May 2020 Issue
Although spin off and carve out activity was strong in 2019 and early 2020, recent market volatility stemming from the COVID-19 crisis has changed the outlook for these types of transactions. In a challenging environment for divestments, increasing uncertainty, complexity and scrutiny will require more data and analysis. But, while current conditions remain challenging, spin off and carve out activity should return to more normalised levels as companies focus on core activities and markets begin to stabilise.
FW: How would you describe the current environment for corporate carve out and spin off transactions? What level of appetite are financial and strategic buyers demonstrating for these opportunities in the current market?
Castillo: There has been an uptick in divestment activity in the past few years. Companies have become more active in managing their portfolio of businesses. They are approaching portfolio management with more rigour and discipline. This has been driven by the need to streamline their operations, to be more responsive to changes in the market and competitive landscape, and to raise additional funds. However, the environment for divestments is also becoming more challenging. There has been an increase in market uncertainty and buyer scrutiny. Transactions are becoming more complex, requiring more data and analysis, because buyer demands are changing. Moreover, the sale process has become more costly and drawn out. Now, with the business disruptions and uncertainties resulting from the COVID-19 pandemic, the market for spin offs and carve outs has slowed down, just like the rest of M&A, as companies are focusing on more immediate liquidity and cashflow concerns.
Greenberg: Although corporate carve out and spin off transaction activity was strong in 2019 and early 2020, recent market volatility and business disruptions stemming from the COVID-19 crisis have impacted the current environment for these types of transactions. As a result, many carve out sales and spin offs are being deferred until market conditions stabilise and businesses adjust to the current environment. While certain deals are still getting done, the current environment presents unique challenges to financial and strategic buyers that could impact their appetite for new deals until they can better assess COVID-19’s impact on target businesses. In addition, some strategic buyers that are dealing with liquidity or other challenges of their own may have a more limited near-term appetite for new deals. On the other hand, certain buyers may see opportunities in lower purchase prices as sellers seek to monetise non-core businesses to address their liquidity issues.
Bonnie: At the present time, as we enter April, market dislocation from the COVID-19 pandemic has adversely impacted the appetite for corporate carve out and spin off transactions with severely depressed equity valuations and many issuers left largely to focus on shoring up their financial health, preserving liquidity and considering how the pandemic will alter their budgets and strategic plans. As issuers come to terms with these issues, it is possible that this environment may precipitate some asset disposition and carve out activity as businesses come under increasing pressure to address leveraged capital structures, raise liquidity and pay down debt. This, in turn, can create acquisition opportunities, particularly for private equity (PE) investors that are continually looking to deploy capital. Over a longer time horizon, carve out and spin off activity will doubtless return to more normalised levels. Companies and their boards will always regularly engage in portfolio review and seek strategic options that can create value for their owners, and a carve out or spin off is a proven way to do this where the embedded value of a particular businesses does not seem to have been given appropriate credit by public markets.
FW: Could you explain some of the main reasons why companies might consider carving out or spinning off parts of their business?
Greenberg: Companies frequently look to carve out and spin off transactions as a way to divest non-core operations and unlock value that may not be reflected in their stock price, based on a sum-of-the-parts valuation. These transactions allow management teams to better focus on their respective businesses post-separation and make capital decisions more aligned with those businesses. In addition, they offer companies seeking to divest a business an opportunity to realise cash proceeds, whether from a third-party buyer or from debt incurred on a business to be spun off, that can be used by the divesting company in deleveraging its balance sheet and shoring up its remaining operations. Spin offs and split offs have the added benefit that they may be structured in a tax-free manner, assuming certain tax requirements are met. To a lesser extent, companies also undertake carve out sale transactions to satisfy regulatory divestiture requirements in M&A transactions.
Bonnie: A trend in public equity markets over the past decade has been the increased preference for so-called ‘pure play’ issuers over more diversified companies. Carve outs and spin offs allow a parent company to divest an ancillary business line so that both companies can focus on their core businesses. Management may conclude that separating an ancillary business line would maximise shareholder value because the separate parts of the larger business would be valued higher than the combined enterprise. This can be the case particularly where the businesses have different growth rates for which the equity markets are not providing enough credit or if the businesses attract divergent investor bases. The parent business and the carve out may also differ in their relative capital intensity and separation can allow both to implement balance sheet strategies and access to capital resources that are tailored to their respective needs. The separation may lead to top-line growth potential by eliminating operational or regulatory conflicts currently existing between business units.
