Value creation in carve-out deals

With competition for deals intense and purchase price multiples reaching all-time highs, private equity houses are increasingly turning to corporate carve-outs to generate returns. PwC partner Tobias Blaser explains how to create maximum value from these non-core assets.

Creating value in portfolio companies has become even harder over the last few years. With record amounts of dry powder to deploy, private equity firms are competing fiercely for assets while high levels of corporate cash are driving strategic buyers to acquire businesses, too. Announced M&A globally reached $2.6 trillion in the first half of 2018, according to Bureau van Dijk, just shy of the record $2.65 trillion announced in the first half of 2017.

In turn, purchase price multiples have rocketed: in 2017, median enterprise value to EBITDA multiples in M&A rose to their highest recorded levels in both the US (above 10x) and in Europe (above 7x), PitchBook data shows.

With such elevated prices being paid, private equity firms are having to work at value creation strategies to ensure they can deliver the promised returns. That often means looking at less well packaged deals found in secondary buyout situations and turning to corporate carve-outs. We spoke to Tobias Blaser, partner at PwC in Germany, about how firms can ensure they have the best chance of maximising the potential value from these non-core asset sales.

Corporate carve-outs have become a more popular source of deals over recent years. Why do you think this is happening?

Carve-outs have certainly been increasing in the last five years. One of the main drivers for this has been corporates’ ever sharpening focus on core competencies. German conglomerate Thyssen Krupp, for example, faced repeated calls from shareholders to simplify its complex structure and cut down on corporate expenses seeking to eliminate the conglomerate discount, as Reuters reported. Another driver is firms starting to create holding structures, as grown companies are often too inflexible to react to market changes quickly. A holding company with a specialised business model allows for a lean structure and facilitates to adapt the corporate group to a demanding transaction market by divesting business units more easily and faster. For instance, Siemens recently listed its healthcare business Healthineers.

We’re also seeing mega-mergers. The Bayer-Monsanto tie-up is one example; Linde-Praxair is another. These large transactions are subject to anti-trust investigations and sometimes the only way to get the deals past the regulators is to agree to dispose of certain parts of the business.

And, of course, with the high prices being paid in today’s market, there is more appetite for divestiture among corporates, so that is driving some of the activity, too.

What type of buyer is showing most interest in carve-outs: private equity or strategic?

We’re seeing high levels of competition across industries. Private equity firms have become much more interested over recent years, as they can see plenty of opportunity to increase the value of these businesses. They are especially interested if these businesses have not been restructured beforehand because there is much greater potential to create value, while strategic buyers may find these less optimised/unrestructured situations more difficult to deal with.

With strong competition from other firms and corporates, how are private equity bidders improving their chances of winning these kinds of deal?

The competitive nature of the market means that private equity firms have to identify these assets early. We introduce and discuss potential carve-out deals with them – from a commercial, financial, carve-out and value creation angle. That way they can create a value creation story and an exit case at the earliest available opportunity and be ready to move on quickly. They are attempting to pre-empt auctions.

While around 80-90 percent of carve-outs still go through the auction process – unsurprisingly, given the competition for assets – they can proactively approach companies at an early stage of the process and avoid lengthy negotiations if they have done the groundwork. In some instances, we’re seeing private equity firms and strategic buyers pair up to acquire carve-outs of large businesses in risk-sharing arrangements.

Working with a strategic partner

You mention that private equity firms and trade buyers are pairing up. How can the arrangement work for both sides, given the often competing objectives of financial and strategic investors?

There has to be a clear agreement from the outset. Often these arrangements are structured so that, for example, a strategic investor will contribute 30 percent or 40 percent of the capital, with the private equity firm investing the balance. However, they will often have the same voting rights on the board. This is in recognition of the fact that a strategic investor can bring considerable knowledge to an investment, such as in-depth sector expertise and market intelligence. The combination of smart, patient capital with this kind of expertise can be quite a compelling one.

For the arrangement to work, there has to be alignment on the plan for the business and, importantly, what happens at the end of the investment. There needs to be a clear exit plan – and investment time-frame – from the outset. So, there could be an agreement to exit via IPO and/or the strategic investor could have an option to buy out the private equity firm’s stake at a later date.

There are some deals currently being worked on that include just such an arrangement and one of the benefits of the two sides pairing up is to deal with anti-trust rules, which can be extremely complex and require the knowledge and insight of a strategic partner to position the acquirer as a viable competitor. Also, while private equity firms mainly provide operational expertise, strategic buyers contribute valuable industry expertise and infrastructure – such as an existing management – that can be leveraged to realise synergies and maximise the enterprise value.

