Savvy private equity buyers have long known that carve-out transactions can be a powerful tool for unlocking value from often under-invested businesses. And although the number of carve-out transactions in the market today is likely to be affected by the same macro forces currently dampening the broader M&A market, we expect that large corporates will continue to look to divestitures as a means to raise capital, shore up losses or focus their resources on core businesses and strategies. Today’s carve-out deals are often marked by two recurring elements that could be in opposition: the complexity inherent in this type of transaction and the speed with which corporate sellers want to move to effect the transaction; managing both is critical for minimizing deal risk.
Complexity may be introduced in several ways. The deal might require carving out decentralized international operations or separating business units in a regulated industry. Or the carve-out may be predicated on a contemporaneous flip of a portion of the acquired business to a third-party buyer. In some cases, a private equity buyer may pursue two businesses for sale by two different owners with a view towards combining them; when one (or both) of those businesses is a carve-out, integration challenges are magnified, particularly when the carve-out business does not have its own management team or is not operationally self-sufficient.
Then there is speed. The race to deal execution in many deals today increases the pressure on buyers to get a handle on the complexities raised by a carve-out in a highly compressed period of time. In competitive situations, buyers may find themselves squeezed by tight deadlines or constrained by limited access to management and diligence.
With these considerations in mind, this article will discuss some of the deal execution considerations for private equity sponsors doing carve-outs in today’s market:
Defining the Transaction Perimeter
At the core of any carve-out is the need to define the perimeter of the business being sold, identify the assets that comprise it and scope the related liabilities that will be assumed. These variables become more challenging to determine if the business has not been operated as a separate division or if it is deeply intertwined with the corporate parent’s operations. A buyer will need to thoroughly understand the scope of shared services between the corporate parent and the divested business (e.g., back-office functions like treasury, tax, legal and HR), how the cost of those shared services has historically been charged or allocated to the divested business and the costs of replacing those services going forward. A buyer will also need to conduct due diligence on the extent of shared facilities, personnel, contracts and other assets and then assess the impact of the carve-out on costs and operations when those facilities, assets or people either transfer with the divested business or remain with the seller and need to be replaced. Close coordination between the buyer and the management team is critical to this diligence, although naturally hampered by the fact that management is still operating in sell-side mode prior to signing when the buyer is negotiating these terms in the purchase agreement.
A key provision in any carve-out purchase agreement is the “sufficiency of assets” representation, in which the seller represents that the buyer is acquiring all of the assets necessary to conduct the business in the manner in which it has previously been conducted, subject to specified exceptions. Needless to say, understanding the exceptions is a critical component of a buyer’s due diligence. Often today, a buyer’s only remedy for a breach of this representation is under a representation and warranties insurance policy—if one is obtained.
The transition services agreement or other transitional arrangements (such as transitional supply agreements and transitional license agreements) can temporarily fill any post-closing gaps. But even with those agreements in place, it is often necessary for the buyer to do some pre-closing work to ready the business for operating on its own, such as standing up an ERP system, entering into new vendor contracts or building out the management team or back-office functionality not provided under the transition services agreement. Parties to carve-out transactions benefit from early and deep engagement in identifying services that will need to be provided to or by a divested business, assessing the mechanics and personnel necessary to provide such services and negotiating both the service fees and the length of time for which the transition services will be needed. It is also important to consider potential limitations that may prevent or constrain provision of certain services to non-affiliates, including third-party vendor consents and regulatory limitations.
Historically, companies did not always prepare comprehensive financials for their component businesses. As a result, when a company decided to divest an operating unit, the unit was unlikely to have stand-alone financials. In recent years, accounting standards and disclosure practice have led segment reporting by public reporting companies to become more stringent and, as a result, public sellers are more likely to have comprehensive financials for a division being divested. In addition, even if there is no public segment reporting, in well-run auctions, carve-out financials will have been completed in advance of approaching potential buyers.
But even with these market practices and evolving accounting standards, buyers seeking to finance a carve-out acquisition often find themselves with insufficient financials to pursue their desired financing. When this occurs, it is often because the precise scope of the business being sold changed during the negotiations, so that the financials produced for the auction no longer match the actual assets and liabilities that will be acquired. New financials can usually be produced, given sufficient time and management attention, but the needed resources may be in short supply in a fast-moving sale process.
In any event, the unavoidable reality for many buyers is that some combination of audited and unaudited financials of a target business will be needed in order to obtain debt financing. It is also generally true that the more comprehensive the financials that are available, the more financing alternatives there will be and, in the end, the more likely that the buyer can pursue the financing structure of its choice.
