Successful carve outs and spin offs
September 2011 | TALKINGPOINT | MERGERS & ACQUISITIONS
FW moderates a discussion on successful carve outs and spin offs between Jim Loss at Bingham McCutchen, Rick van Dommelen at PwC, and Benjamin Roth at Wachtell, Lipton, Rosen & Katz.
FW: Over the last 12-18 months, have you seen an increase in carve outs and spin offs? Can you explain some of the main reasons why companies might consider carving out and spinning off parts of their business?
Van Dommelen: At the same time as the value of overall M&A activity has fallen by 70 percent since the end of 2007, we observed that the level of ‘carve out’ transactions, involving the divestment of one or more non-core assets, has remained relatively high. Although the value of carve out transactions has fallen by over 60 percent, the volume decreased only up to 15 percent. Due to the economic downturn companies have been forced to sell businesses and to refocus on the regions they used to serve. Moreover, governments were less inclined to liberalise markets because of the economic situation. As a consequence, companies had to reconsider their strategies and ways of doing business. More recently, we have seen a substantial increase in deal volume, including carve outs, in the last six months. Buyers, supported by recovery in the debt market, took their chance to acquire these carved out entities. At the same time, companies were eager to divest quickly to benefit from the positive deal market in the first half of the year.
Loss: The reports that I have seen indicate that corporate divestitures in the US have actually declined somewhat in the first part of 2011, but that private equity firms are playing a much bigger role as buyers than they have historically. As a result, from the perspective of the private equity world, there has been an increase in the number of carve out sales to financial buyers in recent quarters, and correspondingly, a decrease in the absolute number of carve outs with strategic buyers. The principal reason that is usually stated by a seller in a carve out transaction is that the business being divested is not part of the ‘core business’ and that the seller desires to focus its energies on its ‘core competencies’. There are, however, often other reasons for a divestiture. For example, a carve out can simply be a means to raise cash needed to support other corporate operations or to pay down debt.
Roth: We are currently seeing a significant increase in spin offs and corporate carve outs. Examples over the last few months include such large companies as ConocoPhillips’ proposed separation into two public companies, Ralcorp’s proposed spin off of Post Foods, Expedia’s proposed spin off of TripAdvisor and Sunoco’s IPO and proposed subsequent spin-off of SunCoke Energy. A spin off, carve-out or other separation transaction can create shareholder value when a company’s businesses may command higher valuations if owned and managed separately, rather than as part of the same enterprise. These increased valuations can arise from capital markets factors, such as by attracting particular investors who may focus on a sector or growth strategy, and from corporate initiatives such as providing clarity of mission that the markets more easily understand, as well as due to improved business performance by permitting management to focus more closely on the respective businesses, thereby maximising growth of each business.
FW: How would you describe the current appetite of financial and strategic buyers for these assets? What steps can companies take to attract acquirers and maximise shareholder value through the sale process?
Loss: A successful carve out requires a great deal of planning. The business being sold may be owned by several different legal entities within a corporate group, employees active in the business may be employed by a number of different legal entities, and contractual relationships of the business may be scattered around among various members of the corporate family. The more these matters can be sorted out prior to a sales effort, the better. Internal allocations – both ‘real allocations’ of resources and ‘accounting allocations’ for financial statement purposes – need to be thoroughly understood and taken into account in ‘packaging’ the business to be sold. Communication with employees, customers and vendors is also a very important part of the divestiture process.
Roth: Potential buyers – from strategics to private equity firms, sovereign wealth funds and other financial buyers – have substantial cash available for acquisitions and strong acquirers are continually looking for opportunities. Even during the current period of market volatility and uncertainty, the strong will pursue attractive opportunities. In many cases, assets may be available at the low-end of recent valuation ranges, and competition may be reduced due to market and business volatility. Preparedness is key to a successful carve out. Most buyers will expect audited financials of the carve out business, which may take approximately 2-8 months to prepare, depending on whether one of the parent’s financial reporting segments tracks the divested business, and the extent of entanglement of the businesses. Valuations will be highest where the seller can deliver a credible standalone financial model and transition plan, with clear visibility as to how the business ultimately will be separated from the parent.
