May 2021 Issue
Spin off and carve out transaction activity was adversely impacted by the coronavirus (COVID-19) crisis and resulting business disruption, with many divestiture processes put on hold amid global uncertainty. However, with market participants regaining confidence and the economic outlook improving, recent months have seen more robust deal activity. Going forward, as the global economy emerges from the pandemic, there is likely to be a considerable appetite for spin off and carve out transactions among buyers looking to refocus on core activities, and sellers seeking attractive assets.
FW: Over the last 12 months or so, have you seen an increase in carve outs and spin offs? How would you describe the market for these transactions, including the appetite of financial and strategic buyers to acquire these assets?
Holgate: Although global M&A deal activity in the last 12 months was impacted by the coronavirus (COVID-19) pandemic, especially in the first half of 2020, over the last 12 months, a number of multibillion-dollar deals still completed in 2020 and overall deal volumes remained high due to a strong recovery in the second half. The number of spin offs in 2019 was the second highest in the past decade and we see this trend continuing as we emerge from the pandemic, shareholders look for increased value and corporates refocus their priorities. We expect private equity (PE) interest in carve outs to remain high, with pressure on PE houses to put their substantial uninvested capital to good use – indeed, some of the largest PE deals in 2020 were acquisitions of carved out business units. Where there is a lack of attractive standalone businesses for sale, financial and strategic buyers will consider complex carve out targets.
Glover: During the early part of 2020, the market for carve outs and spin offs was very active. When the pandemic struck, the market stalled. For several months, existing deals were put on hold and very few new deals were announced. In the fall, however, as market participants regained confidence and the economic outlook improved, the pipeline began to refill. Today, there is considerable appetite for these transactions among both buyers and sellers. On the sell-side, companies are thinking hard about their business models and are identifying non-strategic assets that can be sold or spun off. On the buy-side, strategic buyers are looking for ways to jump-start growth as the economy emerges from the pandemic. PE firms have large amounts of unused capital that they are seeking to deploy and have become active participants in many carve out auctions. Special purpose acquisition company (SPAC) promotors searching for targets have indicated that taking a business unit public through a carve out acquisition can represent an interesting opportunity. Activists, who were relatively quiet in 2020, are stirring the pot.
Greenberg: Corporate carve out and spin off transaction activity was adversely impacted by the COVID-19 crisis and the resulting business disruption and market volatility during the first half of 2020. Many divestiture processes were put on hold during the early stages of the pandemic as businesses struggled to maintain their operations, and buyers were unwilling to pay pre-pandemic valuations in the face of global uncertainty. As we entered the second half of the year, deal activity gradually picked up, and we finished 2020 on a high note with a robust level of carve out and spin off transactions as market conditions improved. We are seeing this trend continue in the early months of 2021 and believe that market conditions are very conducive now to companies considering these types of divestiture transactions. Divesting parties are pursuing carve outs and spin offs to focus on their core businesses as the economy recovers while increasing their capital resources and reducing debt taken on during the pandemic. At the same time, financial and strategic buyers are pursuing carve out acquisitions as an opportunity to acquire businesses at attractive valuations in a competitive M&A market. We are also now seeing SPACs starting to participate as buyers in carve out divestitures, further fuelling activity levels.
Ulmer: Carve outs and spin offs have been quite popular for a while and there are good reasons to believe that this trend will continue for the foreseeable future. For a start, financial and strategic investors have both the resources as well as the appetite to take up the respective assets. Financial investors are continuously searching the market for appropriate targets, while strategic investors use these opportunities to complement their core businesses and to grow their revenues in times when such a goal can hardly be achieved organically.
“Early planning for a carve out or spin off is critical to ensuring the success of the transaction and avoiding pitfalls as the transaction process unfolds.”
FW: What kinds of factors typically compel a company to divest a unit? What benefits and opportunities does it potentially create for the parent company?
