Q&A: Spin offs & carve outs: managing risk and creating value
June 2019 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
June 2019 Issue
FW speaks with Alan J. Castillo at BDO USA LLP about managing risk and creating value through spin offs and carve outs.
FW: How would you characterise recent activity in the carve outs and spin offs arena? What overarching trends and developments are you seeing?
Castillo: There has been an uptick in divestment activity in the past few years. 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. 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, 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.
FW: What kinds of factors typically compel a company to divest a unit of its broader business? What benefits and opportunities does this potentially create?
Castillo: More 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, including 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 remaining core business, invest in new technology, products, markets or geographies, pay down debt, make an acquisition, and return funds to shareholders.
FW: How important is to fully understand the scope of a carve out or spin off transaction from the outset? What steps should be taken to assess and define the perimeter?
Castillo: It is very important to define the perimeter of the carve-out transaction or ‘what is in and what is out’ from the outset. The business to be divested can be defined differently by executives and functions within the organisation. The business’s financials are often prepared utilising historical data that contains improper allocations, excludes certain costs and does not truly reflect the business to be divested. It is, therefore, critical to get alignment on the deal perimeter across everyone in the company. Defining the deal perimeter is an important first step in the divestiture process. A seller can then develop a standalone operating model which can help package the business being carved out to maximise its value. Transaction prices are typically based on the business’s earnings before interest, tax, depreciation and amortisation (EBITDA), so it is important for sellers and buyers to understand the standalone recurring costs or the costs of running the business when developing their valuation models. When corporate and shared services are involved, sellers and buyers need to analyse the business’s existing allocated costs and other operational changes that will result from the carve out – such as loss of leverage on vendor contracts – in order to understand the standalone cost model. The seller must have a clear understanding of the standalone costs and what it will take to carve out the business early in the process. If the seller is unable to answer detailed standalone cost questions from buyers during due diligence, buyers will increasingly focus on that area and potentially gain control of the negotiation. Sellers will more likely recognise greater value by presenting a standalone cost model, because it will help give buyers confidence in the business’s operating model and that it has been properly prepared for sale with a comprehensive separation plan. There are additional benefits to developing a standalone operating model. It will assist with defining the transition services agreement (TSA), identifying one-time separation costs and mitigating stranded costs. Additionally, the standalone cost analysis will be a good foundation for the seller’s separation planning and the buyer’s integration planning, both of which will be greatly accelerated.
FW: Could you provide an insight into some of the common challenges or pitfalls that tend to surface during a carve out or spin off process? What steps can buyers and sellers take to resolve or avoid such problems?
Castillo: The 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 the businesses they are acquiring by day one. Unfortunately, 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 the 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 sellers in TSA discussions, which conveys the advantage to the sellers. 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.
FW: How important is it for buyers and sellers to establish appropriate protective rights, warranties and indemnities? How should they go about managing the associated risks?
Castillo: There has been an increase in the use of transaction risk insurance, such as representations and warranties 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. There are three types of transaction risk insurance: representations and warranties, tax indemnity and contingent liability. Representations and warranties insurance provides coverage for financial losses resulting from breaches of the representations and warranties made by the seller in the sale and purchase agreement (SPA). Tax indemnity insurance provides coverage for the financial consequences of an intended tax treatment being disallowed by the relevant tax authority. And contingent liability insurance provides coverage for ‘one-off’ identified potential exposures that have not yet been defined. 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 the 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.
FW: When negotiating a transaction, what change of ownership considerations need to be made, such as licensing agreements, asset distribution contracts, post-close arrangements and ongoing support?
Castillo: Another 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 intellectual property (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 the 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.
FW: What essential advice would you offer to companies in terms of managing the separation and transition process to create long-term value and mitigate the risks involved?
Castillo: It is crucial to plan and organise the separation and transition process. Divestitures can be very complex, because of the extensive interdependencies among functional areas, processes and systems. Over years, the operations of business units can become entangled with that of the parent and other business units through the implementation of shared services and consolidation of systems. In order to cleanly carve out a business while preserving its value, strong executive leadership, capable project management and effective communications are needed. Robust programme governance structure and processes are required to enable separation teams to understand the operational interdependencies and the critical path to disentangle them, as well as to develop aggressive yet achievable timelines for the carve out. Value erosion can occur during the carve-out process. Often, sellers see the divestiture as a sale of fixed assets and not as the sale of an ongoing business whose value depends on stability. With senior management engaged in the sale process, it is essential to devise a separation strategy that promotes operational continuity and interim performance throughout the entire divestiture. As the divestiture progresses and a deal is signed, it will be important for the seller to work with the buyer to define ‘what day one will look like’. Failure to properly consider the buyer’s 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 standalone, ready-to-run business.
Alan J. Castillo has more than 20 years of experience executing mergers and acquisitions, divestitures and strategic partnerships. He brings deep expertise 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, and has provided leadership on transactions ranging in size from $50m to $10bn. He can be contacted on +1 (415) 490 3107 or by email: firstname.lastname@example.org.
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