Driven by the influence of shareholders, activists and competitive market forces, public companies are demonstrating renewed focus on their core businesses. Reductions in the U.S. corporate tax rate from 35% to 21% have further sharpened this focus by reducing the tax burden of large asset sales. As a result, carve-out transactions will likely become a fertile ground for PE firms to target opportunistic and unsolicited offers for orphaned business units during 2019.
According to PE market research publications, the percentage of U.S. carve-out transactions being conducted by buyout firms is rising, and acquisitions of carve-outs by strategic acquirers is falling. As industries consolidate and companies seek to focus on core assets, strategic entities become more likely to streamline their own businesses through carve-out sales and less likely to become buyers in carve-out transactions of ancillary businesses.
Generally, a carve-out transaction consists of the acquisition or divestiture of part of a business, operating unit or product line. Unlike acquisitions of standalone businesses, acquisitions of carve-outs tend to be more complex and require significant pre-transaction preparation, organization and attention to detail. Carve-out transactions create a greater opportunity for PE buyers through lower premiums and higher returns. However, the complexity of such transactions can result in a higher threshold for success than typical mergers and acquisitions and therefore require careful planning.
Below are some considerations for PE firms to ponder when tackling the inherent challenges faced in carve-out transactions:
Timing and Resources
The purchase and sale of a portion of a larger business enterprise presents special contractual and structuring issues. In particular, a carve-out transaction requires significantly more due diligence, attention to detail and focused coordination among due diligence providers, legal and other advisors, and buyer personnel than an ordinary acquisition. Timing may be accelerated when the target is suffering from financial difficulties or the transaction is a competitive auction. As a result, potential buyers may be expected to complete the carve-out transaction on an expedited basis and will need to marshal the necessary resources to conclude the transaction on the articulated expedited timeframe.
Structuring the Transaction; Tax Considerations
The initial question to be addressed in connection with the contemplated transaction will be determining how to structure the transaction. Given the carve-out nature of the transaction, the sale will likely be structured through either:
(i) the creation of a newco subsidiary, the dropdown of selective assets and liabilities of the parent into the newco subsidiary and the sale of the stock of the newco subsidiary to buyer; or
(ii) the direct sale of selective assets to, and the assumption of certain liabilities by, a newly created subsidiary of buyer.
In the case of a carve-out transaction structured as an asset sale, the buyer should expect to form one or more subsidiaries to provide insulation from potential unknown contingent liabilities. In either case, the nature of the transaction will need to be analyzed and reviewed based on its inherent facts. Some of the structuring considerations include evaluating tax consequences and employment implications, determining accounting treatment and assessing whether approvals or third party consents will be required. Much of the tax planning for carve-out transactions will likely overlap with tax considerations applicable to general sales of businesses. However, the particular circumstances of the carve-out transaction may raise significant novel issues that should be addressed by sophisticated tax advisors.
Purchase Price Considerations
Pricing the transaction will present unique challenges to the PE firm. Unlike an acquisition of a standalone business, the cash flows (e.g., EBITDA) will require significant adjustments to calculate performance on a standalone basis. The likely unavailability of audited financial statements will increase the complexity of calculating the purchase price, and arranging third party financing. Allocated overhead and other historical charges provided by the seller will often not be the best indicator of operating the target business on a standalone basis.
Regardless of the amount and type of purchase price to be paid (cash at closing, seller financing, deferred purchase price, etc.), the PE firm should expect the business to be delivered with a normalized level of inventory or other working capital assets, which would be sufficient to operate the business in the ordinary course consistent with past practice and contemplated growth. Often overlooked by strategic sellers of carve-out businesses, the purchase agreement should include a customary inventory/working capital adjustment by comparing actual closing amounts to a mutually agreed upon target. Purchase price adjustments in carve-out transactions can be extremely complicated and require significant input from accounting professionals and attorneys experienced in carve-out sale transactions.
Identification of Assets
A critical first step is for the buyer to understand what assets, rights and liabilities will be included in the transaction. In addition, shared assets and services that will be provided under transition services agreements will need to be identified during early due diligence. Identification requires a great deal of coordination and communication among buyer personnel, management to be transferred with the business, the drafters of the definitive agreement and the due diligence providers. Often, these important categories have been identified by the seller through interaction and “negotiations” among members of its own management. Seller management remaining with the business often attempt to dictate transaction terms to those employees being transferred to the carve-out business. Buyers should be involved early in the process and actively participate in these discussions (and direct discussions with transferree management) to correctly identify necessary assets and rights and which liabilities should be assumed.
The assets involved in carve-out transactions are generally non-core. As a result, the assets are often neglected and under maintained and managed. Operational reviews will often be required – including the need for reviews by internal PE operational teams, if any, and outside consultants.
