Carve-outs have become a big trend in the M&A market over the past few years. Corporates are looking to divest non-core assets, often driven by geopolitics, shareholder activism and improved returns.

Private equity and private capital have also embraced carve-outs as an alternative to more traditional leveraged buyouts, as Lee Harris, Partner in Corporate M&A at Eversheds and co-writer of new ICAEW best-practice guidance on carve-outs alongside Grant Thornton UK, explains. “Carve-outs have become a prevalent form of M&A transaction, and I can only see that continuing to be the case for the foreseeable.”

The resurgence of megadeals often also necessitates sales to comply with competition law. 

What is a carve-out?

In layman’s terms, a carve-out is usually (though not always) the separation of a non-core element of a business – such as a division, business unit or a defined number of assets from its parent company – to create a stand-alone business for sale. This typically involves the need to disentangle shared operations, systems and contracts. 

Carve-outs are, therefore, typically more complex because the part of the business being sold generally does not have its own legal, financial and operational structure and could include one or multiple subsidiary brands and/or span a single or multiple jurisdictions. 

“Carve-outs are a specialist area of M&A and require a specific skillset,” says David Petrie, ICAEW’s Corporate Finance and Advisory Director. “Depending on the carve-out, they can be exceedingly complex and require careful planning and skilled lead advisers.”

“A carve-out transaction can be undermined if the financials prepared for the perimeter are not detailed and clearly explained,” adds Chris Sharpe, Partner, Grant Thornton Transaction Advisory Services. 

Carve-outs need to be well defined

Defining and aligning exactly what is being carved out is a crucial early step, says Matthew Woodgate, Partner, Grant Thornton Value Creation Advisory. “Sellers can derail a disposal process if they have not done appropriate upfront planning to understand and address the key carve-out considerations they learn during due diligence or are unwilling to provide adequate transition support to satisfy bidders.” 

Buyers – especially in private equity – can undermine the sale without a convincing plan to deliver the separation, he adds. “Like any transaction, there will be natural tensions between the seller and buyer, however this is often more pronounced in a carve-out given the additional complexity and unique characteristics.”

A successful carve-out requires defining the:

• assets;
• liabilities;
• contracts;
• employees;
• intellectual property;
• permits; and
• real estate.

Identifying any legal transfer formalities or processes that may have timetable implications early is also important, says Harris. “Notarial procedures, public filings and [Transfer of Undertakings (Protection of Employment)] TUPE consultations all go to deal execution and certainty.” 

Where the buyer and seller operate in similar markets, foreign direct investment regimes and merger control regulations are increasingly prevalent, says Harris. “These can add a minimum of two months, and often several more, to the timeline to close.”

The importance of transitional service agreements

By their nature, carved-out businesses often do not include all of the core operational functions of a standalone business. As a result, a solid plan for the transition of services, or Transitional Service Agreement (TSA), is necessary to ensure a carve-out is successful.

“Additional legal agreements need to be in place to deal with the transition of services between seller and buyer,” says Petrie. “Typically, these need to support functions around the core activities of the business for around three to six months.”

Poorly structured TSAs can erode deal value through:

• inadequate service levels that disrupt operations;
• unrealistic pricing that inflates costs; or
• extended timelines that delay independence.

“Sellers should consider the impact of the carve-out on their retained business,” says Woodgate, “including dis-synergies and stranded costs, driven by surplus shared resource and onerous third-party supplier terms remaining post-transaction typically.”

The scope, duration and cost of services are the key commercial considerations in a TSA, and these need to be clearly defined from a legal perspective to avoid services falling between the gaps, says Harris. “Other key legal aspects include defining the standard to which the services are to be provided (ie, service levels); extension rights in respect of any services and the circumstances in which services can be extended; liability and indemnification provisions, data sharing and compliance; and potentially dispute resolution mechanisms.”

Ambiguity around asset perimeters

Carved-out assets are rarely clearly defined legal entities, nor do they have a clear perimeter. This can lead to ambiguity, causing diligence issues and inefficiencies, says Harris. “While properly constructed carve-out sale agreements often contain ‘wrong pockets’ clauses, it is far preferable to have clarity and alignment up front,” he says. 

As ICAEW’s new guideline explains, wrong pockets clauses provide the parties with a mechanism, post-completion, to sweep up any assets or contracts that may have been overlooked in the sale process and have been left in the wrong place (legally or economically, or both).

Ensuring day-one separation discussions involving cross-functional teams well in advance of transaction closing will ensure operational continuity and a clear route to separation, Harris adds.

Variations across jurisdictions

For larger, more complex carve-outs, sellers, buyers and advisers need to consider the rules across the various jurisdictions the entity operates in to stay compliant with all relevant laws. 

“In some cases, for example, a new legal entity will need to be created in order to complete the carve-out,” says Petrie. “This will have different processes and timeframes across relevant jurisdictions.”

Trademark rights can also be jurisdiction specific, as can rules around employee consultation and protection. While employees are subject to TUPE regulations in the UK, regulations in other jurisdictions may vary significantly.

Best practice for carve-out deals

Carve-outs are likely to require alignment between stakeholders, including c-suite decision-makers, central finance teams, local finance teams and local management, says Sharpe. “Winning hearts and minds early and maintaining unity is key with all parties likely to be of fundamental importance to preparing the carve-out accounts and more broadly through the transaction process.”

The Corporate Finance Faculty’s upcoming publication, Sell-side Carve-outs, outlines the multiple areas that sellers need to consider when undertaking a carve-out, with suggested best practice to tackle the trickier and more complicated aspects.