Castillo: Increasingly, companies are divesting for strategic reasons as opposed to reactive ones, such as business deterioration, underinvestment or failure. Companies have become more active, rigorous and disciplined in managing their portfolio of businesses, and this has been driven by a number of factors. These include a change in corporate strategy and the need to streamline their operating model, the need to be more responsive to market changes and opportunities, the need to respond to shareholder activism and pressure to redeploy capital and improve shareholder value, and financing needs to reduce debt or raise capital. Divestments can offer companies many benefits and opportunities. The most common use for funds raised from divestments are to invest in the remaining core business, invest in new technology, products, markets or geographies, pay down debt, make an acquisition and return funds to shareholders.
“It is very important for buyers and sellers to establish clear protective provisions in their transaction agreements, particularly where the carve out business has not previously operated on a standalone basis.”
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?
Castillo: The transition services agreement (TSA) can be a challenge for both sellers and buyers. A TSA is a contract in which the seller agrees to continue providing, on a temporary basis, corporate or shared services – such as HR, IT and finance – to the divested business after it is sold. TSAs are necessary in most carve out transactions, because buyers are typically not equipped to provide such services to businesses they are acquiring by day one. TSAs can encumber sellers with unwanted responsibilities and costs, disrupt their operational improvement initiatives and delay the necessary mitigation of stranded costs. Developing a TSA strategy early in the divestiture process can help sellers determine what can be done to minimise TSAs or avoid them altogether. This starts with understanding the complexity of the divestment and what it will take to disentangle the business from the parent. A TSA strategy can also help sellers take charge of the TSA negotiation process with buyers. If TSAs are necessary, sellers should price them at cost-plus, cap them at 12 months, add an escalating pricing structure for extensions, and manage them in relation to stranded cost mitigation plans. Buyers tend to rely too much on the seller in TSA discussions, which gives the advantage to the seller. Buyers need to devote their own resources to gathering information relevant to the negotiation of TSAs. Post-close, a seller may lose the ability to provide the transition services at the expected level due to changes in staffing or structure. This can lead to deterioration in the quality of operations for the buyer. It is, therefore, important for buyers to focus on the details – such as TSA service levels, performance reporting, pricing, issue escalation process and penalties – during the TSA definition and negotiation process. Leaving such matters to the last minute can have significant post-close consequences.
Bonnie: Spin off transactions present management with a variety of challenges. These are transactions that require substantial time and management focus, diverting attention away from operating a company’s core businesses, and they involve substantial one-time costs. Carve outs and spin offs both require the functional and operational separation of a business that has been embedded in a larger enterprise. Operational entanglements and shared services, such as IT, accounting, legal and HR, must be identified and addressed. Legal entanglements, such as contractual relationships, licences, intellectual property (IP) and branding, shared liabilities and credit support, must similarly be worked out. In addition to untangling and separation challenges, a spin off also involves the issues inherent in an initial public offering (IPO). The spinco company must gain the ability to operate independently as a standalone public company, with its own senior leadership and board and its own public company corporate functions, including accounting, financial planning and analysis, investor relations and Securities and Exchange Commission (SEC) reporting. Most spin offs involve support from the parent company in some or all of these functions in the first year or two after separation through a TSA until the spinco has the wherewithal to function unaided. Unlike a spin off, where most aspects of the transaction are within the parent company’s control, a carve out sale implicates the challenges that come with any M&A transaction – the need to negotiate mutually agreeable terms with the prospective buyer and uncertainty about whether the parties will be able to reach such an agreement, as well as the need to address other matters such as corporate governance requirements, satisfaction of each party’s tax objectives and arranging bidder financing if applicable.
