Unlocking hidden value: corporate carve-outs

A carve-out transaction is when a company sells a division or business unit, typically one that is no longer a core part of its operations. Depending on the structure, and consideration paid by the Buyer, a carve-out can also be called a carve-up, spin-out, spin-off or demerger.

Carve-out transactions can be complex and challenging, as they involve the separation of a business from a larger entity, which requires the Seller to identify and account for all relevant assets and liabilities. This can present significant financial, tax, legal and operational risks and opportunities for both Buyer and Seller.

Carve-outs can be particularly relevant for larger corporate entities seeking to optimise their portfolio, refocus on core assets and reduce their leverage, and for financial sponsors seeking to find well-valued targets on which they can use their expertise and backing to generate considerable investment upside.

Whether you are a Buyer or a Seller that is a corporate entity, a private equity house or financial sponsor, there are a number of key issues that will be important for every carve-out transaction, whether domestic or cross-border:

1. What is the equity story of the Target as a standalone business?

Target businesses in a carve-out transaction are often 'unloved' and/or 'non-core' parts of a Seller's group, which over time have typically received less management focus. It is crucial for a Seller to shape a compelling equity story for the Target, demonstrating its potential value as a standalone business with a more active management approach and frequently a differing capital structure.  

For a Buyer, it is particularly important to understand whether the Target can operate independently and how it can drive long-term growth unshackled from the Seller's broader corporate group.

2. How do we separate the Target business from the Seller's ongoing business?

Very few corporate divisions will be neatly contained within one or more distinct corporate entities or operate entirely independently of the broader Seller group. Preparing a business for sale is likely to involve creating a separate legal entity for the carved-out business, and transferring assets, liabilities and employees into that entity. For a successful sales process, a Seller will therefore need to invest significant time to (a) identify the assets to be transferred and (b) formulate a plan for separating those assets from its retained group (including obtaining any lender and other third party consents to the disposal, if required). Delivering a clear and comprehensive plan to potential Buyers as early as possible in the process should inspire confidence and more likely result in a higher valuation and increased deal certainty by reducing contingencies in Buyer offer letters.

An effective separation will require a significant degree of collaboration between the Buyer and the Seller to identify all relevant assets and any interdependencies. However, Buyers should be aware of the misalignment of interests between the parties in respect of the success of the Target as an independent entity post-completion. As much as possible, a Buyer should therefore seek to use its "outside-in" view through the due diligence process to verify input from the Seller as much as possible. A Buyer is likely to take comfort if it is given access to the existing management team of the Target during the due diligence process, particularly if that management team will be retained following completion (given their vested interest in the continued performance of the business).

3. What happens if the separation of the Target business goes wrong?

An immediate priority for any Buyer following a carve-out acquisition is quickly seeking to understand the business from the "inside-out", and to understand any gaps arising from the separation, so they can be quickly remedied.

Depending on the structure of the transaction, a Buyer may be able to make use of a "wrong pockets" provision (which would provide for post-completion asset transfers to the Target or Seller post-completion if any key assets are subsequently identified as missing and/or have been erroneously transferred), but this should only be a fallback. If a transitional services agreement has been put in place (see point 5 below), this may include an "omitted services" mechanism which should also help to ensure the continued provision of any missing services which are necessary for the continued operation of the business. Additionally, W&I insurance or similar products may be helpful but will typically provide only very limited protection in respect of the carve-out itself.

Ensuring that the separation workstream is sufficiently thorough and diligent to identify and extract all of the key assets of the Target business, and to ensure the continued provision of all necessary services, is of utmost importance for a Buyer.

4. Are there any assets of the Target business which are particularly difficult to transfer out of the Seller's group?

The assets which are typically most complex and/or time consuming to transfer as part of a corporate carve-out include:

• Employees – consultation may be required under local legislation (such as TUPE in the UK) or through other arrangements with trade unions and/or works councils. Transitional secondment or services arrangements may also need to be put in place for any employees that do not transfer to the correct employing entity prior to completion.
  
