Key Operational Carve-Out Considerations For Sellers

April 2019

Alan Castillo, Principal – Transaction Advisory Services, BDO USA, LLP
 
There has been a significant increase in divestment activity in the past few years. Divestments will continue to play an important role in the future plans of many companies. According to several market surveys, over 80% of companies plan to divest in the next two years. Companies have become more active, rigorous, and disciplined in managing their portfolio of businesses, so they are able to streamline their operating models, maintain sharper focus and be more responsive to market changes and opportunities. However, the environment for divestments has also become more challenging—there has been an increase in market uncertainty and buyer scrutiny. For example, the price gap between what buyers expect to pay and what sellers expect to receive has increased over the past year. Therefore, it is important for sellers to prepare for the divestiture or carve-out process early and develop a credible value story to achieve their desired valuations.
 
With that in mind, here are four key operational carve-out considerations for sellers:

1. Develop a Stand-Alone Operating Model
Stand-alone operating models can help sellers package the business being carved out to maximize its value. Transaction prices are typically based on the business’s EBITDA, so it’s important for sellers and buyers to understand the stand-alone recurring costs or the costs of running the business when developing their valuation models. When corporate and shared services are involved, sellers and buyers need to analyze the business’s existing allocated costs and other operational changes that will result from the carve-out (e.g., loss of leverage on vendor contracts) to understand the stand-alone cost model. Sellers must have a clear understanding of stand-alone costs and what it will take to carve-out the business early in the process. If sellers are unable to answer detailed stand-alone cost questions from buyers during due diligence, buyers will increasingly focus on that area and potentially gain control of the negotiation. Sellers will more likely recognize greater value by presenting a stand-alone cost model. It will help give buyers confidence in the business’s operating model—that it has been properly prepared for sale with a comprehensive separation plan.
 
There are additional benefits to developing a stand-alone operating model. It will help define the Transition Services Agreement (TSA), identify one-time separation costs, and mitigate stranded costs. Additionally, a stand-alone cost analysis will be a good foundation for the seller’s separation planning and the buyer’s integration planning, both of which will be greatly accelerated.
 
Developing a stand-alone operating model starts with defining the perimeter of the carve-out or “what’s in and what’s out”. The business to be divested can be defined differently by executives and functions within the organization. The business’s financials are often prepared utilizing historical data that contains improper allocations, excludes certain costs and does not reflect the business to be divested. Consequently, it is critical to align the deal perimeter across all functional areas with a clear line of site to the stand-alone cost model.

2. Develop a TSA Strategy
A TSA is a contract in which the seller agrees to continue providing, on a temporary basis, corporate or shared services (e.g., HR, IT, Finance) to the divested business after it is sold. TSAs are necessary in most carve-out transactions because buyers are typically not equipped to provide such services to the businesses they are acquiring by Day 1. Unfortunately, TSAs can encumber sellers with unwanted responsibilities and costs, disrupt their operational improvement initiatives, and delay necessary mitigation of stranded costs. Developing a TSA strategy early in the divestiture process can help sellers determine what can be done to minimize TSAs or avoid them altogether. This starts with understanding the complexity of the divestment and what it will take to disentangle the business from the parent. A TSA strategy can also help sellers take charge of the TSA negotiation process with the buyers. If TSAs are necessary, sellers should price them at cost-plus, add an escalating pricing structure for extensions, cap them at 12 months, and manage them in relation to stranded cost mitigation plans.

3. Plan to Mitigate Stranded Costs
Sellers must evaluate how the divestiture might affect the remaining business. A major concern is the extent to which the divestiture can lead to stranded costs—i.e., costs that were shared with the divested business but will remain with the parent. These stranded costs must eventually be absorbed by the remaining operations or eliminated through right-sizing or reengineering the remaining business. As part of a stand-alone cost analysis, sellers can identify and assess the shared or allocated costs between the business to be divested and the parent which will typically be the source of the stranded costs. Identifying these potential stranded costs early in the divestiture process is important so that sellers can develop mitigation plans. It is also important because sellers often underestimate the time and effort required to execute those plans. A good mitigation strategy will include as many shared people, facilities, and other assets in the transaction perimeter as possible, so that they go to the buyer at close.

4. Plan and Organize for the Separation
Divestitures can be very complex, because of the extensive interdependencies among functional areas, processes and systems. Over time, the operations of business units can become very entangled with that of the parent and other business units through the implementation of shared services, consolidation of systems, etc. To carve-out a business while preserving its value, strong executive leadership, capable project management and effective communication are needed. Robust program governance structure and processes are required to enable separation teams to understand the operational interdependencies and the critical path to disentangle them, as well as to develop aggressive yet achievable timelines for the carve-out.
 
Value erosion can occur during the carve-out process. Sellers often see the divestiture as a sale of fixed assets and not as the sale of an ongoing business whose value depends on stability. With senior management engaged in the sale process, it is essential to devise a separation strategy that promotes operational continuity and interim performance throughout the entire divestiture.
 
As the divestiture progresses and a deal is signed, it will be important for the seller to work with the buyer to define “what Day 1 will look like”. Failure to properly consider the buyer’s Day 1 functionality requirements could result in significant money being left on the table. Sellers too often focus on their own separation issues and not enough on delivering a stand-alone, ready-to-run business.
 
Divestments will continue to be an important part of companies’ strategies. The environment for divestments has also become more challenging. To achieve desired valuations, it is critical that sellers prepare for the carve-out process early and develop a credible value story by: 1) developing a stand-alone operating model, 2) developing a TSA strategy, 3) planning to mitigate stranded costs, and 4) planning and organizing for the separation.