Greenberg: One key challenge in the current environment is resolving the differences between buyers and sellers over valuation. We may see increasing use of earnouts and price-adjustment provisions to bridge valuation gaps. Another common challenge is identifying the scope of the assets, liabilities and employees to be included in the divested business. Shared assets, such as IP and IT assets, facilities and enterprise-wide contracts, require special attention and can be addressed with licences, commercial arrangements and TSAs. The parties will also need to reach an understanding on the allocation of pre-closing liabilities. In spin offs, where no buyer counterparty exists, the parent has greater flexibility to address these issues as it deems appropriate. Finally, in carve out sales, the parties should identify any regulatory approval risks early in the negotiations and ensure that the transaction agreement clearly reflects the parties’ allocation of these risks and consequences if approvals are not obtained.
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?
Bonnie: The contractual agreements in the transaction will define the assets, liabilities, employees and obligations that are intended to be separated and those that are intended to remain. Demarking this division becomes more difficult the more closely integrated the carve out business is with its parent company. Dedicated resources and collaboration across functions, including with specialists in areas such as tax, IP, and environmental and employee benefits, are necessary in order to ensure that the contractual agreements work as intended and to establish appropriate protective measures under circumstances arising prior to, at and after the separation. Further, although separation agreements can define the relative rights and obligations of a parent company and a carve out business as between each other, they may not be effective to bind a third party. For instance, a parent company might agree with its spinco that a particular litigation or other contingency is the spinco’s responsibility, but frequently this will not stop litigants, creditors or other claimants from seeking recourse against the parent company anyway. For this reason and others, the indemnity provisions of the separation arrangements are crucial to ensuring that economic responsibility for particular matters ends up in the place intended.
Greenberg: It is very important for buyers and sellers to establish clear protective provisions in their transaction agreements, particularly where the carve out business has not previously operated on a standalone basis. Buyers typically seek detailed representations and warranties and interim operating covenants to ensure the business is what the buyer expected when it agreed to a valuation. In the current environment, we may see additional representations specifically tailored to address COVID-19 related risks. Conversely, sellers typically seek to limit their potential post-closing indemnity and other liabilities, and often request buyers accept no or limited survival periods and limitations on buyer’s recourse. In these situations, buyers can obtain representation and warranty insurance to protect themselves against these risks. However, such policies do have limitations, including for known risks, and are not a substitute for buyers’ need to conduct thorough pre-signing due diligence, which insurers will require prior to underwriting the insurance.
Castillo: There has been an increase in the use of transaction risk insurance, such as representations and warranties (R&W) insurance, in the past couple of years. Transaction risk insurance was developed to facilitate transactions and addresses indemnification issues that arise during due diligence or negotiation that may prevent the transaction from being closed. Transaction risk insurance provides meaningful benefits to both sellers and buyers. For sellers, such insurance can reduce or eliminate a holdback or escrow and contingent liabilities. This allows sellers to maximise proceeds, get paid faster and have a cleaner exit. For buyers, transaction risk insurance can help their bids look much more attractive to sellers if there is no or limited holdback or escrow required, since buyers will rely on the insurance for indemnification protection. Additionally, such insurance can enhance or increase the amount of protection for buyers. One thing worth noting is that transaction risk insurance does not replace the need for proper due diligence. On the contrary, insurance companies rely on due diligence reports to underwrite such insurance.
“The indemnity provisions of the separation arrangements are crucial to ensuring that economic responsibility for particular matters ends up in the place intended.”
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?
Greenberg: Successfully separating a business, while minimising tax liability, is often a high priority in these transactions. Although the 2017 tax reforms reduced the US corporate tax rate, companies still seek to structure carve out and spin off transactions in the most tax-efficient manner possible. Subject to satisfying certain tax requirements, spin offs or split offs can be accomplished on a tax-free basis. We have also seen increased interest in tax-free Reverse Morris Trust transactions involving a spin off or split off of a business immediately followed by its merger with a counterparty. While carve out sales for cash are typically taxable, the tax impact may be mitigated depending on the structure, and there may be benefits to the buyer in obtaining a step-up in asset basis. In these transactions, it is critical to get the tax, business development, legal and treasury teams and outside advisers on the same page and working in sync early.
