Breaking up may not be easy, but splits are on the increase, with corporate appetite for carve-outs now soaring. In a survey of 500 companies worldwide published earlier this year by Deloitte, 80% said they planned to make up to three divestments over the next 12 to 18 months, twice as many as in the same survey two years ago.

“Divestments have shot up the corporate agenda,” says Jason Caulfield, partner and UK head of divestitures at Deloitte. “The shift we’re seeing in market conditions, including falling inflation and expectations of lower interest rates, are an opportunity for much closer alignment between sellers and buyers.”

Against that backdrop, there are all sorts of drivers for carve-out activity. Sensible companies review their portfolio of businesses regularly, making judgements about where to concentrate investment for the greatest return. But the COVID-19 crisis and the tough economic backdrop of the past 18 months led to many reviews being delayed. “Many businesses’ portfolios are in need of some form of change,” Caulfield says. 

New positions

One contributing factor for an increase in carve-out activity is the changing geopolitical backdrop, says Jeremy Harrison, an M&A advisory partner at EY. “There are a number of territories where corporates previously wanted exposure, but which now seem less attractive and riskier places to do business,” he points out.

The obvious example is Russia, where Western firms have rushed to offload local subsidiaries, but sales of Chinese businesses are also increasing. That reflects a combination of nervousness about China’s slowing economy and concern about tensions with the US. American biotech firm I-Mab sold its Chinese unit I-Mab Shanghai earlier this year amid increasing hostility among US policymakers towards Chinese interests. 

“Carve-outs can also be about redefining your core in line with where you expect growth to come from,” adds Lisa Hooker, UK consumer markets leader and deals partner at PwC. “There is now pent-up demand to use M&A to make a difference.”

That could mean divestments that enable the business to double down on its favoured areas. Unilever, for example, has announced plans to sell off its ice cream business and has also recently sold its Elida Beauty subsidiary as part of a strategy to back its ‘power brands’. CEO Hein Schumacher explained: “These brands will have the first call on capital and resources.”

In other cases, redefining your core might be an acceptance that a new venture in an adjacent market doesn’t have the scale to compete or that others do it better. Tesco’s recent £700m sale of Tesco Bank to Barclays was widely seen as an admission of failure in the financial services market by the supermarket giant.

Pressure to move

The recent rise in shareholder activism also looks likely to increase the number of deals of this type. Law firm Skadden says the number of public activism campaigns increased by 68% last year. “Boards are beginning to look over their shoulders,” says Deloitte’s Caulfield. Divestments are a frequent demand of activists – in December, for example, biotechnology company Illumina promised to sell Grail, a gene sequencing company it had bought only three years earlier, following a campaign by veteran activist Carl Icahn.

Still, carve-outs don’t have to be defensive deals or transactions forced on companies. Often, they’re aimed at giving a successful business further opportunities to flourish, perhaps with shareholders retaining a stake. Plans for a merger between the mobile phone networks Three and Vodafone, announced last year, are a case in point. The UK businesses are being carved out of their parent companies, CK Hutchison and Vodafone, to create what will be the UK’s biggest operator in the market. In January, the Competition and Markets Authority launched an initial Phase 1 investigation into the merger because it could lead to “substantial lessening of competition” – it’s not a done deal.

The rise of the sustainability agenda is also driving activity. When Belgian retail group Colruyt wanted to raise cash for investment last year, it found a willing buyer for its Parkwind renewable energy business in JERA. The Japanese energy company saw the acquisition as an opportunity to accelerate its shift into renewables as it works towards its own decarbonisation goals.

Indeed, the likely increase in carve-outs in the months ahead is being driven as much by buyer demand as sellers’ desire to divest. Private equity investors, in particular, are on the hunt for acquisitions. With dry powder globally now estimated to total $2.6tn, 8% more than a year ago, PE is having to be imaginative about deal sourcing.

Carve-outs represent one potential avenue to explore. Recent UK deals include the sale of Elite, a legal tech business, by Thomson Reuters to TPG; and Allen & Overy’s disposal of its risk management company to Inflexion and Endicott Capital, but this is a global trend. PE buyers may be looking to roll the acquired business into a platform of similar portfolio companies, invest time and money in a neglected business, or use it as a buy-and-build platform. All of which poses a question. If carve-outs are on the rise, are buyers and sellers ready? “These are complicated deals to do,” warns PwC’s Hooker. “It often takes longer than expected to get a business ready to sell, longer to negotiate a transaction, and longer for the buyer and the seller to disentangle themselves after completion.”

