The challenges of carve-out M&A transactions during covid

Coronavirus has impacted all merger-and-acquisition activity, but it has impacted carve-outs even more.

Carve-out transactions are likely to increase because of covid-related economic stress (carve-outs occur when a large parent company decides to sell off a unit). Acquirers such as private equity firms or strategic corporate buyers can then acquire the carved-out unit. Since the carved-out business oftentimes lacks some of the shared back-office functions and typically has underperformed the parent, more heavy lifting is required to stabilize and grow these businesses. Therefore, there is a great opportunity for the buyer to make excess risk-adjusted returns, but carve-out transactions, especially during the pandemic-caused lockdown, carry additional risks and complexity.

Pradeep Khurana, ContinuServe

Given the shock to the economy caused by covid – including supply chain interruptions, retail store closures, business operation shutdowns and increased unemployment – many businesses are facing reduced revenues and worsened cash flow. This economic shock, which was a dramatic change from the strong economy and historically low unemployment in 2019, is forcing boards and CEOs to re-evaluate their business units. In order to improve cash flow, more companies may look to divest non-core or underperforming divisions to generate sale proceeds and to focus the business.

Carve-outs are complex decoupling of business units. This involves separating customer and vendor contracts, insurance, employment relationships, partnerships, sales commission structures and IT systems. Carve-outs also can be litigious if the buyer has trouble separating the unit successfully and/or if there were undisclosed liabilities. People issues are also very complex, and these need to be resolved to avoid litigation and to have a successful operational separation.

Coronavirus has impacted all merger-and-acquisition activity, but it has impacted carve-outs even more. The lockdowns caused by covid add additional challenges for buyers and sellers of carve-out units. For example, safely traveling and conducting in-person meetings are particularly challenging for carve-outs, in which the businesses need to be physically separated and there are a lot of cross-functional meetings required. It is also challenging to hold welcome town halls to explain the transaction to employees. Due diligence meetings and inspections of plants and facilities are particularly difficult.

The acquisition of a standalone business also requires on-site diligence, but at least in these situations the acquired company does not need to recreate systems, processes, brand names and rebuild shared back-office functions. Also, carve-outs typically pose more trauma on an organization since many more processes, leadership, business model and parent dependencies are changing.

There are several key factors for a successful carve-out:

Have a well-drafted, comprehensive Transitional Services Agreement (TSA). The TSA outlines services that the parent selling the company will continue to provide. This includes providing human resources, sales support, IT systems and financial processing for a set period of time on a third-party basis. The TSA is key to providing a smooth landing for the buyer to acquire the carved-out unit.

Have a chief transition officer to help complete the operational carve-out and lead the carve-out task force. Having a key person responsible for the carve-out ensures one person is accountable for delegating responsibility for the myriad transitional tasks.

Focus on deep functional diligence to understand the full scope of what business functions are and are not included with the business. It is important that the buyer understands all of the functions that are and are not included with the business so they can understand the true performance of the carve-out unit. This also ensures that all key functions can be put in place.

Leverage advisors who understand the functional issues of a carve-out (ideally have financial, legal, human resource, real estate and IT experts help with the due diligence and transition execution). Carve-outs require specialized knowledge and there are a lot of steps to consider. By bringing on the right advisors, the buyer can focus on strategic issues.

Since carve-out transactions require more work and more specialized M&A skills, there tend to be fewer interested buyers. This leads to less bidding competition, which leads to lower purchase prices and more buyer friendly deal terms. This then can equate to higher risk adjusted returns. The stress caused by covid may create opportunities for distressed funds and strategic acquirers to pick up orphan units.

By Pradeep Khurana, co-founder and managing director of ContinuServe. Founded in 2003, ContinuServe is a leading provider of back-office consulting and outsourcing services to mid-market companies. ContinuServe is headquartered in Cambridge, Massachusetts and maintains delivery capabilities across the US and globally.

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