Although PE buyers should obtain representations and warranties that all of the assets and rights needed to operate the business are being acquired, one should not rely solely on such representations and warranties. Buyers should perform business, accounting and legal due diligence to independently confirm these expectations. Also, the likely lack of available audited financial statements for the carve-out business may make contractual identification of the assets to be conveyed even more difficult. These requirements create an increased due diligence burden.
The acquired assets will need to be identified (either generally or specifically) in the definitive agreement. There are several methods to do this – the most favorable from a buyer perspective is to first generally describe the categories of assets being acquired and then further specifically list those assets that are important and can be identified, as well as those that should be excluded. This approach provides comfort on the general inclusiveness of what is being acquired, while allowing the agreement to correlate directly with the assets identified in due diligence. Obviously, the failure to acquire the necessary assets will result in an indirect purchase price increase (at best) or the inability to operate the acquired business as expected (at worse).
Identification of Liabilities to be Assumed
In many cases, a carve-out transaction will be conducted on an "our watch, your watch" liability basis. Regardless of how the transaction is structured, buyers will need to identify liabilities to be assumed with specificity. It will be important that the boundaries of these liabilities be appropriately identified in due diligence and the definitive agreement. In a carve-out transaction, subject to certain exceptions, the buyer will generally only become liable for those assets or business either dropped down into the newco subsidiary or directly assumed by the buyer. The buyer’s goal in this context should be to assume only certain mutually agreed upon enumerated liabilities – and not general categories of liabilities. This is particularly important when the acquired business will not have audited financial statements. For example, in the context of a manufacturing or retail businesses, parties must agree upon the allocation of liability (product liability and warranty) for inventory (i) being purchased by the buyer at closing and (ii) previously distributed by the sellers. These types of allocation may have a significant effect upon the ultimate success of the investment.
Transition Services Agreement ("TSA")
There will almost certainly be a need to provide services between seller and buyer after closing. These arrangements are typically provided on a transitional basis after closing. The failure to identify and provide for such services prior to the consummation of the transaction will adversely affect the profitability and viability of the acquired business. Similar to the due diligence conducted to identify necessary assets, a significant amount of coordination is required among buyer personnel, due diligence providers and those drafting the TSA and other definitive documentation. In addition to identifying the nature of these shared services, the terms of the transitional relationship (type of services, performance standard, time period, cost, etc.) will need to be negotiated and documented.
Types of Services - Typical shares services include:
Access to confidential information and data;
Maintenance of product and customer data;
IT services including hardware and software;
Right to use names – brands, private labels, etc.;
Benefits administration; and
Fees - Often conflicts arise as to the fees applicable to TSA services. Buyers should seek to agree upon the cost and scope of such processes early in the process. Particular attention should be given to how such costs relate to historical costs used for valuation purposes, and likely costs after expiration of such TSA services. Allocated costs charged may not be best indicator of future operating costs.
Duration - Sellers are generally not in the business of providing transition services and will want to exit the TSA arrangement as soon as possible. The parties should set realistic service durations on a service-by-service basis. Buyers often are overly optimistic how quickly they can replace the transition services. Buyers should build cushions for continuance of service if uncertainties arise. Consider incentives for both buyer and seller to allow for flexibility for uncertainties, including discounts for exiting services earlier or penalties for extending services. Buyers must also have a well-developed plan for replacing such TSA services after the terms of such services (and any extensions) expire.
Standards of performance - Standards for performance of the TSA services should be articulated in the agreement. Services typically should be consistent with historical performance levels (i.e., those sufficient to operate the business).
Other Factors - Other factors to consider include: how to govern disputes, timing and method of payments, and limits on liability for failure to perform.
Representation of Warranties
Representations and warranties in a carve-out transaction are similar to other acquisitions except that the focus is often on acquired assets and assumed liabilities. Three critical representations and warranties in this context are as follows:
Financial Information - Often, the divested business will not consist of a fully intact entity. As a result, there are rarely standalone financials much less audited financial statements for the carve-out business. However, buyers should seek appropriate representations and warranties relating to carve-out financials for the acquired business. It will be important to be creative in fashioning some level of representation and warranty coverage for historical operating results.
Sufficiency and condition of acquired assets and rights - As noted above, it is important to obtain representations and warranties that the acquired assets and rights (including intellectual property) will consist of all assets and rights necessary to operate the acquired business, except to the extent specifically identified by the seller. Buyers should expect to receive transitional services or licenses for any such excluded assets or rights identified by seller.