Glover: A company may decide to divest a business unit when it concludes that continuing to operate that business no longer fits with its strategic vision. It may decide that the business offers fewer opportunities for growth or less profit potential than other businesses. Or it may determine that the business does not fit well with its other business units, for example because it has different capital needs or serves different types of customers than the other units. By disposing of the business, management can focus more on the businesses that offer better growth or profit opportunities. A company may also decide to divest a business unit for financial reasons. If the company feels pressure to generate cash, a carve out disposition in which it sells a business unit to a third party may provide a good solution. The desire to bolster a faltering stock price may also come into play. The markets often react well to such divestitures, particularly when the proceeds are used to support stock buybacks or dividends to stockholders. In addition, stock markets tend to value so-called ‘pure play’ companies that operate in a single market more highly than companies that operate a number of diverse businesses.
Greenberg: There are several factors supporting the decision to divest a business unit. Divestitures, whether by carve out sale or spin off, provide a means for companies to divest non-core and underperforming operations and unlock parent company value that may not be reflected in its stock price based on a valuation of each separate business. Shareholder activists and other investors have long been supportive of divestitures as a value-enhancing action for companies whose operating performance or market valuations are held back by disparate or underperforming businesses that are not achieving their full potential. In addition, the cash proceeds from a divestiture, whether from a third-party buyer or from debt placed on a business to be spun off, also provide the parent the ability to improve its liquidity and reduce leverage. Spin offs and split offs have the added benefit that they may be structured in a tax-free manner to the parent and its shareholders, assuming applicable tax requirements are met. Finally, companies use carve out sales to satisfy regulatory divestiture requirements in larger M&A transactions involving the parent.
Ulmer: It used to be common practice to build conglomerates in order to create internal synergies for the group and factual hedges. For example, where business A is not doing well, business B might be doing better and could support the affiliate. Now, with carve outs and spin offs, we see the opposite: conglomerates are broken up. Often the hope of achieving internal synergies for the group proved to be too optimistic a goal. Further, the market tends to put a higher value on the respective parts of the group rather than on the group as a whole. Additionally, certain businesses that are no longer able to meet the group’s performance expectations could trigger a divestiture, especially in cases where the strategic focus of the group has shifted.
Holgate: Increasingly, organisations are looking at alternative strategies to remain competitive, maintain or increase profitability and add value for their shareholders. The decision to divest might be generated internally or brought about through pressure from activist shareholders demanding greater return on their investment, a more streamlined and focused organisation or the divestment of business units for other reasons, such as environmental, social and governance (ESG) or regulatory reasons. Not only does a spin off or carve out have the potential to unlock substantial value for shareholders, the parent group can refocus on core businesses and improve operational efficiencies, without having to spend time and resources on non-core and underperforming business units. The retained businesses will have greater flexibility to pursue their own focused strategies for growth – whether organic or through acquisitions – and serve their own distinct customers independently, without having to compete with the divested business unit for management time or the capital to do so.
FW: How important is it to fully understand the scope of a carve out or spin off from the outset, and to assess and define the perimeter?
Greenberg: Early planning for a carve out or spin off is critical to ensuring the success of the transaction and avoiding pitfalls as the transaction process unfolds. Having a clear definition of the scope of the business, assets and liabilities to be included in the transaction is necessary from the outset to be sure that the agreements for the transaction, as well as the financial statements and offering materials of the business to be divested, are being prepared on a basis that reflects what will actually be divested. In a carve out sale, the corporate seller will want to be sure that potential buyers clearly understand what is included so that they can reflect that in their bids to acquire the business and avoid disputes later on in the negotiations about whether specific assets or liabilities are or are not included in the sale. This is particularly important for shared assets that are used both in the business to be divested and in any retained business. In a spin off, the description of the business, assets and liabilities in separation documents and the Form 10 registration statement to be filed with the US Securities and Exchange Commission (SEC) will need to reflect the perimeter of what will be included in the spun off entity. These types of decisions should be made early in the process to avoid misunderstandings that could delay or disrupt the transaction.
