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Divesting an asset? How you can maximize its value and sale price
Special Series: Getting Ready for Acquisitions and Divestments
This article is the first in a three-part series about the important role supply chain executives play in corporate mergers, acquisitions, and divestments. Part 1 examines how supply chain executives can create value and prepare assets for sale in order to maximize the value for the seller. Part 2 will consider the sign-to-close phase, including how to develop a transition plan. Finally, Part 3 will discuss executing on those plans, including stabilizing the assets and integrating them.
It's tempting to think of mergers, acquisitions, and divestments as matters that are strictly for Wall Street or your company's C-level executives. But that is far from the case. One reason is that the supply chain function can be one of the biggest levers for optimizing the value of such transactions. Another is that private equity (PE) professionals who want to close valuation gaps and respond to investors' focus on maximizing returns need to better leverage the supply chain's role in such transactions. As a result, the supply chain function is likely to increasingly find itself in the merger and acquisition (M&A) spotlight, making it imperative that supply chain professionals quickly improve their knowledge in this area.
[Figure 1] Characteristics of different buyer types Enlarge this image
[Figure 2] Missed opportunities for value creation Enlarge this image
[Figure 3] Sample day 1 flow of a product Enlarge this image
[Figure 4] Prioritizing opportunities to enhance value Enlarge this image
There's no time to lose. Rising stock markets and low interest rates have stoked the appetites of both PE and corporate investors for deals, fueling an M&A boom in recent years. Last year, 2015, was a record year for mergers and acquisitions, with nearly US$5 trillion in deal value. The pace may not slow much: EY's 2016 "Global Corporate Divestment Study" found that 49 percent of companies are planning to divest in the next two years.
The robust M&A market offers companies significant opportunities to drive growth and expand capacity, often through the disciplined shedding of noncore assets so they can reinvest in organic and inorganic opportunities. Too often, though, supply chain executives are brought in late in the transaction and so have little ability to influence the outcome. By having a seat at the table early in the merger, acquisition, or divestment process, supply chain executives can not only create greater value from the transaction, but they can also reduce the complexity and market risks that are inherent in any asset separation.
In this first article in our a three-part series about the important role supply chain executives play in corporate mergers, acquisitions, and divestments, we will explain, from the perspective of the seller, the types of deals, the priorities of the various players, and how supply chain executives can improve an asset's value and sale price.
Setting the perimeter of the transaction
There are several types of deals. A divestment can take multiple forms, including:
- A "carve-out," such as a straight sale of a business unit or product line and its associated assets
- A manufacturing-plant-only sale
- An intellectual-property (IP) or license-only sale
- A transition of an asset into a collaborative model with other parties (for example, a joint venture)
There also are different types of buyers. The buyer may be a strategic corporate buyer that is operationally focused and can assimilate the asset into its existing infrastructure, or it may be a financial buyer (a private equity firm, for example) that comes into a deal understanding the market opportunity as well as growth and earnings potential and has a vision for an eventual exit. Figure 1 provides a brief comparison of their differences.
- Supply chain executives can increase the sale price and reduce transaction risk when they're involved early in the divestment process.
- Pre-sale supply chain improvements can translate into multiples of the actual dollar value because a company's market value is often estimated as a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization).
- Driving free cash flow, including working-capital improvements, is a win-win for the buyer and the seller.
- Supply chain improvements can offset a capital gain and may reduce the seller's tax liability.
- Detailed separation planning for people, processes, and systems adds deal value, especially if the seller anticipates the unique needs of the strategic or financial buyer.
Early on, the seller should determine the deal "perimeter," or scope, because it drives the entire sale process and has important supply chain implications. Which assets, people, contracts, and so on will go to the buyer? How will processes such as order-to-cash (OTC) and procure-to-pay (PTP) work during the transition?
Further, the perimeter helps the buyer determine supply chain synergies, identify cost- or cash-takeout opportunities, and understand the services that must be set up at the close or post-close to facilitate business continuity. A clear perimeter also helps the seller reduce disruption to the remaining business, calculate one-time and incremental ongoing costs, and understand the efforts needed to fully separate commingled operations from the parent. Further, the perimeter influences the seller's "stranded costs"—that is, fixed costs that remain after the separation but are no longer covered by revenue from the asset.
Perimeter considerations may include the following:
People. The seller should identify dedicated employees who will convey (transfer) to the new owner. These might include research and development (R&D) associates, plant employees, and business-specific demand planners and salespeople, for example. For employees shared across different businesses, the seller should develop fair criteria to decide whether they will convey; for example, if more than half their time is dedicated to the divested business. The buyer should also figure out an operating model and identify gaps in resource needs, develop retention strategies for key incoming employees, and work on recruiting strategies.
