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.
Applicable Law
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.
Structural Considerations
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
Valuation
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.
Due Diligence
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.
Pre-Merger Agreements
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 Issues
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.
Employment Issues
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.
Conclusion
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.
Footnotes
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.