Holgate: It is extremely important to define the scope and perimeter of the divestment early on. However, it is equally important to ensure that the approach taken remains flexible in order to adapt to issues which may arise. The definition of the scope and perimeter of the deal kicks off multiple workstreams as you focus on what is included and what is excluded and work to package up and present the unit to be divested. It is also necessary to determine the links between the two and the work required to separate these links – or put them on a third-party footing. If the goal posts move, the work will need to be adjusted and updated. This can cause timing delays or lead to new issues becoming key gating items to be resolved. However, with good planning and anticipation, it is often possible for later changes to be factored into the overall timetable without having a significant impact on the wider transaction.
Ulmer: For structuring a carve out or spin off, understanding the respective businesses – the one to be carved out as well as the remaining business – is pivotal. Following the transaction, both businesses need to exist on a standalone basis without either part suffering a loss in value. What is important is that both parts gain in value as a result of the carve out or spin off. Ideally, the scope of the carve out should be clear from the outset. Often, however, this is not the case and the scope is only understood and becomes more specific over the course of the transaction. Interestingly, even the owners develop a much better understanding of their businesses once they start working on a carve out.
Glover: Clearly defining the business being carved out or spun off is a key driver of the deal planning process. The transaction planners should not launch the carve out or spin off until they identify with specificity the business to be disposed of, determine the assets or transition services the business needs to operate successfully and list the liabilities that are attributable to the business. Until they have accomplished this task, they cannot develop a plan and tax strategy for packaging the assets and liabilities so that they can be sold or spun off. They will not be able to persuade a buyer that the business unit being sold is an attractive target, nor will they be able to prepare the disclosure documents required by the SEC in a spin off. In addition, until the transaction planners have determined the perimeter, they will not be able to prepare financial statements for the unit being divested. The SEC requires audited financial statements in spin offs, and most buyers will insist on receiving audited financial statements in carve outs. The perimeter definition also has a critical impact on important deal terms, including the scope of intellectual property (IP) licences and covenants not to compete.
“Spin offs and carve outs are complex transactions that have lots of moving pieces and require input from many disciplines.”
FW: What change of ownership considerations need to be made when structuring the deal? What steps should be taken to organise the separation and transition process?
Ulmer: The main task is to create a business that could be run successfully on a standalone basis. The owner needs to resist the temptation to carve out what is perceived as a burden to the group, unless the carve out assets can create something viable. The process starts with a feasibility study, followed by a more specific definition of the carve out business. The way the separation is structured is at least as important as equipping the carve out business with what is required for it to run independently.
Glover: Spin offs and carve outs are complex transactions that have lots of moving pieces and require input from many disciplines. Transaction planners not only have to define the perimeter, they also have to identify regulatory or contractual hurdles to completing the transaction. On the legal side, they need input from a variety of disciplines, such as corporate, tax, antitrust, employment and employee benefits, IP and commercial transaction specialists. In a carve out, the buyer is likely to engage in extensive diligence. In a spin off, a similar diligence effort is required to prepare an adequate disclosure document. Carve outs require the negotiation of a complex purchase agreement and, especially in asset deals, preparation of detailed schedules. If the transaction involves a global business, extensive consultation with local counsel may be required. The buyer and the seller may be required to make antitrust or other regulatory filings around the world. Given these complexities, detailed checklists, timing and responsibility charts, and frequent conference calls are an absolute necessity.
Holgate: Many organisations are run in highly integrated ways to achieve operating efficiencies, with shared premises, assets, services, systems and people and commingled supplier and customer contracts relating to more than one business. Separating a business embedded within the wider group in this way requires significant diligence to determine the actions necessary to implement the ultimate change of ownership. For example, it may be necessary to obtain counterparty or regulatory consents, complete additional or new registrations and engage with employee representative bodies, in some countries, before a definitive decision to divest is made. The key is planning. Take each workstream, plan through the high-level milestones and the detailed tasks and align with other workstreams, plan for both the initial separation and day one readiness, and the longer-term transition to being independent businesses going forward. Both are equally important.
