Private Equity involvement in corporate carve-outs has increased significantly since the beginning of the pandemic.
In the UK alone, there were 14 carveout deals involving PE funds last year, compared to only six in 2019 It is perhaps unsurprising that carve-outs are on the rise, given the number of businesses that have been left with lower than expected returns on capital and find themselves urgently needing to strengthen their balance sheets.
But these deals are not for the faint-hearted. They can involve a host of complexities and challenges. So why do carve-outs continue to attract such interest from PE firms, and what are the keys to successful investment and the pitfalls to avoid?
During a recent panel session I led at Private Equity International’s Operating Partners Forum Europe 2021, one investor observed that it is precisely because of their complexity that carve-outs appeal to PE firms, stating that: “Risk and complexity might scare a corporate buyer but we love complex deals, because they give us a chance to make a really good return if we get it right.”
This ability to embrace risk and execute deals quickly is one of the main reasons that increasing numbers of businesses are considering PE investment. Unlike many corporates, PE firms are able to commit to long funding cycles. This long-term commitment is particularly crucial in sectors such as telco or fibre.
At the same time, PE investment is sometimes greeted with suspicion by managers who remain in the carved out organisation, who often assume the funder is going to look to cut costs to the bone and quickly flip the asset. The panel agreed that communicating a clear vision for the new organisation is critical in order to overcome this misconception.
As one panellist put it: “The reason we like carve-outs is not because we can take out cost or restructure the business, but because we can take a business that has been left on its own, unloved and underinvested, and actually make it grow.”
Developing a strong value creation plan during due diligence
Although a buyer will rarely get all the information they’d like about the carved out business straightaway, it’s nonetheless important to develop a value creation hypothesis as early as possible. As more information becomes available through due diligence, this hypothesis must be continually assessed and adjusted.
One investor argued the best value creation plans avoid the trap of placing too much emphasis on EBITDA. “If you’re doing that, you’re immediately limiting your growth potential,” they said. “If you want to grow value by multiples, you need to show how you would put ESG, digital transformation, or whatever it is that’s necessary to transform the business at the core of your strategy.”
It’s also important to understand what kinds of business information and data will give the best insight into any potential deal pitfalls.
“I always look out for cashflow,” said one investor. “It’s one of the few things that doesn’t lie.”
Negotiating the TSA and being ready for when your foot is in the door
Although there is often pressure from sellers to get a deal done quickly, it is important for investors to take the time to negotiate detailed Transition Service Agreements (TSAs). While there may be limited scope for wrangling over much of the detail, it is critical to know what you are signing up for.
The panel had one key piece of advice on handling TSAs. “It’s a business decision, so the negotiations have to be led by the business side. Don’t let lawyers run the show.”
When asked about the best approaches to executing the 100-day plan once you’ve got a foot in the door, our panel had a number of critical insights to share:
- Move beyond the TSA as soon as you can, so the carved out business can start building its independence.
- Create a dedicated carve-out team so the CEO and CFO can concentrate on running the business continuity plan.
- Work backwards from your end goal. For example, understand what kind of finance function, IT set-up etc. that you will need at the point of exit, and how you can build towards a seamless transition from day one.
The panel also offered their thoughts on how investors can ensure they are seen as a credible option for the seller.
One investor summed it up thus: “You have to understand the seller and what their motivation is. It might not just be price, so make sure you sharpen all the other areas of your negotiation strategy.”