[co-author: Louie Huang]
As the pandemic drives companies to realign business strategies, look to your corporate treasury function to help prepare for the divestiture of non-core business units.
The outbreak of the COVID-19 global pandemic abruptly ended a historic 10-year boom cycle in the M&A market this year. With the gradual reopening of many economies — despite the threat of a second wave of COVID-19 — the M&A pipeline is slowly beginning to rebound.
Between August and September of this year, U.S. aggregate M&A spending increased by 47.2 percent.1 Some pundits are calling for a considerable increase in the back half of 2020 in both acquisitions and divestitures as companies realign their product portfolios to better serve evolving customer needs.
U.S. private equity spending increased during the same period by 52.5 percent, rising from $35.8 billion to $54.6 billion.2 Private equity firms, hedge funds and other big investors are flush with cash to snatch up fallouts from rescue deals and restructurings. Shareholder activism has also increased to put pressue on companies to sell non-core or underperforming businesses.
For organizations seeking to divest nonstrategic businesses, surveys show that even in a pandemic, companies that start preparing early will reap rewards when the time is right to strike a deal. This article explores how your corporate treasury function can — and should — play a significant role as a strategic business partner in the overall transaction cycle. From due diligence to legal entity restructuring to cash forecasting and cash extractions, treasury can help maximize value on the deal.
Tapping Into Treasury
Within the environment of M&A scrutiny, a company’s finance controllership and financial planning & analysis (FP&A) disciplines take on added importance. This is especially so in a divestiture, where the more comfortable and prepared the buyer is to operate the potential acquisition company on Day One, the more likely the deal will close on time. Similarly, the sooner the carved-out business is ready to operate on a stand-alone basis or has a defined approach to integrate with the buyer, the earlier synergies can be realized along with value preserved or created.
In a divestiture, the Finance department must continue operating without disruption. For example, controllership is heavily involved to ensure the carve-out financials are accurate for the divested business. In FP&A, sound business planning is expected to minimize deal leakage during the transition period, including careful calculation of add-backs such as allocated costs or non-recurring items supporting any Quality of Earnings analyses. Additionally, numerous cross-functional dependencies rely on finance to enable many end-to-end processes, such as procure-to-pay and order-to-cash.
Oddly, treasury is frequently overlooked in a divestiture — even though the function is considered the steward of corporate cash, which is arguably the most important asset on any company’s balance sheet.
Your treasury planning and execution team must work closely within the broader separation management structure during a transaction — a point when communication, information distribution and timing are critical and methodical. Each function must remain informed through the broader separation management office (SMO) SteerCo, including treasury, which should participate in the entire process, rather than as a pure execution specialist.
Treasury must collaborate with legal, tax and other finance colleagues (e.g., controllership and FP&A) in the following four areas to drive the deal to completion.
1. Legal Entity (LE) Restructuring – A divestiture presents an opportune time to restructure the legal entities to isolate the business or businesses being spun off or divested to maximize tax efficiency and deal value. In doing so, new legal entities are formed, rationalized or restructured to enable the transaction. In a carve-out/divestiture, there are generally three types of sale processes in which the business gets transferred to the buyer/NewCo, presenting different implications on treasury.
a. Stock sale – The entire legal LE/balance sheet goes to the buyer/NewCo.
b. Asset sale – Specific assets and liabilities go to the buyer.
c. Drop & sale – This involves forming a new LE and transferring (“dropping”) the related assets and liabilities into the new LE.
In all cases, treasury must conduct due diligence to understand the requirements to operationalize an LE. For instance, certain LE formation requires opening a bank account, and in some countries, a capital contribution is required to operationalize an LE. Such countries are often notorious for long lead times to open bank accounts and may even require a dedicated account for capital contributions in addition to working capital accounts. As a bottom line, treasury will also need to know the valuation of all assets being transferred. A close collaboration between tax and legal is required.
2. Cash Flow Forecasting – In a divestiture, cash flow forecasting becomes a driver in deal execution as the buyer seeks to avoid paying excess cash above working capital requirements at close due to inefficiencies and cost. But forecasting is particularly challenging in a deal environment because the dynamics between customers and suppliers can change, certain financing programs such as factoring and supply chain financing will need to be addressed, and some external/internal debt will need to be extinguished prior to close. Treasury will need to know these cash requirements in advance to avoid any surprises on liquidity planning and interruptions to the business operations.
3. Cash Extraction – To minimize cash at close, the seller must extract as much surplus cash as possible prior. Often, buyers stipulate a threshold or an amount by which they would pay dollar for dollar upon closing of the deal in certain jurisdictions. This strategy is to address the issue of “trapped” cash, where certain jurisdictions have strict currency controls and tax regulations around transferring cash out of the country. Buyers often pay a fraction of the cash balance in very restrictive countries as they calculate the economic impact resulting from tax and regulatory restrictions.
Three common techniques are used to extract surplus cash out of an LE:
a. Dividend – The LE should have sufficient distributable reserve based on the latest available statutory audit to dividend excess cash to shareholders.
b. Return of capital – The LE would liquidate the shareholding of the entity back to the shareholders.
c. Intercompany loans – This is an effective way to shift cash from one LE to another, which typically is followed by a dividend or return of capital distribution.
In all three cases, treasury must work closely with tax and legal teams to discuss the process, including obtaining required board and regulatory approvals, prior to any cash transaction.
4. Treasury Operations – “Cash is king” even in a carve-out, hence treasury cash operations must be carefully planned. For example, daily cash management, including bank balance reporting, must have a continuity plan to minimize business interruption. It is uncommon for a seller to offer transition service agreements (TSAs) covering treasury to buyers for legal and regulatory reasons. However, certain services are in fact permitted to minimize business disruption. A TSA can be expensive and delay post-close integration, but a seller should work with the buyer to determine the plan of action to ensure coverage.
As the world awaits some normalcy to return in the divestiture markets, corporate treasury can serve as an incredible asset to your deal team. This is particularly true when the prospective divested business has a global business footprint and/or complex shared services center operations. What’s more, early preparation and cash planning is even more crucial in a pandemic environment. Your treasury contribution can help you enable a timely deal execution and preservation of transaction value.
1., 2. FactSet US M&A News and Trends October 2020.