Carve-out transactions, which are the sale of non-core assets historically part of a parent company (ParentCo), provide great value creation opportunities for private equity (PE), but PE companies are often losing out.
As mainstream deals are becoming more competitive for PE and trade bidders alike, PE companies are turning their attention to carve-out transactions, which can be undervalued due to parent neglect and to unfocused legacy management teams.
These sale processes are highly competitive though, and from our experience of working for vendors and purchasers it’s clear that PE companies are often losing out to trade bidders, or not getting a seat at the table to start with. Why is this?
PE companies are finding it hard to be competitive in their valuations and pricing, often trumped by a trade bidder’s synergy case
There is a perception by the vendor that trade bidders are better equipped to execute the separation (ie shorter transition and lower risk to the vendor)
How can PE companies improve their chances of success?
White paper thinking
PE companies need to find an angle in the auction process, to identify value that enables them to compete on the same footing as trade bidders. They can do this by adopting a ‘white paper’ approach to define the optimum operating model for the target business that is ‘right sized,’ and rigorously challenging the norms and legacy that the target inherited from its ParentCo. This can help to offset the potential synergy advantages that a trade buyer has.
Because PE investors are not constrained in the same way that corporate bidders are (ie the target needs to fit within an existing model), opportunities may exist across the value chain. Consider for example, technology simplification, procurement savings from increased scrutiny, and back office efficiencies through outsourcing, in-sourcing, or robotic process automation (RPA).
Cash is king
Also consider opportunities to improve working capital performance and instil a cash culture, which is unusual in a non-core business operating as part of a much larger ParentCo. If group disciplines around cash and working capital exist (not always the case), they don’t always filter down.
System design in the target’s future operating model needs to encourage accurate data, and automated reporting, to equip PE companies with information needed to track progress across the life-cycle of the asset.
We are experiencing a trend where PE funds are developing a business information (BI) strategy to support aggregation of reporting from all portfolio companies. This equips Investment Directors with the information to be able to support the target management team post-deal. PE companies that are equipped with both BI reporting capability, and a best practice working capital management approach, are well-placed to create maximum value over the life-cycle of the asset, and release cash for debt repayments or to fund further acquisitions.
Technology is the key area that drives most separation complexity, risk, and cost, but it also presents the greatest opportunity to operate smarter, more cost effectively, and with greater flexibility. The carve-out target is often part of a complex legacy IT environment, with customised enterprise resource planning (ERP), or bespoke system landscape, running on heavily invested infrastructure designed for ParentCo scale. This is rarely the right answer post-sale.
We see opportunities on most carve-out transactions for the purchaser to move to a simplified IT landscape that is cheaper to set up and run through the adoption of cloud based subscription services, is more flexible in adapting to evolving business requirements, and is scalable to support future growth (including buy and build).
Corporate mentality, PE agility
Identifying value is not enough. PE companies also need to persuade the vendor that they can execute the separation in a reasonable time frame while managing risk. This can be done through an understanding of the operational issues, and by having a clear proposal for the separation approach. Most vendors are not in the business of outsourcing. They want to avoid a protracted transition which disrupts their core business.
If carve-out transactions are core for you, develop a ‘playbook’ which defines how you will approach separating and standing up the core services and technology provided by the ParentCo, and tailor each transaction as needed.
For example, understand the most appropriate ERP solutions for your target’s sector, and the data migration road maps that can be utilised to minimise risk and accelerate the separation process, through a tried and tested approach. Not only will this help to build credibility with the vendor, it will allow a more accurate assessment of future operating costs, and the quantum of investment required, that is not overly conservative.
Watch out for management
The motivation and ability of the target management team ranks as a significant risk factor for many PE bidders, in all types of transaction. But the risk is greater in a carve-out context, where there may be a history of operating within the constraints of the ParentCo, sometimes cocooned. This should be a red flag, but what can PE do to mitigate the risk?
Use every opportunity pre-deal to assess management from the first interaction and management presentation, including the informal side conversations. Identify the stars already in place, work closely with them (as far as possible) during due diligence, and consider external candidates.
However, significant management change soon after deal completion can compound the risk, when taking control / stability should be priority. Negotiating a robust transition service agreement (TSA) sponsored by target management is critical, as this should ensure business as usual and allow management change to be made during transition.
There is no silver bullet, but PE should be aware of the people risks, and of opportunities to leverage and develop existing talent.
With the right mindset and approach, PE companies can not only play on a level playing field with trade buyers on separated assets, they can get ahead of the game through deploying agile thinking and pre-planning. However, PE companies that simply enter a process without adequate focus and pre-thinking will get left behind in this increasingly important asset class.