Thorough, detailed diligence helps buyers and sellers
In the right circumstances, a carveout can give a seller’s non-core asset the support and care it needs from a buyer who’s able to make it grow.
Perhaps there is a strategic buyer, with the infrastructure and experience to cultivate the full potential from the asset. Maybe the buyer is a private equity firm with value creation skills that can make the asset worth far more than the initial purchase price in just a few years. In either case, this is an improvement for everyone.
For both buyer and seller, though, the proper purchase price and valuation of a carved-out asset can seem elusive and subjective. Third parties can provide assistance here, with valuation and diligence services at various stages of any deal, including a carveout — and these services are useful because there are so many factors to consider.
But the buyer and seller also want to develop their own understanding of these issues. Grant Thornton valuation specialists say sellers and buyers have many of the same things to consider in their valuation calculations, including who will supply the carved-out asset’s support functions; the potential need for contingencies and earnouts; optimizing tax structuring; and timing of deals.
Here are some key factors both sellers and buyers need to consider as they attempt to get the most out of carveout transactions.
Sellers
Any valuation is heavily dependent on historical financials and balance sheet information, but this information can be difficult to determine when the asset that’s being carved out is heavily intertwined with the rest of the seller’s financials. No matter the difficulty, though, sellers should provide this information.
“They’re going to be a lot further along if they can produce some kind of historical carveout financial statements and some kind of forecast,” said Grant Thornton CFO Advisory Managing Director Maryellen Galuchie. “Obviously, the seller and buyer are both going to do their own forecast, but the seller should have something to start with. Otherwise, they might not get the best price for the asset.”
Sellers should also consider:
- How overhead and stranded costs affect price: If the seller plans to incur the overhead and stranded costs associated with the deal, the transaction might be more attractive to a buyer and fetch a higher valuation of the asset and sale price. When thinking about buyers, sellers can expect that:
- Strategic buyers might have the back-office and other functions in place to support the carveout after purchase. “If you sell to a strategic buyer, the seller will almost certainly keep those costs,” said Grant Thornton CFO Advisory Principal Sylvia Cho.
- PE and other financial buyers might need to bring over more back-office support from the seller in the deal.
- When a PE buyer acquires the carveout and adds it to an existing platform, however, the support functions for the carveout might already exist in the platform company.
“From a valuation perspective, sellers need to properly identify those costs and, of course, the buyer has to agree with your assessment,” Galuchie said. “If they’re not properly identified, the valuation will be affected.”
Any support the seller is providing through transition service agreements also might affect the price.
- Who’s the buyer?: Any valuation the seller arrives at is meaningless unless there’s a buyer willing to pay that price. On some occasions, though, Galuchie has served buyers that have gotten incredible deals because sellers vastly underestimated the value that an underdeveloped asset could bring when owned by a company that truly understands how to support it. Sellers might try to protect themselves from this risk by adding earnouts or contingent payments to the deal, but Galuchie said she doesn’t usually see contingent payments in carveouts unless a new product or services is part of the deal. Tracking earnout metrics after carveouts can be difficult, especially for strategic buyers.
“If you’re a seller and you believe the asset will really take off after the transaction, earnouts or some type of contingent consideration might be worthwhile, but those metrics can be challenging to track,” Galuchie said.
- How can a third party help?: The points in the process where sellers seek an independent valuation can vary greatly, but invariably a third-party opinion goes a long way towards validating a seller’s thinking.
Valuation professionals can be particularly useful to sellers who don’t often participate in transactions and are uncertain of their own valuation and pricing knowledge. Sometimes, sellers who work with an investment banker on their carveouts even seek professional validation of the bankers’ estimates.
“We also have gotten requests from sellers who say, ‘We’ve got an offer. Does this price make sense?’“ Cho said.
- What’s the best timing?: Sellers will want a transaction that allows them to run their business as usual, without causing disruption.
Closing a deal right before the fiscal year-end, for example, might not be the best idea. If the buyer insists on inconvenient timing, that might affect the price — or whether a different buyer is needed for the deal.
Meanwhile, a long time horizon for a carveout can result in a higher sale price if the seller isn’t in a hurry. Initiatives that improve the balance sheet or sales, and/or drive expense efficiencies, can make the carveout more attractive to a buyer.
“It can be very beneficial to address these improvements in the short term,” Galuchie said. “But sometimes there isn’t any time to make the changes and prove they are sustainable.”
- What are the tax impacts?: A carveout will be more valuable when the legal entity is structured to take advantage of credits and net operating losses and minimizes the taxes associated with the sale as well as the future taxes of the remaining entity.
Sellers also need to consider the tax effects of the transaction on the buyer, who might be willing to pay more for deals that reduce their future tax liability.
Buyers
A buyer’s valuation starts with understanding as fully as possible the business that’s being carved out. If a seller says it is impossible to produce standalone financial information that reflects the carved-out entity, be prepared to walk away from the deal or demand a steep discount. You can’t truly evaluate what you can’t measure.
