Capturing value through carve-outs
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Mai 2011 |
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ERNST & YOUNG S.R.L. |
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+40-21-402.40.00
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+40-21-310.71.93
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www.ey.com
EIGHT WINNING TACTICS BUYERS AND SELLERS CAN USE NOW
“You can look at 100 deals and no two will look quite the same – but the essential steps buyers and sellers shouldbe taking to identify, preserve and enhance value are very consistent.” - Ron Charles, Transaction Advisory Services, Ernst & Young LLP
Resurgence in the global economy tends to accelerate the pace of M&A. Carve-outs are again emerging as an attractive option for both sellers and buyers in terms of raising and investing capital. But whether approaching this market as a buyer or seller, there are tactics that either party can deploy to enhance their desired outcomes.
Counterparties to any deal have both complementary but at times conflicting priorities. Through a stronger understanding of the objectives and priorities of their counterparties, buyers or sellers can generally improve the value of their opportunities.
Typically, a carve-out transaction occurs when part of a business is financially and operationally separated from its parent, usually in advance of an IPO or sale. Before proceeding with a carve-out, however, executives should familiarize themselves with the most visible as well as the least expected sources of value and risk. Consider these scenarios:
- Having negotiated the price for a set of carved-out assets valued at USD 2 bn, a buyer is surprised to discover a substantial up-front cost that had eluded due diligence: acquiring new software licenses. This expense drives a spike in the initial outlay and a steep shortfall in the investment’s expected return;
- In preparing the financial statements for its carve-out entity, which included operations in 10 EU countries, the seller failed to include the human capital with the skill sets needed to turn the assets into a stand-alone business. This intellectual property was not transferred as part of the deal, nor was its cost accounted for in the pro forma financial statements. The seller lost credibility with the buyer, resulting in a significant reduction in the bid.
The complexity of a carve-out presents an array of challenges. Recognizing the needs of the buyer, a seller must be transparent about costs, preparing thorough and accurate carve-out financial statements and providing sufficient and appropriate information. Buyers face a different set of challenges. These include valuing the assets, performing duediligence on the seller’s financial statements, as well as maintaining and continuously updating their own deal analyses. A buyer must also prepare for day one and overall integration – which will likely entail negotiation with the seller for a short-term Transition Service Agreement (TSA).
There are many issues, both significant and subtle, that can surface without notice. But by reviewing any transaction from the perspective of both buyer and seller, executives can avoid surprises, gain a clearer understanding of where value can be created or destroyed and, by following through, make a good deal even better.
AVOID AN INCOMPLETE TAX PICTURE
A carved-out business included land and buildings in a number of jurisdictions. In the past, the choice had been made to enable recovery of value added tax(VAT) incurred in connection with some of these properties. This meant that the properties in question should have been subjected to VAT when they were sold as part of the carveout. But the seller had no tax history of the properties and did not establish its VAT status as part of carve-out planning. Therefore, no VAT was charged and the seller was surprised to learn that the tax was due on the sale. To make matters worse, the purchase contract was silent on the VAT, so the tax could not be passed on to the buyer. Eventually, the buyer shared the VAT cost in return for a more favorable TSA. But the problem could have been avoided if the seller had given careful thought to the tax profile of the carved-out assets before the transaction.
INCLUDE THE RIGHT PEOPLE AT THE RIGHT TIME
Timely and appropriate communication is essential to an effective carveout process. Early on, sellers must determine whom to involve and when. At first, the exploratory team should be small. But as the likelihood of moving forward increases, the group needs to expand to include functional expertise in IT, human resources (HR), accounting, tax and other essential disciplines. This is especially important during the TSA definition and negotiation phase. Effectively managing the chain of communication is also critical. Sellers must preempt potential issues with proactive, clear and concise communications that address major stakeholder concerns. Conveying the messages in a positive, well-structured and properly vetted manner will reduce countless concerns.
Sellers - four steps
1. UNDERSTAND BUYERS' MOTIVATIONS
Understanding a buyer’s rationale is essential for the seller to execute the successful design, marketing and sale of carve-out assets. There are two types of acquirers for carve-outs: corporate strategic buyers and financial buyers. The first group is usually seeking assets to complement their existing business. They may integrate the carvedout assets into an existing operating structure and focus on synergy opportunities.
The second group often seeks to purchase a going concern, or to quickly turn carvedout assets into a stand-alone company. They are typically private equity (PE) firms whose goal is to invest, enhance, grow and then exit. They are primarily focused on after-tax cash flows, the cost structure and the management team within the business.
Given the varied motivations of buyers, it is important for the seller to carefully consider how the sale might be structured and how flexibility can be maintained in the process to market the asset to both financial and strategic buyers. For example, financial buyers will typically have a tax optimization structure within which to incorporate the carvedout business. A strategic buyer will likely need fewer back-office assets than a financial buyer and typically possesses a range of corporate functions, as well as a scalable information technology (IT) platform. While there may be interest in taking on a number of additional staff, particularly in areas where they lack expertise, strategic buyers generally need fewer of the seller’s personnel than financial buyers.
By contrast, a financial buyer who intends to run the acquisition as a stand-alone company is focused on whether the necessary infrastructure and personnel are in place as part of the transaction. If not, the buyer is more likely to require ongoing support from the seller, provided for in terms of TSAs. These are typically fixed-duration contracts for the provision of operational support from the seller. Expectations with regard to scope of services, duration, pricing and performance tracking are critical to both parties. TSAs can facilitate the close date, provide an incentive for the buyer to become self-sufficient and ensure that the business continues to perform as expected postclose but the tax implications of TSAs (in particular VAT implications) require careful consideration.
While buyers are aware of the more obvious synergy opportunities, the seller can enhance the potential value for the buyer by highlighting initiatives in progress, or other matters not evident to the buyer. Through review on a potential buyer, the seller can identify ways that intellectual property could enhance products or services within the buyer’s portfolio. Sellers may be able to maintain or enhance value by directing the buyer’s attention to potential tax synergies inherent in the carved-out assets.
Sellers beware:
SIX OF THE MOST COMMON AND COSTLY MISTAKES
1. Weak executive leadership during any transaction leads to missed deadlines, oversights and errors – all of which will be apparent to the buyer pool and result in value erosion.
2. Inadequate resources, either in number or skills, will impact the timeline. A CFO recently lamented that he was being asked to close the books in November, do the year-end closing in December, complete an ERP implementation and, in his spare time, develop a carveout financial statement and start sell-side due diligence.
3. Weak coordination or governance policies will cause unnecessary roadblocks and frustration. Each deal needs a dedicated steering committee with sufficient support to be able to drive functional teams to develop aggressive, yet achievable timelines and efficient functional work streams.
4. A failure to anticipate would-be buyers’ needs can create many last minute requirements that can frustrate and potentially burn out the transition team. For example, if a deal is material to a public buyer, PE or other financial buyers, then the development of audited financial statements should commence early on. Additionally, sellers should consider tax structures that might be efficient to buyers and sellers in the early stages of the transaction.
5. Insufficient or incomplete thought as to the form of the transaction can potentially result in transferring control of certain key components of the negotiations to the buyer or unnecessary tax leakage. Sellers should consider the potential buyer pool before deciding on the form and structure of the transaction.
6. Failure to properly consider the buyers’ day one functionality requirements could result in significant money being left on the table. Sellers too often focus on their own separation issues and not enough on delivering a stand-alone, ready-to-run business.
