Carve-out refers to the business strategy wherein a parent company decides to partially divest one of its business units by selling minority interest of the subsidiary to an outside investor or a group of investors. In other words, the parent company doesn’t sell the business unit outright, but rather sells an equity stake in the business or relinquishes controlling stake while retaining an equity stake. In essence, a company uses the carve-out strategy to capitalize on a business unit that is not its core competency.
Generally, carve-outs are excellent investment options for financial buyers, such as private equity funds, because these are invariably good businesses with experienced management. Still, they just don’t fit into the parent company’s value proposition. In some cases, these carve-outs are the troubled child of the parent companyParent CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies. that can be turned around by the new buyer through some financial or operational support. There are also instances where the existing management senses the opportunity and amasses capital to purchase the business unit, which may result in a leveraged buyoutLeveraged BuyoutLBO (Leveraged Buyout) analysis helps in determining the maximum value that a financial buyer could pay for the target company and the amount of debt that needs to be raised along with financial considerations like the present and future free cash flows of the target company, equity investors required hurdle rates and interest rates, financing structure and banking agreements that lenders require..
Example of Carve-Out
Now, let us look into the spin-off of Lehman Brothers by American Express as an example of carve-out. In the year 1994, American Express announced the spin-off of its investment banking unit (Lehman Brothers) to form a new independent entity that was jointly owned by shareholders of American Express and employees of Lehman Brothers. The core business of the unit included corporate services, signature charge card, travel and financial planningFinancial PlanningFinancial planning is a structured approach to understanding your current and future financial goals and then taking the necessary measures to accomplish them. Because this does not begin and end in a specific time frame, it is referred to as an ongoing process.. The services were marketed under the brand name of American Express. American Express also infused more than $1 billion into Lehman Brothers in the form of capital to financially support the newly formed company. Although the former parent had no directors on the board of Lehman Brothers, it continued to get a share of the entity’s future profits.
How Does Carve-out Work?
The seller needs to understand what is the motivation of the buyer is investing in the carved-out business unit. The buyer will usually have their own reasons for purchasing the business unit, and the seller should be aware of it. Based on the buyer’s objective, the seller will then market its assets or the carved out unit to the potential buyer accordingly.
The seller will then have to prepare the Pro-forma financial statementsPro-forma Financial StatementsPro forma financial statements refer to reporting the companies' current or projected financial statements based on certain assumptions and hypothetical events that may have occurred or are likely to happen in the future. The company's management can include or exclude line items which they feel may not accurately measure its estimates. of the carved-out unit for valuation, funding and compliance. It should clearly indicate costs involved before the carving out process and immediately after that. Effectively, the potential buyer should know what they are investing in and whether or not it makes sense financially.
The seller should maintain transparency about the cost of purchase of the carved-out unit. Typically, the seller should be aware of the valuation of the carved out unit and ensure that all the valuation factors have been taken into account, and nothing gets overlooked. It helps in packaging the carve-out assets and market them in a better way.
Finally, the seller needs to assess the impact of the carve-out on the remaining business. Especially, the negative ones are analyzed to understand how the remaining divisions will go about their business after the divestmentDivestmentDivesting, also known as divestiture, refers to the sale or transfer of the significant assets, divisions, investment of the business due to some financial, political or social reasons such as a business can sell the department which is not a core part of the business and is not providing benefits to the company so that the business can focus on the units that can provide better earnings.. Basically, the cost structure and profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. of the remaining businesses are assessed.
Spin-Off as a Carve-Out
The spin-off is another form of carve-out in which a new independent entity arises from the existing parent company. Over the period time, that new entity is split from its parent to acquire legal, commercial and technical independence. On the other hand, the parent, in this case, doesn’t sell the shares of the business unit, but rather creates a completely separate entity out of the business unit to form a standalone or independent business, with its own management and shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares..
Most of the shareholders in the new entity are from the existing shareholders of the parent company. Further, the parent company continues to have an equity stake in the new entity to have a share in its potential future profits.
This has been a guide to carve-out and its meaning. Here we discuss its overview, how does it work along with practical example. You may learn more about financing from the following articles –