Corporate caution creating carve-out opportunities for PE

The uncertainty created by Brexit and other political events around the world in 2016 has caused many business owners to become more cautious and take the foot off the pedal to shield themselves from potential turmoil. The last 13 months have seen the UK decide to leave the EU, the election of US president Donald Trump, and the rising popularity of anti-globalisation politics. The lack of clarity about the introduction of trade tariffs and the future of freedom of movement across Europe, alongside currency volatility and the increasing costs of labour, has corroborated the wary feeling among entrepreneurs.

According to unquote" sister publication Mergermarket, Europe saw a 29% increase in corporate divestments in 2016, as 244 deals were signed compared to the 173 transactions recorded in 2015. Notably, the second half of the year also saw a 31% increase compared to H1, with a peak of 30 divestments recorded in December 2016. However, the stats also highlight a 55% slump in H1 2017 compared with the same six-month period in 2016.

This last statistic is echoed by unquote" data findings. On the one hand, recent weeks have seen a number of spin-outs involving PE houses across Europe. The market is currently witnessing the dissolution of TotalErg, which triggered the divestment of several non-core assets including Restiani, acquired by Italian buyout house Ambienta in July 2017. Additionally, Leeds-based private equity house Endless bought Affinity Workforce, the recruitment arm of FTSE 250 outsourcing group Capita, in June 2017; Arx Equity Partners carved out Czech baby food producer Nutricia Deva from Danone Group in January 2017; and most recently, Triton acquired SGL Group's cathode and furnace lining, and carbon electrode divisions, SGL CFL and SGL CE, for a combined enterprise value of €250m in August.

But looking at the broader picture, deals sourced from either local or foreign parents have become increasingly scarcer in recent years. In 2013, nearly a fifth (18.5%) of all European PE-backed buyouts were spin-outs. That figure has consistently dwindled year-on-year to settle on 10% in 2016. And despite the flurry of announcements in recent weeks, the wider uptick in the leveraged buyout market means that the share of spin-outs in 2017 so far is even smaller, at 8% of all transactions.

Changing tack
This could be about to change as European corporates continue to navigate choppy waters. According to two recent carve-out surveys by Aurelius Equity Opportunities and EY, the ongoing uncertainty is set to drive an increase in corporate divestment activity across Europe, as businesses are looking to release capital to better cope with the situation.

A total of 51% of the European companies surveyed by EY said they intended to make divestments within the next two years, in order to adjust their capital allocation and gain a competitive advantage. Moreover, 80% of these businesses said a crucial factor in this approach is political instability across their own region, with 77% of the companies referring in particular to Brexit. Furthermore, the poll revealed the sentiment is likely to continue, with 77% of all surveyed businesses saying geopolitical uncertainty will increasingly influence their future divestment plans. It is worth noting that globally the same sentiment is remarkably lower, with just 49% of companies in the Americas and 41% in the Asia-Pacific region believing likewise.

Looking at the different regions across Europe, 33% of the 200 advisory and corporate respondents recently polled by investment firm Aurelius saw the UK as the area they expect to experience the most corporate divestment activity in 2017, while 27% of these thought that the DACH region will witness the highest increase in disposals.

Setting aside the impact of geopolitical risks, the key driver behind corporates selling is most often a need to refocus on their core operations, according to 65% of Aurelius's surveyed businesses, while the need to free up capital was seen as the next biggest driver by 11% of respondents. This trend concerns European corporates seeking to streamline their businesses, as well as international companies looking to rationalise their European holdings.

Divestments, carve-outs and spin-outs are complex processes that require private equity firms with a certain operational structure… Not all fund managers have the right skill-set to work on these transactions" – Enrico Silva, EY

If this sentiment was to actually translate into an influx of investment opportunities, GPs on the hunt for value in an increasingly frothy market should be at the ready. "The big attraction of divestiture and carve-outs for private equity is that the fundamental value driver for the vendor is not in maximising the sale price, but improving the efficiency of the remaining group," says Phil Burns, managing partner at corporate finance house Clearwater International. "Therefore, for the parent company, it is not a fully value-driven exercise. This means there are interesting value opportunities for private equity, compared with other areas, in which [deal] value is the absolute driver of the outcome and therefore there is more competition.

"Thus, private equity perceives carve-outs as an opportunity for huge value-creation. [GPs] will look for assets that might have not received appropriate investments or have not received the most quality management time, aiming to drive them more efficiently and improve their operating performance. There is perhaps a higher profit growth opportunity compared to a performing asset that has already been private-equity-owned."

This is compounded by the fact that not everyone will be able to capitalise on these opportunities, argues Enrico Silva, a partner at EY. "Divestments, carve-outs and spin-outs are complex processes that require private equity firms with a certain operational structure," he says. "Besides business evaluation and the assessment of value-creation opportunities within the business as a standalone, GPs are required to enhance the management team, as well as create a new commercial structure that can support the firm and replace the previous parent. Not all fund managers have the right operational skill-set to work on these transactions. This therefore reduces the competition among them."

Proceed with caution
Even those willing to take on the challenge need to be ready for a stiff test of their deal-doing and value creation abilities. The most immediate and biggest hurdle for the incoming private equity investor is "to make an accurate assessment of the profitability of the target as a standalone when it is managed as a non-core part of a larger group," says Burns. In fact, the business could also lose some synergies and trading relationships that its parent provided, as well as some cost-based efficiencies. "The next issue is the profit-improvement plan and understanding the resources required to deliver this plan, including the optimum shape of the management team," he says.

The speed of negotiations and efficiency in the deal structuring process are also key for private equity buyers in carve-out transactions; in particular, accurate identification of transitional service agreements (TSAs) including those related to tax efficiency, legal risks and labour regulation, is paramount. This is crucial as it determines how a target is structured during the transition phase. It can therefore have an impact on both costs and the profitability of the asset and ultimately a GP's ability to generate returns in the long run.

Another consideration is that compared to strategic investors, which can incorporate assets within their existing structures and thus enjoy greater operational efficiencies, private equity buyers often have to invest more to successfully manage a carve-out transaction. This can potentially result in a lower offering price. Therefore, fund managers need the ability to secure financing and close the transaction quickly with a considerable amount of upfront cash consideration – although the current borrower-friendly credit market can allow fund managers to lock down the right opportunity, taking advantage of the ongoing uncertainty in the market.

Provided they can rise to the occasion, the forecast uptick in corporate divestment activity could provide an ideal platform for GPs eager to showcase their value creation prowess – not to mention stand out from their peers as they spend time and energy on increasingly expensive vanilla deals.

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• EY (Ernst & Young)
• Clearwater