Redimensioning through carve-outs as part of a future strategy

Opportunities and success factors

In recent years, carve-outs have become increasingly important as part of a strategic corporate finance approach.
In 2021, this trend will intensify, driven by the appetite of large private equity firms for more profitable parts of a group, but also in particular by the increasing realization of established companies, as can be seen in the most prominent examples of ThyssenKrupp and Siemens, that an individual division can act more easily and agilely without being organically embedded in a large group.
Another accelerator of carve-outs is the redimensioning that is essential for survival in the post-Covid era.
Slumps in sales, changes in customer requirements and the market environment are forcing companies to reassess their portfolio and take action.
But what forms can such a redimensioning strategy take as part of future planning?

In particular, transformation projects in the area of digitalization and the company’s IT structure should have been driven forward more strongly by the exceptional situation in 2020/2021 at the latest, and with a view to the future, this development must be strengthened in the long term.
At an operational level, companies must now use this time to scrutinize their current setup.
This ranges from evaluating the entire supply chain, including reviewing production and locations, to examining the existing organizational structure, decision-making processes and hierarchies.
General business planning and development must be examined and evaluated with regard to the profitability and risk of individual business units and product portfolios.
Potential must be identified and, if necessary, the scope streamlined through equity carve-outs or acquisitions via other M&A processes.

The following explanations relate to this redimensioning environment.
Carve-outs as part of the repositioning of a company.
But what makes this process successful?
How can a carve-out become a profitable driver as part of a future and redimensioning strategy?

Best practice examples

Some practical examples underline the growing popularity of carve-outs as a strategic tool.
To stay with the example of Siemens, it can be said that the company has established itself as a carve-out expert over the years.
Recent examples include the spin-off of Siemens Energy and the spin-off of the traffic control division under the name Yunex Traffic, which was announced on February 12, 2021.
At ThyssenKrupp, the spin-off of the elevator division was successfully completed in 2019 and a carve-out of the steel division was considered for the first time in the last quarter of 2020.

Definition and reasons for a carve-out

This approach now gives rise to the definition of an equity carve-out: the spin-off and sale of part of the company in the form of an individual division or a subsidiary.
This can be done in conjunction with an IPO in which shares are sold.
However, the parent company does not have to sell all of its shares and can continue to hold a large proportion, as is the case with Siemens Healthineers, for example.
This is the case with Siemens Healthineers (85% is still held by Siemens AG).
The overriding aspiration in any form of spin-off is the hope that the division will perform better in the new organizational structure than before, i.e. achieve higher shareholder value.
But what are the general motives that prompt a company to take this path?

Carve-outs usually take place against the backdrop of a strategic restructuring and realignment, whether due to the desire to focus more on core competencies or simply because the business unit no longer fits the business strategy.
At the same time, the desire for more flexibility and agility can also be a driver for such transactions.
In addition, a carve-out of a unit can also take place due to its positioning in a current trend for maximum sales proceeds.
This means that these spin-offs attract a great deal of media interest and serve a current market preference.
This can be seen, for example, in the carve-out of Siemens Energy from the large parent company; topics such as renewable energies and hydrogen technology are currently generating a lot of excitement on the stock markets and companies that serve these topics are achieving high valuations, which in turn can benefit the parent company through an increased inflow of liquidity.
In addition to these strategic motives, return expectations and financial requirements play a major role.
If, for example, a business unit fails to meet certain profitability targets or is unable to keep up with the returns of the other business units, it may be spun off.
Another advantage for the parent company as a whole is that the sale of the shares results in an inflow of funds for the company and can therefore strengthen its financial situation.
If not only a part but the entire shares are sold, this attracts PE investors or companies interested in the strategic integration.
The challenge for them is to define a suitable price for the business unit.
A precise financial reporting structure is usually not available due to the embedding in the parent company and so the entire M&A process turns out to be a complicated undertaking, which requires extremely detailed due diligence, not least due to ambivalent future prospects and turbulence in the international stock markets caused by Covid-19 and the associated difficulties in valuation.
The reasons for a carve-out can be manifold and range from the main factors mentioned above, such as focusing on core competencies or increasing liquidity through the sale of shares, to the competitive weakness of the unit to be spun off.
Frequently, an opportunistic sale also occurs, e.g.
This can also lead to an opportunistic sale, for example as part of an “unsolicited approach”, and geopolitical uncertainties can also be a driver for a carve-out.

In principle, the majority of companies that have completed a carve-out have seen increased growth and profitability at both the subsidiary and the parent company following the transaction, and investors on the markets also appreciate this process in the majority of cases and see a higher valuation as justified in contrast to a valuation as a whole of all former business units.