Employee benefits and employee matters - Sellers will likely expect the buyer to offer employment to all employees located at the transferred facilities or otherwise serving the carve-out business (on terms and conditions no less favorable in the aggregate that the current terms and conditions on which such employees are employed by seller), and adopt and agree to be bound by the collective bargaining agreements (if any) applicable to such employees. As a result, it is important that the representations and warranties provide the buyer with a comprehensive understanding of the nature of the terms of such benefits and agreements.
Buyers will want to specifically identify which employees are necessary or desirable to operate the business after closing, and will need to hire such employees after closing. Sellers will often “cherry pick” talent and include poor performers (or unavailable workers) in the business to be transferred. Look for employees new to the unit, and employees on leave. Significant care should be taken in identifying employees to be transferred. As noted above, sellers will likely expect the buyer to offer employment to all business employees (on no less favorable terms and conditions). As a result, historical employee censuses, pre-closing employee benefits provided to such employees (including benefit plans) and requirements under union agreements should be analyzed.
Carve-out transactions often involve the acquisition of businesses that depend on intellectual property rights shared among the carve-out business and businesses to be retained by the seller. This intellectual property will need to be identified and the parties will need to arrange for cross-licensing arrangements and potentially intellectual property transfers. Often the chosen approach will depend on the nature of such intellectual property and the relative importance to the retained and transferred businesses. Buyer should expect that these arrangements will be subject to passionate negotiations between buyer and seller. The buyer should also consider the scope of any such licenses in respect of any planned changes to the carve-out business. In addition, careful consideration should be given to ownership and license of intellectual property rights in the context of positioning of the business for resale.
Modification of Certain Assumed Contracts
The buyer will need to identity whether modification of the existing terms of any material customer, supplier or other agreements to be assumed are required or desirable. Generally, bargaining power may make it easier for sellers to obtain such modifications/concessions prior to closing than it is for the buyer after closing. Also, some contracts may not be assignable and will require some creativity in giving buyer the benefits and burdens of such contracts after closing.
FTC or DOJ Required Divestitures to Resolve Antitrust Issues
Acquisitions of carve-outs sometimes arise in connection with the buyer in a combination transaction entering into a consent agreement with the Federal Trade Commission (“FTC”) or the Department of Justice (“DOJ”) requiring it to divest certain assets or business operations to resolve anticompetitive issues identified during an investigation of the combination transaction. These types of transactions are guided by considerations somewhat different than normal carve-out transactions such as:
Covenants not to compete - It is customary for a buyer in sale transactions to obtain covenants not to compete from the seller. In the context of an FTC or DOJ consent agreement requiring a divestiture, such covenants would be prohibited since the purpose of the divestiture is to maintain the premerger level of competition between the merging firms.
Expedited Basis - Because FTC or DOJ approval of the buyer of the divestiture package may be necessary before the parties to the combination transaction are cleared to complete their merger, the seller will look for buyers that have the ability to complete the carve-out transaction on an expedited basis. Buyers should expect that sellers will insist on a very tight timeframe to complete the “carve-out” transaction. As a result, the buyer will need to marshal the necessary resources to conclude the transaction on the articulated expedited timeframe.
Exclusivity - Exclusivity is generally not provided in the context of an expedited forced disposition. Alternatively, buyers sometimes seek expense reimbursement payable by the seller if the transaction is consummated with another bidder.
FTC or DOJ Prior Approval - In order to obtain prior approval from the FTC or DOJ to acquire the carve-out business, the PE buyer will need to present a detailed business plan to the FTC or DOJ demonstrating that it will be able to compete effectively on a long-term basis as a standalone business after the closing. The FTC and DOJ also frequently require PE buyers to obtain prior approval before they can resell the carve-out in less than three years.
Closing Conditions - Other than requiring FTC or DOJ approval of the divestiture buyer and the closing of the combination transaction, required divestiture agreements, which must also be approved by the FTC or DOJ, typically contain few additional closing conditions.
Forced Transactions Breakup Fee - It is possible that the carve-out transaction may not close due to the failure of the two merger parties to complete their combination transaction. Buyers may seek a break-up fee or expense reimbursement if the transaction does not close because the underlying combination subject to FTC approval does not close.
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Public companies have renewed their focus on operating their core businesses. As a result, the number of carve-out transactions being conducted by PE firms can be expected to rise. This renewed focus and the higher return potential will create an exceptional opportunity for PE firms to acquire orphaned business units. These potential opportunities, however, will need to be balanced against the higher threshold for success created by the complexity of carve-out transactions. Many PE firms have formed internal task forces that focus on particular market or industry group opportunities. The focus of these task forces should be expanded to target orphaned business operations as potential acquisition targets.
*The author would like to thank James A. Fishkin for providing assistance with the antitrust content in the article.