Process and enablers. The seller should identify key processes, such as OTC and PTP, determine whether they are commingled with other parts of the business, and, if so, decide whether to carve them out or provide them as a transition service until the buyer is ready to either "stand up" (build) the process or capability if it does not already exist in its business, or absorb the transferred operations into existing processes and capabilities. The seller should also identify regulatory registrations that will transfer; the buyer may have to apply for those that cannot transfer, which, depending on the circumstances, might include things like new-product registrations and import licenses. The parties further need to understand any contracts that relate to the assets being divested, such as those with raw-material suppliers, co-manufacturers, and other vendors. Dedicated contracts should be reassigned to the buyer. Contracts that are commingled may have to be split before being assigned to the buyer. The buyer may also need to establish other contracts, for example with new vendors and logistics service providers, before the deal closes.
Systems. The seller should identify which information technology (IT) systems are conveying with the deal and consider the potential implications for those that the seller will continue hosting. Applications, such as material requirements planning (MRP), product lifecycle management (PLM), and OTC platforms, often are shared with other of the seller's business units. The seller has the opportunity to increase the attractiveness of the deal during diligence, either by planning for separation of these systems and data prior to Day 1, or by providing a clear view of the efforts that will be required by the buyer to exit the transition service agreements (TSAs). These measures greatly increase transparency and decrease the perceived risk for the buyer.
Creating value and improving sale price
Once the company has determined the perimeter of the targeted divestment, the supply chain function has a significant role in enhancing the deal's value.
Companies that focus on creating value prior to the sale are 75 percent more likely to receive a higher-than-expected price.
Source: EY, "Global Corporate Divestment Study," 2016
Most companies already are focused on improving their supply chain, benchmarking against peers, using lean programs to drive out waste, and improving performance to align with enterprise objectives. In addition, supply chain executives can play a major role in divestment planning. Their initiatives can greatly improve the business's operations and free cash flow, potentially resulting in a larger buyer pool and increased competition for the asset for the following reasons:
1. Improvements to the supply chain have a multiplier effect. The main reason supply chain professionals can play a significant role in increasing the sale price is that the cost-saving changes they are able to enact help to increase the market value of the asset. Market value is often estimated as a multiple of EBITDA. Multiples vary by industry. For example, consumer products companies currently have an EBITDA multiple of 12.0-14.0,1 so a $1 improvement in supply chain costs would be 12.0-14.0 times more valuable than the actual savings when it comes to selling the company.
2. Increased tax efficiency makes an asset more attractive. The asset targeted for divestment may currently be operating under a tax structure that is suboptimal for the asset as a stand-alone entity. Moving forward, the asset could be converted to a tax-effective operating model, globally centralizing activities such as procurement or planning in low-tax locations and increasing supply chain efficiency while reducing income taxes. Further, the investment can potentially offset the capital gain from the transaction and may reduce the seller's tax liability.
3. Improved inventory turnover releases cash. Increasing inventory turns over a time horizon reduces the amount of cash used to purchase goods relative to the cash generated from sales during that time period; this in effect releases cash that can be invested in other areas of the business. EY's experience is that in divestments of non-core businesses, cash-release opportunities can exceed 10 percent or even 15 percent of revenues. According to EY's "Working Capital Management Report 2016," the leading 2,000 U.S. and European companies in terms of revenue have up to US$1.2 trillion of cash unnecessarily tied up in inventory. This is equivalent to nearly 7 percent of their combined sales. In other words, for every $1 billion in sales, the opportunity for working-capital improvement is, on average, US$70 million.
That's the high-level view. Below are some examples of specific value-creation opportunities across the various pillars of the Supply Chain Operations Reference (SCOR) model: Plan, Source, Make, Deliver, and Return.
Improving overall equipment effectiveness. Overall equipment effectiveness (OEE) takes into account the various subcomponents of the manufacturing process (availability, performance, and quality). Increasing OEE is valuable because it can enhance capacity for growth and increase manufacturing throughput. Understanding this metric also helps private equity professionals compare assets and roll out beneficial practices across their portfolio of companies, helping them reach their synergy and return-on-investment targets. In addition, the seller can use OEE as a measure of current manufacturing performance.
Making structural changes to the manufacturing and distribution network. Network optimization typically is a strategic exercise in which modeling and optimization techniques identify opportunities to reduce cost or inventory and improve customer service. Network optimization is generally high-impact, but it also is time-consuming. However, depending on the scope of the changes, the benefits can be accelerated to make a tangible impact on an asset's sale price. For example, in one transaction EY worked on, the divested asset's primary manufacturing location was going to be transferred to the buyer. However, various value-added manufacturing activities were performed on work-in-progress inventory at other locations that were to remain with the seller. While this arrangement made sense for the seller, it created unnecessary transportation flows and added more costs for the buyer. To solve that problem, the seller was able to consolidate all manufacturing operations associated with the asset into a single facility and then transferred it to the buyer, thereby eliminating waste and helping to boost the asset's selling price.
