Sellers are increasingly focused on speed to deal execution because competition is fierce and valuations are high. In this type of deal environment, it is more important than ever to perform high-quality sell-side diligence to meet timelines and avoid value erosion.
In our experience advising on 400-plus deals annually, the quality of sell-side analysis in a carveout situation is often inadequate, making it paramount for buyers to engage a due diligence team that does not repeat the same mistakes as the sell-side advisors. Similarly, sellers looking to divest businesses or business units should choose advisors who will engage in high-quality, “bottoms-up” analysis (more on what we mean by that below) that will expedite deal completion, reduce separation risk, and avoid value erosion during the deal negotiation process.
Here are four big mistakes we are seeing the sell-side make when presenting standalone businesses.
1. “Top down” benchmarking that misrepresents the true cost to run the business
- In our experience, sell-side models reference industry benchmarks or the existing corporate allocations to determine standalone costs; this ignores the complexities of the actual business and often understates the true cost to run the business (overstating standalone EBITDA).
- What appears to be “bottoms-up” cost build is really just a list of “typical” costs put together to justify the top-down benchmark – such a list is rarely complete.
Apply a true “bottoms-up” approach to building standalone costs with resources who have practical functional expertise (e.g., brokers who understand the cost for health and wellness plans and potential dis-synergies for the smaller NewCo population).
2. Failing to engage NewCo management
- Due to the legitimate desire to keep the transaction confidential, management is seldom engaged in the standalone cost development process; this is often revealed during buy-side diligence sessions, where it awkwardly becomes clear that management is largely unaware of and unwilling to stand behind the estimates that the sell-side advisors developed.
- Savvy buyers easily sniff this out and discredit the sell-side work, sometimes abandoning the deal.
Engage management “under the tent” and obtain their buy-in on how the standalone business is being presented to buyers.
3. Not bringing IT experts to the table
- Given that IT costs typically represent 50% or more of the total one-time standup costs, we are continually surprised by sell-side diligence providers relying on M&A generalists instead of IT practitioners to estimate standalone adjustments and one-time separation costs.
- We often find that failure to bring IT experts to the table in separation planning not only results in understating standalone cost (and overstating EBITDA), but the analysis also fails to uncover potential strategic shifts that could end up representing cost savings for NewCo. This can be a game-changing advantage to a buyer who brings experts to the table and can find a way to operate the business at a lower cost in the future.
- Realistic scenarios should be modeled for different types of buyers (i.e., financial vs. strategic), including one-time and standalone costs, as well as TSA schedules and planned durations.
IT can kill your deal – it often costs more to run and takes longer to separate than other functions, therefore it should receive extra attention in the sell-side process.
4. Overstating the impact of proforma value creation initiatives and savings by ignoring competing carve-out priorities
- Given the frequent absence of IT experts on sell-side diligence teams, the realistic planning and IT roadmap development analysis that should drive the separation is rarely performed (and when it is, the analysis is often unrealistic).
- A carveout may take years to complete based on complexity, and it is often unrealistic to assume that any meaningful transformation initiatives can occur during this timeframe. Sophisticated buyers are not going to pay for the EBITDA earned by these initiatives unless a realistic plan is in place to achieve the goals.
A realistic transformation roadmap needs to be developed and presented with the sell-side analysis that acknowledges the carve-out workstream and TSA deadlines and intelligently positions high-priority value creation projects.
While the scope of sell-side diligence should be contained for economic reasons, the process should not be skimped—or there is a risk of deal value erosion during the sale process. Poor sell-side diligence is a risk to both buyers and sellers in a carveout situation, but when done well can be an opportunity for significant value creation. It also streamlines the process, creates fewer headaches during the deal process, and helps sellers avoid losing leverage if the buy-side diligence report is unfavorable. Ensure your diligence provider is bringing the right team to the table and asking the right questions.