As of September 2020, the world is starting to look cautiously ahead, following the global ‘stand-still’ caused by COVID-19. Governments are gradually rolling back social distancing measures, as societies and businesses are becoming used to the ‘new normal’.
In the context of M&A, deal-making has also been significantly affected by COVID-19, with lower deal volumes and deals being put on hold. Globally, Q1 saw a 25% fall in volume from the same period last year (Source: Aon, “Global M&A and Transaction Solutions Risk in Review 2020”). In EMEA, 384 transactions were announced in H1 2020, with the number of deals 20% down year-on-year (481 in H1 2019). Transactions that did close tended to be on the larger side, with combined deal value increasing over the same period from EUR 61.3bn to EUR 65bn (Source: “Mergermarket Buyouts: Market Overview & Financing Trends (1H20)”).
In the second half of 2020, there are now signs that M&A activity is picking up again. Over the last few months, Aon’s team has noted the resurgence in areas such as IPO’s and corporate divestments. Carve-outs, in particular, are high on the agenda – both as a possible way to raise funds and due to longer-term drivers, such as a push towards re-rating via specialisation.
One trend is that companies are now refocusing on bolstering their financial capacity, ensuring sufficient liquidity and streamlining their operational profile. With severe recession concerns looming on the horizon, strategic reviews and corporate restructurings now represent commonly-deployed tools. Many of our clients are seeking to improve financial metrics and demonstrate a coherent corporate strategy by divesting non-core business units.
Combined with a high level of “dry powder” in the private equity industry, a significant increase in carve-out transactions is expected over the next 18 months. From a buyer’s perspective (e.g. private equity, or another corporate), the current climate may offer the attraction of reduced cash valuations. Prospective buyers may therefore look to find ‘bargains’ – providing the target’s risk profile can adequately fit their risk appetites.
At the same time, reduced availability of debt-financing will mean that ever-greater emphasis will be placed on tightly managing transaction cost-drivers. Deal-makers will look to their M&A functions and external advisors to achieve transaction cost-reduction, effective synergy-realisation and value-creation. With this article, we will highlight some of the key carve-out considerations from recent experiences and outline Aon’s approach to supporting carve-outs.
Typical Carve-out Challenges
Executing a carve-out transaction can be a very complex undertaking, which is also heavily dependent on how deeply integrated the target business is within the seller’s organisation. It is important to recognise that the process of carving out a portion of the business – preparing it for sale, running due diligence, negotiating and executing the sale & purchase agreement (SPA), before finally integrating it into the buyer’s organisation – can be incredibly disruptive to the seller’s daily business-proceedings. In addition, the carve-out process may have a financial impact on the target’s business, cause additional risk exposure and have an adverse effect on employees and the balance sheet.
Recent research by TMF Group revealed that around a fifth of carve-outs result in millions of dollars wasted because of inefficiencies (Source: TMF Group, “Cross-border carve-outs”). 78% of corporates and 64% of PE funds said delays in completion could have been avoided with more preparation. Both parties say that these delays cost them 10% or more of the deal value. The message, therefore, is clear: preparation and planning are key to achieving a successful carve-out.
In practice, deal-makers’ first priorities may be driving the M&A project from due diligence through to completion and securing the necessary establishment of legal / business entities. However, it is also important to dedicate sufficient attention and resources to other carve-out workstreams as early as possible. Long-term deal prospects may ultimately be decided by how successfully the deal assets – whether Human Capital, Intellectual Property, or other – were carved out and then integrated into the new structures.
Ultimately, mismanagement of any of the factors above may not only delay deal completion but also create significant costs and adversely affect whether original deal objectives are realised. Based on our recent experience, the current market has shifted its focus onto the following key issues:
- Achieving a smooth transition of employees, including delivering uninterrupted benefits coverage (as may be required by the deal terms). For the buyer, this may include determining ongoing pension and benefits provision for employees. Updating contracts within available timescales may be challenging and the required process might vary significantly from jurisdiction to jurisdiction.
- Developing and implementing a strategy for harmonising, or keeping stand-alone, the employee benefit and insurance programs. This can achieve immediate savings and realise deal synergies from Day 1.
- Being aware of the timing requirements for implementing new insurance coverage, benefits and other programs. There is often some lag-time between signing contracts, paying premiums and securing the coverage. In general, when subsidiaries or business units are purchased out of a corporate group, they will often lose the cover under the parent company, which may also have an impact on costs.
- Onboarding of all required functions and systems, which may become lost on separation from the seller. Of these, payroll tends to the most critical for Day 1.
