Private equity investors love corporate carve-outs.
Corporate carve-outs is a private equity buyout strategy that offers superior returns for the distinguishing investors.
Essentially what happens is that a large corporation with multiple different business units wants to divest one of the segments. So the divested segment gets “carved-out” from the parent company and becomes a standalone business.
The carve-out segment can be “spun-off” as its own public company, in which case the shares are distributed to the shareholders of the parent company. Or it can be acquired by a strategic or financial buyer (PE firm).
The private equity firm will submit a bid to acquire the divested business in a carve-out transaction. The Board of the parent company will evaluate the offer and if it’s more economically attractive than a spin-off or sale to another buyer, then the parent company will sell it to the private equity firm.
These large corporations may want to separate the segment from the parent company for a variety of reasons. Their management team could be the target of activist shareholders and pressured to streamline business focus. They might need a large cash injection to de-lever or to invest in projects with higher returns. Or the segment may be underappreciated by the market and it’ll get a better valuation as a standalone business.
Carve-Out Lesson #1: Unloved and Underinvested
Oftentimes, the business unit being divested by the parent company and carved-out by the PE firm is considered “non-core”.
These carve-out businesses often make up a small percentage of the parent company’s total revenue / earnings. And as such, senior management of the parent company doesn’t really spend their days focusing on that business because it doesn’t move the needle and so time is not well spent.
Ok, so senior management teams of the parent company doesn’t focus on it. But the management of the business unit must focus on it, right?
You would think, but it’s often shocking how the real world works.
Let’s understand their incentives.
These management teams are usually compensated in the form of base salary, cash bonus and then some equity incentives.
Often times, the management of the carve-out segment are compensated based on the performance of the parent company as a whole. Not the performance of their own business unit.
See the problem here? The top management at the parent company don’t focus on it. Worse, the business unit’s own management team aren’t incentivized to maximize its value either.
Like the top management at the parent company, the management of the business unit also knows that their business line doesn’t move the needle.
As a result, many of these businesses aren’t operating at their fullest potential.
Carve-Out Lesson #2: Aligning Management Incentives
With the carve-out, management is now held accountable for the performance of their own company.
Under private equity ownership, weak executive officers are let go and replaced by the PE firm’s new hires. Management’s annual compensation is also restructured to tie to the company’s key performance indicators.
To further incentivize management, many PE firms allocate a common option pool. In other words, the PE firms give management teams a cut of the gains on the investment. Management can often make millions from this if the investment goes well – way more than what they would make under original parent company ownership.
Now that their personal net worth and earnings are tied to the business performance, you see an immediate shift in their behavior.
All of a sudden they become laser-focused on growth and cash flow generation.
After all, who doesn’t want to make millions?
Carve-Out Lesson #3: Revenue Boost
On the top-line front, revenue is usually below what the carve-out business could be achieving.
First, the quality of these carve-out businesses’ products & services are below their full potential.
There’s often some fixable issues that arose due to parent company’s underinvestment and lack of focus.
Case in point.
There was a Mexican beer business that was sold to a US company a few years ago. The business was part of a larger conglomerate and was unloved and underinvested. When they ship the beers to their customers, the cases will often arrive late and sometimes damaged (i.e. some bottles are broken).
The company that acquired the carve-out business fixed this and immediately saw a significant uplift in sales.
Second, the pricing is less than optimal.
As part of the underinvestment, the larger parent company would often save costs without doing diligent market research on the non-core asset’s pricing power. They don’t fully recognize how much price increase they can pass on to the customers and leave value on the table.
This is usually uncovered as part of a private equity firm’s commercial due diligence. The service provider for the CDD should be able to pinpoint the specific products / services where there’s high price inelasticity. Fully utilizing the pricing power in these areas will boost revenue & margins.
Third, there’s usually something wrong with the company’s sales force.
Lots of things can go wrong here. There could be too many underperforming sales people. Their commission % could be too low or too high. Maybe they’re not compensated on new sales so they’re not incentivized to win new customers. Maybe they’re not compensated on retention so they don’t care about customer cancellations.
By optimizing the sales force, you’re one-step closer to reaching the true revenue potential of the business.
Carve-Out Lesson #4: Profitability Enhancement
On the cost front, the carve-out entities often have a lot of fat that can be reduced under private ownership.
The exact amount and areas of potential cost savings are uncovered through cost due diligence.
Headcount reduction is a key cost reduction lever here.
Based on the cost DD findings, the newly incentivized management will fire the underperformers and save on their compensation. Redundant / duplicative positions will be eliminated to centralize responsibilities. Some full-timers might be converted to part-timers. Some roles might also be offshored to emerging markets to take advantage of lower wages.
These headcount expenses are generally part of back-office and won’t affect revenue generation.
So by making these headcount changes, the carve-out business immediately sees a boost in profit margins.
And on top of that, the PE firm will instill a more rigorous cost discipline to limit expense growth. So future expenses will grow at a lower rate and allow operating margins to expand.
Other levers for cost reduction can include business process outsourcing, automation, and restrictions around entertainment & excessive corporate leisure.
Collectively, these measure will expand the company’s EBITDA margins and bring the company’s earnings power closer to its true potential.
Carve-Out Lesson #5: Transition Services
While there are significant upside to be achieved among carve-out businesses, they also involve a lot more work.
The key problem here is that the carve-out business is not a standalone business. It may have its own website and brand name but it doesn’t have its own infrastructure.
