, implemented and tested replacement systems and process. Keeping a close eye on the pricing of any such agreements is also important, avoiding any surprises. Balancing the autonomy of management versus the desire to control management decisions, particularly in areas where PE may want to reduce costs, are where management may provide some resistance. PE firms are increasingly having their transaction and value creation personnel seconded to portfolio companies to mitigate this risk, however the risk of ‘going native’ is a real one that can often hinder PE firms’ ability to drive rapid cost reduction.
Rattay: Carve-outs always involve business change which can be hard to execute. For very complex carve-outs, completely new legal structures need to be set up, new sets of financial accounts created, most of the employees selected and transferred, new operations and facilities set up and IT systems either cloned or newly created. A carve-out is in essence a complete corporate transformation at the complex end. Many PE firms which are serial carve-out acquirers have developed a carve-out playbook that they use to plan and execute the separation. PE firms also tend to shy away from deals where there is an underprepared vendor which has not thoroughly developed the target operation model, associated headcount and cost structure and transition plan. Many PE firms mitigate against the risks of carve-out through a robust 100-day plan, which covers, firstly, the key value driving initiatives of the deal, secondly, early stage investment in the business typically aimed at catching up with underinvested divisions or operating companies, and thirdly, the separation plan to make the business fully standalone.
FW: In what scenarios might a carve-out prove unsuccessful or unsuitable for the PE value-creation playbook?
Caulfield: There are no specific scenarios in which a PE approach should be ruled out, however there are indeed factors that can derail a successful carve-out. Often these are based on unrealistic assumptions of what the PE firm and management can achieve in the forecast period, in a short space of time, particularly around headcount reductions and the ability to maintain day-to-day operations, all while preventing revenue erosion. In other areas there may be more macro factors at play that impact a business’ ability to remain competitive, be it foreign exchange movements or new protectionist actions or tariffs, such as those we are currently witnessing in the US.
Rattay: The lack of a robust and evidence-based commercial plan is often a roadblock for PE in a carve-out scenario – as is the case for any standalone investment. The lack of a well-developed standalone cost base and carve-out plan can put off some buyers, but the more experienced PE funds are typically able to see through the fog and develop their own view of the separation plan during the due diligence process. This is then validated in the 100-day planning process before deal completion, and in the subsequent execution phase.
“One area that seems to get less attention is the detailed mechanics of how capex investment and operational improvement translate into positive cash-flow impact in the forecast period.”
FW: When structuring and financing the deal, are there any unique issues that should be examined in the context of a carved-out business? For example, how important is to fully understand the perimeter of the entity in relation to its former parent company?
Bunker: It is extremely important to understand the precise perimeter – both the legal entity and operational perimeter. Some of the most complex carve-out transactions involve situations where the legal entity and operational perimeter need to be aligned with TSAs post deal. The structure of the TSAs needs to be thoroughly addressed in the deal negotiation process – for example, do the TSAs cover the right services, provide for a sufficient time frame, and at an appropriate cost? Protecting against value-leakage during the TSAs negotiation process is often a high-value part of getting a carve-out right.
Rattay: Value can often be created through efficient structuring of the carve-out. Getting clarity on the assets being divested as part of the deal and clear financials which allow lenders to assess the performance of the divested business are both key. Dependencies with the parent company need to be clearly set out, as these can often move from internal to market-standard terms – frequently resulting in significant changes in profitability margins for the carved-out business.
Spencer: Understanding what is in the perimeter and coming across is key. However, sometimes it is more important for PE to know what is not in the perimeter but will be required for day one and beyond. More often than not, PE will most likely have to stand up new business functions to support those services not included in the perimeter. One area that typically causes unique issues are ‘shared services’ environments which can provide business services such as finance, HR, customer services, IT and facilities. While TSAs can usually provide support for day one, there are often some business services that sellers will not offer. Being able to identify what these new business services will cost to implement and run, as well as the timescales and risk involved, is key when structuring an investment.
FW: At what stage in the M&A cycle should you start considering value creation? How do you identify the key drivers of value and how do you ensure they are delivered?
Habbas: Value creation starts from the very outset of the M&A cycle. The investment thesis will be premised on an opportunity to drive value from the target asset. Having clarity around the set of key value-creation initiatives and a strategy, as well as understanding, of how to deliver them, will underpin the investment thesis. As the M&A cycle progresses, it becomes increasingly important to develop a more detailed view of how to achieve the value and also any risks or issues that might prove stumbling blocks to achieve them. Typically, the opportunity to deep dive into the detail becomes available once the deal completes, known as the 100-day planning stage, through greater management and data access. The post-completion value creation planning emphasises validation of pre-deal identified key initiatives, identifying any additional key initiatives, and prioritising those that will drive the majority of the value – 80/20. Clients often make the mistake of not developing value creation plans that are pragmatic, actionable and measurable in hard cash and EBITDA benefits, while also having a sharp focus on quick wins in the early stages of new ownership, particularly in cash and working capital management. Identifying the drivers of value occurs through detailed work with the management team who are all stakeholders in the business, review of the financial information, and previous experience across multiple businesses. In order to deliver the value, it is fundamental to follow a pragmatic approach, addressing the key drivers that have the greatest impact on the business first – either opportunity value or risk – before then moving on to the lower-priority drivers. Providing clarity on the actions to be taken, visibility of both financial and non-financial results, and accountability is key to ensuring delivery of the value into the business.
