Text version of interview
Let’s talk about corporate divestitures. Where do you start with the planning of divestiture?
The start is clearly defining what it is that you are selling, so the most critical step is setting what we call the deal perimeter. The structure and the definition of what you are selling drives the structure of the financial data that’s going to be critical for getting the deal done. The financial complexity that arises from this definition can pose a challenge and can often take quite a bit of time, especially when doing carve-outs.
Can you elaborate on the difference between a typical private company that goes through the sale process versus when you are working with a corporation that’s carving an entity out?
On the corporate divestitures, doing a carve-out is always complex at some level, because most of the time, what you are selling has rarely been presented in the whole financially.
When you are doing a corporate carveout, by definition, you are preparing and marketing a business that’s never been looked at on a standalone basis, and the management team or the finance team hasn’t ever pulled together that complete set of financial historical information aligned to exactly what’s benign sold. The definition of what’s being sold could be geographically-based, product-based, or contract-based.
Divestiture of a complete organization, in the case of a private company, can have similar levels of complexity, but for somewhat different reasons. This complexity is usually driven by having a poor finance team, finance processes, and/or technologies. For instance, you could have a founder-led organization that’s only focused on the cash flow, so they are not necessarily reflecting things accurately from a historical accounting perspective. A carve-out is never cut and dry and they are all different.
What’s the difference when you are working with a private company versus a public company when approaching a carve-out?
It depends on the type of exit or carve-out that they are doing. Sometimes you can have a public company that’s doing a carve-out divestiture, but they are divesting through a tax-free spinoff, which is essentially an IPO. These are usually larger deals. Essentially, you are taking a piece of a publicly-traded company, you are carving it out and you are going to issue existing shareholders exchange shares.
For every share you own in the former parent company, you are going to get whatever shares in this entity that are spinning-off. When you do that, just like an IPO, you have to provide a standalone set of financial statements audited under PCAOB standards. You need to think through full perspectives level data that has to be filed to complete the transaction. If you are carving out a piece of the business and selling it, that is a process that can take months, whereas spin-offs can take years.
Are there public disclosure requirements when you are doing a public spin-off?
You are going to disclose what you are doing, you are going to have to issue it in Form 10 with the SEC and you have to update it until the spin-off is effective. A part of that effectiveness is that you are going to have historical financial statements that are filed with the SEC.
Can you tell me more about PCAOB?
That’s the oversight board that issues the auditing rules and requirements for publicly traded companies. When you're having to get an audit under those standards, what the auditors have to do is a lot more complex if they are a publicly held company, versus if they are a private company, where you don’t have that much risk. We have learned that, in case of privately held companies that are getting ready to do a divestiture, many times audit financial statements are just wrong.
In the deal terminology, the purpose of an audit is valuing a company in an M&A transaction. When we get involved in private company transactions it’s more likely than not that we are going to find adjustments to the historical financial statements. One of the tactical takeaways is not to rely on audits, because we always find things that auditors missed. The same applies to carve-outs. When there is an accounting error, we have to restate financial historical information, which ties back to the parent company, so technically, it is the parent company that should restate for this if its material.
The trick is, most of the adjustments that you find, especially if it’s a large parent company divesting a small entity, wouldn’t be material at the consolidated level, therefore the parent company usually doesn’t see this as an issue. However, in the case of a spin-off, this can become a big deal.
Where do QoEs fall into this?
The quality of earnings, in theory, is generally done for three reasons. One, you reduce surprises that you will encounter when the buyers come in and perform their due diligence. Two, the package that’s presented as a part of the QoE is going to result in the seller having more credibility with the buyers when they’re analyzing the business, whether it’s a carve-out or a wholesale divestiture of a privately held company. Three, reduce the timeline of the buy-side due diligence.
The first one should always happen, while the second and third do not always happen. Reducing the timeline of buy-side due diligence is determined by the scope and quality of the procedures done in that QoE.
In the United States, it was very uncommon to do any form of vendor due diligence, sell-side due diligence, and there wasn’t even anything called QoE. The sell-side preparation from an accounting perspective was much more focused on the big transactions that had that standalone carve-out audited financial statements prepared. Now, it is rare to find an investment bank that will take an entity to market without having one of these done. The reason for that is that they have been burned so many times by going to market with a set of numbers that get blown up when the buy-side diligence team comes in. A cardinal sin in a sell-side process is taking something to market without having numbers vetted by someone like me.
Can you walk me through what planning a divestiture looks like from an accounting perspective?
