How to get carve outs right

John Robertson: Hello and welcome to The Insight in 15. I'm John Robertson, and today I'm joined by Mala Shah, who's from our integration and separation team here at KPMG UK. And today we're going to be talking about carve outs.  

Mala, thanks for joining us today. We've only got 15 minutes, so we're going to jump straight in. It feels like I kind of start every conversation at the moment talking about the Iran conflict and the closure of the Strait of Hormuz, but it feels to me that must be having an impact on the deals market. So where are we with the deals market right now? 

Mala Shah: Okay. Well there's always going to be some kind of activity going on globally, right? But actually we've been really, really lucky. The deals market has been pretty active throughout that whole time. And even with the Iran conflict and everything. And I think that's driven by a few different things. The first thing I would say is that the security of energy supply is driving some uncertainty for people, and that's driving deals.  

You've also got increased pressure on financing and more scrutiny on that. So trying to get cash out is difficult. But then you're seeing various movements in the market as well. So whether it's energy transition in the ENR sector or consolidation in other sectors, that in itself drives deal activity. And for every up there's always a down. But downs actually mean quite often that there's more carve outs that need to be done. And so we're really lucky that actually from a carve out perspective, we have been busy throughout. 

John: Okay, well that's a beautiful segue, isn't it, on to carve outs. So, perhaps for my purposes more than for our viewers, but could you quickly tell us, what do we mean by a carve out? 

Mala: Yeah, sure. So a carve out is just when a business is looking to sell a part of themselves. So it could be a brand, it could be a business unit, it could be a site, and it's a carve out because you're trying to literally take it apart from the seller and find all of the dependencies that sit with the seller and trying to break those dependencies, basically. 

John: Okay. Brilliant. Let's jump into sort of the practical stuff. 

Mala: Sure. 

John: Now, from my perspective, there'd be two views of this. There'd be kind of like the person selling and then the organisation looking to buy. So maybe if we start from the seller's perspective, what do I need to be doing to have a successful carve out? 

Mala: I'd just like to correct you, actually. I think there's three perspectives you need to think about. First is the sellers. Second is the buyer, as you mentioned. But third, the actual piece that's being carved out, which I'll refer to as carve-co as we go through the interview. So I think if you were thinking about it from a seller's perspective, there's probably three or four key things that you want to make sure that you're doing. 

One is starting the process early, so not waiting until a deal is announced before you start thinking about actually, how am I going to carve this business out? But really getting yourself to a position where you're able to go out to the market and saying, this is my separation plan, this is how I'm thinking about it, and this is what the value is to you. 

The second thing is making sure that the deal team and the operational team are really well aligned, and so that they're working together in terms of telling that story. 

The third point is making sure that you have both the seller and the carve-co involved from the appropriate point in time, because what you don't want to do is go out and have a conversation with buyers that the carve out management team aren't involved with, or aren't aligned with. 

And then lastly, I think it's making sure that you have a really, really robust set of financials because that's the piece that when a business is, or a buyer is, looking to diligence, that's the piece that they're really going to test. Are your numbers correct? Do they follow what the audited financials show? And can you actually prove or evidence what you've said is going to be the ultimate numbers that that carve out business is going to have? 

John: Where do organisations tend to go wrong with this? 

Mala: So I think again, there's a few things. The first one is, as I say, not involving or not starting early enough and leaving it to chance that once you've got a deal, you can just get the carve out done. 

The second one is getting that sort of robust set of numbers. It's often not as easy as just pressing a button on a system and something coming out. If you think about it, a business' financials are littered with allocations. There might be things that have happened which are extraordinary in any one year. So all of that needs to be cleaned up. And you need to spend some time thinking about how is this business going to really operate when it's standalone? 

And that brings me on to my third point. Often when companies are thinking about a carve out, they'll go, it works like this today, and it should work exactly the same tomorrow. But actually, if you're thinking about it and that business is going to be sold as a standalone business, it probably needs change. It needs to be fit for purpose. It needs to think about doing things differently, to actually flow through into the numbers and show a much more attractive financial baseline for bidders to bid on. 

John: Okay, so when you're doing that carve out and you're saying, okay, I've got a business that operates like this today, it's not necessarily going to operate like that tomorrow, what are the things I need to be thinking about there? 

Mala: So the sorts of things to be thinking about are, you know, how many people are you going to need to run this business. Just because you have a shared service centre in one place today, and then you've got some local people, actually, is that the right model going forward? So really scrutinising the number of people and the way in which roles are done. 

Mala: The second piece is thinking about, you know, in a large organisation, often everything's got all the bells and whistles and it's very gold plated or gold standard. Actually, as a standalone business is that really what the requirement is? 

And then I think the other piece is just thinking about actually are all the processes needed, because again, you know, there's a lot more reporting that's needed in a larger organisation. You're not going to need all of that when you're smaller. So just thinking through all of the intricacies of what processes are needed, how many people, how are we going to run from a systems perspective, and how can we do things differently? 

John: Are there sort of dependencies here that you need to think through with the original parent organisation? 

Mala: Absolutely. And that's probably the first starting point when you're thinking about a carve out really, is what are all of those dependencies? And you'd see those both through the allocations, but also just having conversations with the management teams and really understanding what is provided to and from the carve-co with the seller. 

And then working through for each of those dependencies, is that dependency really going to be needed going forward or how can you replace that dependency? So is it through people? Is it through changing a process? Is it through a system? Is it through outsourcing? And going through each and every one of those items and working through that. 

The other thing to think about as a seller is actually what's the impact of selling this business on you? So thinking about, does this give you any capability gaps within your organisation that you're going to need to replace? 