Each carve-out scenario is different, but many carve-out businesses rely on the larger parent company for the general corporate infrastructure & overhead (i.e. office space, IT systems like phones & computers, enterprise software, legal & compliance personnel, finance division, etc).
After all, the whole point of being part of a larger company is to achieve cost-synergies.
So what happens after the carve-out? Where’s the carve-out company going to get these services from? A gap in these services will be very disruptive to the operations and the investment.
The conventional solution is to get the parent company to continue provide these services for a defined time period in exchange for a fee. This gives the carve-out business some breathing room and time to stand up on its own.
To do that, you have to negotiate the transition services agreement (TSA).
The TSA is an agreement between the parent company and the carve-out business that lays out the terms of these ongoing infrastructure support. It identifies the services that the parent company will & will not provide and quantifies the expenses that the carve-out company will have to bear.
Most carve-out businesses’ financials already include the allocation of corporate expenses to the unit, so the TSA expenses shouldn’t be a shock to the company’s earnings.
Carve-Out Lesson #6: Duplicative Expenses
You know how when two companies merge together, they achieve cost synergies?
Well when a carve-out business separates from a larger parent company, there are dis-synergies.
While the parent company will continue to provide infrastructure support for a period of time, at some point these services will end and the carve-out business have to stand on its own feet.
Think about this in practice. You can’t wait until the transition services is over to start ramping up carve-out company’s own corporate infrastructure and back office. You have to start building the team during the transition period and give them time to pick things up.
For example, you have to start hiring your own finance team during the transition period so they can learn from the guys at the parent company. You might have to move into a new office so you have to rent the office for renovations all the while you’re paying the parent company for your current office space.
That way, you minimize the separation disruption to the business and by the time TSA ends, the carve-out business is already standing straight on its feet.
The takeaway is that there’s a period during the transition, where the carve-out business incurs duplicative spending on the same corporate infrastructure services. It has to pay the parent company for the transition services AND incur the expenses of its own team.
Because of this duplicative expense burden, the profit margins for the first few years can be artificially suppressed. This is due to the nature of the transaction rather than a reflection of the business earnings power.
Model wise, these duplicative expenses represent real cash outflow. However, for valuation purposes, you should add these duplicative expenses back to reflect the business’s true underlying earnings power.
Carve-Out Lesson #7: One-Time Expenses
So now let’s think about how the actual separation process.
Who’s going to manage the separation process? This is a very labor-intensive process and you need experts who are experienced in project management.
Private equity professionals are not all-powerful and this is beyond your core competence.
You need to staff up the carve-out business’s project management office (PMO) so you might need to hire people for this. That means more salary expense and headhunter fees. You’ll need outside advisors to guide the team through the process. That’ll cost hundreds of thousands in fees.
Then there’s the need to change the carve-out business’s legal entities, which will serve as the baseline for all the taxes and bank account openings. That means lawyer fees.
Next you need to set up the business’s own enterprise software. That’ll usually involve one-time setup fees.
The carve-out business may also need to rebrand itself and communicate to its customers and suppliers regarding the change-of-control. That means marketing costs and PR costs.
See the pattern here?
In addition to the duplicative expenses, there’s also significant one-time operating expenses AND capital expenditures to facilitate the carve-out.
Did I mention there’s also Cost to Achieve Cost Savings?
Recall that the PE firms will enhance earnings through cost reductions. Well, the business will have to incur one-time expenses in order to achieve these cost savings. For example, it might need to bring in consultants to oversee the process. Or it might need to pay severance packages. You need to include these costs to achieve savings in your model.
It’s extremely important to diligence the costs needed to facilitate the carve-out and include them in the model. These expenses may be one-time, but can kill your year 1 cash flow and force you to draw on the revolver.
Carve-Out Lesson #8: Valuation Implications
The concepts we discussed above have important implications on entry & exit valuation.
On the entry EV / EBITDA valuation front, you need to adjust both the numerator and denominator.
For Enterprise Value, you need to add the present value of all the carve-out expenses that aren’t included in your sources & uses.
Presumably, these expenses aren’t included in your sources & uses calculation because they’re not incurred at closing. Therefore, you need to add the PV of the Duplicative Expenses and One-Time Expenses to the Enterprise Value. This is the true value that you’re paying to purchase the business.
For EBITDA, you should look at both the status quo earnings and the true earnings power of the carve-out business.
It may appear that you’re paying a multiple in-line with public peers’ trading profile based on the status quo earnings perspective. But the status quo EBITDA is unfairly low and sometimes substantially below the company’s true earnings potential. Taking into account the operating enhancements, you may find that the multiple is a steal based off the run-rate EBITDA.
At exit, you can argue that carve-out companies deserve a valuation multiple uplift.
That’s because the company is probably standing on its feet by time of exit and next buyer won’t have to bear carve-out risk. Because the investment at exit has a lower risk profile than at entry, you should consider the possibility of multiple expansion.
Conclusion
That’s it on corporate carve-outs. This article is meant to highlight the specific areas to consider and look into during diligence than a catch-all for all carve-outs.
At the end of the day, each carve-out is its own unique deal. It’s up to the investment team to diligence and identify the key investment merits and weaknesses.
We hope this has been helpful and would love to hear your thoughts.
For Further Reading
Other PE Buyout Strategies that Generate Superior Returns
About 10X EBITDA
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