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Carve-outs are Attractive for M&A, but Complications can Decrease Value

carve-outs

Carve-outs are Attractive for M&A, but Complications can Decrease Value

Before the COVID-19 pandemic brought mergers and acquisitions to a standstill, dealmakers increasingly turned to carve-out deals –the sale or divestiture of a business unit or division from a company. Our research shows carve-outs have increased by 200% since 2016, demonstrating the attractiveness of these deals.Our research shows carve-outs have increased by 200% since 2016, demonstrating the attractiveness of these deals.

But carve-outs are far from straightforward, especially across borders. The more jurisdictions involved, the higher the degree of complexity firms must navigate. (Complexity, in this case, refers to the headaches and distractions that arise when complying with new regulations, language barriers, borders, currencies, and laws.)

The increased complexity of a carve-out creates both opportunity and risk for buyers. On the one hand, not many firms have the expertise or resources to re-incorporate a business from a parent structure, meaning the few companies able to do this have a natural advantage. On the other hand, the execution risk is increased significantly, and value can be quickly lost from carve-outs if not executed correctly.

A recent survey by TMF Group found that 34% of senior executives from private equity firms with buy-side experience and 27% from corporations said their most recent cross-border carve-out failed to deliver on expectations, with 24% and 19%, respectively, saying costly overruns significantly impacted the deals. If a deal is delayed by more than four months as a result of business entanglements across jurisdictions, the average resulting cost overrun comes to about 16%.

Consider how one financial executive in India described an overrun deal: “We hadn’t expected it to be seamless, but we weren’t prepared for the effect on costs, and we had to make some hasty financial decisions to get the deal over the line.”

If a transaction takes place across jurisdictions, the complexity of those deals increases once local regulations come into play. Examples of regulations that, though innocuous, can significantly delay the deal-making process include:

-In some markets, it can take up to 60 days to open a bank account

-In others, business licenses are required before the new entity can register for VAT, while the company may need a local fiscal representative or director

-Some markets, such as the U.S., carry significant differences between states for regulations pertaining to licenses, tax registrations, and employment regulations

If these complexities aren’t accounted for at the start of the deal-making process, the monetary value of the deal can decrease, as evidenced by the 1 in 5 deals that create millions of dollars in extra costs. Take it from a head of finance at a Finnish corporation: “Complying with the domestic requirements, such as legal, accounting, and taxation, were the most difficult aspects for us to manage…rather than solving complex operational issues, we were more concerned with getting the company ready for various compliance items.”

Conversely, having a presence in the country in which a deal is conducted increases the likelihood of a deal going well. Those with a limited or no presence in the target’s country were more likely to have disappointing outcomes, with 38% of respondents who had limited or no presence at all in the carve-outs jurisdiction noting their most recent carveout had been mostly unsuccessful in terms of reaching its strategic goals.

There is, of course, the question of when deal activity will return to a pre-COVID-19 pace. It’s a question of when, not if, because private equity firms are sitting on large cash piles, interest rates are historically low and companies are distressed. Companies facing a cash flow crunch may be more likely to sell off non-core assets than consider an outright sale of the entire business. The environment is ripe for carve-outs in the near future, although valuations may look a lot different than six months ago.

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Randy Worzala is Head of Business Development – North America at TMF Group, a multinational professional services firm based in Amsterdam, providing accounting, tax, HR and payroll services to international businesses. The company has around 7,000 employees in 80 countries.

How US tax overhaul has led to increased international investment and M&A activity

The limit on interest deductibility is impacting the way that firms finance domestic mergers and acquisitions which is fueling the existing trend for US companies to pursue foreign M&A.

Why invest in foreign companies?

Growing a business internationally has always been attractive to US companies. Businesses are still structuring for tax purposes, however the main reasons for going abroad are now; the desire to find new markets with more customers, access fresh talent and technology and optimize international supply chains. Foreign markets can be an attractive destination for leading US brands given that if you can succeed in the world’s most competitive consumer market you may find you thrive in less developed economies.

 

Deduction changes

With the recent tax reforms in the US, there have been some changes in the way deductions can be applied affecting the financing of domestic mergers and acquisitions. Often mergers are at least partially funded with debt which would be paid off in the form of a dividend. The dividend would be deductible making it a tax efficient way of financing the acquisition.

This deduction has been reduced greatly in the 2018 US tax reform. Companies were previously unrestricted in the amount of interest they could deduct before tax, but now there is a cap deduction of 30% of their 12-month earnings before interest, taxes, depreciation, and amortization (EBITDA). After 2021, the limitation becomes even more constraining by switching to 30% of EBIT only – that is, the deductions for depreciation and amortization are removed from the calculation, lowering the cap even further.

The deduction applies only when acquiring domestically, so not when buying a foreign company. You can still get the full deduction on dividends for a foreign owned corporation. Based on the current interpretation of the legislation, if you are looking to finance via debt, buying a foreign company will still allow you to benefit from this type of funding mechanism.

Why foreign M&A is more attractive

For insights and an introduction to M&A and carve-outs, take a look at the “M&A and Carve Outs from A to Z” eBook.

Other elements of the tax reform are also likely to drive further M&A and make it more likely that US firms look abroad for these acquisitions:

  1. The tax reform was structured to incentivise businesses to bring money back to the US if they are holding historic earnings off-shore. This windfall of foreign held monies will enable some companies to invest more, with a portion of this spending likely to fuel M&A.
  2. Related incentives to bring money back to the US have also reduced the tax on repatriation of future foreign earnings. Meaning that the return of investment for these foreign assets is improved.

What we are hearing from our clients is that US companies will continue to look to the global market as a way of leveraging faster growth and diversifying their business.

TMF Group

TMF USA are experts when it comes to M&A and international expansion, supported by a strong global presence in more than 80 countries worldwide. While there are always challenges when it comes to foreign investment the recent tax reform has introduced a whole new set of considerations. Please get in touch to find out how we can support your business achieve its global ambitions.

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