A marketing of high-yield bonds is likely to require more disclosure of financial information and to a higher accounting standard than other forms of financing. These bonds are typically sold to investors in a transaction exempt from the registration requirements of the Securities Act of 1933, pursuant to the “Rule 144A safe harbor” provision. For an offering to be eligible for this safe harbor, an issuer must satisfy certain informational requirements, including providing the “issuer’s most recent balance sheet and profit and loss and retained earnings statements, and similar financials for such part of the two preceding fiscal years as the issuer has been in operation (the financials should be audited to the extent reasonably available).”
Notwithstanding the apparent flexibility of the rule, under customary market practice, a high-yield offering under Rule 144A is modeled on a public offering of comparable securities, which would typically include two years of audited balance sheets, three years of audited statements of income, changes in stockholders’ equity and cash flows and two additional years of selected financial data, all as required under Regulations S-X and S-K of the Securities Act of 1933.
While market practice allows for deviation from this standard in cases where the full package of financials is not available, it is uncommon for disclosure to include fewer than two years of audited financials. If at least two years of audited financials and unaudited interim financials for the target business cannot be provided within the contemplated time frame for the closing of the transaction, a buyer risks losing the option of tapping the high-yield bond market and may instead need to obtain alternative financing that in some cases could be more expensive and less flexible. If the buyer is faced with that prospect, however, there are several possible options:
- Push the Seller. Given the potential impact that not having financials has on a buyer’s cost of capital and on the portfolio company’s post-closing operating flexibility, before pursuing other financing options, a buyer should probe assertions that the necessary financials are not available or cannot be produced on an acceptable timeline. Depending on the dynamics of the sale process, it may be useful to share with the seller the projected impact of these increased costs on the value of the target business to the buyer. In the end, a more costly financing is a shared problem, and there can sometimes be a shared solution.
- Push the Arrangers. If, even after probing the situation and looking for solutions, the financials necessary for a customary marketing of high-yield bonds will not be available in time, a buyer should still consider pressing its prospective arrangers to provide bridge commitments supporting the bond offering. As noted above, as a technical matter, the Rule 144A safe harbor information requirements are more lenient than customary market practice. Therefore, an offering supported by less financial disclosure (e.g., only one year of audited financials) may still comply with Rule 144A, as long as applicable antifraud rules and regulations can be satisfied. Given the unusual nature of this type of bond offering, though, it may be difficult to predict market appetite and, as a result, potential arrangers are likely to be resistant to underwriting a bridge on this basis—or at pricing that would be attractive to the buyer. However, given the right circumstances, including an attractive credit and a competitive “bake-off,” it may be feasible.
- Second Lien Financing. Depending on the size of the financing shortfall, a sponsor could consider a syndicated or privately placed second lien financing. These types of financings are likely to be more expensive, and the related covenants might be more restrictive than could be obtained in a traditional high-yield offering. However, as compared to a high-yield offering, a second lien financing will provide greater flexibility to refinance or repay the junior portion of the capital structure. A buyer will need to take into consideration both the direct incremental costs and the potential impact of lost operating flexibility of these financings.
- Unitranche Financing. A buyer could consider avoiding debt marketing altogether and pursue a unitranche financing. This type of financing is likely to be more expensive than a non-flexed syndicated financing, and the related covenants are likely to be more restrictive than could be obtained in a traditional syndicated capital structure, including the possibility of having a financial maintenance covenant. A buyer will need to take into consideration both the direct incremental costs and the potential impact of lost operating flexibility of a unitranche financing. Because of the immense growth in this space over the last several years, supply in this market can provide a solution for large cap deals in a manner not possible only a few years ago. For carve-outs involving targets in the software business, a unitranche financing may also present an opportunity to obtain a loan that is based on the company’s recurring revenue rather than EBITDA.
- Seller Paper. Whether in the form of debt or equity, seller paper can be a possible bridge until the necessary financials can be produced and a customary 144A bond offering can be made. Obviously, this option is likely to be unattractive to the seller, but a buyer may well argue that the seller should bear some responsibility for the lack of requisite financials and play a role in resolving the issue. The availability of this alternative will depend on the dynamics of the given sale process. The cost of and flexibility of covenants, if any, in seller paper will depend on the negotiating leverage of the parties and, therefore, will differ on a case-by-case basis.
