Carve-Out Deals are Thriving in Post-COVID Economy
By Fred Campos, CPA, MBA, CEPA, Southeast Transaction Advisory Services Leader
As a result of the disruptive effects of the COVID-19 pandemic on the global economy, the past couple of years have seen a number of corporations and investors tweaking their strategies to remain profitable in spite of the uncertain landscape.
Carve-out deals are transactions in which a corporation sells off a unit of the company, whether a specific product line or a division of services. There has been a notable increase in carve-out activity among large corporations and private equity (PE) firms. Recent examples include U.S.-based firm KKR’s purchase of Viridor Waste Management, carved out from the U.K.’s Pennon Group, and international firm EQT’s acquisition of Schülke & Mayr GmbH, a provider of hygiene solutions and a subsidiary of Air Liquide S.A.
These are merely two examples of what appears to be a significant trend in mergers and acquisitions (M&A). According to data from Dealogic, the first half of 2021 saw $281.1 billion in carve-out deals transacted in the U.S. alone, an impressive 197% increase year over year.
An Unsurprising Adaptation
While the reasons behind the surge in carve-out activity are certainly dynamic and far from one-dimensional, there is an increasing level of mutual interest among those at the heart of these deals. The fact is that corporations and PE firms are navigating something of a perfect storm in relation to global markets. The combination of pandemic-related impact to corporate bottom lines and a pre-existing trajectory of significant transformation in business practices has made carve-outs an attractive alternative for sellers looking to capitalize on the current high multiples while exiting divisions that no longer align with their long-term strategies.
The influence of the pandemic on much of this activity is perhaps the easiest to pinpoint and dissect. In 2019, U.S. PE firms had a record-breaking year of fundraising, reaching an all-time high of $326.1 billion according to PitchBook’s 2021 annual U.S. PE Breakdown report. But when the COVID-19 virus inflicted damage on many corporations and lead to a temporary pause in M&A activity, PE firms were sitting on an extraordinary amount of dry powder. And yet, PE fundraising activity continued at an accelerated pace as firms raised an additional $272.2 billion and $301.3 billion during 2020 and 2021, respectively.
Now, as the economy bounces back, PE firms are looking to invest the cash that otherwise would have found a home before the markets stalled; meanwhile, affected corporations are looking for efficient ways to boost profits, reduce debt, and ultimately create new value for shareholders in a post-COVID economy. So in one sense, what we’re witnessing is simply a conditional adaptation brought about by the combination of exceptional fundraising by PE firms and the economic impacts of the pandemic. And we’re not even considering the impact of special purpose acquisition corporations (SPACs) and their so-called “blank checks.” We’ll leave that for another day.
Similarly, shifting societal attitudes and regulatory initiatives have been forcing adaptations on investors and corporations since before the pandemic, and carve-outs have proven to be an efficient strategy. Environmental, social, and governance (ESG) concerns, for example, have been looming over large corporations for years, and the anticipation of harsher regulations in addition to the stirring of activist shareholders continues to impact boardroom decisions. Corporations looking to position themselves favorably in relation to new standards and expectations can consider carving out underperforming or potentially problematic business units in exchange for a boost in cash reserves.
While a number of conditional factors have made carve-out deals a viable option today, the strategy requires a level of caution and due diligence that would be nearly impossible to overstate. Despite their current rise in popularity, carve-outs still come with a variety of challenges.
Most of the challenges related to carve-outs stem from the inherent difficulty of extracting a business from its parent corporation in a cost-effective, minimally disruptive way. Carve-out deals often exclude critical back-office functions, such as IT infrastructure, HR, and logistics, because such functions are tethered to the internal operations of the parent company. In order to partially (or entirely) offset the additional stand-alone costs, buyers commonly rely on synergies to make the deal more attractive. As a result, it is critical that buyers plan the transition with intense care, and with absolutely no shortage of legal, financial, and operational due diligence. Failure to identify inherent pain points or conceive of a workable plan for extrication can lead to underestimating the overall cost of the transaction and/or a prolonged and costly disruption of operations.
Fortunately, carve-out deals aren’t entirely new. Well aware of the potential risks, experienced PE firms tend to understand exactly what they’re getting into at the outset of negotiations. What is more difficult, however, is knowing exactly how long the carve-out surge will last as the impact of the pandemic wanes and the economy establishes a steady and more predictable footing. So while it appears that we can expect carve-outs to be a prominent aspect of M&A activity into 2022, after some time the conditions that have made this unconventional strategy favorable will inevitably dissipate, likely prompting corporations and investors to conceive of another round of practical adaptations.
Marcum’s Transaction Advisory Services team has been involved in numerous carve out deals and has the knowledge you need should you want to explore a carve out. Contact Fred Campos at [email protected] to learn more.