The Craft of the Carve-Out

Briefing

Q1

2014

An Executive Summary of the Privcap Thought Leadership Series “The Art & Science of Dealmaking”

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Carve-Outs

Key Findings

1. Under-loved corporate divisions can become successful independent companies

2. Many risks accompany the separation of a business unit from its parent

3. Management must be aligned with sponsors and LPs in the creation of wealth

4. A sound plan can prevent a failed carve-out5. Newly independent companies must be monitored very closely

Adam Blumenthal Managing Partner Blue Wolf Capital Partners

The Panelists

Ed Kleinguetl Managing Director Grant Thornton

Aaron Wolfe Managing Director Sun Capital Partners

1. Under-loved corporate divisions can become successful independent companies.

A lot depends, of course, on why the division is under-loved. If it’s under-loved because it’s dysfunctional and hasn’t made a dime in years, it will never be a successful independent company.

So what should managers look for when measuring the potential of a corporate carve-out? “We want to un-derstand the position of the company in the market-place, its market share, the quality of its products or its services, and how they compare to competitors,” said Aaron Wolfe of Sun Capital Partners, whose firm has completed more than 90 corporate carve-outs world-wide. “Then we ask: What are the benefits and what are the potential risks of separating that business?”

GPs must determine if there are conflicts with the corporate parent that are preventing the subsidiary from pursuing good opportunities. They must exam-ine the benefits the parent is providing, whether sales, presence, corporate credit, or back-office functions. They must ensure that divisions without direct cus-tomer contact can establish that contact after they’re separated.

Once a promising division has been acquired, GPs must do what they do best—execute. “Before we do any work on a transaction, we ask: What’s the value we can add from a strategic and operational perspective?” said Adam Blumenthal of Blue Wolf Capital Partners. “One thing private equity funds are good at is change man-agement. We’re good at assessing a current state, iden-tifying a future state, and creating a road map from the

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present state to the future state. That’s our core skill—and that’s not necessarily the core competency at large corporations.”

2. Many risks accompany the separation of a business unit from its parent.

Separation anxiety is a part of almost every corporate carve-out, because it is a rare carve-out that breaks from its corporate parent at a spring sprint—or even a healthy canter. “It’s going to wobble,” said Ed Kle-inguetl of Grant Thornton. “Just make sure it doesn’t collapse, that there’s business stability.”

Kleinguetl said it was important for managers to sweat the small stuff—“the systems, the accounting, and all the little tentacles that provide life support to that business. Knowing all those connections and how to separate them becomes very important in due dili-gence.”

Wolfe observed that before going ahead with a carve-out, GPs needed to take a step back, to understand why the two businesses got together in the first place. “Typ-ically a merger is completed because somebody believes there are synergies, there’s some benefit to the acquisi-tion occurring,” he said. “Those benefits may be con-solidating back office or sharing sales force. So when a corporation is looking to divest that business, all those benefits that were generated over the years have to be extricated, and you have to think through how to rep-licate them.”

Some of that replication is straightforward—for in-stance, accounting and insurance. Some is difficult. What if the businesses have been sharing a central dis-tribution system? How do you create a new one? What if they’ve been sharing a sales force? How do you transi-tion customer relationships?

3. Management must be aligned with sponsors and LPs in the creation of wealth.

Management is vital to the success of any private equity deal, but it is especially important in a carve-out. Man-agement teams normally welcome PE-backed carve-outs

Carve-outs can be the ultimate win-win. They can produce large returns for firms, and they can open up new career avenues—with handsome compensation—for the managers who stick with the spinout, especially those who invest their own money.

Blumenthal said his firm encouraged man-agement teams to invest, because it created an alignment of interests. “If they have up-side but no downside, their interests are de-cisively different from ours. People who have a free call on money behave differently from people who are managing their own money. One of the reasons that the carve-out struc-ture can execute a change strategy more rapidly is that the interest alignment is so well done.”

Carve-outs give managers an opportunity to take a leadership role that’s not only well compensated but more personally satisfy-ing. The trick for private equity is identify-ing those managers for whom the personal satisfaction and the wealth creation are sig-nificant drivers.

“If you have a management team for whom both the personal satisfaction and the wealth-creation opportunity are meaning-ful, that really is the first step,” Blumenthal said. “It’s not true of everybody. People do self-select out.”

Skin in the Game

Adam Blumenthal

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because they see a chance to make a lot of money. Their incentives must be set up to ensure that they succeed only if the carve-out succeeds.

Wolfe said compensation packages should include a competitive base salary for management and a properly aligned annual incentive bonus that’s focused on easily identifiable metrics, usually tied to profitability and set at reasonable targets.

“The reward for leading an organization over a period of years and successfully exiting it should be a number which is very meaningful,” Blumenthal added. “Wealth creation ought to be the driving force for the senior lead-ership.”

