Unlocking Value In Carve-Out M&A Transactions
In this Law360 article, partners Kevin Crews and Rami Totari discuss the structure of carve-out M&A transactions and their unique intricacies and challenges.
The market for carve-out transactions has remained resilient despite relatively muted merger and acquisition activity.
Large companies are increasingly refocusing on their core strategies and utilizing carve-out transactions as they take a portfolio-level approach to optimizing their businesses, ultimately generating liquidity through the sale of noncore assets that don't align with their longer-term visions.
From a buyer's perspective, a carve-out transaction can present a compelling opportunity to grow an existing business synergistically with a complementary set of assets or alternatively, in the case of a financial buyer, to utilize available capital to acquire an underinvested business at an attractive valuation.
Some of the largest M&A transactions in 2023 were carveouts, including GTCR LLC's recently announced acquisition of Worldpay Inc. in a transaction valuing the business at $18.5 billion.
Preparing for a Carve-Out Transaction
Because carve-out transactions involve an operating unit that must be disentangled from a seller's overall business and either integrated into a buyer's structure or operated on a stand-alone basis, they often require a high degree of sophistication in planning and execution.
Approaching the various intricacies present in carve-out transactions with thoughtfulness and preparation will result in a smoother transaction, both pre- and post-closing, leading to a more seamless transition of the business from the seller to the buyer.
Structuring the Sale
The divested business will invariably be intertwined with the remaining business of the seller, and an analysis of the entanglements is a fundamental prerequisite prior to consummating a transaction.
For example, the two businesses may share commercial contracts, physical facilities, back-office functions, a labor force, real property rights and intellectual property rights, among other complexities, each of which needs to be carefully and comprehensively addressed.
Following the separation analysis, sellers may elect to implement an internal reorganization, pursuant to which they will transfer a specified set of assets and liabilities intended to be divested into a newly formed subsidiary.
Oftentimes, in the case of in-scope contracts, sellers can take advantage of customary affiliate exceptions to anti-assignment provisions and transfer such contracts into the newly formed subsidiary, averting the need to seek consent from a large number of third parties.
However, certain other contracts — e.g., with customers or suppliers — may need to be utilized by both the divested business and the remaining business, necessitating such contracts to be split or replicated in consultation with the respective counterparties. The equity of the newly formed subsidiary will often then be sold to the buyer to consummate the carve-out transaction.
Alternatively, carve-out transactions are commonly structured as asset sales or, in cases where the ownership of the in-scope assets is concentrated in one or more subsidiaries of the seller, equity and asset sales.
While asset sales are more likely to implicate contractual anti-assignment provisions and require additional third-party approvals, buyers may prefer this structure, which in certain cases allows them to obtain a step-up tax benefit or limit the set of contingent liabilities assumed in the transaction.
Given the asymmetry of information between sellers and buyers in carve-out transactions, carve-out purchase agreements commonly contain a sufficiency of assets representation that provides buyers comfort that the assets they will be receiving are satisfactory to operate the divested business on a stand-alone basis, as well as a wrong pockets covenant that requires any in-scope assets that are inadvertently held back by the seller following the transaction closing to be transferred to the buyer for no additional consideration.
Other Key Considerations
In addition to determining the structure of a carve-out transaction, the parties will need to address other key carve-out deal points, certain of which are described below.
Transition Services Agreement
Transition services agreements are a unique feature of carve-out transactions and serve an essential role to bridge any gaps created by the transfer of ownership of the business.
The transition services agreement provides the framework pursuant to which the seller will continue to provide shared services to the divested business until the buyer can secure such services either in-house or through third-party contractual arrangements.
Transition services are frequently provided at below-market rates, typically at cost plus a nominal margin. Administering the transition services arrangements between the parties requires close coordination. A common approach is for each party to designate one main point of contact to ensure effective communication and administration of the furnished services.
The transition services agreement is usually fully negotiated and agreed upon concurrently with entry into the underlying purchase agreement, which provides the buyer with sufficient comfort there will be minimal business interruption to the divested business following closing.