- Balance sheet strength is a common issue post-sale in carve-outs, as the acquired business loses the support from its former parent, but this has been further compounded by COVID-19 and the potential strain on the Newco cashflow position and supply chain credit strength.
COVID-19 Impact on Carve-outs
Current circumstances may present additional carve-out challenges as a result of COVID-19 and its impacts. As well as affecting the wider M&A market, this may have unique implications on each target business and the overall process of bringing a new company to market. High quality risk data is required in order to obtain terms. Fully understanding how the target has responded to the crisis, and analysing longer-term implications, should already be an integral part of any due diligence process.
However, it is also important to keep in mind that COVID-19 may also have wider consequences for a carve-out process. As just one example, business insurance capacity has now reduced in several key lines of business and geographies and underwriting processes may now require longer waiting-periods and approval-processes.
For most companies, COVID-19 will have had significant impact on their employees – whether through the use of government furlough schemes, transitioning employees to flexible working patterns or working from home. Attention to Human Capital issues, within carve-out workstreams, is now more important than ever. Medical premiums are expected to rise beyond typical inflation rates, which will add additional pressure to programs being carved-out and may require further negotiation with insurers.
Financial wellness and job security may become a key part of the total reward package for employees, for whom the prospect of being transitioned to a new employment structures may become more daunting. Employee experience of carve-outs is likely to change significantly, with many traditional Day 1 onboarding processes no longer possible, or needing to be adapted for the virtual environment. Clear, positive communications around carve-out timing, and any impact on employees’ wellness and benefits will be very important. Longer-term, the very concept of ‘employee brand’ and future of work is likely to change, so any prospective buyer should remain attuned to this rapidly-evolving situation.
Carve-out at Aon
At Aon, we believe that M&A is a situation, not a solution. Our key strength is the ability to quickly identify material risks and issues and support clients in mitigating these. Our carve-out team is focused on cost-reduction, synergy-realisation and value-creation, which we deliver via the following workstreams:
- Human Capital – retaining, incentivising and successfully integrating employees is critical to realising deal value and achieving the transaction’s original objectives. We work with clients to identify Human Capital-related deal value issues early in the sale process. It is crucial to uncover and understand balance sheet liabilities, potential price-adjustments and any unions/works councils issues which may prevent a deal from going forward. Certain employee programs, such as Defined Benefit pension plans, may also carry significant future cash contribution obligations. Human capital provisions and legal requirements may vary significantly by country. Early vesting of Long Term Incentive Plans will need to be carefully managed to retain the key employees. Where appropriate, we can offer an additional ‘deep-dive’ focus on understanding the target’s workplace culture and Total Rewards philosophy.
- General Risk and Insurance Management – how will the insurance and risk management be structured post-close? We can help develop insurance strategies to offset liabilities through the SPA, including past liabilities and incurred-but-not-reported claims. As noted earlier, the other important factor is the readiness of Day 1 stand-alone insurance programs and risk management tools, including design, development and implementation.
- Transaction liability insurance – are there deal-execution risks to either sell-side or buy-side, for example if the other side withdraws or fails to deliver on the agreement? Transaction liability insurance is a powerful tool in facilitating deals and may be especially important in the current economic climate. More traditional tax, litigation and contingency insurance may also be used and represent links to the broader M&A market. These are increasingly recognised as strategic capital-management tools that can solidify financials and unlock liquidity.
- Credit Solutions – carve-outs often mean the buyer facing demands for security or collateral either from sellers in respect of the transaction, or inherited from the target’s customers, suppliers or regulators. By leveraging the insurance market appetite for credit risk, Aon builds solutions to these demands that are typically both off-balance sheet and with a lower cost of capital.
- Cyber – is there exposure to cyber risks? As many businesses have discovered at significant cost, M&A activities can become the perfect incubator for serious cyber-attacks. Partially-integrated businesses in a complex patchwork of systems may contain security blind-spots and vulnerabilities. A hacker may be dormant for years, only to re-awaken in a newly-integrated parent business. Executives may need to be highly risk-averse and potentially assume the other side has already been compromised, then set out the carve-out or integration strategy with a clear target operating model. Protecting the core business value should always come first.
- Intellectual Property – has the segmentation and separation of the patent portfolio been done already? Successful completion of a carve-out requires complicated decision-making regarding the ownership and future use and cost of IP assets. Patents, in particular, have often been developed by central R&D or may be providing IP protection across several business units. A data-driven patent portfolio segmentation and analysis to bring key insights on the quality, value and “usage” of patents between the selling entity and the carved-out business can support complex negotiations and can identify IP assets which are a material part of the carved-out entity and potential cost-synergies through patent-pruning or sales.
Contact our M&A Specialists