Van Dommelen: We see, more and more, that sellers frequently need to break up assets that they might once have sold as a whole, into smaller parts, in order to overcome limited bidder leverage. Bidders are also more frequently joining forces in consortium arrangements, particularly for larger deals and are more cautious now than ever before. This implies that for the seller to be successful, a divestment requires much more preparation than before. Today it is essential to bring flexibility into the process by anticipating any potential realistic outcome. To maximise sales value and shareholder value, the seller needs to point out how to reduce the risks related to the separation and how to add value in the separated business. It needs to identify and quantify the upsides for acquirers and articulate these clearly in the divestment plan. Such a plan should include the costs related to the target operating model, setting out, function by function, the necessary headcount and other support costs likely to be incurred, or that can be saved.
FW: What change of ownership considerations need to be made when structuring the deal? For example, what kinds of complications can arise when licensing agreements or asset distribution contracts are involved?
Roth: Detailed due diligence will need to be conducted on a wide variety of agreements and documents. For example, the parent’s debt agreements must be reviewed for covenants limiting asset transfers and restricted payments. It will also be necessary to identify and examine contracts relating to the business to be separated, as assignment and change in control provisions may be implicated depending on which entity is party to the agreement and whether that entity is part of the divested business or will remain behind. Agreements relating to both the divested and remaining businesses – for example, leases for shared office space or licences for shared software – may need to be replaced with separate agreements for each business, or alternatively arrangements need to be made to provide the non-party with the benefits and burdens of such agreements. Further, in regulated businesses, licences may be granted to specific entities and not readily transferable. For these and other reasons, spin offs and carve outs tend to take several months to diligence, negotiate and document.
Van Dommelen: Change of ownership in the context of a carve out generally raises a range of legal concerns that are very deal-specific. For example, as in any M&A transaction, a change of ownership may trigger change of ownership clauses in certain contracts, including licensing agreements or asset distribution contracts. Such clauses generally stipulate a right for the contracting party to terminate the agreement in case the ownership of the other party changes. Such clauses may in practice be used to renegotiate contract terms as well. Change of ownership generally also affects the shared services received from the group and often requires transitional service agreements to be entered into between the selling group and the carve out business, for instance IT services, IP licences and payroll services. In general, it also requires the involvement of works councils and trade unions and sometimes competition authorities.
Loss: The allocation of owned and licensed intellectual property is one of the most difficult issues in many carve out transactions. Sometimes owned intellectual property is shared by the seller and the business being divested and the parties must decide who will continue to own the IP and who will be left with ‘only’ a licence to the IP. Sometimes, however, a seller tries to retain ownership of IP not because it actually needs the IP in its own businesses, but because it is useful to own the IP as a defensive tool, or because the seller is concerned that the IP could ultimately end up in the hands of a competitor when the divested business is sold. Carving up licensed IP also raises difficult issues in that many IP licenses – for example, desktop software licensed under an enterprise level license or enterprise level software used for financial reporting – do not permit the licenses to be divided up between two unaffiliated entities. Licensing of shared trade names, trademarks and services marks can also create issues. Such names and marks may represent a key part of the value for certain products and services, but the seller may not be comfortable with the buyer using these names and marks for a long period of time out of concern that such use will dilute their value to the seller. In these cases, the seller will require the buyer to transition the acquired business to new trade names, trademarks and service marks and the parties will have to negotiate who bears the cost of doing so.
FW: How important is it for buyers and sellers to establish appropriate protective rights, warranties and indemnities in these transactions?
Van Dommelen: Like in any M&A transaction, it is important to establish appropriate protective rights, warranties and indemnities. For carve outs there are generally some specific concerns, for instance relating to defining the carve out business: it should for instance be clear which employees, assets, contracts and so on transfer with the business and which remain with the group. This can be rather complicated, in particular when certain assets are used in both the group and in the carve out business, and employees who work for the entire group and for the carve out business. A buying party would also want to ensure for instance that the carve out business has sufficient assets and employees and for instance IP rights, to run its business. A selling party would want to ensure the opposite.