Greenberg: When separating assets in a divestiture, the parties will need to carefully assess the impact of the transaction on change of control and anti-assignment clauses in the contracts, licences and permits of the separated business. There may also be shared contracts, licences and permits that benefit the parent’s other businesses that will need to be split or replicated as part of the separation process, and the parent may also have in place guarantees of the obligations of the divested business that need to be addressed as part of the transaction. To be prepared to address these items, it is important for the divesting party to identify a team early on to conduct self-diligence to identify the potentially problematic areas and determine how best to address them. From an operational standpoint, the parent should also identify a team to consider the steps needed to prepare the business to be ready to operate on a standalone basis once it is separated and whether it will require ongoing services or other commercial arrangements from the parent post-closing to operate independently. The parent should also consider whether there may also be a need for reverse services to be provided by the divested business back to the parent post-closing.
“Negative tax implications can kill a deal, and often do. Even if the potential business is already independent, tax aspects could undermine the plan.”
FW: Could you provide an insight into some of the common deal breakers that surface in carve out and spin off deals, and how such problems can be overcome?
Glover: Regulatory issues, such as the need for antitrust clearance or other regulatory consents, are common deal breakers in carve out deals. Parties may try to proactively address these issues by engaging experts early to help analyse potential issues and advocate for the deal with the government, collecting and organising the information the government is likely to request and contacting the regulators before making required filings to present support for the deal in advance. Similar issues also arise with respect to third-party consents or licences to transfer particular assets or conduct target businesses. Deciding when to approach the third party to seek consent can be tricky. You must balance the desire for deal certainty with concerns about giving the third party ‘hold-out’ value. Spin offs may also be abandoned if critical approvals cannot be obtained, although antitrust concerns are less likely to present issues in spin offs. Other deal breakers for a spin off include market conditions and doubts about the spun off entity’s viability as a standalone public company. The latter may be overcome by transferring additional revenue-producing assets to the spun off entity.
Holgate: If the proposals create a large unmitigated tax liability, that can be a deal breaker. If a deal gets to signing, the conditions to completion are typically antitrust clearances, shareholder approval and completion of any pre-closing separation, which may require local regulatory approvals. Increasingly we are also seeing specified foreign direct investment (FDI) approvals as conditions to completion and these are taking more time and effort to obtain. Sometimes the diligence on the transaction perimeter leads to the realisation that the business unit to be divested contains crucial elements required for the remaining business. This may lead to a change in perimeter or additional transitional or ongoing commercial arrangements but can also be a showstopper if there is no acceptable solution available. Early focused diligence is key to identifying the deal breaker issues upfront and ensuring there is a structural or contractual solution before incurring significant time and expense.
Greenberg: One issue that commonly comes up in carve out negotiations relates to the scope of the parent’s retained liabilities and indemnification obligations. Sellers typically seek to limit, as much as possible, the pre-closing liabilities of the business retained by the seller and the risk of post-closing claims from the buyer, while buyers typically seek to protect themselves against pre-closing risks and seek indemnification for breaches and specified retained liabilities. These differences can be overcome with negotiated caps, baskets and other limitations on the seller’s indemnification obligations and through the use of representation and warranty insurance, which has become increasingly prevalent in carve outs. In spin offs, where no buyer counterparty exists, the parent has greater flexibility to shift liabilities to the spun off business as it deems appropriate, subject to ensuring that the spun off business is solvent. Another key issue to resolve is the scope of assets and contracts included in the divestiture, particularly the treatment of shared assets and shared contracts and contracts where third-party consents are required. The parties may need to negotiate licences, service agreements and other commercial arrangements to address these issues. In a carve out sale, the parties will also need to negotiate the allocation of risk related to regulatory approvals needed to complete the deal, which can be addressed through contractual limits on the buyer’s obligation to accept regulatory remedies that exceed specified materiality thresholds and reverse termination fees payable by the buyer if it is unable to obtain the approvals.