None of these alternatives is as good as having full financing optionality, and carries its own particular cost-benefit analysis. However, when confronted with a carve-out acquisition in which customary financials will be unavailable to execute an optimal financing, one of these alternatives might prove to be a workable solution for a buyer.
The degree of complexity involved in addressing legal issues associated with human resources (HR) matters in carve-outs will depend on a number of factors, including the extent that the divested business’s employees and compensation and benefit plans are mixed in with other businesses or operations of the seller.
At the more complicated end of the spectrum are situations where employees of the divested business are entangled within seller’s other business units: employees are shared with other business units, paid under seller’s general compensation plans and receive benefits under seller’s general benefit plans. Disentangling the employees and standing them up in a new business entity requires significant diligence and pre-closing preparation to:
(i) develop and implement a methodology to identify which shared employees will transfer with the divested business;
(ii) determine when the buyer will need to replace benefit plans and payroll, or if seller will provide temporary post-closing coverage of business employees for a negotiated fee; and
(iii) allocate assets and liabilities relating to the divested business employees (e.g., in defined benefit pension plans, retiree medical coverage, forfeited equity, bonuses, severance and other compensation and benefit items).
From an HR perspective, carve-outs are simpler if the divested business is already operating as a standalone group, with a subsidiary in this group directly employing all business employees who are dedicated exclusively to the business, including non-U.S. employees. Sometimes, in anticipation of a sale, a seller will stand up a business in a subsidiary group, which will spare a PE buyer the efforts and costs of disentangling the business from the seller (although it will likely require diligence to confirm that all business employees have been properly transferred there, and that compensation and benefit plan liabilities and assets have been appropriately allocated).
Location of the employees is another factor that can increase the complexity of a carve-out and require substantial advance planning. This is particularly true if employees are distributed globally in countries that have specific regulatory requirements applicable to the treatment of employees in these transactions or in countries where works council and union consultations are required.
Key HR questions that arise in carve-outs include:
- Which employees are being transferred with the business (e.g., can a PE buyer select employees it wants, or will a fixed methodology be used)? Do any employees have a legal “right” to transfer (as is the case in certain non-U.S. jurisdictions)?
- What is the process for transferring business employees? Will the transfer occur automatically, or will the buyer need to make individual offers to employees (which can be a time-intensive and costly process)?
- What compensation and benefits will a buyer be required to offer to employees and provide, and for what period? Are there any compensation or benefits items that a PE buyer would refuse to assume or continue?
- What benefit plans will be available to the business employees at closing of the PE buyer’s acquisition?
- An acquired business may have standalone benefit plans and payroll that will transfer with the business. Otherwise, a PE buyer needs to establish new benefit plans.
- If new plans cannot be set up before closing, a seller may allow the acquired business employees to continue in the seller’s benefit plans and payroll for a transition period, or a PE buyer may need to use a third-party PEO to provide employee benefits until it sets up new plans. Both alternatives could be costly.
A carve-out buyer and its advisors should carefully analyze the aggregate dollar value and holders of outstanding seller equity or cash long-term incentive (LTI) awards of the business’s employees at the closing, as well as the treatment of those awards in connection with the transaction. If employees forfeit unvested awards, a seller may seek to require a buyer to make up those awards. A buyer will also want to identify and quantify liabilities of change-of-control, retention or enhanced severance arrangements (e.g., during a preset post-closing period) and include these amounts in consideration of overall transaction value.
Defined benefit pension plans are also of particular interest to PE buyers in carve-outs. Typically, a PE buyer will not be interested in continuing or mirroring any defined benefit pension plan or retiree medical plan that seller had offered due to the variability of such plans’ funding obligations and service costs. As a result of the carve-out, business employees may forfeit anticipated benefits in a seller’s defined benefit pension plan because their transfer to the buyer will be considered an employment termination that cuts off service credit and eligibility for levels of benefits. Government regulators can try to demand that a selle
r contribute additional cash to an underfunded benefit plan as a result of the carve-out acquisition, and the seller may try to push all or part of that cost on the buyer. In the United States, if the business employees participate in union multiemployer pension plans, withdrawal liabilities from the plan could be triggered unless the buyer agrees to stand in for the seller in the multiemployer pension plan and continues to contribute going forward.
Carve-outs can raise particularly thorny issues regarding the allocation and sharing of intellectual property (IP) assets:
- IP Allocation – Often, it is possible to allocate IP assets just like other assets, but a default allocation standard may not always be feasible for IP. The intangible nature of IP can make it difficult to conclusively identify all IP assets used in the divested business and the relative use of such IP among the seller’s businesses. Adopting an allocation standard that does not account for these unknowns could result in inadvertently transferring IP assets to a divested business (or vice-versa). Therefore, specificity in identifying IP assets, coupled with buyer-favorable transition services and licensing arrangements, may be used to supplement any default allocation standard.
