What is a Carve-out Transaction?
M&A practice, perhaps to a greater extent than other areas of legal practice, has lead to the popularisation of commonly used - and misused - legal terminology. Carve-out transactions refer to the acquisition or divestiture of part of an organisation, which has not necessarily been contained as a separate legal entity. In the most basic terms, carve-outs are typically recognisable as the sale, by a group, of an operating unit. The "unit" is part of a larger organisation that has broader functions.
Depending on such factors as whether the target business unit is to be sold in its entirety, whether the parent company is a publicly listed entity, the purpose of the divestiture and the intentions of the purchaser, carve-out transactions are sometimes referred to as "spin-offs", "spin-outs", "equity carve outs" or "demergers" amongst others. Whatever terminology we use to refer to this aspect of M&A practice, there are significant reasons to anticipate the growth of carve-out transactions in the UAE legal market over the next year to 18 months.
Current Motivation for Carve-outs
As global markets recover, investors are looking to increase activity. The capital to fund the aggressive leveraged buyouts that characterised the pre-crisis market is simply not available in most circumstances. Carve-outs can be suitable for more specific acquisitions and, while they are not by definition necessarily small-scale transactions, they do provide a good platform for the more conservative purchaser intent on a specific target or the capital-seeking seller who wants liquidity but desires retention of its central business.
Sellers may potentially pinpoint an operating unit as being suitable for divestiture for a host of reasons, including because it may be: non-essential to core operations; capable of generating greater shareholder value as a stand-alone entity or sale product; underperforming and expendable; or, simply, as a potential source of significant liquidity.
Conversely, purchasers are typically looking for significant upside potential by acquiring a unit that compliments their core business activities and is suitable for post transaction integration. For example, they may be seeking to integrate vertically for supply or distribution reasons, or horizontally to expand market share or geographical footprint.
The status of the vendor, in terms of its corporate organisation as well as its jurisdiction of incorporation will impact the process and timing of formalising any carve-out transaction. For example, whether the unit is part of a joint stock company (public¹ or private) or a limited liability company and whether it is established in a free zone or on-shore in the UAE are points of significance in determining how best to isolate and package a unit to allow for it to be carved out of the group.
For the purposes of this article, it will be sufficient to note that besides the particular laws and regulations designed specifically to create economic spaces to promote and facilitate one or more particular business activities a free zone may be designed to foster, most federal laws and regulations of the UAE are also applicable throughout the territory of each free zone. Most companies in the UAE are governed by the Federal UAE Commercial Companies Law². As with any M&A transaction in the UAE, due regard for the rules and procedures flowing from the CCL must be observed.
In terms of legal structure, an optimal scenario would feature the target unit as an isolated subsidiary of the vendor with unique operational characteristics. In other words, if the target unit is already quite distinct from the rest of the vendor group's operational profile in that there are fewer shared resources (contractual benefits, employees, assets, etc.) then it should, in theory, be easier to isolate, legally³.
While carve-out transactions fall within the broad rubric of M&A practice, there is some merit to considering them a distinct sub-set of M&A transactions. Carve-out transactions inherently introduce certain specific challenges to an acquisition dynamic. These features include a particular emphasis on isolating certain corporate functions, including IT, employment, supply and distribution dynamics, etc., from the vendor group.
Further, unlike with the sale of a whole business, the sale of a unit may not be "clean" because it is likely there will be aspects of the business such as contracts, assets, services and/or management functions intertwined throughout the group. The vendor may need or want to retain the benefits of some of these functions for the continued operations of the remaining group.
Because the corporate landscape in the UAE is predominantly characterised by the limited liability company ("LLC") as the operational vehicle of choice, unless otherwise indicated, we will focus on LLCs as buyer and seller. Specifically, we are assuming that the seller group will create and isolate the divestiture unit as a free standing UAE LLC, with the purchaser intending to buy the shares of the isolated entity4.