Success factors

But when does a carve-out prove to be a suitable and successful strategic tool for the parent company?
To put it simply, a carve-out makes sense if the unit in question feels that its integration into the group structure is hindering its development, i.e. if the potential of this area cannot be fully exploited in the current organizational structure.
If the carve-out is identified as the more successful alternative, the process begins, which can be very lengthy depending on the complexity.

The first success factor is therefore strategic evaluation.
This means that at the very beginning there is the aforementioned realization that a carve-out could increase shareholder value.
This is followed by the definition of the objectives to be achieved and the parameters under which the carve-out should take place.
This is the answer to the desire for strategic repositioning and must define the extent to which the carve-out should take place, i.e. which carve-out makes sense and what implications this has for the parent company.
It should also be determined at this point whether there is a valid buyer market at all and the timing for the entire process should be fixed.

The second success factor also lies long before the actual spin-off.
In order to make this as smooth as possible, the company should start with a “stand-alone approach” beforehand.
This means reorganizing all functional areas for independent operation in good time in order to increase the speed of the actual spin-off and the selling price in the event of a complete sale.
Potential buyers demonstrably appreciate this effort in the form of a higher price.
This “stand-alone approach” includes the IT area in particular, which is otherwise embedded in a complicated architecture, especially in large corporations, but other functional areas such as the entire supply chain as well as back-office activities such as finance and controlling also play an important role.
This assessment is always an individual one and depends on how independent the unit to be outsourced already operates within the company.
Depending on the extent of the overheads and management involvement, but also the embedding in the company’s entire value chain, the stand-alone transformation becomes increasingly complex and should be taken into account early on in the time planning.
If this is not done completely, it can lead to significant delays in the process, one of the biggest challenges and obstacles to a fully successful carve-out.

The third success factor is the transitional service agreements (TSAs).
These deal with four central issues:

Over what period of time are which services supported?
Detailed definition of the scope of services and assets and over what period of time they will be provided
How are these services provided?
Answering the type of provision, which services are provided internally and to what extent external groups are involved.
How is pricing defined?
Examines the complex question of how the services within the TSAs will be remunerated and what the costs will be.
How is management carried out in the interim organizational structure?
Establishes a temporary governance structure and monitoring mechanisms.

If these are defined to a large extent and last for a period of more than one year, the buyer sees them as a great insurance against uncertainties in the post-merger integration, with the result that this is reflected in a higher purchase price, as the buyer appreciates them.
Business continuity plays a crucial role here and to guarantee this, a certain period of time is needed to build up the functions and processes on the buyer’s side and replace the TSA.
On the other hand, it is important to note that TSAs should not last too long, as otherwise there will be lengthy and complicated interdependencies between buyer and seller long after the transaction, tying up too many resources on the part of the seller.

Fourthly, regardless of the extent of the share sale, be it 100% or only a small part with an existing majority by the parent company, it is important to know and regularly evaluate the entanglements within the group, as these play a significant role in the speed and overall success of the carve-out.
A lack of understanding of the organizational links between the unit to be carved out and the parent company is a clear obstacle to a successful project and leads to higher costs.
Only after a fundamental analysis, which should be carried out at an early stage, can the foundations for a profitable divestment be laid.
This is also where a promising philosophy comes into play: the use of a specialized team of experts from different areas who are familiar with the carve-out project and who accompany the entire process from the initial analysis of the embedding and interdependencies in the group structure to the development of the “stand-alone approach” and the implementation of the TSAs.
It is also important to counteract any skepticism among employees and customers during this process and to proactively involve and inform them in order to counter uncertainties in good time and avoid the resulting migration and termination of employee and customer relationships at an early stage.
Resistance from employees or employee representatives is one of the showstoppers of carve-outs.
All of this is very resource-intensive but can have a beneficial and lasting influence on the carve-out process.
A senior executive or transformation officer can be appointed to manage the process and play an important role in this entire project.

Conclusion:

It can therefore be concluded that carve-outs have great potential, especially in the current situation, to significantly increase shareholder value for the seller, buyer and carved-out unit.
However, due to the complexity of such a project, there are a number of things to consider, starting with the appropriate strategic definition of the future business positioning, the business unit to be divested, its stand-alone capability and the precise formulation of the TSAs.

One bottleneck will be suitable managers who work at the intersection of strategy, M&A, restructuring, corporate finance and operations and who can implement carve-outs in a strategically clever and targeted manner, taking all challenges into account.

About the author: Dr. Stefan Gros works as Chief Financial Officer and Transformation Officer ad interim for companies in transitional situations.
He is a lecturer for Business Valuation and M&A at the Catholic University of Eichstädt Ingolstadt.
Further information is available at www.stefan-gros.de.

Contact: sg@stefan-gros.de