Smooth transition?

Think in terms of years rather than months, Hooker suggests. It might take as long as 12 months to get the business to a position where it can be sold. Then, after completion, there are likely to be transitional service agreements (TSAs) in place – so that the buyer isn’t left with a business unable to perform core services such as IT or property management. TSAs last for at least 12 to 18 months, possibly longer.

Preparation is key, says Rob Baxter, UK head of corporate finance at KPMG, who urges sellers to plan for the separation process well before they begin to even speak to potential buyers. 

“It is vital to define your perimeter – to identify exactly what you’re selling,” Baxter says. “That can be really tough, depending on how integrated the business is with the rest of the group, so identifying those separation hotspots in advance, and making plans to deal with them, is really important.”

Some carve-outs are neater than others. Sellers may be divesting distinct legal entities with clear boundaries – or they may be selling disparate assets spread across multiple entities and jurisdictions. However, even seemingly straightforward deals often turn out to be anything but. It’s rare for a business to exist entirely in isolation within a larger group; in most cases, it will depend on other parts of the group for certain services – back-office functions such as finance and HR, perhaps.

People will be a key consideration. Who works for the business to be sold, do they work only for that business and will they transfer to the buyer? Such debates have practical implications, but also need to be handled sensitively; intellectual property is a key asset for many companies, so the last thing either side needs is an outflow of talent spooked by uncertainty.

Technology is another potential pain point. Will the business need to continue making use of the seller’s systems for a period after the sale? If so, how will that be governed with a TSA that provides protection for both sides? Similar questions may need to be asked about physical infrastructure – real estate, warehousing and logistics, for example.

Negotiating TSAs can be tricky, warns EY’s Harrison. “There’s a natural tension because buyers are often looking for a lengthy TSA so they have more flexibility as they integrate, while sellers are looking for full, clean separation as quickly as possible.” Building incentives into the agreement may help bridge the gap; it is common, for example, for the price of shared services to rise during the second year of a TSA to motivate the buyer to move quickly to its own services.

The other big area of work for the seller will often be to develop a clear set of financial statements for the business to be divested. “Your understanding of its financial performance may actually be quite limited,” warns KPMG’s Baxter. “You may never have needed distinct reports and accounts for the business; a buyer will want to see a detailed profit and loss account, but creating something that stands up to robust diligence may be challenging.”

With so many complexities, there is plenty of scope for things to go wrong. In Deloitte’s research, 98% of companies say they have been forced to abandon at least one divestment in the past year. Of course that can be for a plethora of reasons but, says Caulfield: “Very often, the thing companies say they wish they had done differently was starting that preparation earlier.”

Flexibility around completion may be required. “Buyers need to have a sufficiently clear idea of what they’re buying, so they’ll need to see that financial track record,” says Lucie Cawood, head of the private equity and financial sponsors group at law firm Travers Smith. “And almost all carve-outs are executed through completion accounts, rather than the locked box mechanism that has become more common in other types of M&A transaction.” The former provide a means with which to adjust the final purchase price based on the visibility of the business that the buyer gets at completion.

Buyers of carve-outs will also have other challenges. “Management and governance will need attention,” says Harrison. “The business may not be coming with an established executive team or clear management structures, so you will need to bridge those gaps; often there is not a CFO in place who has had historic responsibility, oversight or accountability for numbers relevant to the perimeter or business unit being sold.”

“There may also be serious operational issues for buyers,” adds Baxter. “If the buyer plans to run it as a standalone business, does it have everything it needs to function effectively? Otherwise, what does the integration plan look like? What does the cost of TSAs in the transition period add to the cost of the deal?”

Support of advisers

Given all these complexities, both buyers and sellers may need additional support when doing carve-outs. In addition to the usual cast of corporate finance advisers, investment bankers, diligence specialists and law firms, an adviser with experience of running separation processes may be valuable – both in advance of the deal and during the execution period after completion.

From the seller’s perspective, a carve-out entails a third leg of work during the deal process, with consideration of separation as well as price and structure. “There’s a real risk of deal fatigue with these transactions,” warns PwC’s Hooker. “You’re asking people to do a whole lot more on top of their day job, possibly for an extended period.”

For buyers, meanwhile, advice on how the carved out business will function is likely to be just as useful. Travers Smith’s Cawood also points to additional potential complexities. “The carve-out steps need to be phased and executed in the right way from a legal and taxation perspective,” she warns. “Look out for tax leakage risks and legal clearances required, particularly where deals have an international dimension.”