Castillo: Tax liabilities and exposures can add significant challenges in a spin off or carve out transaction as buyers generally want sellers to cover such amounts. However, tax liabilities typically do not crystallise for months, sometimes years, after close – in other words, time periods much longer than either party wants to escrow funds. Historically, buyers and sellers would usually risk weight the tax liabilities and price them into the deal; sometimes, the parties would agree to remain bedfellows for years until tax years close for examination. However, transaction risk insurance has become the new normal to cover tax liabilities and exposures. By shifting the risk to a third-party insurance company, buyers and sellers can now focus exclusively on the business, while leaving the taxes to the tax experts to deal with. Structuring a spin off or carve out in a tax efficiency manner is paramount. Often, significant value can be unlocked by deferring corporate and shareholder taxes. Unfortunately, each carve out or spin off transaction is unique, and there is no magic bullet to achieve tax efficiencies. Tax advisers need to be brought in early to the adviser team to determine if a tax-free transaction is possible, or, alternatively, if the transaction would be taxable, how best to mitigate triggering any unnecessary tax liabilities.
Bonnie: A primary driver of spin offs is their tax efficiency. Unlike a carve out sale, a spin off represents the opportunity for a parent company to divest a business in a transaction that is tax-free to its stockholders. The rules in the US tax code that govern tax-free spin offs are exceedingly complicated and the preconditions for tax-free treatment can limit the candidate businesses for a spin off, as opposed to a sale. The parent in a spin off may ask the US Internal Revenue Service (IRS) to provide a private letter ruling that supports the desired tax-free treatment of the transaction based on its particular facts and plan for separation. Even if such a ruling is received, the parent almost universally receives an opinion of counsel confirming certain requirements for tax-free treatment, upon which the IRS will not rule. Achieving the desired tax outcome in a spin off depends not only on how the separation is effected, but also on the actions of both the parent and spinco after separation.
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?
Bonnie: Significant attention is required to craft the agreements governing the separation to effectively allocate assets, rights, liabilities and operations and to design principles and mechanisms that can address unforeseen issues, such as bankruptcy or termination risk for each party. Parties will need to undergo a careful diligence exercise when structuring the deal to uncover potential issues, including each party’s needs after closing. Existing proprietary assets should be diligenced to determine their rightful owner, which is ordinarily the primary user, and existing contracts will need to be reviewed carefully to determine whether a divested or retained entity is the counterparty and whether assignment, change of control provisions or other key provisions would be triggered as a result of the transaction. For example, depending on the language in each contract and the applicable governing law, sometimes when a business that is a licensee or party to a contract is being divested, the transaction may be deemed an impermissible assignment due to the change in the owner of the carve out or spinco business, notwithstanding that the identity of the contractual counterparty did not change. Further, a partial assignment may not be permitted so as to permit the divested and retained business to share the contract. Moreover, the contract may be held at the parent company level and not be available to the divested business after closing.
Castillo: A challenge during the carve out or spin off process is addressing shared functions, including personnel, processes and systems, third-party contracts for customers, vendors and partners, and assets such as facilities and IP. As part of defining the deal perimeter, sellers decide which party, the parent or the business to be divested, keeps these shared functions, third-party contracts and assets. Generally, the parent gets to keep these unless they are predominantly used by the business to be divested. The party that does not get the shared functions, third-party contracts and assets will need to find ways to replace them. For shared functions, there is sometimes room for negotiation between the seller and the buyer, especially when it comes to deciding who keeps shared personnel. Sellers are often willing to negotiate, because not only would it help get the transaction done, but it would also help mitigate stranded costs which some of these shared personnel will become. It is important that, during these negotiations, neither the parent nor the business to be divested is allowed to cherry-pick the best resources. Post-close, a TSA can enable a smooth transition until the buyer is able to replace the shared functions. For shared third-party contracts, the party that does not get the contract will need to either subcontract to the other party or negotiate a new contract with the customer, vendor or partner. Subcontracting can limit the ability of the subcontractor to access the third party or control the terms of the relationship. On the other hand, subcontracting can help the subcontractor avoid loss of leverage, which can be very important with vendor relationships. For shared assets, the party that does not get the asset will need to either negotiate an arms-length contract with the other party for the right to continue to use the asset post-close or find another company that will give them access to a comparable asset. As with shared functions, there is sometimes room for negotiation between the seller and the buyer, especially when it comes to deciding who keeps shared facilities. Post-close, a TSA can enable a smooth transition until the buyer is able to replace the shared assets.
