Carve-Out Curveball: How to Hit a Home Run

By, Gary Appelbaum, Managing Director & Eric Salit, Vice President, Accordion 

We’ve said it before and we’ll say it again: the carve-out is the financial equivalent of the curveball. But here’s something new: it’s no longer just a secondary pitch, at least not in private equity circles. Not only do carve-outs account for 10 percent of all M&A activity, the percentage of carve-outs conducted by buyout firms (as opposed to strategic buyers) is on the rise, and sharply at that.

And that’s important, because, at the risk of overextending the curveball analogy, the carve-out is ‘filthy stuff.’ The inherent complexities of the deal can puzzle even serial acquirers.

Nowhere does that complexity rear its confounding head more than in the subsequent integration of a carved-out business. Here, strikeouts can happen at an alarming, if understandable, rate. So, let’s take a look at what’s behind the swings and misses:

Strike 1: Overlooking the clubhouse culture

Every player has a unique presence, and every clubhouse a distinctive personality. Understanding the dynamics of each – with respect to the transferred employees’ eagerness for the ‘trade’, receptivity to a new team, and ability to acclimate – must be a critical part of any integration strategy.

It is, however, particularly critical in a carve-out scenario, where employees arrive with a history with the seller/previous business. Now untethered from that former organization, they may have a feeling of disenfranchisement that will need to be addressed. On the flip side, they may well feel invigorated by a sense of opportunity, which should be nurtured.

For that reason, buyers should use the diligence phase not only as an opportunity for talent assessment, but as a time to take the cultural temperature of the seller’s organization, the business being carved-out, and the transferring employees.

Are these employees losing a sense of brand identity that had been important to their career, or, at least, their perception of it? If so, buyers will want to be mindful of employee hesitancy as they seek to integrate, creating rebranding or talent absorption strategies that serve to counteract employee apathy.

Or, have the transferred employees long felt part of an orphaned-business within their previous owner, and now view the carve-out as an opportunity for their business to shine, or at least, be more of a visible presence in a new organization. Here, while the lift may be lighter, it will be no less important. Buyers will want to take an approach to talent integration that nurtures early optimism and creates leadership roles to match it.

In either case, an honest assessment of clubhouse culture, and a proactive integration strategy to match, will be critical components to long-term organizational and deal success.

Strike 2: Ignoring the important acronyms

The Transition Service Agreement (TSA) is one of the most critical aspects of any carve-out scenario, where buyers are at the mercy of sellers providing continued, adequate services (as determined appropriate).

An effective TSA should follow a robust due diligence process around carve-out elements so that it can meticulously account for which processes, functions, and technologies the business will support independently post-close, and which will need seller assistance and/or additional capability development. But for all that meticulous pre-close planning, some things invariably get left out.

And that’s where we see a critical swing and integration miss – the omission of an Omitted Services Clause (OSC). The OSC obligates the seller to continue previously provided services that were inadvertently excluded from the TSA and, as such, can be a buyer’s best friend, ensuring that business continuity isn’t negatively impacted by the absence of those services.

What it doesn’t do, however, is ensure the quality of those services. What can? Buyer leverage – and in a carve-out integration that leverage can come from the unlikeliest of places: Reverse Transition Services (RTSAs).

An RTSA component of a TSA, (where services from the buyer are provided back to the seller, post-close), can create an element of reciprocity in the service quality conundrum. It often comes into play where transferred employees had been supporting other parts of the seller’s business not included in the carve-out, leaving the seller with substantive work that may need to be backfilled; (this is particularly relevant where the seller operates in a shared services model).

While the RTSA may first seem burdensome, the informed buyer will soon recognize it as their best insurance policy. With an RTSA, the seller must now also rely on the quality of transition services rendered by a buyer. As a result, the seller has a vested interest in making sure the transition services it provides the buyer meet the quality standards it expects to receive in return.

If baseball is a sport singularly obsessed with acronyms (RBI, OBP, OPS), private equity teams playing the carve-out integration long game must share in that obsession, focusing on the right combination of letters: TSA, OSC, RTSA.

Strike 3: making the wrong trades

In 1920, the Boston Red Sox traded Babe Ruth and the rest was history. The ‘Curse of the Bambino’ taught a lesson to every GM: don’t trade your star player. It’s a lesson that has relevance beyond baseball, in a deal environment, where sellers should heed it, and buyers need to account for it.

While sellers may be eager to carve-out a product or service portfolio, they’re in no way eager to part with the more talented executives associated with that business. In fact, the sage seller will find any number of reasons (shared services, employment loopholes, strategic imperatives) to keep those ‘A’ players around, even when said players squarely belong with the carved-out business.

And, that’s a problem, because absence of these expert team members during integration will negatively affect the future value of the business being acquired.

The lesson to the buyer here is two-fold.

First, heed the scouting reports: Conduct deep enough due diligence into the human capital aspects of the deal, that you understand, can identify, and can negotiate for the critical team members that must transfer with the deal, because they will be integral to integration and/or to the future of the business.

Second, mind the roster: You want a curated team of ‘A’ managers, coaches, and players. There’s a reason ‘people’ are mentioned first in the ‘people, process, technology’ triangle. Here, the priority placed on the importance of quality talent should far exceed quantity of talent..

Is there room for strikes in a carve-out integration? Certainly. All integrations are complex; doing one on the back-end of a carve-out only multiplies that complexity. There will be mistakes, or at least a fair amount of swings and misses. What there can’t be, however, are strikeouts. A buyer who ignores clubhouse culture and critical acronyms (TSA, OSC, RTSA), and who makes the wrong trades, is a buyer doomed to a failed integration and underachievement of the anticipated future value of the business.

On the other hand, a more strategic and well-planned approach to the curveball that is a carve-out integration, infinitely increases the chances of hitting a homerun, or, at the very least, having a successful plate appearance.