Managing buy-side carve-out

Buy-side target slice

In a buy-side carve-out, a company acquires a business unit that is simultaneously being separated from its former parent Group. The term often also implies that carve-outs can either be sold to another organisation (the buyer) or left to form a new stand-alone entity (fully independent or operating under the original parent company). These deals come with complexity and uncertainty, but they also offer a chance to acquire valuable assets with untapped potential. The challenge is to manage financial risks and help turn that potential into value.

Carve-out transactions are structured in two ways; a buyer can purchase the legal entity or entities that hold the carved-out asset or just the asset- refer to IFRS 3. An asset-only approach can be cleaner, as the seller can retain the full historical balance sheet and P&L while building out the carve-out financials—helping them avoid disclosing performance elements that may be comingled with the rest of their operations.

Due diligence is just the starting point for in these deals; the real work often comes afterward.

One of the key steps is to identify “dis-synergies” and potential stranded costs that can erode value if left unaddressed. Then to keep these challenges at the forefront, pursue two other critical tasks in a buy-side carve-out. Firstly, build flexible financial models that can adapt as new information emerges. Second, ensure that transitional service agreements (TSAs) are appropriately scoped, priced and executed to support operational continuity when the deal closes.

This article focuses on buy-side carve-outs, where another organisation buys the carve-out and the buyer then faces the task of successfully integrating it from the perspective of the organisation buying it. It also assess the potential to create value be it working capital, purchase price economics and TSA agreements¹.

Synergy issues and stranded costs

In a buy-side carve-out these issues should be addressed during due diligence but also need to be addressed and mitigated as more information becomes available just prior to deal close and during integration.

Dis-synergies are negative financial or operational impacts that result from separating the business from the seller and integrating it into the buyer’s organisation. Stranded costs arise when resources inherited from the seller are no longer fully utilised in the new setup. To manage dis-synergies and stranded costs requires pressure testing and updating financial models as new cost information becomes known and using financial oversight to shape TSAs that support the deal’s value creation goals.

Attaining a clear financial picture

What makes buy-side carve-outs challenging is the difficulty of building an accurate financial baseline for the future organisation. A seller will prepare the target’s stand-alone financials to be as marketable as possible, potentially differing from the reality of what the buyer is getting. Even months after the deal closes, finance often struggle to get a clear picture of the target’s financial performance. For example, a company failed to realise that the seller’s low operating costs were the result of underinvestment in equipment maintenance and logistics. To address existing customer pain points and improve service, the buyer would need to make significant upgrades, resulting in higher ongoing costs than anticipated.

Depending on the separation process complexity level and the enterprise resource planning entanglement between the carve-out and the seller, the buyer may need to rely on modelling to build an apples-to-apples financial baseline.

To develop a reasonable view of the new company’s full value creation potential can only come once there is confidence in the financial baseline. But in a carve-out, that baseline is often incomplete—the business isn’t a stand-alone entity at the time of acquisition, which is why TSAs are required. While TSA costs can be a moving target, they offer a useful proxy for estimating the costs that are not yet visible in the carve-out’s baseline that the buyer will ultimately need to absorb.

This baseline model can then be updated as teams gain clearer insight into the asset’s financials, potential dis-synergies, stranded costs and the evolving terms of TSA agreements. Corporate Development who owns the value creation model should work with functional and business integration teams to ensure the model stays current and that value capture plans and targets are adjusted as needed.

Finance can use models to run “what if” scenarios and to determine how value capture plans and targets would be updated in each case. Scenarios can include additional TSA costs, dis-synergies, or unexpected needs for additional third-party spending, among other issues the buyer might encounter¹.

Working capital

During a carve-out, buyers should evaluate how much it will cost to fund operating accounts as well as the overall balance sheet of the new asset or entity. They may need to provide capital at the start of deal close to ensure that funds continue to flow or rapidly add money to the asset’s balance sheet once in operation.

If a large seller with a mixed and varied corporate model is divesting a part of its business, the leadership involved in the deal could have limited experience across working capital funding cycles. It is common for buyers and sellers to negotiate on certain components of the balance sheet. For instance, a buyer may be unwilling to take on debt that a seller pushed down into the asset in a manner that is not operationally justified, or for tax reasons.