- Treatment of Shared IP – Regardless of the standard applied to the allocation of IP assets, there will be certain IP assets (whether identified or unknown) that are allocated to one business but that will continue to be used, or will be planned for use, by the other. Such shared IP can create a complicated web of entanglements and should be addressed carefully in deal documents. In some cases, parties are willing to agree to broad, perpetual one-way licenses or cross-licenses ensuring that the other business has freedom to operate with respect to shared IP. In other cases, however, commercial and competitive considerations require a more specific identification of IP assets subject to the license and more narrowly scoped license rights flowing between the parties. This is particularly the case for patents, trade secrets and know-how, but heightened attention should be paid to the licensing arrangements for all shared IP assets, including trademark and brand rights allocated to one party that are necessary or desirable for short-term or long-term use by the other party post-closing. Parties should also take into account go-forward matters, such as ownership and licensing of a party’s improvements to any licensed IP.
- Commercial Arrangements – Arrangements for shared IP rights may also be necessary in carve-outs where there will be ongoing commercial dealings between the seller and the divested business after closing. For example, a seller that retains manufacturing capabilities and plans to supply components to a divested business post-closing might consider retaining all rights in manufacturing-related IP for such components and excluding this IP from any post-closing license to the divested business. This arrangement might also provide the divested business with certain benefits, such as a reliable source of goods and no need to stand up new operations and relationships immediately after closing. Where circumstances exist that make such arrangements advisable, the parties can consider mechanisms to ensure that the party without ownership or license rights in relevant IP is not disadvantaged, such as an obligation on the seller to assist the divested business in transitioning to an alternate source of supply upon termination or expiration of the commercial arrangement.
Data migration and data protection matters are becoming a greater focus in carve-out transactions—and for good reason. From a business and a legal perspective, the buyer and its advisors need to diligence which data should be transferred or otherwise made available post-closing to the divested business. Will the divested business have historical pricing or cost information relating to its customers or vendors? Will it retain know-your-customer records or other books and records relating to its customers? Will it have historical personnel records? What restrictions will there be on transferring or providing access to such information when the business is no longer part of the parent?
Just as with the employee service and IP matters discussed above, parties should assess the nature of data that will be transferred or shared in the carve-out. The sizeable risks associated with violating data protection laws and contractual obligations, as well as data breaches and business continuity matters, all warrant careful attention. Depending on the data at issue, it can be important to conduct a thorough review of binding obligations regarding that data, including confidentiality obligations and restrictions on, or best practices for, transferring or sharing such data. The transaction documents—most likely the transition services agreement—should clearly establish the parties’ respective responsibility for compliance and remediation of any potential data breaches or other cybersecurity incidents and should clearly allocate liability for any resulting claims and damages.
As noted above, today’s carve-out deals are often multi-jurisdictional. These types of carve-outs require the buyer to work closely with tax advisors experienced with carve-out transactions to ensure that it satisfies all local tax obligations arising from the transaction. There are three primary types of local transactional tax obligations to consider in a carve-out:
- Transfer Taxes – A number of jurisdictions will impose a one-time, non-refundable tax on the transfer of certain types of assets, most notably real property. Generally, transfer taxes are based on the gross purchase price attributable to the relevant assets.
- Value-Added Taxes – Certain jurisdictions impose a value-added tax on asset sales, though such transactions may qualify for an exemption. For example, many jurisdictions will exempt the sale of a going concern from value-added tax, though the application of any such exemption is very fact-specific and requires close coordination with tax advisors. Similar to a transfer tax, a value-added tax is typically imposed on a gross basis. Unlike a transfer tax, however, a value-added tax often is refundable to the buyer or available to offset future payments of value-added tax, though receipt of such benefit may take a number of years depending on the relevant jurisdiction and the divested business’s sales therein.
- Indirect Capital Gains Taxes – Certain jurisdictions tax capital gains attributable to the sale of companies operating or formed within that jurisdiction. Unlike a transfer tax or value-added tax, an indirect capital gains tax is customarily based on the seller’s gain from the sale attributable to the relevant jurisdiction rather than the gross purchase price paid by the buyer. As a result, some of the information necessary to calculate this tax may not be available to the buyer.
