Due Diligence for Carve-Out Transactions

We’re seeing a clear shift towards “old school” value creation in today’s landscape of sustained higher interest rates, investor risk premiums, and elevated capital costs, investors demand tangible free cash flow, operational efficiencies, and strategic allocation. Carve-out transactions are becoming increasingly attractive, offering opportunities to acquire underinvested businesses at compelling valuations. 

However, these deals are inherently complex. Parent companies often hold asymmetrical knowledge, requiring buyers to conduct thorough due diligence to assess risk and future profitability accurately. This resource focuses on key areas to consider for successful carve-out acquisitions.

Key Due Diligence Areas for Carve-Out Transactions

Effective due diligence is crucial for understanding a carve-out's true value and potential. This includes assessing separation costs, stand-alone expenses, and potential revenue impacts. Collaboration across financial, tax, legal, IT, and operational due diligence streams is essential. It’s recommended that you focus on the following: 

• Sustainability of Revenue and Customer Relationships
• Costs Allocations from the Parent Company
• Transfer of Intellectual Property Rights
• Information Technology
• Employee Benefits & Insurance
• Retention of Employees and Management Gaps
• Real Estate & Occupied Space

Sustainability of Revenue and Customer Relationships

The long-term success of the carve-out transaction will be directly correlated with the staying power of the customers and revenue. While the intention is to reinvest in those customers and grow them organically, unbundling them from a larger corporation without fully understanding how that relationship was obtained can and will lead to customer attrition and churn. 

Customer Retention Strategy

To mitigate customer attrition, buyers need to develop a comprehensive customer retention strategy in collaboration with the sellers during the carve-out process. This strategy should include early detailed communication about the transition, assurance regarding service quality, and outreach to key clients. 

Due Diligence Considerations for Revenue and Customer Relationships 

• Buyers conducting due diligence on a carve-out target should request all material contracts to understand relationships and performance obligations.
• Customer dependence on shared services, IT systems, customer support, branding with the parent company, and revenue by customer to analyze concentration risks.
• Details around customers who have declining revenues or have churned so revenue projections can be normalized on a historical and forward-looking basis.

Costs Allocation from the Parent Company

Carve-out transactions often have complicated cost allocations because shared services and assets are split between the parent company and the divested unit. Accounting standards require a "reasonable" method to assign these costs, like using revenue or activity levels. However, these allocations might not reflect the true future costs, potentially making the business seem more profitable than it actually is.

Considerations for Dealing with Corporate Cost Allocations

• Identify shared costs between the parent company and the carve-out entity, such as corporate overhead, HR, legal, employees, marketing, IT expenses, and real estate.
• Include intercompany transactions that were eliminated for financial statements.
• Assess the impact of shared costs on the business's agility and customer base to determine necessary services via a transition service agreement (TSA).
• Estimate stand-alone costs or the costs needed to run the business without the parent entity, which often involves significant assumptions that could differ from actual post-transaction costs.

Due Diligence Considerations for Cost Allocations from the Parent Company

•  Buyers should request all shared service agreements and departmental budgets between the business unit and the parent company.
• Understand how the parent allocates costs to the business unit to compare with anticipated costs for separating operations.
• Expect historical cost allocations to result in fewer full-time employees and insufficient IT, marketing, HR, and legal support for the business unit to function independently. However, cost reductions may exist if the parent company allocates specific expenses across all business units regardless of actual need.

Transfer of Intellectual Property Rights

In a carve-out transaction, intellectual property rights (IP) include patents, trademarks, copyrights, and other intangible assets sold or licensed with a divested business unit. It's important to determine how to separate and allocate these rights between the buyer and the remaining company. When shared IP is involved, licensing agreements are needed to identify which IP assets are being transferred and how the remaining company will continue to use them.

Considerations for the Transfer of IP

• Examples of IP issues include brand names and logos, customer data, patents, and proprietary software and technology.
• If the parent company keeps the IP, the buyer should negotiate a license agreement for post-transaction usage consistent with historical usage.
• Buyers need to consider the impact if the parent company sells the licensed IP, which could cause material costs and disruption, affecting the carve-out business's valuation.
• Clearly define the royalty structure based on factors like revenue from the licensed IP, usage volume, or specific milestones achieved by the buyer.

Due Diligence Considerations for the Transfer of IP

• The buyer should consider conducting a comprehensive legal review of the business unit's relevant intellectual property assets and assess whether the IP being acquired allows the buyer to operate without infringing on third-party rights.
• Verifying that the seller truly owns all the IP being sold and reviewing for existing licensing agreements or potential infringement claims from other parties.
• The buyer should consider hiring a valuation firm with expertise in valuing the fair market value of the IP being transferred so an established benchmark can be used to negotiate licensing payments or royalties if required to maintain access. The buyer should consider the cost of replacing and incorporate any ongoing payment streams to the parent company as part of the business plan and the impact on enterprise value. 

Information Technology

IT is becoming an increasingly significant portion of corporate budgets. Companies bundle and package IT products and services to optimize costs and outcomes. Larger corporations use economies of scale to get better pricing. However, this can create challenges when divesting business units that rely on shared services, such as pricing terms that don't adjust automatically, licensing issues, and allocation of employee time and equipment usage.

Considerations for Information Technology

Separating a business unit can be more complex than it seems. To minimize IT-related challenges in a carve-out transaction, it's crucial to assess the divestiture's impact from an IT standpoint. The seller must determine which IT services, assets, and employees will be included in the carve-out, which will stay behind, and how data will be transferred. Providing transition services can enhance the business's value to the buyer, potentially justifying a higher purchase price. The increased price and greater deal certainty may outweigh the costs of offering these services.

Due Diligence Considerations for Information Technology 

•  Identify and address potential IT issues early, including system dependencies, data migration strategies, and necessary licensing agreements.
• Ensure data accuracy and security during the separation process, especially with sensitive customer information.
• Engage a firm with specialized knowledge of IT systems, data migration, and complex carve-out transactions to identify potential issues early, such as outdated systems, data security vulnerabilities, and poor integrations.
• Conduct due diligence on historical IT expenses and capitalized costs as part of the business plan and forecast to ensure sufficient spending going forward. IT spend can significantly impact valuation and cash flow.

Employee Benefits

Since the separated business unit will now have its own employee base, the acquiring company needs to understand the existing employee benefits package, including costs, coverage levels, and potential liabilities related to transitioning employees to a new benefits plan. 

Considerations for Employee Benefits

If the parent company has intricate benefit plans, isolating the appropriate portion for the carved-out unit can be difficult. The buyer may need to modify legacy benefit plans to match its own benefit plan framework, which could result in higher costs. The buyer should initiate discussions on employee benefits early in the due diligence process to anticipate potential challenges and formulate a transition plan. Additionally, a buyer should engage legal and benefit plan advisors to address potential complexities and integration challenges of employee benefit plans in a carve-out transaction. 

Acquisitions can create uncertainty and concern among the employees of the acquired carve-out business. The buyer should consider maintaining clear and consistent communication with those employees to ensure they understand any changes that may impact them either during the transaction process or shortly after the transaction closes. To address these issues, human resources should be utilized to aid in a smooth post-closing transition.

Due Diligence Considerations for Employee Benefits

• Engaging with benefits consultants or legal professionals to interpret complex plan details and identify potential noncompliant areas.
• Evaluating the details of each benefit plan, including health insurance, retirement plans, coverage levels, eligibility requirements, and funding status.
• Determining the financial implications of maintaining or modifying employee benefits for the carved-out business unit, including evaluating the company's current cost of benefits, specifically employer contributions and employee premiums.
• Uncovering potential liabilities related to underfunded pension plans or past benefit plan issues for carve-outs can be especially problematic. 

Retention of Employees and Management Needs

Determining which employees will stay with the seller and which will transition to the divested business unit is crucial. In cases where the seller operates multiple business units and relies on centralized or shared services, many employees may support both the divested and retained units. Whether these employees stay with the seller or transfer to the buyer is often negotiated, especially if they perform functions the buyer lacks. The buyer also needs to address management team gaps and roles to fill. The financial impact of employee retention and additional management roles includes compensation, bonuses, benefits, and payroll taxes.

Considerations for Retention of Employee and Management Needs

Identifying which employees are directly associated with the carved-out business and which are shared with the parent company is crucial. Developing plans to retain key employees during the transition and minimize potential talent loss is essential. Early due diligence should focus on identifying management gaps and any critical executive roles required to support the business unit. Employees or managers working across multiple business units within the parent company should be prioritized and addressed in discussions with the parent company. Employees supporting multiple units will often be allocated to the carve-out, requiring P&L adjustments if they are retained or remain with the parent company. Additionally, employee-related costs, such as severance payments and retention bonuses, should be factored into the transaction valuation.

Due Diligence Considerations for Retention of Employee and Management Needs

• Assess current HR systems and employee data to determine the feasibility of transferring information to the new entity. Request an employee payroll roster, organizational chart, and compensation data.
• Inquire about all open positions within the business unit, distinguishing between immediate needs and growth roles.
• HR and legal teams should review compliance with labor laws related to employee transfers, including data privacy and notification requirements.
• Obtain all existing employment contracts to identify key terms such as severance packages, non-compete clauses, and retention considerations.

Real Estate & Occupied Space

Shared facilities, whether leased or owned by the seller, can be challenging in a carve-out transaction. Securing and maintaining the physical space for the business post-transaction is crucial. Relocating during the transition can disrupt operations. Companies often operate within a single facility or across multiple shared facilities, which saves costs but creates complexities that need careful management.

Considerations for Real Estate & Occupied Space

When a business unit operates within a shared leased space, there are two main options: a sublease or a direct lease with the landlord. In a sublease, the corporate parent leases the facility to the buyer, often needing the landlord’s consent. This involves various considerations, including risks for both the buyer and the parent company. The seller must assess shared costs like maintenance, utilities, and structural expenses. The second option is for the buyer to establish a direct lease with the landlord, which may require negotiating broader lease terms, adding complexity and impacting timelines. Both parties should collaborate to avoid the landlord leveraging the deal for higher rents or additional concessions.

Due Diligence Considerations for Real Estate & Occupied Space

• Request a thorough review of all lease and land contracts related to the real estate.
• Compare lease expenses against historical income statements to ensure all costs are fully accounted for, including any renegotiated lease payments resulting from the transaction.
• Evaluate the impact of selling a leased property, particularly whether zoning laws permit redevelopment into a higher-value asset, potentially forcing the buyer to relocate operations and cause significant disruptions.
• Engage a reputable environmental engineering firm to conduct a Phase 1 environmental study to assess risks such as pollution, hazardous materials, and compliance with environmental regulations, ensuring any hidden liabilities are disclosed.

Maximizing Value in Carve-Out Acquisitions

Acquiring a carve-out business can be complicated, and buyers should consider the impact of the bullets discussed above (amongst many others) on the carve-out business EBITDA and valuation. Additionally, buyers should consider performing thorough due diligence to identify risks and properly mitigate those risks identified in a carve-out business. This will allow for careful planning so the business can be successfully, efficiently, and effectively integrated after the transaction closes. With careful analysis and planning, carve-out businesses can make excellent new platform companies or can complement an already established business.  

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