In the current economic climate, a carve-out of non-core business or assets will often make sense to companies seeking to focus their efforts on their core offering and shore up their balance sheets, and may also make sense in the context of a wider restructuring (see our recent work on the Pizza Express Group restructuring for an example of such a carve-out).
The key factor will often be an assessment of the available structuring options to realise a split between the divested and retained businesses. Whilst the actual carve-out transaction may entail a sale of assets and/or shares, one potential alternative to either a pure asset or share deal is for the seller to transfer the business and assets to a newly incorporated company, and then to sell the shares in the newco to the buyer.
A distressed seller will often face the dilemma of wanting to proceed as quickly as possible with the sale, whilst also achieving best value for the disposed assets.
Establishing an achievable scope of due diligence is a key step in any sale process, more so perhaps in a distressed M&A transaction and under present circumstances where UK Government measures (or stringent COVID-safe protocols adopted by companies themselves) may impact the flow of information and access to management (e.g. site visits).
Buyer risk is further compounded in a distressed M&A scenario. The scope of “business” warranties on offer will often be limited, or, where a transaction is structured via an insolvency process, non-existent. The buyer will therefore likely not be able to rely on disclosures against such warranties flushing out areas of risk.
If the buyer is acquiring outside of a formal insolvency process, it also has to grapple with the risk of the carve-out transaction itself (and past transactions) being subsequently challenged by creditors of the seller (if they consider the value of the transaction to be too low). Early expert advice in this regard will be crucial for both buyer and seller.
If warranty coverage is restricted, an incentivised management staying on as part of the transaction may be able to supplement pared-back business warranties (even if only by means of specific disclosures). However, question marks will arise over the covenant strength of those managers and the willingness of the buyer to claim against the very people charged with turning around the target’s fortunes.
In these circumstances (or where a sale is being undertaken under a formal insolvency process), it may be possible to seek a “synthetic” warranty and indemnity (W&I) insurance policy which can provide a buyer with meaningful warranty protection without subjecting the warrantors (or the administrators in an insolvency scenario) to any additional liability. Rather than being included in a sale and purchase agreement, with synthetic W&I coverage, warranties are appended to the W&I policy itself. Whilst W&I policies generally only cover unknown risk, it is also possible to seek specific insurance policies to cover identified risks.
It is important to note though that to avoid blanket exclusions on the W&I policy, insured parties must make certain that their due diligence is sufficiently broad and appropriate (for example to avoid blanket exclusions in respect of COVID-19 losses, due diligence would need to analyse the impact of COVID-19 across the target organisation or asset).
Business continuity and separation issues
Understanding the complexities of the carve-out and how the target business can operate as a standalone business from completion will be a key consideration for any buyer. Any such analysis will include (amongst other things):
checking whether the transfer of assets is free and clear of liens/charges
analysing whether any third-party consents are required (for example, consent to change of control under key customer/supplier contracts)
reviewing any tax consequences that might arise and separation requirements (for example, VAT de-grouping)
identifying any liabilities that will follow the assets
understanding intra-group balances and identifying which of those may need to be unwound
consideration around any necessary transitional services arrangements
Generally speaking the more ties the carved-out target business has to the business being retained, the more difficult it will be to make the transaction work. That said, and as highlighted above, the current economic pressures may override any such concerns and, if the economics are such that both parties are willing to make the transaction work, transitional services arrangements often provide interim support to make the transaction viable in the longer term.
Finally, if the carve-out is being undertaken in a distressed environment, it will be important to ensure that any carve-out is undertaken in a way that protects both the seller (including its directors) and the buyer in the event of any current or future insolvency of the seller.