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Why Overcoming IT Challenges is Critical to the Success of “Carve-Outs”

Technology has long been a critical element of M&A transactions. Done right, it can be a key driver of value, enabling business processes to operate more efficiently. Done wrong, it can have devastating consequences.

Effects of mismanaged technology transfers can range from service disruptions to customer loss and even trigger liquidity crises. This is particularly true in "carve-outs," which have become increasingly popular among both corporate and private equity investors.

Unlike mergers, carve-outs involve the acquisition of a business unit from a parent company to create an independent business. The new company, which formerly relied on shared corporate support services, is forced to build new technology capabilities, making the transaction riskier than merger integrations, which typically focus on identifying synergies and cutting costs.

Consider the experience of a major chain of health clubs that acquired additional clubs through a carve-out. While the acquiring business expected to easily transfer data for customers of the other clubs, the process went awry and disrupted the billing systems. Some customers received the wrong invoices. Others received no bills at all. There were breakdowns in the process through which monthly membership dues were paid. Revenue plunged and cash collections dropped dramatically within a month, causing the company's banks to shut off its credit line and forcing the buyer to make a major, unplanned capital infusion. A situation that was entirely avoidable had put the very future of the company at stake and radically altered the deal's economics.

Stabilize, Then Optimize

Time is among the biggest challenges with IT in carve-outs. While it can take six months or more to establish a new corporate IT operation, parent companies (that is, sellers) are typically only willing to provide transition services for a minimal amount of time, creating operational risk for the buyer. Complicating matters, investors are sometimes reluctant to spend the time and resources to properly plan for the IT transition, hoping to manage costs in the event the deal falls through.

In ideal situations, investors take a "stabilize, then optimize" approach - doing what's critical to avoid major near-term problems and, at the same time, establishing a plan to properly support the new business in the future. One of the essential components is to set up a well-defined communication plan that clearly outlines the proposed changes and any concerns from employees, suppliers and customers. In addition, it is important to create a short escalation path with senior management. This will ensure decisions related to the carve-out are made in a timely manner. Although simple and logical, the success of the transition hinges on meeting critical deadlines and keeping impacted parties informed.

The first step for a carve-out is to assess the gap between the technology assets being acquired and the standalone business' day-one operational needs. It is important to take a “global” view of the organization to minimize risk and negotiate the right deal price. For example, “buying” new technology assets will impact capital costs, while “renting” assets through an outsourced option can be expensed. Once the decisions have been made, the costs must be included in company budgets and in any future deal projections.

In addition to reviewing core systems and back-office functions, it is essential to inventory all software licenses in use by the parent company. Licenses needed by the new business must be renegotiated. Transfer agreements must be established so that IT support will be available after the transaction closes and the new business will not be subject to significant fees, which can be assessed for running afoul of licensing agreements.

Managing IT Infrastructure

The next step is to determine who is going to manage the new business' IT infrastructure. In the early stages of the transaction, especially if transition service agreements are cost prohibitive or limited in duration, IT outsourcing options should be evaluated to stabilize the new business as quickly as possible.

Cloud computing is a topic gaining a lot of attention lately and is often seen as a viable option for small to mid-size organizations that want to leverage the “pay-as-you-go,” self-service internet infrastructure. The benefits to cloud computing include eliminating large capital outlays of cash, while maintaining the flexibility to scale services as the business grows. However, over the long term it may be less expensive for some organizations to invest in their own infrastructure. The estimated break-even point on managed services is approximately three to five years.

Managers must also begin to plan for key hires to lead and manage the technology operations. In the short term, organizations can seek temporary resources for skills required to complete an integral part of the separation. Having the right level of knowledge and functional experience are key factors for the success of a complex and time-restricted carve-out.

Carve-Out Success Story

Consider the divesture of an asset management firm that operated in 25 locations globally with over 1,600 employees. One of the biggest challenges the company faced - outside of aggressive deadlines, high transition service costs, and strict regulatory concerns - was its entire infrastructure platform (including the staff to run the department), which needed to be built from the ground up.

Alvarez & Marsal was hired before the transaction closed to assist with designing a new technology strategy and to aid in executing and building out infrastructure capabilities. This included outsourcing the corporate data center and disaster recovery sites, setup of the help desk and desktop support functions, and third-party hosting of a financial accounting package. In addition, over a five-month period, 200 business applications were successfully migrated from the former parent company to the new corporate infrastructure.

As a result of proper planning, communication, and execution, the company successfully migrated from its transition service agreement six months earlier than planned - saving the organization significant expenses.

Conclusion

Carve-outs present a number of significant challenges, particularly due to the technology requirements of today’s businesses. Proper IT planning as part of the due diligence process - in the early stages of a transaction - is essential to implementing a transition plan that is designed to minimize risk, reduce the likelihood of costly business disruptions and help to ensure the ultimate success of the deal.

Anthony Treccapelli, Managing Director, contributed to this article.