Next, buyers need a clear-eyed understanding of their own business and the synergies they can bring to the new business unit after the transaction. They need to ask:
- How much will it cost to stand up the asset once it’s acquired?
- How much time will it take to integrate? Or, do you perhaps not want to integrate?
- Can another buyer bring the same synergies to the deal that you can?
The answers to all these questions will help determine the value the deal can bring and the price you want to pay. And third-party diligence is just as important to buyers as it is to sellers. These services of course need to dig deeply into details about the carved-out entity, but they also should include an intense analysis of the buyer to figure out how the deal will drive value in the future.
Valuation pre-work can help the buyer validate their thesis and understand the impact of enveloping a carveout. Post-deal valuation work is also valuable, as organizations need to record all assets, including intangibles, and liabilities at fair value. Additionally, valuation professionals can assist both before and after the deal with determining the fair value of contingent consideration (such as earnouts).
Buyers also need to consider:
- How are you financing the deal?: Buyers who borrow heavily to finance a deal need to consider the effect on their overall business. Although valuation essentially is a measure of what a deal is worth, buyers also need to ask themselves what they can afford to pay without putting stress on their remaining business.
At times, earnouts and contingent payments can benefit buyers more than sellers if earnouts significantly reduce the upfront price of the deal. It can be preferable to pay more at a later date with the knowledge that the deal delivered the value you expected — or even more. Buyers also use deferred payments on deals, which helps to finance the transaction.
- Are there cross-selling opportunities?: Many times, a carveout will be complementary to a company’s existing business, and cross-channel promotion can create a rising tide that lifts all ships.
For Disney, for example, purchases that delivered properties such as ESPN and Lucasfilm created an almost endless array of cross-pollination opportunities that benefit everything from streaming services to amusement parks.
The one caveat is this: If you buy an asset that’s too similar to an existing asset, you might end up cannibalizing some of your existing business.
- The effect on people — and of people: There are numerous people issues to consider in the value of a carveout.
Buying a carveout can give a company opportunities for some of its rising stars to take more prominent roles in the integration.
Retaining key people from the carved-out entity might require retention bonuses that will affect the cost of the deal and the price the buyer might be able to pay.
“A lot of buyers don’t think about the people considerations, but they’re critical to help you maximize the value of the transaction as a buyer,” Cho said.
- The tax impact: Taxes should be considered in the sale and the structuring of the legal entity moving forward.
Are you better off structuring the transaction as an asset deal or a stock deal? The answer — and the future tax implications — will affect the value of the deal to the buyer.
- The deal timing: Just like sellers, buyers need to consider the best timing for a deal. Galuchie has one client that will only close a deal at the end of the month to minimize the extra accounting efforts.
“It’s just more of a hassle to have an unnatural cutoff,” she said.
A buyer might be willing to pay a bit more for a deal where the timing is most convenient.
Is the carveout right for you?
All these considerations for buyers and sellers are complex and often intertwined, and they typically require the deep experience of valuation professionals to navigate successfully.
The value of an asset and the price of a transaction can cause a company to walk away from a deal, or to confirm that a transaction is the right move for them.
“Carveouts can have a lot of arbitrage and a higher return profile if you do them well, but they can be counterproductive if you do them poorly,” Cho said. “It needs to be the right deal, and the timing is important. The purchase of a carveout needs to sequence with your existing business in a way that you have the tolerance for it and not just the appetite.”
Contacts:
Sylvia H. Cho
Principal, CFO Advisory Services
Grant Thornton Advisors LLC
Sylvia is a Principal with the Advisory Services practice of Grant Thornton LLP’s Chicago office.
Illinois, Chicago
Industries
- Asset management
- Insurance
- Life sciences
- Manufacturing, Transportation & Distribution
- Private equity
- Technology, media & telecommunications
- Transportation & distribution
Service Experience
- Advisory
Maryellen Galuchie
Managing Director, CFO Advisory Services
Grant Thornton Advisors LLC
Maryellen Galuchie is a managing director in Forensic Advisory Services and Grant Thornton’s Southern California Forensic Advisory Services practice leader. With more than 30 years of experience.
Los Angeles, California
Industries
- Healthcare
- Manufacturing, Transportation & Distribution
- Technology, media & telecommunications
- Transportation & distribution
Service Experience
- Advisory
- Valuation
Todd Patrick
Principal, CFO Advisory Services
Grant Thornton Advisors LLC
Todd Patrick is the National Managing Principal of the Valuation & Modeling practice of Grant Thornton LLP. He is based in Dallas, Texas.
Dallas, Texas
Industries
- Asset management
- Energy
- Hospitality & Restaurants
- Life sciences
- Manufacturing, Transportation & Distribution
- Media & entertainment
- Services
- Retail & consumer brands
- Technology, media & telecommunications
- Transportation & distribution
Service Experience
- Advisory
- Valuation
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