He said he favored a cascading set of alignments that starts with LPs and flows to the shop floor. “Endow-ments, foundations, pension funds—they have needs and expectations. We’ve made promises to them. We want that to cascade down to the management team so that we and they are aligned. And we’re big fans of cascading that down another level. There’s no reason a midlevel manager shouldn’t also have compensation aligned with the needs at the source of capital.”

Kleinguetl agreed. “There has got to be balance,” he said. “Whether it’s through incentives or the buy-in of equity in the new venture, there does have to be align-ment for success, period. And push it down as far in the organization as you can. Because people really do want to do the right thing for their company; they just need to know what it is.”

4. A sound plan can prevent a failed carve-out.

Most GPs approach a new deal with a 100-day plan to enhance the chance of value creation. A similar plan will create value in a carve-out—but the plan must be crafted to address the complexity of the deal.

Such a plan, commonly called a transition services agreement, must be focused and decisive. “It begins with due diligence, when you identify all the depen-dencies upon the parent,” Kleinguetl said. “What assets and people need to be transferred? And as soon as those are locked in place, particularly the transition services agreement, the acquirer immediately has to be think-

Just because a corporate division is under-loved doesn’t mean it’s over the hill. Some of the best carve-out deals come when private equity firms identify strong divisions that are struggling only because the corporate parent has decided they no longer fit the grand corporate scheme.

Often these units are not getting the internal funding they need to thrive. “You can have a very good $100 million division that’s part of a multibillion-dollar company, but it’s fight-ing for capital resources,” Wolfe said. “When the corporation is setting its budget for the year, the allocation may not be going to that $100 million division because it’s non-core to the business.”

Often a corporation makes a decision that, due to changes in the global economy, it wants to take its overall business in a new direction. And some of its existing divisions, even though they’re performing well and producing good products, may not fit with that new direction.

In these situations, the corporation is right to spin out the business, said Wolfe. The job of private equity managers is to be there when it happens. “There are a lot of reasons why very good divisions may not receive the capital or the authority to do what needs to be done. But for the overall parent company, the right decision is to divest that unit and go on with its plans.”

A Change in Strategy

Aaron Wolfe

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ing about how to transition off that agreement.”Wolfe said there were two vital aspects to any plan.

The first was the carve-out itself and the action items that needed to occur to make the business a stand-alone entity. “Fundamentally you’re buying a business that still needs to operate and to service its customers,” he said.

Secondly, Wolfe said PE sponsors need to identify the key services to be transitioned from a carve-out perspec-tive, including the management of IT systems, back-of-fice functions, and financial systems. “It’s essential to put together a plan that quantifies the expected cost, the expected end date of those services, and the people who are responsible for transitioning them,” Wolfe said.

That final point is key, he added, because knowing who’s responsible for an objective enabled a GP to en-sure that person had the skills and resources to get it done.

5. Newly independent companies must be monitored very closely.

Executive dashboards are especially useful in spinout deals to monitor progress and keep the carved-out com-pany on track. But what metrics should they use?

“Cash,” Blumenthal said. “When you do a carve-out and you’re using legacy systems, no matter how good your diligence, the chances of those systems providing useful information about the key value drivers within the business is maybe 35 percent. So know your cash balance. If you monitor that, it’s a pretty good guide.”

Wolfe said that every Tuesday evening his firm re-ceived a “flash report” from each of its businesses. The reports track various vital signs, including cash. There are also monthly reports that include a meeting with management.

“When we sit down and talk with our management teams, we really want to understand what’s happening. We don’t just want to be told the good things. We want to understand the good, the bad, and the ugly so we all are making sure we’re addressing those issues real time.” •

The key to a successful carve-out is a good transition services agreement that enables the new company to gradually separate itself from the support provided by its corporate parent and move to its own systems.

“Something like payroll can probably be transitioned in less than three months,” Kleinguetl said. “On average, most support services have a window of about six months in a transition services agreement. IT might be the longest lead time, even up to a year or 18 months.”

But from the minute the transaction closes, the private equity buyer needs to be thinking about what systems are in place at the mo-ment and what systems need to be in place soon to support the continued growth of the business.

“There’s very little time. Six months is gone in a heartbeat,” Kleinguetl said. “The real key in these plans is to not only think about making sure you’ve got a stable foundation but how you transition yourself off those old systems as quickly as possible.”

Lost in Transition

Ed Kleinguetl

Grant Thornton refers to Grant Thornton LLP, the U.S. member fi rm of Grant Thornton International Ltd.

One of the six largest global professional services � rm, Grant Thornton specializes in helping private equity � rms and their portfolio companies realize their potential. We have the industry knowledge and breadth of resources to advise on all aspects of the private equity transaction from deal origination, through structuring and value creation to exit planning and execution – all delivered quickly through a single point of contact who has the experience and know-how that complements your expertise. To help unlock your potential, visit GrantThornton.com/Growth.

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Series / Carve-outs

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Carving, Then Thriving Happy Management, Happy Carve-Out Carve-Outs: Plan of Action

This thought-leadership series is sponsored by Grant Thornton.