Ulmer: Tax aspects and IP rights are often discussed when the feasibility of a carve out or spin off is assessed. Further, workforce and pension liabilities play an important role in structuring a separation. Respective costs and liabilities need to be allocated between the businesses, as sellers are more likely to shy away from restructuring a business first after the decision to divest has been made. Finally, transitional services need to be agreed for an interim period so the carve out business can be continued until it is integrated into the purchaser’s group. All these elements, if not addressed, could turn into significant hurdles for a transaction. When structuring the carve out, sellers should be guided by what they would wish to acquire, should they be in the purchaser’s position. The costs for achieving these objectives are then subject to negotiation among the parties.
FW: What advice would you offer on structuring the deal in a tax-efficient manner, to address actual or potential liabilities?
Ulmer: Tax is certainly one of the most important factors when a carve out is structured. Negative tax implications can kill a deal, and often do. Even if the potential business is already independent, tax aspects could undermine the plan. Most deal breaking complexities arise from specific circumstances; therefore, it would be difficult to give general advice. But in any case, tax aspects should be addressed right from the beginning of the structuring process, so a feasibility decision can be made early on.
Greenberg: Structuring a transaction in a tax-efficient manner is often a high priority in divestiture transactions. Corporate sellers typically seek to structure carve out and spin off transactions in the most tax-efficient manner possible consistent with the parties’ business objectives. Transaction parties should ensure that there is careful planning with outside advisers to obtain the best result possible. Having a clearly defined plan for each step of the separation of the business and identifying the tax implications and interdependencies of different steps will help to avoid issues later. Subject to satisfying certain tax requirements, spin offs or split offs can be accomplished on a tax-free basis and can be considered as an alternative to a taxable sale where appropriate. Tax-free Reverse Morris Trust transactions, involving a spin off or split off of a business immediately followed by its merger with a counterparty, may also be considered. The tax requirements for effecting the internal and external separation steps are often complex and will need to be carefully planned for. Companies seeking to implement a tax-free spin off or split off should also consider the need for tax rulings and tax opinions and should factor the time necessary to obtain those rulings and opinions into their transaction timetables.
Holgate: Tax usually underpins the transaction structuring and needs to be given early consideration. On a spin off, for example, a key consideration is ensuring shareholders are not exposed to additional taxes as a result of the spin off. There will be differing rules around tax structuring in different jurisdictions and individual rules and exemptions would need to be analysed to determine the most efficient go-forward structure and the most efficient way of creating it. It may be necessary to seek specific rulings from tax authorities to mitigate the risk of future tax liabilities and agree tax liability sharing arrangements with the business being spun off or the buyer, in the case of a carve out sale. It is also important to balance tax efficiencies with other non-tax considerations. For example, a tax-efficient structure may not work from a business operations perspective or may result in a structure that is difficult to finance.
Glover: Involve tax experts in deal planning as early as possible to explore structuring options. For example, instead of selling assets to the buyer, it may be advantageous to transfer assets and liabilities of the retained business to other parent entities and sell the equity of the company conducting the target business. If the buyer is about the same size as the target business, tax experts can evaluate the feasibility of a tax-free Reverse Morris Trust transaction, in which the parent spins off the target business and the spun off entity merges with the buyer. In some circumstances, they may be able to conclude that the spin off will qualify as tax-free to both the parent and its stockholders under IRC Section 355. From a liability perspective, sellers are more likely than buyers to favour stock sales because the buyer assumes the target’s historical liabilities. Sellers may also qualify for long-term capital gain tax rates in a stock sale. Buyers are more likely to prefer asset sales because it is easier to pick and choose which liabilities to assume, and the tax basis of the acquired assets will be stepped-up to fair market value at closing.
“Early focused diligence is key to identifying the deal breaker issues upfront and ensuring there is a structural or contractual solution before incurring significant time and expense.”
FW: Looking ahead, do you expect to see more of these transactions in the M&A market? What underlying deal drivers are in play?