Divestiture planning starts with clearly defining what’s being sold. In a work that we do, we always prepare a pictorial representation of what’s being sold from an entity and business perspective and where all the financial data is coming from. Pulling this from different systems, the quality of those systems, the consistency or the lack of data, and the people that we can speak to all can make things more or less complex.
If you think about the carveout example, you can have a direct feed from the parent company ERP to some level and this feed can take you down to some level of accounting. A lot of times it’s only marginal, so you get a direct margin for this business, but then, everything else is in other places. You have to figure out a way to pull SG&A costs out of the system.
From the balance sheet perspective, assets and liabilities can be held in different entities across the board, so you need to find out where that’s coming from as well. You collect extracts from different places so everything can come together and that’s a huge part of preparing financially for divestiture.
The other important piece is thinking through what other elements that aren’t in adjusted EBITDA are going to be important for the buyers in evaluating this transaction. A typical one would be the gross margin by a customer and SKU margin. Once you get to the baseline of comfort with the historical financial data that’s when you can start focusing on the adjustments that you can start making that are more deal-specific. This is where you get to the quality of earnings adjustments.
What are some of the unique scenarios in divestitures from the accounting perspective?
What’s unique and consistent is that sellers almost always lack the appreciation for how hard this will likely be. They lack the appreciation for the effort that takes to get things cleaned up and how beat up they are going to be when the other side comes in and digs into this. The other unique and surprising, yet common occurrence are errors in historical accounting.
What are some other challenges you come across?
The biggest challenge is when the financials have been released before really digging deep into the financial data, which makes everything harder. In these cases, we have to do quite a bit of work to help bridge the gap between what the history actually was and what was released. The advice is to get this done before you go to the market.
Is there a specific time frame?
If I am speaking to an investment banker the time frame is as soon as you sign up your mandate. Similarly, if you are a seller, corporate or private, ideally I have this conversation with the seller before they have even selected the investment bank. We start pulling this data together and that actually allows them to make their selection of the investment banker easier and helps their mandate as well.
Another challenge we face is when we are not given full access to data. Everybody wins when we have access to data. A challenge is also a difference between the historical and the forecast. The deals have been burned when the management team did all the work on the forecast and kept us in historical accounting. Then they go to the market and give out the blatantly different assumption that’s used for a cost structure in the forecast. It would take us an hour and just being part of these conversations to have caught that before it goes out.
What’s your advice to the buy-side in order to get the deal done?
You really have to dig into the financials. What we do on the sell-side is exactly what we do on the buy-side. We map out where all the data is coming from, we reconcile it back to the historical books and records that feed into some level of an audit financial statement. We make sure it all holds together before we start getting into understanding and analyzing the management pro forma adjustments in the QoE table.
We have private equity clients that specialize in buying corporate carve-outs that aren’t prepared in this way. What they need to focus more time and effort on is less about getting the deal done, but rather preparing for successfully transitioning the deal to their ownership. That is about thinking what day one is going to look like operationally, thinking about the ways to extract the entity from the parent company, and start operating as a standalone and what could be possible challenges.
If you are a corporate acquirer you need to spend more time doing the due diligence phase on really understanding what the integration challenges are going to be and how you are going to integrate this company once you close the acquisition.
Does some of that map over well when you start looking at the other company in terms of interpreting that as a part of your integration plan?
Yes, absolutely. In theory, you should be evaluating what those standalone costs or what your synergies are in the due diligence process. Therefore, you should have an understanding how you’re actually going to integrate it. When you are evaluating your quality of earnings adjustments, you are going to look at historical adjusted EBITDA, what are you going to accept from it, what’s the cost, and how you are going to execute that cost once you own it.
What’s the craziest thing you’ve seen in M&A?
I’ll go back to my first carveout experience. I was doing a deal in Germany and they set up containers for us without air conditioning at the chemical plant in Frankfurt in the middle of summer, back in the days where the professional dress code was also required. You had everybody dressed in suits, working 12 to 15 hours a day, in the heat, trying to do a carveout where half of the team has never done one before.
The other crazy part about that transaction, which was part of the culture, was that if someone is older than you in age there was this extra level of respect and the lack of your need to review their work product. We had this huge Excel model doing the corporate carve-out into one person’s computer, not backed up on anything, not reviewed by anybody because the guy was in his fifties. None of the senior acquisition managers or partners would review his work because it would be viewed as disrespectful.
At the 11th hour, there was a huge blowup and a formula error so there were twenty of people sitting in a metal container at midnight trying to figure out what to do because Excel didn’t work anymore.
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