  
• Software licences – new licences may need to be procured (sometimes with considerable cost and timeline impacts) or workaround 'pass-through' mechanics agreed, to ensure the Target continues to have access to key software systems post-carve-out.
  
  
• Electronic data – as well as the operational difficulties for separating and migrating data from shared or integrated IT systems, data protection laws in each relevant jurisdiction add another layer of complexity, particularly where personal data is involved. Preparation of a migration plan for these data transfers will be a key transaction workstream.
  
  
• Commercial contracts – some contracts relating to the Target business may sit in the 'wrong place' in the Seller's group and therefore need to be novated, or there may be "shared" contracts (i.e. benefitting entities on both sides of the carve-out) which need to be separated. Whilst many contracts will allow a contracting party to assign it rights under the contract or to subcontract its obligations under the contract to another member of its group, there will often be a restriction on assignment and subcontracting to third parties outside of its group, meaning that the consent of the counterparty is likely to be required, which will also generally be the case for the novation of a contract or for the separation of any shared contracts. This process will often take time and the co-operation of the relevant counterparties, and likely come at a cost.
  
  
• Real estate – the transfer of real estate assets (and, in particular, leases) may require landlord consent and/or a guarantee from the transferor in order to novate leases, or sub-lease to the Target. Additionally, co-located operations or shared premises require a detailed understanding of the usage and capacity required for both the carved-out Target business and the remaining Seller business. Transitional licences to occupy shared premises may need to be put in place.
  
  
• Licences and other regulatory approvals – in addition to antitrust and foreign direct investment laws (including the UK National Security Act 2021), which can apply to a pre-completion reorganisation as well as the broader sale to the Buyer itself, certain operational licences may not be transferable, requiring new applications to be made. In regulated sectors, this may involve demonstrating to regulators that the separated entity can still meet compliance requirements independently.

5. Will any transitional services be required to or from the Seller's group post-completion?

It is common for the parties to agree one or more transitional services agreements ("TSAs") or reverse transitional services agreements as part of a carve-out transaction, given the interdependencies that typically exist between members of a corporate group. The services provided under a TSA typically include HR, IT (including data storage and pass-through of software licences), accounting and payroll administration services, but can include many other services and supply arrangements depending on the nature of the businesses, the sectors in which they operate and the extent of interdependency. We have advised on a number of particularly complicated carve-outs involving a double-digit number of TSAs which were required to ensure that the Seller and Target could continue to operate successfully following the carve-out. 

The aim of a TSA is to facilitate a smooth transition while minimising disruption to each party's ongoing operations. The duration, scope and cost of the transitional services will need to be agreed and clearly detailed in the TSA. Much of this will depend on whether the Buyer has its own centralised intragroup service function and, if so, how quickly it can integrate the Target into those arrangements, or whether third party services need to be procured. We will be writing separately about the key issues to consider when drafting or negotiating a TSA.

6. How will the Target business be branded?

Of particular concern is whether the Target business uses a brand (including a trade name or trade marks) which the Seller intends to continue to use for its retained business post-completion. If so, the Buyer will need to consider either (a) obtaining a licence to continue to use the brand post-completion and/or (b) rebranding the Target business entirely (typically with the benefit of a short-term licence to allow it to continue to use the brand for a limited wind-down period following completion while the rebranding exercise takes place). Some carve-out transactions also involve the parties entering into a brand co-existence agreement (depending on the similarity of the brands and which party owns the relevant intellectual property rights).

A licence under option (a) allows for continuity and a smoother transition, but leaves the Target tied to the reputation of the Seller's brand and may involve a cost in the form of a licence fee. The Target's permitted use of the brand will also typically be subject to various restrictions (e.g. sectoral and/or geographical) and there is potential for issues down the line if the Seller is unwilling to renew the licence at the end of the initial licence period. Whilst option (b) may result in additional up-front costs, rebranding has the advantage of establishing a distinct identity for the standalone Target business as well as providing a higher degree of control over the Target's brand, although it may initially result in a loss of goodwill which was attached to the prior brand.

