Montagu on managing risk, seizing opportunities with carve-outs

Corporate carve-outs present a host of operational challenges, but with the right execution they can become highly valuable businesses, says Tim Cochrane, director and head of the Full Potential Partners team at Montagu.

This article is sponsored by Montagu.

As large companies emerge from the pandemic only to enter another difficult economic environment, many are looking to divest non-core businesses to generate cash and focus on what they do best. Last year, even before inflationary pressures started to bite, carve-outs surged, with global value totals reaching $2.3 trillion, up 67 percent on 2020 figures, according to Dealogic.

These deals offer private equity firms a range of opportunities, but they are not for the faint-hearted. Tim Cochrane, director and head of the Full Potential Partners team at mid-market private equity firm Montagu, discusses what it takes to execute a carve-out successfully and where the market is heading.

Where are you seeing most opportunities in carve-outs in today’s market?

Tim Cochrane

Carve-outs from large, listed businesses are usually triggered by some kind of change, either at the parent company or in the economy, as management ask who the best possible parent is for each business. There is also an increasing trend for companies to periodically evaluate their strategies and make divestments of businesses that are no longer a good fit for the parent company.

We focus on healthcare and technology-enabled businesses, so that is where we see most opportunity. We recently announced two carve-out deals: Maritime Intelligence and EPFR (Emerging Portfolio Fund Research), both from Informa.

From our experience we see that carve-outs can happen across economic cycles, and different economic conditions can cause companies to think differently.

Has the rationale for carve-out sellers shifted as the economic outlook has become more challenging?

Over the next 12-24 months or so, the broader economic environment will drive carve-out transactions. Many realise that even if a business has a strong enough balance sheet to withstand a potential downturn, there is substantial benefit in focusing on core competencies if the economy takes a turn for the worse. Companies are asking whether there is a better owner for some of their businesses and taking the opportunity to monetise this through transactions.

How do you source carve-outs, given that they are often not widely marketed?

When restructuring a business, the parent’s management team tend to have two main criteria. The first is that they want to achieve a fair price for the business.

The second is that they want an efficient and timely process. They do not want the sale to be time-consuming or disruptive to the parent company or the business being sold, and they often have particular timetables to run to.

Montagu builds long-lasting relationships with businesses across multiple sectors, and with our significant experience and track record in delivering carve-outs we are able to give potential vendors confidence that we can execute efficiently throughout a deal process, helping to unlock deal opportunities.

Carve-outs tend to be on the more complex end of the deal spectrum, so what does it take to make these transactions successful?

They are far from straightforward. It takes experience, plus appropriate and skilled resources to make them work. We have completed 28 carve-outs since 2002 – that’s about half of the deals we have done in that period.

There are complexities in each of the three deal phases. In the pre-signing period, which tends to take between six and eight weeks, you need to understand what is in the deal’s perimeter, including, for example, people, infrastructure, IT, systems and intellectual property. It’s likely you will need to build out new teams in areas such as finance and human resources, for which the business would previously have relied on the parent company. The EBITDA changes because the original overhead costs no longer apply – there will be new ongoing costs and there will be one-off costs as you hire new people and replace items and systems.

At this stage, you also need to understand what transition service agreements (TSA) and long-term service agreements you need to have with the parent company while you put in place the right infrastructure, and what access you will have to key requirements, such as data. That takes experience and confidence because if you get this wrong and you underestimate your costs, the deal will suffer.

And what about the other two phases?

The next phase is after signing, before completion kicks in. This stage usually runs for eight to 12 weeks and involves turning the TSAs into legally binding commitments. For example, you have agreed that the parent company will provide HR support, but you need to dig into the detail of what exactly you need and for how long. You need to be clear and precise to ensure that the TSAs work the way you need them to.

At the same time, you will be onboarding the interim executives who will run the business and build up the organisational framework. They need to manage employees and customers, which takes clear and careful communication.

Finally, post-close, you are finalising building the operating model, executing the TSAs, building out new teams and often putting in new IT systems. Often the IT in place works well for large organisations, but not for smaller, more agile businesses, which need simpler systems. All this takes around two years to implement fully.

There is a lot that can go wrong – the ongoing cost estimates might be out, you can fail on implementation or miscalculate the length of the TSAs. You need to be good at supporting management to design interim and target operating models and you must have the capabilities to support management in rapidly ramping up hiring – these are what drive success in these deals.

Do you have any examples of how you have managed some of these complexities?

Janes is a great example of what is required to build the right operating model. Janes is the leading global provider of open-source defence intelligence, trusted by militaries, governments, the intelligence community and the aerospace and defence industry. The business was previously owned by IHS Markit and has a legacy of over 120 years. While it involved carving out a whole business, what we were acquiring was a brand, the underlying data capabilities and the front-end of the business, but limited HR and finance functions. Janes also needed investment in new technology that allowed customers to manipulate the data.

The new Janes management team had to build out new HR and finance teams as well as scaling the salesforce internationally. There was an opportunity to invest in its customer-facing technology to address customer needs to interconnect defence-related datasets. Overall, there was a 12-month transition period that was governed by around 150 TSAs – that’s a lot of detailed planning.

Miraclon – a leading provider of imaging technologies for the graphics customisation of printed packaging materials that has developed innovative printing for packaging – is another example that shows how much resourcing can be required in these situations. We carved this out of Kodak by acquiring the assets.

Initially it was reliant on Kodak for its support functions, including HR and finance, as well as for some of its logistics and supply. Management identified the need to hire 100 full-time employees, doubling the number of non-manufacturing staff. This presents challenges, such as how you find talent, how you onboard that number of people and how you create the right culture. You want to create a collegiate culture, a coherent operating model and a vision for the business.

Our team supported Miraclon through this and helped find a senior team that could work with the CEO to create the right culture and bring in all the necessary staff. At the same time, the business had around 140 TSAs with Kodak, which we wound down slowly.

You have also completed carve-outs that involve subsequent M&A. How do you manage that added complexity?

That’s right – we acquired school software business ESS from Capita with a plan to merge it with education technology provider ParentPay following the deal’s completion. It was already a complex deal because ESS was highly dependent on Capita and we needed to close the deal within just six weeks of signing. On top of that, the potential ParentPay merger was subject to regulatory approval.

As a result, we had to be flexible in our planning. We needed to move quickly, but we also had to plan for both eventualities of the merger being or not being approved. It meant minimising some design choices until we had some clarity on whether the merger could go ahead – for example, would we need a new enterprise resource planning system or would that create extra complexity if the merger went ahead?

Our experience and therefore confidence in supporting these sorts of deals enabled us to get this over the line to back ParentPay Group.

How do you see carve-outs evolving over the coming years?

Given the economic climate, we will see an increase in carve-outs as corporates look to monetise non-core businesses, bolster their balance sheets and focus on their core capabilities.

There will also be demand for carve-outs. As a private equity investor, you can create significant value just by carving out a business because there are a lot of potential sponsors that would be interested in these companies but that do not have the experience to execute this type of deal.

However, you can also create additional value beyond that – the carve-out is just the starting point. You can then layer on the usual value-creation strategies, such as M&A, investing in technology and expanding into new geographies, products and customer bases.