Greenberg: The lingering effects of the COVID-19 crisis and the expected economic recovery should continue to support carve outs and spin offs for the foreseeable future. Companies impacted by the crisis will likely continue to pursue divestitures to improve their liquidity and shore up their balance sheets. Divestitures will also provide a means to unload underperforming business units and enable companies to focus on their core businesses as the global economy recovers. In addition, we can expect to see shareholder activists and other investors continue their push for carve out divestitures and spin offs to unlock value and improve returns for investors. The strong interest of financial and strategic buyers in acquiring these businesses, together with the recent entry into this market by SPACs, should further fuel carve out activity.
Holgate: We are expecting another busy year of corporate carve outs and spin offs. Pre-pandemic shifts in markets and the effects of the pandemic, including accelerated adoption of new technologies, will reshape the priorities of many corporates. For some there will be a need to create liquidity and reduce debt. Distressed M&A activity could increase later this year. In pandemic-resilient sectors with reliable cash flows, increased valuations could drive deal activity. ESG factors also affect decisions regarding business portfolios. Activist investors play a significant part in influencing divestment decisions and post-pandemic this could become more acute. Proposed divestitures which were put on hold pre-pandemic could resume. Increasing antitrust scrutiny could lead to more carve out disposals to enable the main deal to close. Many corporates, having weathered the pandemic, will be considering ways to rebuild and take advantage of the opportunities created. Finally, the recent surge in SPACs in the market for acquisitions presents additional opportunities for corporates to divest for cash and for carved out business units to be taken public.
Glover: I expect we will see more carve outs and spin offs in 2021 as the forces that began to drive deals last fall continue to gain momentum. On the buy-side, there is pent-up demand from both private equity and strategic buyers as a result of the M&A slowdown that followed the onset of the pandemic. PE buyers in particular have a lot of dry powder. The significant increase in the number of new SPACs looking for targets is also helping to create a sellers’ market. As markets stabilise, activist investors are resuming calls for public companies to dispose of specific businesses. On the sell-side, sellers are eager to take advantage of this demand for deals to sell or spin off non-core assets or businesses, including those that are in distress due to the economic downturn caused by the pandemic.
Ulmer: I do think that we will see this type of transaction for a while. Many corporate groups are still very diversified and activist shareholders have made it a priority to find conglomerates that are valued below the collective value of their individual parts. Financial investors have a lot of dry powder at their disposal and for many strategic investors, picking up carve out assets is the only option available to grow their revenue in the short to mid-term. So, there is no reason for this to dry up any time soon.
Based in London, corporate partner Gillian Holgate has over 30 years’ experience advising on private and public M&A, including carve out sales, demergers and spin offs, joint ventures, reorganisations and restructurings, IPOs and other equity offerings. She has advised public listed and private companies, in the UK, the US and elsewhere and across a range of sectors. Her work is almost always cross-border and often multijurisdictional. She can be contacted on +44 (0)20 3088 3135 or by email: gillian.holgate@allenovery.com.
Michael J. Ulmer’s practice focuses on domestic and international private and public M&A transactions, joint ventures, general corporate advice and private equity transactions. His work extends to a broad range of industries and clients, including leading German corporates, Mittelstand companies, and domestic and international financial and strategic investors. He has vast experience in assisting clients from the Middle East with outbound investments. Mr Ulmer joined Cleary as a partner in 2016. He can be contacted on +49 69 97103 180 or by email: mulmer@cgsh.com.
Stephen I. Glover is a partner in the Washington, DC office of Gibson, Dunn & Crutcher and co-chair of the firm’s global mergers and acquisitions practice. Mr Glover has an extensive practice representing public and private companies in complex mergers and acquisitions, joint ventures, equity and debt offerings and corporate governance matters. His clients include large public corporations, emerging growth companies and middle market companies in a wide range of industries. He can be contacted on +1 (202) 955 8593 or by email: siglover@gibsondunn.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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