“Understanding what is in the perimeter and coming across is key. However, sometimes it is more important for PE to know what is not in the perimeter but will be required for day one and beyond.”
FW: Could you outline some of the essential due diligence and risk management aspects that should be incorporated into the transaction?
Caulfield: Naturally, some due diligence activities have become somewhat standardised on both buy-side and sell-side, for example financial due diligence. Value creation, however, still appears to be an area which is covered to varying degrees in due diligence products on both sides of the transaction. In terms of diligence of the business plan, the underlying assumptions are typically covered under financial due diligence and impact of forecast cost saving programmes in operational due diligence. One area that seems to get less attention is the detailed mechanics of how capex investment and operational improvement translate into positive cash-flow impact in the forecast period. This quantification of these improvement initiatives – never mind the delivery of them – can be significantly more complicated than simple assumptions based on previous experience, as forecasts are often based on entering new markets, which are inherently less certain. For businesses where significant operational change is required to deliver the returns indicated in the investment thesis, we would expect the achievability of the forecast savings to be an increasing area of focus in the diligence process, rather than something left to wrestle with post-closing.
Rattay: A divestment from a corporate has the added complication of requiring due diligence on the target operating model, financial implications of the separation, the transition plan and associated one-off costs and the required TSAs to facilitate the move to a fully standalone operation. This is on top of the usual commercial, financial, legal and tax due diligence requirements, so it is a much more complex due diligence process. Also, the position of the carved-out business during the due diligence is often ‘theoretical’, with many operational step changes that still need to be implemented. So, a PE bidder will need to invest time in very detailed due diligence and benchmarking to assess whether the picture presented by the vendor really stacks up. Given the operational change of carve-outs, transaction completion is also much more complex than on a standard buyout. In order to mitigate risk around this, successful PE buyers develop and execute a detailed day one plan and link clear obligations of this day one plan to the vendor. The final risk mitigation is a good and capable management team that is on top of driving the business during the separation process, as this can be disruptive for the business. After all, the best executed carve-out is useless if the management team takes its eye off developing the topline.
FW: What steps can PE players take from the outset to prepare a carved-out company for exit and generate expected returns?
Rattay: Getting an early view of management’s own plans to transition to standalone and forecast improvement initiatives is key. Often the level of supporting detail will be minimal, and so assumptions should be challenged extensively to test their reasonableness. Post completion, there will be many other issues that arise that could derail the focus on value; effective prioritisation of initiatives during the development of the 100-day plan can help mitigate this.
Mark Bunker is a partner within Deloitte’s transactions practice based in London. He has over 17 years’ experience of advising both private equity and corporate clients. Mr Bunker specialises in leading high profile, international acquisitions, disposals and carve-outs. He is a chartered accountant and fellow of the ICAEW. Mr Bunker graduated from Imperial College with a degree in Mathematics and Physics. He can be contacted on +44 (0)20 7007 4395 or by email: mbunker@deloitte.co.uk.
Jason Caulfield is the global leader for M&A Operations and Value Creation Services at Deloitte. He has over 20 years experience in identifying and delivering performance improvement and EBITDA/cash improvements in complex carve-outs for corporate and private equity. He has a DPhil in Physics from Oxford University. He can be contacted on +44 (0)20 7303 4883 or by email: jcaulfield@deloitte.co.uk.
Mo Habbas is a partner with over 20 years of operations and consulting experience in value creation. His focus is value creation planning and implementation for private equity acquisition targets and portfolio companies. His experience in value creation covers rapid diagnostics, large and complex transformations and cost reduction programmes. He has an MBA from INSEAD. He can be contacted on +44 (0)20 7007 1515 or by email: mhabbas@deloitte.co.uk.
Jan Rattay is a partner in the M&A Operations team in London. He works with clients on pre-deal, full value potential assessments, carve-outs, assessing and executing synergies, and delivering value during the first 100 days of ownership. He can be contacted on +44 (0)20 7303 8973 or by email: jrattay@deloitte.co.uk.
Jason Spencer is a partner in Deloitte’s Technology M&A team, with over 20 years of industry, consulting and transactions experience. He focuses on technology due diligence specialising in pre-deal separation and integration, IT assessments, business systems diligence, IT operating models, data analytics and post diligence integration. Sector experience includes retail, manufacturing, FMCG and supply chain. He can be contacted on +44 (0)20 7007 9603 or by email: jasspencer@deloitte.co.uk.
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