In recent years, we have seen large corporates actively managing their portfolio of business lines, with a growing number of firms of all sizes participating in carve-outs. As a matter of fact, over the last 3 years, we have seen more carveout transactions and deal value than during any other period in the last two decades.
In the first half of 2021 alone, some major corporations announced carve-outs across sectors. In tech, we saw ATT, DirectTV carveout and sale to TPG and a Verizon, AOL/Yahoo carveout and sale to Apollo; in consumer products, Shiseido struck up deals w/Advent and CVC to carve-out parts of their portfolio of brands; and in retail, we saw Saks 5th Avenue carving out their e-commerce business to Insight Partners. This is just to name a few of these deals in consumer-facing and recognizable brands, but we have also seen similar levels of activity in the industrials and manufacturing sectors.
What’s more, we expect these levels of activity to continue.
What is driving this trend?
In short, there are several factors that are compounding the popularity of carve-out deals in PE in terms of both supply and demand.
On the demand side, we are in an environment with record levels of dry powder. The competition for good stand-alone assets is also increasingly challenging. Whereas investors may have been dissuaded by the added complexity of a carveout transaction in the past, as competition for stand-alone assets increases, investors are now more willing to add carve-outs to their consideration set. And of course, the more of these transactions that funds do, the more efficient and effective they become at executing them and realizing the value – so that begins to re-enforce itself.
On the supply side, companies are facing renewed pressure from Investors and boards to manage their portfolio and focus on their core businesses to drive growth. This pressure is bringing a lot of assets to the market. Many companies are also using this as an opportunity to raise cash and improve liquidity, particularly as they emerge from what was for many sectors a difficult past eighteen months.
These factors come together to create an environment where carve-out transactions will continue their pace – if not exceed it.
Why are carve-outs so attractive?
What many PE investors have realized is that, despite the increased complexity, when done right, carve-outs often provide superior returns vs. stand-alone acquisitions.
This is due to a few reasons – which are fairly intuitive. The asset being carved-out is often the “neglected one” in the parent portfolio in terms of management focus and investment. So, it is logical to think that these assets likely haven’t come close to their full potential.
On the other side of that coin is a good value. Because the sellers don’t often recognize the value creation opportunity in the asset, they often don’t price that in – so investors are effectively able to pick up these assets at a discount.
In fact – the carve-out event provides the opportune time to revisit the asset’s operating model, which really gets to full potential value creation.
But, beware the complexity…
While each situation is unique, there are several factors that make carveouts more complex than a stand-alone transaction may be.
First, it is important to acknowledge that the degree of complexity is directly correlated with how entangled the asset is with the parent company. If an asset that is already run as a separate business unit, with in a decentralized operating model it would be a more straightforward transaction than an asset whose operations and infrastructure are deeply embedded in the parent company.
Second, there may also be an information asymmetry problems. Sometimes, investors find that the parent company is either unable or unwilling to share reliable data on the asset. This can be because they’ve never tracked it – or, in some cases, sharing that information would reveal broader information about the parent or its other businesses.
There are also times when interests aren’t always aligned between buyer and seller. The seller will want to retain the best assets and people and they will want to end the TSA as soon as they can so they can focus on their core business.
And last, but not least, the transaction itself can become a distraction to the day-to-day running of the business. This in itself can sometimes cause declines in performance and attrition of top talent, among other issues.
While carveouts are certainly not without their challenges, there are some key steps that investors can take to mitigate them.
So how do you mitigate the challenges?
The most important first step to take is to be clear on the definition of the business being carved-out. The deal must have clarity on what – and who – will be coming with the asset, and what’s staying with the parent. It is crucial to align on what resources will be shared – not just Corporate IT, but IP, Customers, Suppliers, etc.
It is crucial to also be much more front-footed in your value creation planning. That often means taking steps like rethinking the operating model during the diligence phase itself and building a credible value creation plan - and aggressively pursuing it post-close. For many investors, putting as much focus upfront on value creation as they do on risk mitigation is a difficult shift in mindset – but not doing so leaves a lot of value on the table.
Finally, don’t underestimate change management and communication when planning the story of the carve-out. The story has to make sense and has to be compelling to the employees. They need to know why they should stick around to see your next great phase of the business.
When considering a carve-out, it is crucial to understand that sellers who can execute carveouts have the ability to generate a better return, and investors who are savvy on carve-outs have the ability to drive higher value creation. It is clear that carve-outs bring a lot of value to the table, as long as these key concerns are taken into account.