If the Buyer elects to rebrand the Target business post-completion then, prior to agreeing the term of the wind-down licence of the existing brand, it should obtain a practical understanding of how long the rebranding exercise will take (i.e. how extensively is the brand used throughout the Target business – for example, is it used on signage, vehicles, marketing materials, template documents, etc and what are the associated logistics and costs of removing/replacing these).

7. What are the tax consequences of carving-out the Target business?

This will require detailed input and analysis from tax advisors as to the structure and cost of any carve-out, and any exemptions or reliefs which may be available. For example, if the book value of Target business assets is materially different to the fair market value of those assets, this could give rise to a significant corporation tax charge absent an applicable relief.

8. How do I value the Target?

In the absence of standalone financial statements for the Target business, a well-advised Seller should consider preparing sell-side standalone accounts to help bidders assess the value of the Target. However, this has a cost attached and may not reflect the true 'go-forward costs' of the business, as the financial statements will often look at historical central cost allocations that may vary post-completion. Any Buyer will therefore need to ensure that its financial due diligence is sufficiently thorough to enable it to form a clear view on valuation.

In addition to understanding the stand-alone financial position of the Target business it will also be important for any Buyer to value any dis-synergies arising as a result of the carve-out, for example the loss of volume related discounts that the Target business may have had the benefit of as part of a larger corporate group.

9. Will the Buyer be able to obtain debt financing for the transaction?

Carve-out transactions have been an increasing trend in M&A transactions for some time, and lenders (both traditional banks and newer debt funds) are familiar with the complexity and additional uncertainty involved in a carve-out.

However, given their nature, every carve-out transaction will have its own unique quirks. As a result, these can benefit from 'lender education' processes which aim to cut through the complexity and help any external debt provider, who will be one step removed from the central negotiations, more quickly get a clearer understanding of the Target business to ensure a smoother transaction process.

10. Who will run the Target business post-completion?

With a carve-out transaction, there is less continuity for the business' management than on a typical private equity or financial sponsor-backed buyout – it is likely that a portion of the Target's management team will remain with the Seller post-closing. The Target's existing management team may also be more accustomed to a larger corporate vehicle, with limited motivation to support growth in the newly independent Target business – although some incumbents may feel empowered in the post-completion structure to drive the Target as an independent business.

The Buyer will therefore need to assess (a) whether the incumbent management team within the Target business has the right mix of skills and attitude to drive future growth as a standalone business and (b) how the Target's management team post-closing can be incentivised to support that growth, for example through employee incentive schemes.

Simply put, because they present a genuine win/win opportunity for the Seller (and its shareholders) and the Buyer.

Carve-out transactions can allow a Seller to streamline its business, helping to support future growth of the core business whilst also generating an immediate cash return for shareholders and/or reinvestment or deleveraging. Divisions sold in a carve-out transaction are frequently 'unloved' assets, often purchased by a previous management team, and/or undervalued by shareholders – most significant carve-out transactions from companies listed in the UK in the last 12 months have been for a higher valuation multiple than the valuation multiple given to the broader group pre-transaction where the valuation of the sum of the parts is greater than the whole.

For a Buyer, acquiring a carved-out business can present a real opportunity to add value, by taking a more hands-on approach to managing the business post-completion, increased capital allocation for growth and/or providing more specific expert understanding of what was previously a non-core asset. Additionally, carved-out Targets are often sold for a compelling valuation, allowing room for significant upside with a focussed growth strategy.

Experienced advisors can take a significant amount of the pain out of the process, allowing you to focus on developing and delivering on the post-completion growth strategy of the Target or retained Seller group.

We have a wealth of experience working on carve-out transactions in the UK, EU, US and beyond. Selected recent deals include advising: