Millions lost in carve-out deals
August 20, 2020
There is a general expectation that the recession following the COVID-19 lockdown will create a major wave of new business restructuring deals. Companies will need to focus more on their core business and cut branches. Some will even sell their whole business. In modern economies, increased M&A activity has always been high after the initial shock of a recession. However, not all of the business transactions are successful.
A recent study by TMF Group concludes that a third of global carve-outs fail to go according to plan. In 92% of private equity and 85% of corporate carve-outs, overruns added more than 10% to the cost of the original deal. Why does this happen?
The reasons for the overruns in the study are consistent with Midagon’s own findings and experiences. The biggest contributor involve local variations in legal and regulatory requirements that are not fully understood during the planning phase. The local variations in business practices, processes and systems, in general, are typically recognized very late in the carve-out implementation phase.
The deal preparation team is normally a small insider group on both sides. The parties have limited visibility of the other side during the due diligence process. The true complexity is revealed only after the deal is signed and the implementation begins. The pre-deal analysis is often superficial or oversimplified, and the detailed planning starts with the deal implementation.
The situation is risky, since the terms of the deal are already fixed. Even worse, the transition service agreement has tight deadlines, sometimes with severe sanctions for overruns. The seller’s side often has a limited interest in solving the up-coming issues.
Due to limited pre-deal planning, I sometimes joke that in carve-out deals the supply and demand meet. The seller does not know what they are selling, and the buyer does not know what they are buying.
The first advice is a no-brainer. The deal preparation teams must do more detailed analysis before closing the deal. This is definitely in the buyer’s interest, since it will lead to a more realistic valuation of the target of the deal. The deal negotiation becomes harder, but this will eventually be recovered in the carve-out implementation.
The COVID-19 lockdown shifts the focus towards written documentation, since the face-to-face communication is more limited than usual remotely. If there is a low level of documentation, the deal preparation teams will have an additional challenge of gathering facts and creating new documentation in parallel to the deal negotiation.
The in-house teams often have limited experience with complex M&A deals and carve-outs. Targeted external expertise can be helpful, especially in legal and ICT tracks. Professionals have prepared templates and checklists, which leave less room for surprises. The true professionals also know the typical problems and pitfalls, and how to navigate away from them. If chosen properly, the external service providers can also get a jump start on the deal implementation project.
Regardless of how well the planning was done, the real battle starts when the deal is signed and the countdown towards Day 1 starts. The first one to three months of the transition period are often wasted doing staffing and hiring. This should be done in parallel with the deal negotiation. The carve-out project is sometimes initially done as a side-job by business managers, and the true complexity is revealed much later.
The speed is crucial. How quickly we can map and plan the detailed carve-out scope, and how quickly we get the implementation teams working on them. This calls for high professional competence, but also caution.
Business continuity, risk management and the timetable come next. The carve-out cannot disturb the daily business and destroy the value of the deal. On the other hand, the transition period only allows for a limited amount of change. Therefore, it is usually a best practice to first create a fully functioning, independent carve-out target. Later, it can be developed, merged and restructured to the meet the need.
Finally, a well-managed carve-out implementation and cost control can help to achieve success. The cost and risk factors need to be understood, and the project must be steered to the optimal outcome. The optimum is not always exactly as initially planned, and a slight budget overrun is usually tolerated to meet the other priorities above. However, in our projects, we are never even close to 10% of the total deal value, as mentioned in the TMF Group study. The overrun is usually less than 10% of the originally planned carve-out cost.
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