By Scott Brady ,
Managing Director, Marsh Private Equity Mergers & Acquisitions
18/01/2023 · 7-minute read
Although merger and acquisition (M&A) transaction volumes have cooled off from the highs of 2021, carve-out acquisitions remain popular as sellers continue to shed non-core businesses and seek to raise their own capital. Strategic investors and private equity firms continue their pursuit for new investment opportunities and bolt-on acquisitions to execute on their growth strategies.
But carve-outs are substantially different than other M&A buyout deals, and come with a range of unique risks that, unless carefully identified and addressed, can derail a transaction. They can also create extensive unforeseen liabilities or costs for new owners, potentially leading to dislocations in valuation.
A carve-out transaction takes place when a business sells only a part of itself, such as a division, a subsidiary, or select assets. This means that a potential buyer is only purchasing part of an existing company. Carve-outs can be on a “stock” or asset only basis, so buyers may be purchasing legacy liabilities associated with the acquired business.
Because carve-outs tend to be components of a much larger company, they rarely have standalone insurance policies that are specifically written for the carved-out business. Instead, these components are most commonly insured under master programs purchased by their parent company. These master programs are written specifically for the parent company’s operations. Limits, program design, and retentions, among others, typically are structured according to the needs of the parent company. Ordinarily, these parent programs will stop providing coverage to the divested carve-out when the transaction closes.
Additionally, carved-out businesses often depend on the parent company for critical services, such as IT and human resources, and they often do not have systems in place that allow them to continue operating independently once the sale has taken place. Unless the buyer has a robust infrastructure that can continue to seamlessly provide critical services upon closing, sellers often continue to provide these services as part of the purchase agreement for a specified period or through a transition services agreement.
As the sale date approaches, buyers will need to secure insurance for the carved-out business and confirm that coverage can incept as soon as the transaction closes. Some buyers encounter a number of hurdles, which can lead to delays, purchase price adjustments, or even cause deals to fall through. As buyers seek to identify potential challenges that could affect negotiations, companies interested in purchasing a carved-out business should focus on three main areas:
Parent programs typically provide coverage for the entirety of an organization, and companies generally allocate premiums and associated retained losses to the various constituent operations or subsidiary entities. These costs and insurance-related reserves flow through the P&L and balance sheet, often on a pro forma basis, when a carve-out is being sold.
However, buyers often find that a seller’s allocations are inadequate. Sometimes the discrepancy is due to flawed allocation models, either for risk transfer premiums, losses, or both. Also, since large companies typically purchase coverage for their subsidiaries as part of their overall program, economies of scale can result in better rates in the aggregate, compared to what a carve-out can obtain on its own.
Such economies of scale are often lost and standalone costs can rise, sometimes considerably. Unless the buyer is a similarly sized company that can absorb the new entity within its overall insurance program, buyers often find that the cost to insure the acquired business is dramatically different and typically much higher than they were expecting or previously paying (or being allocated).
Buyers should have a clear understanding of the carve-out’s total cost of risk — including costs associated with risk transfer premiums, retained losses, and brokerage and vendor fees — of the business they are about to purchase. It is important to consider whether these risks are likely to change after the deal is done.
Understanding the economics of the insurance for the carve-out entity (or assets) can enable buyers to determine if there are any go-forward potential insurance-related challenges associated with the transaction.
An adverse surprise is among the biggest challenges that can derail a transaction or lead to unexpected — and often unbudgeted — costs. It is critical to focus on due diligence to minimize the risk of surprises. Thorough due diligence is typically needed to ensure appropriate coverage is in place for legacy claims that occur before the transaction close.
As part of negotiations, buyers, their M&A insurers, and legal advisors will endeavor to gain a clear understanding of how and when they will be given access to prior policies to understand legacy liabilities and occurrences. Sellers frequently have significant retentions, making accrued liabilities and exposure to legacy claims significant reserve items.
It is important to understand the funding mechanisms for retained liabilities as well as buyers’ ability to make claims against legacy insurance policies. Buyers and sellers should have a clear line of sight on their respective roles and responsibilities, as well as on what liabilities are being transferred with the transaction. Buyers should determine what risk transfer mechanisms may be available to ring-fence these liabilities. As part of a buyer’s due diligence exercise, it is prudent to seek to understand the quantum of these liabilities and the extent of ongoing accruals that will flow through the P&L, which could require purchase price adjustments and/or indemnity structures.
It is also essential to understand the seller’s risk management practices and the carve-out business’s needs. This is especially important when a level of interdependence between the part of the company that has been sold off and the former owner remains following the sale, for example when a seller continues to provide certain services as part of the purchase agreement.
These ongoing arrangements can present complications for certain lines of coverage, such as cyber, where insurers are scrutinizing companies’ cybersecurity controls before deciding whether to provide coverage. If certain services, such as IT, will remain under the seller’s purview for a period of time through a TSA arrangement, it can be challenging to obtain the information that is typically required by cyber underwriters during placement discussions, leading to potential challenges securing adequate coverage. It’s important to address these potential challenges before the transaction close.
Having early visibility into the potential challenges related to a carve-out transaction can lead to better deal outcomes. These problems may become material deal matters, so having transparency and mutual understanding around the financial implications and logistical requirements is essential for both buyer and seller. This collaboration can put buyers in a better position to quantify risks and negotiate accordingly, while offering clarity to sellers. Comprehensive due diligence allows organizations to better identify adverse surprises and address them during negotiations or be prepared to tackle them after the transaction is finalized.
It is best practice to involve risk managers early on so that they can help you identify potential challenges that may crop up when purchasing coverage for a new entity. A risk management team, together with an M&A insurance advisor, can help identify red flags that could make it difficult to secure adequate coverage, such as insufficient information about the risk management practices of a seller that will continue to provide certain services.
Carve-out transactions carry specific challenges that require focused attention. While bad news does not have to derail a deal, having the necessary information will help buyers take the most financially effective decisions.