Key legal considerations on infrastructure carve outs

July 2023  |  SPECIAL REPORT: MERGERS & ACQUISITIONS

Financier Worldwide Magazine

July 2023 Issue

Carve-out transactions are transactions for the sale of part, rather than all, of a business. Since the global pandemic, these types of transactions have been particularly prevalent in the European infrastructure sector.

The beginning of the pandemic in 2020 saw KKR’s acquisition of the £4.2bn carve out of Viridor, a UK energy from waste business, from Pennon Group. Since then, there have been a string of carve outs in this space, including the spin out of Suez’s French water business to a consortium led by Meridiam to facilitate the Veolia takeover.

New processes, like Alliander’s proposed sale of its energy services company, Kenter, continue to be launched. The digital infrastructure sector has been particularly active, including planned (and some past) sales of various data centres by Altice and Iliad, CK Hutchison’s carve out of its European towers business to Cellnex, Orange’s carve out of its French rural fibre broadband business, Telenor’s carve out to sell stakes in its towers’ businesses and United Group’s carve out of its Eastern European telecommunications tower portfolio to Tawal.

The surge in infrastructure carve outs has been prompted by a number of factors. First, many infrastructure assets or portfolios are so large that it would be challenging to find a buyer that has enough capital to pay the equity cheque for the whole asset. Carving out specific capex-intensive businesses to facilitate capital investment into those businesses is a driver of many of the processes in the digital infrastructure space.

Furthermore, a focus on energy transition has driven a number of corporates and financial sponsor-backed portfolio companies to sell parts of their businesses which do not align with fund investment objectives or meet environmental, social and governance (ESG) criteria, rather than undertake the often costly exercise of decarbonising a ‘dirty’ asset. An example of this would be Viesgo’s decision to carve out its coal-fired power stations.

The complexity of carve outs can vary significantly depending on how co-mingled the in-scope business is from the retained business. Certain core infrastructure assets such as wind farms and energy from waste plants are often already partitioned within their own special purpose vehicles, so the divestment of these assets is normally straightforward – so much so, that their disposals are not always termed carve outs, but simply divestments of one or more projects. For other infrastructure assets, a complicated web of interrelated contracts and related liabilities may sit under the same entities, and the steps required to effect their transfer may require more detailed analysis.

This article examines some of the key issues that arise during carve outs, with a focus on how it applies to the infrastructure sector.

Defining the transaction perimeter

It is important in any carve-out transaction to be clear about the transaction perimeter. Even if a buyer and seller agree conceptually on the scope of the divested business, information asymmetry means the seller will always have better visibility on what assets, liabilities and employees are necessary for the operation of the target business in the ordinary course.

Indeed, sellers themselves often underestimate the level of integration and commingling, which is often identified by the buyer during its diligence. A buyer will therefore seek various protections in the transaction documents to ensure the carve out is effective, and that it is acquiring the expected scope of the business to which it has ascribed value.

Completion should be conditional on all or substantially all of the carve-out steps in accordance with the agreed plan. The steps plan for the implementation of the carve out, sometimes known as the separation steps plan, requires a significant amount of due diligence, planning and preparation by the seller and its legal, commercial and tax advisers. There is often some flexibility for the seller to make changes to the separation plan, particularly for the purposes of complying with legal and tax requirements.

Furthermore, for more complex carve outs, an assessment may need to be made of whether the business is ‘day one ready’ (i.e., ready to operate in the ordinary course) before the condition is deemed to be satisfied. On infrastructure deals, the effective transfer of key operating assets, contracts and permits into the transaction perimeter will be critical and likely form part of the day one readiness assessment.

Following completion, a buyer will expect to have ongoing protection against errors or omissions which have occurred in carrying out the separation steps – that is, assets not effectively transferred or unknown liabilities attributable to the retained business. In the transaction documents, these protections are normally structured as ‘no liability’ and ‘sufficiency of assets’ warranties and ‘wrong pockets’ provisions. No liability and sufficiency of assets warranties give the buyer the opportunity to sue for damages in the event of a breach, however sellers are normally given a reasonable remedy period to rectify any issues before the claim can be made.