A buyer or seller can also agree and negotiate on a “working capital hurdle,” which is a benchmark or baseline of net working capital that will transfer with the business at the time of deal close. By doing so, both parties would have a clear idea of how to manage various components of working capital, including inventory, accounts receivable and accounts payable. It is important to develop this hurdle, where a buyer’s valuation will typically make certain assumptions about the level of accounts receivable present on the balance sheet at the time of deal close and how much of that will be fully recoverable. But if either of these amounts deviates materially from the hurdle, the buyer can adjust the purchase price after deal close. In most cases, the parties agree to put a portion of the purchase price consideration into an escrow to accommodate adjustments in either direction and to release any remaining balance to the seller once the hurdle period has ended.

The seller should strive to deliver the carve-out asset at the established working capital hurdle, replacing the balance sheet’s cash components pound for pound and replacing the assets inventory at a resell cost versus the cost of goods. In this way, the seller cannot write down inventory without an offsetting penalty.

Purchase price economics

The long-term economics and impact of the near-term costs for the carved-out entity or asset should be handled in the valuation and ultimately the purchase consideration. For example, if a buyer insists on decreasing TSA pricing below the actual cost to deliver, then the seller can recoup the gap by increasing its sales price. Conversely, if the seller does not agree to an unencumbered transfer of IP needed to fully monetize the asset, then the buyer can seek to decrease its purchase price. There may also be instances where the carved-out asset requires significant capital expenditure. Buyers should discuss these costs and factor them into the final economic consideration for the assets.

TSAs to protect continuity and manage financial risk

TSAs are among the most operationally important and financially sensitive components of a buy-side carve-out. They involve complex interdependencies, rushed timelines and high values. Despite their temporary nature, they can carry significant consequences for business continuity and the overall success of the deal.

Finance will have final authority on what the buyer will ask for and agree to in the TSA contract, which involves judging which services warrant inclusion, how long they should last and how much they are worth.

While TSA costs eventually disappear, they are often replaced by new cost structures on the buyer’s side, making the financial baseline a moving target. Gaps in identifying entanglements, scoping and negotiating TSA terms, implementing the agreements, or exiting them on time can lead to more than just operational disruptions. They can have a direct impact on the ability to deliver on the deal’s value creation goals.

TSA life cycle

Set the scope and priorities for TSA coverage and spend, the buyer will need a TSA to gain access to people, services and systems from the seller for a limited period of time until it can build the capabilities itself.

Other agreements and arrangements may also be needed, including a reverse TSA (where the buyer provides services to the seller) or a manufacturing services agreement (where the buyer uses the seller’s manufacturing facilities).

Shape TSA terms to reflect the buyer’s true needs and cost structure. By the time the deal is signed, there is usually a first draft of the TSA contract. This draft is usually completed with limited input from business, functional and local teams, even though they often have a better understanding of entanglements with the parent business. Once the deal is signed, it is essential that teams work together to finalise a TSA that addresses all the buyer’s needs to avoid any day-one disruptions. At the same time, it is important for the buyer to stay close to the TSA rationale and pricing, as TSAs tend to be a significant cost line in the P&L. Once there is alignment on the TSAs, specific employees who run the processes should be identified and trained in how to provide or use services across both organisations. There should be an established governance structure and regular meetings to ensure performance tracking, smooth interaction and a simple way to manage change requests and escalations.

Exiting TSAs in a timely manner can often accelerate value capture efforts and provide short-term profitability uplift. However, exiting a TSA too quickly sometimes leads to business disruptions, creating unforeseen or unnecessary costs. It is important to carefully weigh which TSA exits to prioritise based on analysis of business risks, opportunity costs and savings. It is best practice to start developing TSA exit plans long before the deal closes.

Buy-side carve-outs test Finance’s ability to manage complexity while maintaining a clear line of sight to value. Coping with dis-synergies and stranded costs is essential. It is also vital to build financial models that can adjust to new information and to ensure that TSAs are properly scoped and structured to support operational continuity without inflating long-term costs. By guiding both efforts with discipline and foresight will help ensure that deals deliver on their strategic and financial promise².

Dee Singh Kothari is a senior partner at Kothari Partners

¹ Contact Kothari Partners for a free confidential discussion on how we can help. The author nor Kothari Partner’s accept any liability for the incorrect application of these ideas either used by companies, employees or other individuals alike. Contact us on how we can help with the now. 

² At Kothari Partners, our approach is to help our clients understand their current situation, identify the value and decide on the scope, vision and set of strategies for what they could achieve for their business. We help plan their implementation and support them and deliver the solution/ change needed, so it is properly and permanently embedded in their organisation.

We aim to help past and future clients by delivering high-quality work to their organisation, generate real efficiencies and free up time to support better business decisions.