A carve-out is a corporate maneuver where parent company divests an equity stake of its business, often a subsidiary or a business unit, to form a new standalone company with separate financial statements.
This is typically achieved through a sell-side M&A process or an Initial Public Offering (IPO). The parent company usually retains a majority stake in the new separate entity.
The primary objective behind a carve-out is to refocus on core operations while improving financial performance.
How does a Carve-Out work?
A carve-out strategy is when parent company divests an equity stake of its business as a standalone entity. This is typically done through a company sale or an Initial Public Offering (IPO), although the parent company often retains a controlling stake.
The primary aim behind an equity carve-out could be to unlock the value of the subsidiary, raise capital, refocus on core operations, or compliance.
Carve-Out preparation
An equity carve-out begins with a thorough analysis to identify the portion of the business to be carved out, followed by a valuation of the subsidiary. Legal, financial, and operational due diligence ensures a smooth transition.
Once the due diligence is completed, the parent company proceeds with the IPO or other divestiture methods to separate the subsidiary. This involves preparing legal and financial documents, complying with regulatory requirements, and communicating with stakeholders.
The carved-out entity will have its management structure, although there might be shared services or agreements in place for continuity of operations. It's a complex process that requires meticulous planning to ensure the success of both the parent company and the carved-out entity post-transaction.
Post Carve-Out
Post carve-out, the subsidiary operates as a separate, standalone entity with its own financial statements and possibly its own stock if it was an IPO. A set of agreements will define the relationship between the parent company and the subsidiary, covering areas such as shared services, supply agreements, and other operational linkages.
The success of a carve-out often depends on how well the transition is managed and the clarity of agreements between the parent company and the subsidiary, ensuring a clear distinction of responsibilities and operational autonomy.
Over time, the carved-out entity can choose to operate independently or, in some cases, might be fully divested by the parent company, depending on the evolving business strategies of both entities.
When to consider a Carve-Out?
Carve-outs are a strategy for large corporations. A common reason for carve-outs is when divisions or business units are underperforming, and the parent company wants to focus on its core business.
However, the business unit shares operative processes with the larger parent company, such as support functions. To sell the business, it needs to be a standalone company. A carve-out is the solution in such a case.
Here are several scenarios where an equity carve-out can create value:
Focus on core operations: Companies often consider carve-outs to refocus on their core operations. A carve-out is executed to shed non-core assets if a division or subsidiary is not aligned with the company's primary business or strategic objectives
Underperforming or non-synergistic assets: If a subsidiary or division is underperforming or not generating the expected synergies, a carve-out can be a way to separate these assets from the parent company, potentially enhancing the parent company's financial performance
Raising money: Carve-outs can be a mechanism to raise money. By selling off a part of the business, the parent company can generate cash, which can be used to reduce debt, fund new initiatives, or return capital to shareholders
Regulatory compliance: There may be regulatory requirements or antitrust concerns that necessitate a carve-out to comply with legal mandates or to obtain approval for a merger or acquisition
Carve-Out benefits
Carve-Out benefits to the new entity
An equity carve-out can benefit the new subsidiary by giving it more operational autonomy. This allows the new company to pursue its own strategy, attract its own set of investors and allocate resources specific to its business objectives.
Furthermore, with its own set of financial statements, the new company can demonstrate its performance and potential to the market more clearly, which can be particularly advantageous if the parent company's broader operations have overshadowed it.
Carve-Out benefits to the parent company
On the other side, the parent company stands to gain from a carve-out by shedding non-core or underperforming assets, which can lead to a more focused organizational structure and better financial performance.
The cash raised from the carve-out can be redeployed towards core operations, debt reduction, or other strategic initiatives.
Moreover, by divesting a subsidiary, the parent company may also become more attractive to investors who prefer clearer business models and operational transparency.
The carve-out can also alleviate regulatory or antitrust concerns by reducing complexity or divesting conflicting business segments.
When a Carve-Out is not a good idea
Carve-outs are strategic maneuvers that optimize a company's operations or financial structure by separating a subsidiary or business unit.
However, they are not always a silver bullet and come with challenges and risks. In general, they must significant value and make financial sense. There must be a financial benefit at the end of the carve-out.
Here are some scenarios where a carve-out might not be a good idea:
Dependency on the subsidiary: A carve-out will disrupt business continuity if the parent company heavily depends on the subsidiary for specific business operations. This will ultimately go against the overall business strategy and negatively impact its financial performance
Loss of synergies: If there are significant operational or strategic synergies between the parent company and the subsidiary, carve-outs create operational barriers. Once the transaction is completed, operational steps that were previously internal are now outsourced to a separate entity and may need to be priced at fair market value, potentially increasing costs
High transaction costs: Transitioning a subsidiary into a standalone unit involves separating existing business processes and IT systems into two companies. That's how a carve-out works. Sometimes, a business unit is deeply integrated, making it hard for the company to sell off the business unit outright. If this entire project costs too much, there are no benefits in building a carved-out company
Costly buy-back: Carrying out a carve-out is typically a permanent decision, as the likelihood of the parent company buying back the stake in the subsidiary in the future is relatively low. Buy-backs are often expensive and can cast a negative light on the parent company's decision-making and long-term strategy, making the initial decision to carve-out a significant and lasting one
Market conditions: If market conditions are unfavorable during the carve-out, finding a potential buyer and getting the desired valuation for the subsidiary can be challenging. This could potentially reduce the amount of cash the parent company can raise through the carve-out
Carve-Out vs. Spin-Off
The main difference lies in the ownership and distribution of shares:
In a carve-out, the parent company sells a portion of its stake in a subsidiary through a company sale or an IPO,
In a spin-off, shares of the subsidiary are distributed to the existing shareholders of the parent company, creating a separate, independent entity
A carve-out is characterized by the partial divestiture of a subsidiary or a business unit, with the parent company selling a minority stake to outside investors. The parent company usually retains a controlling interest, allowing it to maintain operational control over the carved-out entity.
Carve-outs are typically executed to raise capital, improve financial performance, or comply with regulatory mandates. The money obtained from carve-outs can reduce debt, fund new initiatives, or return capital to shareholders.
On the other hand, a spin-off entails the distribution of shares of a subsidiary or business unit to the existing shareholders of the parent company, resulting in a completely independent entity. Unlike carve-outs, the parent company relinquishes all ownership and control over the spun-off entity.
Spin-offs are often aimed at unlocking the value of a subsidiary, which might be undervalued as part of the larger entity, or creating more focused and efficiently operated entities.
While spin-offs do not generate immediate capital for the parent company, they may lead to better valuation for both entities, benefiting shareholders in the long run.
How to approach a Carve-Out
Here is how a corporate would approach a carve-out:
Strategic assessment: The first step is identifying which business unit or subsidiary within the organization needs to be separated. The carve-out should fit into the larger strategy of the company and should have benefits in the long run
Deal preparation: Perform due diligence covering financial, operational, and legal aspects. Assess the operational dependencies of the two companies. Prepare carve-out financial statements
Deal process: Obtain a valuation of the business unit to be carved out. Execute the transaction, whether it's an IPO, a direct sale, or another form of separation together with the new investors
Operational separation planning: Plan the operational separation, including assets, liabilities, and employees. Develop a transition services agreement for any services that will continue to be provided by the parent company
This process can take between 8 and 24 months.
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