Corporate carve-outs: key tips for slicing the pie right

Market and M&A conditions continue to be ripe for corporate carve-outs. In this article, we discuss our key legal tips for navigating success through the complexities of corporate carve-out transactions.

In brief

• Corporate carve-outs tend to be complex as they involve the separation and sale of a business that may not be structurally or functionally standalone within a corporate group.
• Seller planning and preparation is paramount, including early consideration of legal and tax issues for perimeter setting and separation planning.

What is a corporate carve-out?

A corporate carve-out refers to the process by which a corporate seller divests certain business(es) from its portfolio or group (referred to in this article as the “target business”).

The level of integration between the target business and the seller will determine how complex the transaction is. This ranges from:

• the least complex – standalone target businesses that are housed within a standalone legal entity with minimal or arms’ length interdependencies with a corporate seller; to
• the most complex – highly integrated target businesses with shared regulatory approvals, shared resources, leveraging group contracts and a requirement for post-completion long-term arrangements between the target business and the seller group.

The motivation for a corporate carve-out transaction is varied – it can range from regulatory or similar pressures (eg PwC Australia’s divestment of its government consulting business to Allegro Funds and the various financial sector divestments sparked by the findings of the Banking Royal Commission); strategic review where investors may see additional value in separated businesses (eg Perpetual); divesting non-core businesses to deleverage (eg Campbell’s sale of Arnott’s to KKR); energy transition (eg UK’s National Grid’s sell-down of its interest in its transmission and metering business); to the commencement of a sale process for a business division following a strategic review (eg Healius).

Key issues

We set out below a number of key issues that a buyer and a seller will need to consider as part of a carve-out transaction.

Defining the Perimeter

Perimeter setting is the most important step in the carve-out process. It is the process of defining the parts of the seller’s business that will form the target business.

Legal, finance, tax and operational due diligence and structuring is critical at this step in the process to ensure that there is clarity as to the scope of the business being acquired and an efficient way for the separation to take effect.

A pro-forma balance sheet and P&L statement is usually set, with due diligence then undertaken across multiple disciplines to ensure that the separation process results in the target business housing the correct assets and employees to deliver the expected pro-forma revenue and factors in the liabilities (on a standalone basis).

Different types of buyers are likely to have a different area of focus when agreeing on the perimeter – for example, trade buyers who have overlapping management expertise may not have the same requirement on transferring personnel as a sponsor who is acquiring a platform business.

For sellers, bringing the appropriate stakeholders from the seller and proposed target ‘into the tent’ at this early stage is important to ensure that the correct perimeter can be set from the start.

A related tension that sometimes arises at this stage is the level of contact (if any) a seller will allow the buyer to have to the key employees/executives from the target business. The transaction efficacy of introducing the buyer to those target executives early in the process must be balanced against those executives ‘crossing sides’ too early in the process (particularly where the seller’s knowledge of the target business is concentrated in the target executives).

Shared services and contracts

The key categories of services and contracts that usually have a degree of entanglement between the seller’s business and the target business are data and IT, key suppliers (including physical premises) and key customers and brand and IP. Intra-group arrangements also require identification and replacement (if critical).

Data and IT separation is complicated and usually the most costly element in a corporate carve-out process. It includes an assessment of the costs to separate and also the ongoing standalone costs to the target business after the target business ceases to have access to the umbrella arrangements benefitting the larger corporate group. The planning and due diligence phase will also inform the scope of the transitional services arrangements (TSA) that a buyer will require from the seller (including for how long and at what cost, and contingencies if third party consents are not forthcoming from relevant suppliers). The parties will also need to consider the potential need for a data access arrangement post TSA to provide ongoing access to data that the buyer needs to operate the target business to the extent such data is not transferred to the buyer as part of separation.

The separation of brand and IP in a corporate carve-out can also be complex, particularly where there may be an ongoing need for both the remainder seller business and the target business to continue using and accessing IP that has been developed to date. For a seller, the phase-out on brand use (assuming it is being retained) will also be important.

Historical liabilities

Where the driving factor for a seller considering a corporate carve-out is to ring fence its exposure to historical liabilities, a key area of negotiation is the extent to which the seller would be willing to stand behind such liabilities in order to facilitate the carve-out and the scope of any such liabilities.

For example, seller indemnities for historical liabilities were a feature in the financial services divestments following the Banking Royal Commission.

Employees

The determination of employees who are in-perimeter can sometimes be a tricky exercise, particularly where employees or executives have responsibilities that span both the target business and the retained seller business. Managing and aligning the interests and wishes of the employees, seller and the buyer may not always be straightforward and expectation setting from all sides is important at the outset.

From a seller’s perspective, where the carve-out process involves the transfer of in-perimeter employees, ensuring that the buyer’s offer terms are adequate to manage redundancy risk will be important. On the other hand, a buyer would want to ensure the employee transfer process results in the correct cohort of employees transferring across to the target business, with appropriate protections in the form of conditions precedent if particular thresholds are not met (with the ability to re-cut the commercial deal or otherwise seek alternative forms of compensation or comfort from the seller – for example, the enforcement of non-compete and non-solicit obligations against employees who do not transfer across to the target business).

Designing an appropriate employee incentive package (including, where appropriate, a management equity plan) in consultation with key leaders from the target business from the outset will often assist the buyer in the process.

Tax implications

Corporate carve-outs also raise a number of tax issues which need to be considered, such as:

• Tax and duty liabilities on a restructure: There should generally be minimal Australian income tax implications for moving Australian assets within a tax consolidated group. However, Australian and foreign tax issues may arise in respect of assembling foreign assets. Australian stamp duty leakage can also arise given claw-backs and post-association requirements for duty relief in some states. Some states (Victoria and NSW) now limit reconstruction relief to 90%.
• Employee equity: There are tax implications for adjusting existing employee equity incentives, both for those leaving and those remaining.
• Sale proceeds: Where sale proceeds are to be returned to shareholders, careful thought needs to be given to how that occurs (i.e. capital return, dividend, share buy back or some combination of the above) and the tax implications for investors.
• Tax losses: Carve outs can result in a failure of the ‘business continuity test’, which needs to be satisfied in order to carry forward tax losses once the continuity of ownership test is failed.

Planning, preparation and due diligence are the keys

There will be multiple ways to slice the corporate carve-out pie but to achieve the best outcome, a high degree of planning, preparation and due diligence, coupled with the involvement of the correct stakeholders from the start, are the keys to a successful corporate carve out transaction for both the seller and the buyer.