Loss: Many divestitures to financial buyers require a number of important ancillary agreements which are not often needed in the context of the sale of a stand-alone business. For example, most carve-outs involving a financial buyer require some kind of ‘transition services agreement’ (TSA) under which the seller agrees to provide certain support services to the buyer for a period of time after the closing – generally a year or less – while the buyer gets the new business up and running on its own. Under some TSAs, the buyer also agrees to provide certain services back to the seller for a period of time while the seller fills in a business ‘hole’ resulting from the sale. Many carve-outs with financial buyers also have commercial agreements between the buyer and the seller for the provision of goods or services over a time frame longer than that of a typical TSA.
Roth: Spin off transactions often involve transfers of liabilities from entities that stay behind to entities that are being divested, and vice versa, coupled with indemnities. Care will need to be taken in identifying the relevant liabilities and determining which entity will assume responsibility for them, in light of valuation, tax, accounting and solvency considerations. In a spin off, initially at least, the same shareholders will own both the parent and the spun-off company so from an economic ownership perspective, the shareholders will own the same assets and liabilities following the transaction regardless of where those assets and liabilities reside. However, over time ownership will vary and investors in each company should have reasonable protection that they will not incur liabilities properly belonging to the other business. Likewise, as the tax treatment of these transactions is complex, the parent and spun-off companies need to agree a clear set of rules regarding the allocation of tax risk.
FW: What role can tax liabilities play in making the deal more or less attractive to parties involved? Can you provide an overview of how companies can structure these deals in a tax efficient manner?
Loss: Tax considerations often play a central role in a carve out transaction. For example, a seller with high basis, low value assets may be motivated to sell those assets in order to use the tax loss to shelter taxable income from other operations or to carry-back the loss to prior years in order to receive a tax refund. In some cases, the cash generated by such tax loss ‘harvesting’ can be many times greater than the purchase price being paid for the business being sold. These kinds of situations can, however, sometimes create issues for the buyer, especially in the context of a distressed divestiture. If the buyer is acquiring current assets with a fair value that is greater than the purchase price being paid, the buyer will, in essence, acquire an embedded tax liability that will be realised as these low basis, high value assets are converted to cash, which may result in a much higher effective tax rate than would be expected.
Roth: Tax considerations often determine the form, and occasionally the viability, of contemplated transactions. In general, in order for a spin off or split off to qualify as tax-free to the parent company and its shareholders for US tax purposes, a number of technical requirements must be satisfied, including distribution of ‘control’, business purpose, and five year active business. In addition, a parent company may be able to obtain cash in a tax-efficient manner through debt-financed cash distributions from the spun off company and debt-for-debt or stock-for-debt exchanges. To preserve the tax-free nature of a spin off or split-off, tax sharing agreements typically restrict the spun-off company’s ability to engage in M&A transactions for certain periods following the separation. A common tax issue in carve out transactions, which can have a significant impact on the purchase price, is whether the transaction will be structured as a stock purchase or asset purchase for tax purposes.
Van Dommelen: Managing the cash tax out will increase the value of a deal. This can for instance be achieved in a carve out through a sale of assets to a newly incorporated company upon which a capital gain can utilise available tax losses. At the level of the new company the assets will have a step up in basis which in principle can be depreciated going forward, that is, by lowering the annual taxable profits. Another way may be to optimise the value chain, for example by transferring the intangibles to a lower taxed jurisdiction which subsequently charges royalties to the subsidiaries.
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?
Roth: Pure valuation considerations aside, a potential obstacle to any carve out, spin off or other separation transaction is the inability to quantify and/or cleanly allocate significant contingent liabilities. Indemnities are helpful in addressing these concerns but, necessarily, are limited by the indemnitor’s credit profile. The inherent delay between announcement and closing of the transaction exposes it to risks of market disruptions or adverse changes with respect to the business to be separated, making advanced planning crucial to the prompt and successful consummation of the transaction. Retention arrangements may be appropriate to ensure that key personnel do not leave prior to closing, thereby threatening the prospects of the business to be separated and possibly the transaction itself. Carve out transactions may require regulatory approval, in which case parties must negotiate contractual provisions defining their obligations in seeking approval and addressing the risk that it will not be obtained.