Also, warranty and indemnity (W&I) insurance coverage can be obtained for these warranties, subject to the insurers’ diligence of the separation steps plan. Any changes to the separation plan post-signing will therefore require insurer sign-off, so as not to invalidate the insurance coverage. Wrong pockets provisions similarly ensure that any in-scope assets or liabilities which have not been transferred into the transaction perimeter are promptly transferred in, and any assets or liabilities which relate to the retained business are transferred out – typically at the seller’s cost.

Regulatory issues

Concessions, permits and licences can be fundamental to infrastructure businesses. These are often personal to an entity, so the entities holding the relevant concessions, permits and licences must be transferred into the transaction perimeter as part of the separation steps. Where these entities cannot be transferred, it is important to ensure that an in-scope company reapplies for these or alternatively that the relevant concessions, permits and licences are transferred, subject to necessary consents. The reapplication and consents process can be long and time-consuming under many regimes, so this will need to be factored into the overall timeline and day one readiness assessment.

Many infrastructure assets are in sectors which are considered to be sensitive for foreign investment purposes. In some cases, a mere internal restructuring (i.e., transfer of shares or assets to an affiliate) could trigger regulatory approvals, such as under the UK National and Investment (NSI) Act regime or the Foreign Investment Review Board in Australia. Where approval is required for an internal restructuring, it is most likely required for the eventual sale to the third party as well – so where possible, it is often most efficient to apply for approval for both at the same time.

Key contracts

If an in-scope contract has been entered into by a company that will remain with the retained business, that contract will need to be assigned or novated into the transaction perimeter. Such assignments and novations often require third-party approval or countersignature in order to be effective. Depending on the relationship and other dynamics with such third parties, the procurement of such approvals and signatures can add significant uncertainty and delay to the separation.

Stakes

In the energy sector, asset owners often hold majority or minority stakes in projects, alongside operations and maintenance (O&M) providers or other stakeholders. Parties should consider whether such stakes are in scope, and if so, ensure that any restructuring or sale to a third party is carried out in accordance with any joint venture agreements. In many cases, consent of another shareholder, rights of first offer or refusal or tag-along rights may apply to any such transfer.

Long-term agreements

In situations where a material portion of the current or prospective revenues or costs of the in-scope business is or will be generated from arrangements with the retained business, robust long-term contracts for such arrangements should be agreed. These commercial contracts are usually critical value drivers and are very heavily negotiated as part of the transaction. Even if there are existing intercompany arrangements in place, these arrangements are likely to be short form.

For new long-term arrangements, it is important to consider what rights and obligations the in-scope and retained businesses should have on matters including exclusivity, security of supply, pricing certainty, warranties, termination rights, risk allocation and responsibility for operations and maintenance.

For some infrastructure assets, sellers will also provide O&M or other management services to the project. In such circumstances, it is important to consider whether these services should be continued post-closing, or insourced or outsourced to an independent services provider.

Transitional services agreements

Transitional services agreements for most carve outs will normally cover support for IT, accounting, payroll, HR and legal and compliance functions – any services that were provided to the in-scope business by the seller on a group level, but will be retained by the seller after completion of the transaction.

The scope and duration of transitional services for core infrastructure carve outs is typically smaller and shorter compared to carve outs in other asset classes. Traditionally, core infrastructure assets require smaller management teams and personnel. In theory, therefore, it should take less time to set up back office functions or outsource to an external provider. Of course, this varies depending on the nature of the business.

Completion accounts

The purchase price mechanism for a carve-out transaction will typically be structured as a completion accounts adjustment or a hybrid completion accounts and locked-box mechanism, as the in-scope business is unlikely to have standalone accounts. As with any completion accounts deal, the specific accounting policies applying to the adjustment, and the definitions of ‘cash’ and ‘debt’, will need to be carefully negotiated and tailored to the business in question.

For example, real estate-intensive assets may have large amounts of cash trapped in deposits used to secure key leases. It is important to agree upfront whether this cash is excluded from the adjustment of the purchase price payable by the buyer.

 

Amy Mahon and Jiaying Zhang are partners at Simpson Thacher & Bartlett LLP. Ms Mahon can be contacted on +44 (0)20 7275 6595 or by email: amy.mahon@stblaw.com. Ms Zhang can be contacted on +44 (0)20 7275 6187 or by email: jiaying.zhang@stblaw.com.

© Financier Worldwide

BY

Amy Mahon and Jiaying Zhang

Simpson Thacher & Bartlett LLP

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