Legal Hurdles in M&A Transactions: Carve-outs in the Chemical Industry Are Complex and Require Thorough Advance Planning
This article was originally published in CHEManager in German and is focused on German law, although many of the concepts it covers are relevant to carve-out transactions in other jurisdictions. You can read the original article here.
The chemical industry’s transformation toward CO2 neutrality has gained momentum. ESG factors are leading to market changes. Carve-out transactions play a significant role in this. There are numerous players in the market: private equity funds as well as strategic investors. Interest in specialty chemical companies is particularly strong. But carve-out transactions are extremely complex, especially in the chemical sector. As diverse as the various carve-out considerations can be, so too are the respective legal requirements and special features applicable to chemical carve-out transactions.
M&A activity in the chemical industry is high. The shock of spring 2020 was followed by a catch-up effect that continues to this day. The chemical industry is particularly exposed to the challenges of social and economic change. The transformation of the energy supply and rising focus in the areas of environment, social affairs and governance – so-called ESG factors – have led to adjustments to existing business models and the development of new ones. Active portfolio management and the increasing sale of non-core activities are leading to a high level of M&A activity – increasingly in the form of carve-out transactions. The favorable market conditions with a high number of interested parties and plenty of liquidity (especially among private equity investors) in the market are accelerating the trend. This trend also accelerated during the COVID-19 crisis and the subsequent phase of economic recovery, because companies are now increasingly thinking about strategies to restructure their work and production processes and to set up their portfolios in a sustainable and robust manner.
Carve-outs Are Complex M&A Transactions
The general complexity of carve-out transactions results from the large number of issues and the need to involve various stakeholders, especially management, employees, suppliers and customers of the carve-out business. In addition, the typical carve-out transaction is very “asset-heavy”, so that a large number of operating assets and properties are affected, which have to be separated or divided up.
Furthermore, the business areas have often grown organically over a long period of time, so that the dependencies on and interdependencies with other business areas are correspondingly large: permits have been issued for several plants en bloc or there are shared supply or customer relationships, so that stand-alone operation of the carve-out business is not easy to establish. For this purpose, so-called Transitional Service Agreements (TSAs) are often implemented. Under these agreements, the parent company must still provide services for the carve-out business for a certain period of time. Finally, historical environmental liabilities and legacy issues must be taken into account.
Carve-out Transactions: Variety is Standard
Carve-out transactions include different variants such as the public carve-out, the sale to private equity investors or carve-outs as asset deals (e.g. the sale of chemical parks).
1. Public carve-out: Public carve-out refers to the sale of one or more business units, often as part of an initial public issuance (IPO) on a stock exchange. The business unit to be sold is initially spun off. At this point, the parent company still holds all the shares. The next step is the IPO of the new company created by the spin-off. In the initial years after the IPO, the parent company continues to retain a significant stake – often for tax reasons on the one hand and to ensure a certain stability of the carve-out business on the other hand (such as the carve-outs of Lanxess and Covestro from the Bayer Group). The goal of maximizing shareholder value by creating an independent company with its own objectives, independent of the parent company, appears to be achievable in many cases. Most carve-out companies outperform comparable indices. In this respect, the capital market often values the individual companies more highly than the sum of these units in a conglomerate. In addition to the general carve-out issues that require legal independence, the complexity of public carve-outs is increased by the capital market requirements of the IPO (including the preparation of a corresponding prospectus).
2. Sale to private equity investors: In recent years, private equity investors have played a prominent role in M&A transactions in the chemical industry (which have often been carried out as carve-out transactions). In particular, target companies from the specialty chemicals sector have been the focus of attention due to their high margins. Active portfolio management by strategics led to the carve-out of businesses that were profitable but that could not develop as well as capital-intensive businesses in a group with a different focus. From a transaction perspective, the advantage of selling to private equity buyers is that antitrust approval procedures (merger control) are often – although not always – much simpler and faster than with strategic competitors, which means that transaction certainty and speed may be higher.
On the sell-side, it should be noted that private equity companies typically aim to distribute the purchase price received to their investors in the short term and to avoid later liability from the transaction, so that as a rule hardly any representations and warranties are issued. Warranty & indemnity (W&I) insurance [which may also be referred to as representation & warranty insurance] is regularly used in these company sales. In particular, warranties and indemnities from the purchase agreement are insured, so that the risks of breaches of warranties/indemnities are shifted to the insurer.
3. Carve-outs as asset deals: If the available time frame of the transaction permits, an internal separation of the carve-out business can be carried out in advance. This can be done by means of singular succession (asset deal) or a spin-off in accordance with transformation law (universal succession). In the case of an asset deal in particular, the principle of clarity must be observed, which requires that the respective assets are clearly recorded and listed. The respective contracts must also be transferred, which generally requires the consent of the respective contractual partner. In this respect, the carve-out in the context of an asset deal requires particularly detailed documentation.
In the case of a spin-off under transformation law, the assets can be described in a more general, determinable form. The consent of the contractual partners is also not required, as the contracts are transferred by operation of law. However, in the case of a spin-off under transformation law, it should be noted that there is a five-year subsequent liability for the liabilities of the carved-out business (or ten years if the liabilities relate to company pension plans). If the carved-out business is limited to one location, the advantages of structuring the carve-out as an asset deal often outweigh the disadvantages, for example, in the case of the carve-out of a chemical park.
Conclusion: Careful Preparation Is Essential
Even before the start of the COVID-19 pandemic, a sharp increase in carve-out transactions was observed. In the context of the economic recovery following the initial stages of the COVID-19 crisis, companies are increasingly trying to optimize their portfolios. Carve-outs require thorough advance planning. The legal and factual requirements are complex. Potential investors require meaningful financial information. At the same time, the business unit to be spun off does not (yet) exist. The legal situation must be well analyzed with regard to permits, employees, contracts, real estate and assets, and the carve-out must be carefully structured accordingly. In addition, the required TSAs must be prepared in good time.