Financial Statements
Carve-out transactions will very likely require the seller to prepare unaudited or, in certain cases, audited financial statements covering the divested business, as it is often not a distinct reporting division, and allow buyers to rely on such financial statements.
Carve-out financial statements give buyers a window of visibility into historical operations of the divested business and, in addition to aiding in buyers' diligence efforts, are frequently required in connection with capital-raising activities — e.g., buyer's debt financing efforts — and requested by representation and warranty insurance providers.
Further, public company buyers may have U.S. Securities and Exchange Commission reporting obligations that require a specific set of historical financial statements to be filed depending on the significance of the acquisition relative to the buyer's existing business.
While preparation of financial statements is ordinarily a long-lead and resource-intensive undertaking for the seller, this workstream critically affects many aspects of the transaction and should be considered early in the transaction timeline.
Real Property
Shared facilities or real property interests as between the divested business and retained business present a unique set of challenges in the context of a carve-out transaction, especially if the real property interests involve a third party, such as a lease, right of way or easement.
Shared leased real property is often addressed through a sublease arrangement or a renegotiation and bifurcation of the primary lease with the landowner, while rights of way and easements must be split into separate real property interests that can be, respectively, retained by seller for its ongoing business and sold to buyer with the carved-out business, in each case requiring the third-party owner's consent.
Conversely, shared owned real property is often addressed bilaterally between the seller and buyer either through a leasing arrangement or a subdivision of the property followed by a conveyance of title to the applicable portion of the property.
Any transfer of real property requires a careful examination of potential title and environmental liabilities.
Intellectual Property and Information Technology Systems
A similar analysis needs to be conducted with respect to IP and IT related assets, including software and other IP licensing arrangements and seller-owned IP rights used by the divested business.
Access to data and IP can represent a meaningful portion of the transaction value, and buyers need to ensure they are adequately receiving the benefits thereof while complying with applicable regulatory regimes, including related to data privacy, and protecting against cybersecurity and related concerns.
Seller Indebtedness
Prior to consummating a carve-out transaction, the parties must consider the seller's debt profile, as assets that are intended to be sold may constitute pledged collateral or be housed within a restricted subsidiary, in each case with certain limitations imposed thereon.
Close coordination with lenders and their counsel is advisable in such cases, including an evaluation of whether any cash consideration received in the carve-out transaction must be used to pay down any of the seller's outstanding debt.
Additionally, if the seller intends to amend or refinance any of its debt in connection with the carve-out sale, the quality of the lien release that buyer will receive at closing with respect to the divested assets may be affected.
Tax
During negotiations, buyers should pay close attention to potential tax liabilities, including legacy liabilities of the seller's consolidated business, that will be deemed to follow, on a joint and several basis, the carved-out business — e.g., so-called dash six liability.
Tax considerations are commonly a central driver of deal structure, and employing both tax advisers and legal advisers is critically important.
Employees
The parties will need to identify which members of management will remain with the seller and which will move with the divested business following the transaction, which is acutely important in instances where such individuals provide overlapping services to the divested business and the retained business.
The parties can address any resulting gaps in various ways, including through short-term consulting arrangements and employment and benefits-related transition services agreements.
Further, buyers will need to carefully address human resource matters, including benefit plans and payroll, following closing.
Representations and Warranties Insurance
Representation and warranty insurance is currently underutilized, albeit gaining more prominence, in the carve-out market, with fewer carve-out deals retaining representation and warranty insurance compared to more typical M&A transactions.
Often the seller parent will stand behind representations and warranties with a traditional indemnity, due to the complexity of carve-out transactions and the depth of the disclosure demands from representation and warranty insurance underwriters, as well as the fact the seller will continue to operate an ongoing creditworthy business.
Conclusion
Parties considering the purchase or sale of a carved-out business should approach the transaction with intention and forethought given the complexity inherently involved in such processes.
Despite their unique intricacies and challenges, carve-out transactions, when carefully planned and diligently executed, offer both buyers and sellers the opportunity to generate outsized returns in an otherwise vigorously competitive landscape.
