M&A and Transaction Solutions
M&A: Eyeing Carve-Outs and Costs Through a Risk Management Lens
July 14, 2022
An iceberg’s size is deceiving if viewed only from above the water’s surface. Similarly, a carve-out acquisition’s stated value also can be misleading if significant costs and operational challenges are unrecognized.
Experienced risk and insurance advisors view deals through a unique lens. They surface risk-related issues, quantify their financial and operational impacts, and arm acquirers with vital information to negotiate a fair sale price and understand their actual operating costs.
Take a closer look at some potential issues through an M&A risk management lens.
The carve-out’s risk profile is different from the parent company’s.
A conglomerate might be known for investing in its people, processes and property. However, it might not invest in businesses it intends to sell.
For example, a global manufacturer decided to divest a plant. The buyer’s risk advisor discovered that the company had underinvested in the operation’s maintenance CapEx for years. Equipment was old, poorly maintained and lacked safety controls. The plant’s experience modification rating (MOD) was above 1, meaning it experienced more claims than industry peers. Further, the workforce’s average age was 58, and the plant had higher medical claims than its peers.
When a carve-out’s risks are worse than those of its peers, it impacts the cost of and the buyer’s ability to obtain workers’ compensation insurance, product liability insurance, general liability insurance, employment practices liability insurance and employee benefits. A risk advisor can quantify those impacts for the buyer.
The carve-out’s stand-alone operating costs may not be accurately represented.
Consider this. A large corporation had self-insured retentions for its workers’ compensation. When a claim came in, they paid it. They didn’t report claims to the insurance company until they met the threshold. The quality of earnings report identified only a portion of the claims and premium running through the income statement, with much of the information coming from the seller’s accounting department.
The buyer’s risk advisor discovered that the actual cost to insure the carve-out was underrepresented by 35%, or about $2.5 million. The buyer was paying a 10x multiple to secure the business. Armed with accurate insurance expense estimates, the acquirer reduced its offer by $22.5 million.
Accurately valuing a carve-out’s stand-alone “cost to insure” is critical. It can mean the difference between a profitable acquisition or an unprofitable deal. If pro forma operating costs vary significantly from the initial plan it also can impact management incentives.
The carve-out transaction may contain hidden liabilities.
Sometimes untrained eyes don’t see significant issues. For example, a sale agreement required the buyer to assume financial responsibility for insurance claims as of the sale date. The acquirer thought it was reasonable until a risk advisor explained they would be liable for any claims made as of the sale and any unresolved claims made before the sale.
Fully understanding the financial ramifications, the buyer negotiated this requirement out of the deal. The seller had to establish an escrow account to cover potential liabilities.
Buyers must be aware of all sorts of transitional risks. For example, as part of a large corporation, the carve-out likely provides robust health benefits that the new entity may not be able to offer employees. The acquirer must determine how to transition and pay for the services until the next enrollment cycle while satisfying compliance requirements. There can be diseconomies of scale within the insurance and risk markets.
An Eye for Value
Viewing carve-out acquisitions through a risk management lens can reveal critical information for understanding the actual value and operating costs of a purchase target. Let Hylant help.
The above information does not constitute advice. Always contact your insurance broker or trusted advisor for insurance-related questions.
Kip’s areas of expertise include strategic planning and customized consultation for captive plan evaluation and design. He directs Hylant’s private equity and mergers & acquisitions, insurance due diligence, deal facilitation structuring, alternative risk finance structuring, cash flow analysis, large casualty and loss sensitive program design and placement.
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