What about any stranded costs? So let's use an example of, you lease a building at the moment. You're giving away one floor to the carve-co. What about the rest? Are you going to need all of that or is there something you need to think about in terms of reducing that cost for yourselves? 

So thinking about also, how does this impact your financials? 

And then the third piece is how long do you want to run any services for, in reality? So is it 12 months? Is it 24 months? But having a really clear idea of any transitional services that you want to provide. 

John: So what do we mean there by transitional services? 

Mala: So it's a set of services that one of the parties will provide to the other for a short period of time, and short could be three months, it could be 12 months, it could be 24 months. And that's really defined by the seller as a starting point. Buyers can then negotiate that obviously. But typically you would see transitional services for IT, for example, because it's very difficult to separate all of your IT in a short period of time to enable a deal close within six to 12 months. So typically you'd see some transitional services for IT for 12, 18 months. 

John: Are there any things there that people miss, you know, those dependencies? Are there things that sort of trip people up? 

Mala: I think, to be honest, the thing that we see the most is that everyone thinks that the carve out is going to be really simple. It's always underplayed how complex and complicated it's going to be to actually put into practice. And so spending that time upfront and really going through function by function and thinking through from a people, process, assets, contracts and technology perspective, where are those dependencies? And going forward how do you replace those dependencies is going to be really, really critical. 

And you can do that very quickly. You can do it in two or three weeks. So the rest of the process takes time. But that initial assessment we can do very, very quickly. 

John: You say that's really quick. What does that actually involve in practice? 

Mala: What that really involves is two things. One is getting an understanding of what are all the allocations into the business, because that shows you the financial transactions that are happening and where money is being moved between the part that's being carved out and the seller. 

The other part of this is actually, we just do conversations with people in the business to say, just tell us how your function works. How many people do you have? What roles do they do? What are the processes that split within what's already in the carve-co and what's provided by the seller? 

John: Okay, now you put me right at the beginning and said there were three perspectives. We talked about the seller a bit. You've got the carve-co as well. So basically the people who have been identified to go with the business that you're selling. How do you kind of keep them engaged, I guess, one through this process and then when they've gone, because this must be, I mean, this is a big change potentially for them, right? 

Mala: Yeah, it is, and, you know, it's never easy. But I think one is having the engagement from the start. And I think it's always underplayed how much you need to do from a communication perspective, not just for the business that's going or the people within it, but for suppliers, for employees, for your customers. 

Often businesses will have some form of retention scheme as well for key individuals in that target company who will receive a retention bonus for staying with the business, for helping carve it out and staying with the business beyond that as well. 

John: I'm going to have some people working in other parts of my business who are also working in the part that I've identified to sort of sell. How do I kind of make those decisions about, I guess, who stays and who goes? 

Mala: I think where I would start is actually having a really clear principle about how you're going to split the employees. And in the UK it makes it a bit easier, you have regulation like the TUPE regulation, which is quite specific about what you can and can't do. 

But having a really clear view of, this is the approach that we're going to take. So, you know, an employee spends 70% or more of their time as an example, we're going to put them in perimeter to go, versus others who only spend a smaller proportion of their time. 

So that's probably the main element of the way of doing it. But then I think there's also, as you think about what does this business look like in terms of what does it need going forward, that will also determine how you think about the numbers of people and the individuals that need to go in. 

John: Okay, let's move on and have a think about this from the buyer's perspective now. So if I'm a buyer and I'm looking at this part of an organisation that's going to be carved out, what are my red and green flags? 

Mala: I think initially it will be looking at the numbers. So making sure that you've got a set of numbers that you can diligence, that you can tie back to financials and you actually understand what the adjustments are that have been made. 

But really importantly, and certainly what I look for when I'm working for a buyer, is do they have a separation plan? How well has it been documented? And can I follow the logic of it? How does that then translate into the numbers? And where do I see execution risk? 

So, you know, it's easy to say, well we do this today, we're going to completely change it for tomorrow, but actually what's that plan to get there? Because you can't just switch one thing off and start the other thing the next day. So is there a really clear plan that has been put in place? 

And then the last thing would be, how much does the management team buy into what the seller is telling me? Because for me, that's a really, really important piece that the target company or the carve-co need to be really, really behind the plan that's been set out. If they don't believe it, why as a buyer would I? 

John: So I asked you this from the seller's perspective earlier, but from the buyer's perspective, what are the things that people get tripped up by? 

Mala: The buy-side review of the separation plan isn't always done, and really understanding what you're going to receive on the first day. So that for me is really important. And we don't always see buyers doing that. 

The second piece is really understanding what are you going to do with that business once you've acquired it? So thinking through, okay, am I going to integrate this or is it going to run on a standalone basis? 

If it's going to run on a standalone basis, hopefully what you're receiving is what you need. If it's going to be integrated, well, how am I going to integrate it? Is it fully going to be integrated or only parts of it? And therefore where do I see where the synergies are and how do I translate that into value for myself? 

And then the third piece that often from a buy side that you see is the deal is done by the M&A team and they don't talk to the people who actually then have to do the integration and actually receive the business when it's first separated. So having the operational team involved earlier is often a bit of a pitfall. 

John: Okay, fantastic. I think we're almost out of time. So I just want to ask you, we ask all our guests sort of what's the one big takeaway that you would like our listeners to go away with today? What's the key thing? 

Mala: The key thing for me is start early, make sure that you're thinking about value as well as the operational impacts, and communicate because the communication is so, so important once you actually get into the carve out itself. 

John: Mala, thanks for carving out some time to be with us today. Hope you've enjoyed the episode. If so, please do subscribe on Apple Podcasts, YouTube, or Spotify. Hope to see you again on The Insight in 15.