Particular Carve-Out Dynamics5
At the outset of any divestiture/acquisition transaction, cost/benefit analysis will be among the driving factors. Accurate business valuation is one of the most significant elements of any M&A transaction and carve-outs are no exception to this rule. Carve-out transactions do pose certain specific challenges. There are various methodologies for determining an initial share valuation and this exercise will usually be done by the target in conjunction with its financial advisors.
In part because of the challenges in making a carve-out attractive to a potential purchaser, the vendor should be aware that it may need to invest increased time and resources, in advance of any sale, in isolating the unit (e.g., disentangling vertical integration and facilitating independence of management function) and making it a viable business for the purchaser from day one post-closing.
With very few exceptions, an acquirer cannot know what it is purchasing or how to assign a meaningful value to the target business without first conducting a thorough legal due diligence investigation. This core fact-finding exercise cannot be supplanted as the most meaningful indicator of the constitutional, financial, regulatory and operational well-being of a business unit. Legal due diligence, often done concurrently with financial due diligence6, provides the substance for negotiations and key provisions in the documentation of the acquisition process.
The engagement of financial advisors with regional experience, the presence of in-house legal personnel and sound corporate practices as well as the vendor group's experience with carve-out transactions 7and its readiness for participating in a rigorous due diligence review are all issues that should be taken into consideration at an early stage in the process once a carve-out unit has been identified for sale. These factors will affect timelines and budgets for proceeding and impact the likelihood of a successful sale.
In respect of methodology and relevant information, as with any corporate acquisition, the acquirer should be seeking all information that could materially affect its reasonable understanding of a target unit, its business, assets, goodwill, etc. It is standard practice for an initial legal due diligence request to seek information across the full range of administrative and operational categories.
With carve-out transactions, the prudent acquirer will be
mindful of certain particular characteristics that should inform
the due diligence process to uncover additional costs and provide
the seller group with a more accurate checklist of requirements and
costs to effect isolation.
Confidentiality and non-disclosure agreements ("NDAs") are generally acceptable and enforceable under the laws of the UAE8. NDAs are implemented as standard practice in connection with mergers and acquisitions, as are exclusivity agreements, which seek to prevent one or both parties from negotiating with a third party pending conclusion of discussions between the parties. These agreements can tend to be a greater focal point with respect to carve-out transactions because the range of confidential information provided by the seller group typically strays into details about other aspects of the seller group. Exclusivity agreements may need to be of a longer term than would otherwise be the case, because of the need for the purchaser to formulate a comprehensive isolation and acquisition strategy.
Non-binding comfort instruments setting forth the core aspects of an intended merger or acquisition, such as letters of intent, memoranda of understanding or heads of terms, etc. (LOIs, MOUs, HOTs, respectively) are the rule rather than the exception in UAE practice. These documents can provide a valuable framework for the acquisition plan; and, in terms of a carve-out, these documents can be used to highlight conditions precedent to the transaction. Specifically, defining exactly what comprises the unit and where the lines are to be drawn as to what the seller group retains and what the purchaser acquires and in what corporate form (i.e., the mechanics of isolation) should be included so that potential deal-breakers can be identified at an early stage.
It has been a natural trend for group companies to benefit from economies of scale in negotiating and implementing supply and service contracts where possible. Increased care and performance as well as decreased prices are often achieved through using group clout in this manner. This corporate advantage can have a negative impact when a business unit is being spun off. Specifically, shared services can create ties throughout a group that hinder a clean break for the divestiture of a unit. This is perhaps never more evident than in terms of Information Technology9.
Electronic data and communications are one - but by no means the only - area where pooled group services routinely add a challenge to a divestiture plan. Whether or not and how data and services can be segregated by group will impact the time, cost and effectiveness of any isolation plan to facilitate a divestiture. For example, if recently re-negotiated license agreements that benefit an entire group need to be revisited to ensure the viability of a business unit being spun off, such issues need to be identified early in a potential carve-out deal and dealt with so that the parties can quantify the impact and provide a plan for effectively dealing with it.