Van Dommelen: More and more, potential buyers require comfort on the achievability of the target’s projected financial results and the deliverability of the acquired business. As carve out transactions are generally more complex, buyers will require additional comfort in these areas. In recent years several of our clients considered the information and separation planning provided by sellers to be insufficient or lacking transparency and withdrew from auction processes. Often, operational relations exist between sellers and the target company, for example by means of a supplier-client relationship. This relationship may be an important driver of the financial results of the target company. Sellers tend to offer three- to five-year contracts to safeguard volumes and or margins. However, potential buyers may consider continuation of the relationship in the longer term as uncertain, which has a negative impact on their valuation of the target company. This results in a difference between the valuation of the seller and the buyer.
Loss: While disagreements as to price are a potential deal breaker in any transaction, this is perhaps a bigger risk in a carve out transaction for several reasons. First, in many carve outs, especially if the buyer is a financial buyer, there can be a kind of negative arbitrage. That is, the smaller standalone business may be less efficient than it was as part of a larger business because it has a higher fixed cost structure or lower pricing power with customers or suppliers. In such situations, the business is actually worth more to the seller than it is to a buyer and there is, thus, a greater chance that there will be a gap between what a seller wants to receive and what a buyer is willing to pay. Of course, sometimes exactly the opposite is true because the carved-out business will be able to operate more efficiently and nimbly on a stand-alone basis. Also, many carve outs are not material to the seller, which can give a corporate seller the luxury of holding on to the asset for another year or two and try again if it is not able to get the price that it wants. This, too, can also cut the other way. Many carve outs turn out to be bargains because the seller simply is not motivated to get the last dollar. The seller simply wants to get this ‘little deal’ done and move on to more important business, so the sale price is not that important. This is the perfect situation for a buyer.
FW: Looking ahead, do you expect to see more of these deals in the M&A market?
Van Dommelen: We expect that the relatively positive trend in the number of carve outs will continue because of additional financial constraints, as well as legislation and regulation, for example the continuation of carve outs within the financial services industry and the energy markets. Moreover, companies will further optimise their structures in order to maximise shareholder value.
Roth: Spin offs, carve outs and other separation transactions are a key feature of the M&A landscape, and are driven by the same factors that affect the tide of M&A activity: health of the public equity markets; attractiveness of available financing; and the stability and trajectory of the overall economic environment. They are also a favourite topic of shareholder activists, who have become increasingly vocal in the M&A marketplace over the past few years. If recent market jitters continue, plans for these transactions may be delayed or abandoned as companies find a dearth of available buyers and inhospitable public markets. If, however, the economic environment returns to a more stable state, the frequency of these transactions can be expected to increase.
Jim Loss is co-chair of the private equity group of Bingham McCutchen, a full-service law firm with more than 1000 attorneys in 14 offices worldwide. Mr Loss has more than 25 years’ experience in mergers, acquisitions and private equity transactions. He has represented both strategic and financial buyers and sellers in a wide range of transactions across many industry groups and has represented financial buyers in numerous corporate carve out transactions. Mr Loss can be contacted on +1 (714) 830 0626 or by email: email@example.com.
Rick van Dommelen is a partner within PwC’s Transaction Services practice in the Netherlands, with over 13 years of transaction experience advising strategic and financial clients across Europe providing buy-side and sell-side consulting. He has extensive transaction experience in complex projects managing change, e.g. mergers, carve outs, post deal work and restructuring projects. He can be contacted on +31 88792 6476 or by email: firstname.lastname@example.org.
Benjamin Roth is a corporate partner at Wachtell, Lipton, Rosen & Katz. His practice focuses on domestic and cross-border mergers and acquisitions; leveraged buyouts and other private equity transactions; capital markets transactions; and general corporate and securities matters, including proxy fights, hostile defence and corporate governance. Mr Roth has advised a broad range of public and private companies and financial sponsors in the United States and abroad in a variety of industries including healthcare, pharmaceuticals, technology, financial services, retail, energy, and industrials. He can be contacted on +1 (212) 403 1378 or by email: BMRoth@wlrk.com.
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