Unplanned cash burn and EBITDA erosion are common in carve-out transactions. In most of the deals we engage with, there are multiple points where buyers and sellers allow value to leak over the course of the transaction.

It is critical for financial buyers to have carve-out and industry experience on hand in order to know where to focus, to have detailed analysis ready to support negotiations, and to make a small number of high impact changes to the sale and purchase agreement (SPA) and transitional service agreement (TSA), to keep focus on the overall deal thesis.

Targeting areas of potential leakage can increase the overall confidence that the carve-out will be successful and realise the buyer’s investment thesis.

Carve-out deals create multiple points of value leakage

Several key factors lead to value leakage in a carve-out:

• A lack of clear information at the point of signing a deal;
• The difficulty for buyers of assessing separation costs and phasing;
• The pressure to get the deal done without coming across as ‘difficult’; and
• The architecture of a typical auction sales process.

The operational activity to deliver a carve-out and establish the target business on a standalone basis are both detailed and complex. Initiatives include IT systems separation, staff transfers, contract breaks, production facility and office moves, and more. All of these require specialist experience to accurately assess the potential costs, effort required and implications for the carved-out unit.

The SPA and TSA core transaction documents are not well equipped to deal with the uncertainties present at the pre-signing stage of a separation. Key questions – who is obliged to do what? Who delivers IT separation and when? And who pays? – are likely to be answered in general terms rather than with specifics.

However, without robust views of cost materiality, separation duration and initial cash requirements, it can be risky locking into SPAs or TSAs and difficult to push back during negotiations.

How buyers should deal with sophisticated sellers

The process of preparing a business to be carved-out is becoming increasingly sophisticated and at times also commoditised. Well-prepared sellers maximise their proceeds before deal completion by carefully managing the disclosure of separation related information and using highly configured seller-friendly SPA and TSA mechanisms. This protects sellers by shifting costs and effort to the buyer, usually with a notional “joint planning” mechanism during sign-to-close as a mitigation of buyer risk. However, typically most value will already be lost through the SPA and TSA heads of terms.

Dealing with unprepared sellers

When a seller is unprepared for a separation the risks of value leakage for the buyer can increase through uncertainty. In our experience the buyer will make preliminary value estimates, but estimates may be complex to justify to a buyer and often conceded in the broader deal negotiation. Therefore, buyers should focus on the seven key drivers of value leakage.

At A&M, we see seven drivers of value erosion. The seven drivers arise when a lack of information creates uncertainty, which can be difficult to protect through SPA drafting, allowing the seller to push potentially significant costs to the buyer. Additionally, inflexible TSA design at deal close allows the seller to offset their stranded cost by creating high dual-running costs for the buyer. The most common value leakage drivers are:

1. Third party consents: We frequently see open-ended cash and EBITDA exposure related to transferring contracts from seller to the NewCo. This is an area where the buyer is highly dependent on the seller and is particularly complex in technology functions and businesses. Additionally, we are increasingly seeing software suppliers using TSAs as a revenue stream, with complex terms preventing delivery of software under the TSA without incurring significant costs.
2. TSA bundling: Individual services are often bundled into groups to reduce the seller’s stranded costs, but which increase the buyer’s dual running costs and limit exit flexibility
3. TSA notice period: The seller’s preference for certainty over flexibility can create excessive notice periods, potentially forcing buyers to extend short transitional services (often with onerous costs) by default.
4. Software licence re-purchase: Any shared third-party contract could be subject loss of volume discounts when split, but software maintenance licences often require up-front repurchasing. Given the volume in most businesses these costs can quickly aggregate to be material.
5. Third party cost pass-through: If TSAs cover a long period of time, it is not unusual for underlying supply contracts to end, leaving the buyer to renegotiate or find alternative suppliers.
6. Staff transfer dates: The usual focus is on understanding staff transfer requirements on completion. However, some staff can be caught up by transfer law due to delivering TSAs which have then to be included in the buyer’s run or severance costs.
7. Staff volume vs. capability: The seller will seek to retain talent in shared teams resulting in the buyer needing more FTEs to replace shared historic levels. This incremental cost is then a downside to expected standalone costs.

Industry sectors amplify different drivers

The value leakage drivers above are common to carve-outs across all industries. However, the prevalence and impact vary; for example, software licence re-purchasing is more likely to have a material cost impact in a technology platform business, whereas TSA bundling is more significant in multi-site global manufacturing.

A&M’s perspective

Separations do not take place in isolation. In addition to managing day-to-day operations as a carve-out takes place, there may be restructuring work or target operating model transformations taking place too. These all need to be taken into consideration as you build up to your final offer and move towards deal signing.

During this process, mitigating value leakage is vital. Practical experience, implementation pace and a relentless focus on creating deal value are the ingredients that will define success and failure. It is critical to have carve-out and industry experience in order to know what to expect and to deal with uncertainty through fast-paced and complex carve-outs.

A&M: Leadership. Action. Results

A&M has worked with private equity firms in Europe and globally to stabilise financial performance, transform operations, catapult growth and accelerate results through decisive action.

Our professionals have extensive experience supporting sellers and buyers through carve-outs and divestments, helping guide businesses through tough, complex situations. To learn more about our expertise and to understand the full scope of our Private Equity Performance Improvement work, contact a member of our team.