Depending on the jurisdiction, the buyer or the divested business itself may be primarily liable or secondarily liable (including as withholding agent) for each of these taxes. The buyer should address the sharing of each of these taxes in the applicable acquisition agreement, as each tax is often treated differently.
Insurance and Risk Management
Insurance for most divisions and subsidiaries is typically placed at the corporate level, and in a carve-out, a buyer typically will need to put an entirely new insurance program in place effective as of the closing. This process usually requires the expertise of professional risk managers and outside counsel. As an initial step, the coverage that has historically been applicable to the divested business’s operations should be carefully reviewed. The buyer should conduct an in-depth analysis of the necessary risk transfer for the new stand-alone company (including appropriate limits) and projected costs, which may be significantly different without the premium efficiencies realized by the parent as part of parent’s larger corporate program.
The primary goal is to avoid any gaps in coverage by ensuring the new stand-alone insurance dovetails with the previous parent policies. If the seller does not retain liability for pre-closing occurrences, the buyer should seek full access to any “occurrence based” policies at the corporate level applicable to pre-closing occurrences of the divested business, as new stand-alone occurrence policies will not cover pre-closing occurrences. With respect to any “claims-made” policies accessible to the divested business prior to closing, the buyer may want to procure “tail coverage” at closing, which would cover the divested business’s claims made post-closing for pre-closing wrongful acts of the divested business for a set period of years. This tail coverage should also cover wrongful acts that span the closing, as the business’s new stand-alone claims-made policies will not cover claims involving pre-closing wrongful acts. Alternatively, the buyer could seek access to the seller’s claims-made policies for claims involving pre-closing acts.
Getting it Done: Deal Management
When approaching a carve-out, private equity buyers face a large number of complicated, intersecting workstreams, including the need to: (i) develop an optimal tax structure for the business; (ii) establish entities to acquire the assets; (iii) obtain corporate, tax and other operational registrations, licenses and permits the entities need in order to conduct business; (iv) open bank accounts and transfer funds to entities, whether as required by local law in connection with entity formation or for general operating purposes; and (v) if not provided pursuant to a transition services agreement, enter into leases and other contracts with vendors whose services are necessary to operate the business (e.g., payroll, enterprise resource planning software). Many of these steps must be executed in a particular sequence (for example, a buyer won’t be able to open a bank account before the entity has been formed), making sequencing and timeline management critical in the pre-closing period.
When a carve-out involves foreign jurisdictions, complexity can be magnified due to a number of factors. These may include: (i) difficulty in obtaining regulatory approvals or forming a new entity expeditiously;(ii) enhanced corporate formalities, such as requirements for original or certified documents (or even fingerprints); (iii) the need to negotiate local acquisition agreements to establish the allocation of the purchase price among foreign operations for tax purposes and satisfy local conveyancing and filing requirements; and (iv) the lack of familiarity by local authorities with private equity buyers generally.
In addition, local law in the covered jurisdictions could impose additional regulatory requirements, create successor liability considerations that may not be consistent with the negotiated deal between the parties and raise other tax and employee-related issues. The time necessary to address these issues has the potential to lengthen either the pre-signing or the signing-to-closing timeline or increase the possibility of deferred closings.
As soon as possible, the private equity buyer and its advisors will need to establish a detailed plan for standing up the business. Doing so requires close coordination and collaboration between a buyer’s and seller’s advisors on a range of levels: at the level of the overall transaction, at different functional levels and at the local country level, if foreign assets are involved. The plans should not only identify the broad categories of steps that need to take place before closing but also specify the inputs required before a particular workstream can commence and the anticipated timeline for obtaining those inputs and for completing the workstream once begun.
Establishing timelines will undoubtedly involve the use of imperfect estimates. The parties and their advisors should understand the assumptions on which these estimates are built, as well as the impact on other aspects of the transaction if those timelines are not met. The parties and their advisors should be aggressive in their efforts to meet—and, if possible, beat—timelines; any cushion achieved on one portion of the timeline could potentially offset missed timeline targets elsewhere in the separation process. Where appropriate, contingency plans should be identified to mitigate downstream impacts if timeline assumptions are not met. For example, if a new buyer entity is not operationally ready in a certain jurisdiction by closing, are there workarounds under the transitions services agreement or under third-party vendor agreements? Is a deferred closing in that country feasible? Ultimately, the parties and their advisors will need to maintain open lines of communication throughout the sign-to-close process in order to overcome these obstacles.
Private Equity Report Spring 2023, Vol 23, No 1