Labour relations are governed principally by the federal UAE Labour Law 10. Most of the free zones provide that the federal Labour Law will also apply within their respective territories with or without some modification11. Generally, in the UAE the law relating to the employment of a workforce is particularly favourable to the employer in terms of determining precisely what the rights and obligations of employees and employers are in any given context and allowing a fair degree of flexibility for the employer to manage its workforce.
In terms of carve-out transactions, determining which employees should stay with the vendor group and which should be assigned to the target unit and spun-off is the first issue. The second major concern is determining a plan to effectively deal with issues of termination or transfer including the mechanics of such issues as benefit plans, bonus payments, vacation entitlements, statutory gratuities, etc.
From the seller's perspective, employees who provide services across the group (not just to the divesting business unit) will need to be retained or replaced, while a purchaser will be more focused on determining what equipment, services and employees are essential to protecting the operational viability of a business unit post acquisition. The buyer will also be cautious that the seller is not using the carve-out in an attempt to unload unnecessary or underperforming personnel. From both sides of the transaction an early and accurate evaluation of the spectrum of impact is key to understanding implications for cost, timing, maintenance of confidentiality, etc.
Current Market Favours Carve-outs
The global recession has had significant impact on the M&A market. Deal flow has been down and as we move out of recession, investors tend to be looking for distressed acquisitions or similar transactions that give them an opportunity to use capital in acquiring assets and/or equity interests at prices below the level they would be in a more robust market.
For a number of the same reasons we can anticipate that carve-out transactions will become a more prominent feature of the M&A market in the short and perhaps medium term.
Determining an appropriate structure to optimise the up-side potential of a carve-out transaction (for both the seller and purchaser) requires a solid understanding of the target business unit and (i) how it operates within the current group, and (ii) what factors need to be addressed to give it the greatest chance of fitting in to the purchaser's vision (whether that is as a stand-alone entity or as part of a vertically or horizontally integrated component).
In basic terms there are those assets which have to be moved to make the transaction work and those assets that cannot be moved. In reality many - if not most - assets will fall somewhere between those definitives but it is those benchmark items will guide the process. Careful planning for early phase negotiations, implementation and post closing strategy are the keys to identifying the primary issues to a carve-out transaction and determining a sound plan for addressing them.
1 While it is beyond the scope of this particular article, it should be noted that a number of issues that characterise merger and acquisitions practice with publicly listed companies (e.g., procedurally, The Law Governing the Emirates Securities and Commodities Authority and Market (Federal Law No. 4 of 2000, as amended) and in terms of disclosure requirements, Resolution No. 3 of 2000 Re: Regulations on Disclosure and Transparency) are quite different and should be kept in mind.
2 Law No. 8 of 1984, the "CCL".
3 There are a number of factors to consider in preparing a carve-out strategy and the corporate history of the unit may provide suggestions, e.g., previously acquired units are often easier to isolate or re-segregate than organically developed units.
4 Subject, of course, to all applicable rules including foreign ownership restrictions pursuant to Article 22 of the CCL.
5 This is by no means an exhaustive list of features to an M&A transaction that take on particular significance in the context of a carve-out transaction, rather, it is a representative example of common challenges arising in carve-out scenarios (each deal is different and there would be certain transactions, for example, where dealing with carve-out impact on the real estate or IP component of a spin-off would come to the fore).
6 It should be noted that the suitability of a unit for carve-out will also be impacted by its suitability for financial divestiture and both the seller and buyer side should have financial advice on the implications of a proposed transaction.
7 If the seller group does not have experience with corporate divestitures, a number of consulting companies can provide guidance in this area.
8 However, the extent of recourse for breach would be limited to damages and would not include specific performance.
9The personnel, hardware, software and services underpinning IT in group entities are particularly likely to both represent pooled resources and account for substantial budget allocations.
10 The Law Regulating Labour Relations, Law No. 8 of 1980, as amended.
11 The DIFC is the exception, having enacted its own employment law, which shares some characteristics with the UAE Labour Law and imports a number of concepts from European law models.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.