Indeed, firms are very conscious of competition in these deals. Whenever we introduce such a deal to private equity, houses are very interested to know the bidder universe and which strategic buyers are likely to make a bid – sometimes with a view to teaming up with them.

What do firms need to have ready if they are to move fast on a deal in today’s market?
Firms need a combined team of inter alia carve-out, financial, IT, operational and legal advisors to assess the full value creation potential and have the advisor team onboarded prior to the transaction ideally. These teams need to align and co-operate closely and seamlessly and the ultimate goal of every work stream should be to create and deliver deal value in each functional area. For instance, a lawyer might highlight a legal topic but should also understand that it might have an impact on the commercial and operational aspects of a deal, and run through this with the respective advisors.

Due to the multidisciplinary nature of carve-out topics, the carve-out advisors are usually in the lead to drive communication and manage the overall value creation process. In our experience, it really helps to have advisors on board that have worked together on a number of transactions over the years – you really need an A team on your side to win. PwC’s deals practice supports private equity clients and provides guidance along the whole M&A process.

For sell-side clients, we usually start by helping to define a clear deal vision and strategy. Firms need to have a well-defined concept regarding the assets to divest and need to consider the right transaction structure as well as the right timing to make a move.

For buy-side clients, the process usually starts with a rigorous due diligence and value assessment to validate robustness and upside potentials of the target. We then accompany our clients along the entire deal cycle, from negotiations to day one readiness and even to the post-deal value realisation which in turn may also include an exit strategy.

So what kinds of value creation strategy are the most effective in carve-out situations and how can firms hone in on the right course of action?

Before acquiring the business, firms need to know what has to be done with an asset so they can get moving from day one. That means looking at the strategic levers, such as additional M&A in the form of further add-on acquisitions or divestments. They need to have a clear picture of how they are going to grow sales, either through entering new markets or enhancing or developing new products.

They also need to understand what they can do alongside the P&L – top-line initiatives such as volume scaling, price adjustments or footprint optimisation as well as bottom-line via COGS optimisation or G&A right-sizing. Many carve-outs often emerge from their parent with an over-sized corporate function – there is often significant overhead that gets transferred. Simply right-sizing this part of the business can have a significant and lasting effect on the bottom line.

Procurement is often another area of focus – it is usually not in perfect shape and so much can be achieved through re-negotiation and changing suppliers. On the other side, dis-synergies resulting from lower bargaining power when ceasing purchasing under the parent’s umbrella have to be bypassed. And then there is optimisation of the business’s regional footprint, which will contain some legacy arrangements that made sense while the business was part of a larger entity, but don’t necessarily as a separate business. Does it need the presence it currently has in different areas and/or should it move into new areas to maximise sales potential?

Firms need to identify some of this during due diligence, but also have clean teams that continue to identify and validate value creation possibilities throughout the deal process.

What’s the key to getting this right?

Given the high multiples being paid, firms need to fully realise the value creation potential in a business to make the numbers work. Sometimes, you see firms do all the preparation and then leave it to management to get on with the work. In fact, it requires a comprehensive carve-out assessment which provides visibility on the current status of operational entanglements, day one readiness with regards to operations as well as on the standalone financials such as the standalone EBITDA and an optimised EBITDA. So, the carve-out assessment indicates potential red flags and their corresponding mitigation.

Effective private equity firms monitor the business regularly against detailed KPIs and they interlink value creation measures with the P&L. Firms should also focus on leaving TSAs (transition service agreements) as quickly as possible – they need to create a business that can operate on a standalone basis and the sooner this is done, the more identified value they can create and the more hidden value they can unlock. Overall, adequately orchestrating throughout the post-deal phase is key to realise the envisaged values.

That said, management also clearly has an important role to play here – strong teams really drive value creation.

And what kinds of development in the process are you seeing when it comes to carve-outs?

One trend we are seeing with more experienced corporates is that they are working to create a standalone business ahead of the process to minimise having to negotiate and put in place TSAs. So, for example, they may already have implemented IT systems and outsourcing agreements so the business can operate separately from day one. That can help boost the pre-sale value of a business as it reduces risk for a private equity buyer and it helps the seller because it’s a cleaner break.

The other trend is the increasing importance of digital disruption and digital deal analytics to private equity buyers. Firms are focusing on this much more than in the past and they now use digital teams to assess and identify value creation potential from a technological perspective.

This article was sponsored by PwC and first appeared in the Operational Excellence supplement that accompanied the October 2018 issue of Private Equity International.