Greenberg: When separating assets in a carve out or spin off, the parties need to carefully review how the transaction structure may impact any change of control and anti-assignment clauses in the contracts, licences and permits of the separated business. For example, a transfer of stock may not trigger an anti-assignment clause in a contract that does not otherwise contain change of control or similar language. Where third-party consents are required, the parties will need to consider the possibility that consent cannot be obtained. While it is common to provide for workaround arrangements under which the economic benefits and burdens of the contract will be passed along, these arrangements can be less desirable than having the contract assigned outright, and the arrangement may be challenged by the contract counterparty. Thus, the parties to these transactions will need to carefully consider third-party consent requirements as part of their discussions.
“Companies may be forced to divest business units or assets that are underperforming or no longer core to their strategy in order to improve their capital allocation and liquidity.”
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?
Castillo: All indications suggest that divestments will continue to be an important part of the future plans of many companies. According to several market surveys, over 80 percent of companies plan to divest in the next two years. Additionally, expectations are high that activist investors will lead the push for more carve outs. An economic slowdown may also lead to a further increase in carve out and spin off activity, just as it did during the 2007-08 financial crisis. Companies may be forced to divest business units or assets that are underperforming or no longer core to their strategy in order to improve their capital allocation and liquidity.
Greenberg: The duration and ongoing impact of the COVID-19 crisis is difficult to predict at this point. While spin off and carve out activity levels are likely to be reduced during the crisis, we do expect to see more spin offs and carve outs once market conditions stabilise. Companies impacted by the crisis may have an even greater need for liquidity and a desire to focus on their core businesses and may see these transactions as a path to achieving that. If buyer interest is limited, we may see more spin offs as an alternative to carve out sales. Shareholder activists who have historically pushed for these types of transactions to unlock value may continue to do so. Furthermore, distressed companies may pursue carve out sales as they restructure their operations. At the same time, financial and strategic buyers with the capital to make acquisitions may see this as an opportunity to invest in undervalued businesses.
Bonnie: Corporate tax reform in the US has lowered the tax drag of carve outs and other strategic options. As a result, this may lead to companies utilising spin offs less often as the potential comparative tax advantage associated therewith has narrowed. However, both carve outs and spin offs will continue to remain options that companies will consider when evaluating which potential strategic alternative can deliver the most value in each specific circumstance.
Alan Castillo has more than 20 years of experience executing M&A, divestitures and strategic partnerships. He brings deep knowledge in pre- and post-close strategic and operational diligence, planning, implementation and optimisation. He is the national leader of the transaction advisory services (TAS) operational practice, which helps clients address the operational aspects of transactions to maximise value and minimise risk. The practice provides corporate and private equity clients operationally focused transaction services. He can be contacted on +1 (415) 490 3107 or by email: ajcastillo@bdo.com.
Josh Bonnie is co-managing partner of Simpson Thacher & Bartlett’s Washington, DC office and is one of the preeminent IPO lawyers in the nation. He regularly counsels public companies on spin offs and other significant strategic transactions, capital markets offerings and general corporate and securities law matters. He has been featured in The American Lawyer’s ‘Dealmakers of the Year’ and is recognised in Chambers Global: The World’s Leading Lawyers for Business. He can be contacted on +1 (202) 636 5804 or by email: jbonnie@stblaw.com.
Thomas W. Greenberg is a corporate attorney whose practice focuses on M&A, both negotiated and hostile, private equity investments, securities transactions and other corporate matters. Mr Greenberg represents public and private buyers, sellers and target companies, private equity firms and investment banks in a variety of US and cross-border acquisitions and dispositions, investments, joint ventures, restructurings and financings. He also counsels companies on shareholder activism, securities law compliance and corporate governance matters. He can be contacted on +1 (212) 735 7886 or by email: thomas.greenberg@skadden.com.
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