Rationalizing stock-keeping units (SKUs). A transaction should prompt the seller to review its product portfolio. The seller can eliminate redundant and unprofitable SKUs to reduce operational and regulatory-transfer activities.
Sourcing from multiple suppliers to reduce risk. The seller should have a strategy in place to keep supplies available as contracts transfer to the buyer. Dual-sourcing of the most critical raw materials can reduce the risk of disruption to product deliveries without adding excessive complexity. A large seller may, in the normal course of business, have been able to rely on only a single supplier, thereby gaining efficiencies and economies of scale. But a PE buyer of a carve-out business might require supplier redundancies so it can obtain priority in receiving raw materials when there is a shortage. The seller can alleviate this concern by providing the divesting business with an additional supplier for the most critical raw material in advance of a deal. Consolidating Tier 2 suppliers and a long list of indirect suppliers also helps drive down costs and reduce transfer efforts.
Making working-capital improvements prior to divestment. Another value-capturing opportunity for a seller is to drive working-capital improvements, releasing cash tied up in inventory, accounts payable, and accounts receivable. Focusing on working capital can be a win-win for the buyer and the seller, since not only can the seller make improvements and extract cash prior to the sale, but also the buyer acquires a more inventory-efficient business, which has more value. This is critical for PE buyers that typically focus on free cash flow because of the debt leverage.
EY's 2016 "Global Corporate Divestment Study" found that only 37 percent of executives extracted working capital prior to turning over the asset. But, as shown in Figure 2, another one-fifth of respondents wished they had done so: 21 percent said releasing cash from working capital was the value-creation initiative they did not undertake but would have benefited from most.
Although certain benefits from making structural changes to optimize working capital take time to realize, opportunities for quick wins abound. One example is rebalancing the inventory mix, typically by improving the underlying logic for stocking and replenishment decisions to better align with demand. A better mix can support greater sales and production volumes with a lower inventory balance. It can also improve margins by reducing the need for overtime, order expediting, and obsolescence write-offs.
Understanding information technology interdependencies. The seller's information system is one of the key factors determining the duration of a supply chain separation. Perceived IT-separation complexities and a need for extensive support via a transition service agreement can diminish buyer interest and negatively impact the bid price.
IT platforms and services typically are shared between the divested asset and the remaining company, and they can quickly become a sticking point for both Day 1 and the full separation. Enterprise resource planning (ERP) platforms and plant-level applications, such as manufacturing execution, quality management, and warehouse management systems (WMS), often are shared across plants and distribution centers. Identifying and migrating historical data (for example, data required to support demand planning) often leads to difficult discussions between the buyer and the seller, but they can be avoided with early planning and transparent communication. Before the close, there are opportunities to create significant value by rationalizing applications and establishing stand-alone capabilities through cloning or cloud-based solutions. These can reduce operating costs and lower risk for a PE buyer.
As they implement those and other strategies for creating value and improving an asset's sale price, supply chain executives may want to keep in mind the suggestions in the accompanying sidebar, which can help to ensure the success of their transactions.
Preparing for due diligence
Due diligence is the process whereby a prospective buyer requests and collects financial and operational data from the seller for the purpose of making an informed decision regarding whether or not to bid on the asset, and to determine the value of the asset in order to set an offer price. Good preparation—including anticipating the buyer's questions and assembling relevant supply chain data into a "clean room" for confidential data sharing—can help the buyer make an informed decision. (A clean room is an independent entity with legal oversight that allows for commercially sensitive data to be analyzed prior to the closing of a deal.) Data sharing to support due diligence includes numerous details, such as operational locations, historical production and shipment volumes, three-year forecasts of key product lines, agreements with key suppliers, and more.
To plan properly for execution, the seller has to understand not only its own operations, but also the interests of different types of buyers. Considerations may depend on the industry and channel type. For example, in a regulated industry such as pharmaceutical manufacturing, the buyer needs in-depth information regarding supply chain quality systems and the chain of control.
The seller should perform self-diligence on the operations of the asset to be divested within the context of the broader enterprise, particularly for those assets that are commingled in a shared-services environment. A useful exercise is to create end-to-end product-flow maps that describe the physical, financial, IT, and legal-entity flows from raw-material suppliers through to manufacturing and distribution, and to customer locations via various routes to market. A sample map is shown in Figure 3, though for a global supply chain the map can be quite detailed and complex. This map can provide invaluable information for the buyer and can help support development of a transition operating model, which will be described in the next article in this series.
Planning for asset separation
Sellers should develop a separation plan before going into discussions with the buyer, but they often fail to do so. As shown in Figure 2, 25 percent of companies surveyed in our "Global Corporate Divestment Study" said that the value-creation initiative they did not carry out but now feel they would have benefited from most is operationally separating the business either partially or fully. (Subject to regulatory approvals, it is possible to sell a business without operationally separating by providing services for a limited time period.)
Companies with an operational separation plan are 33 percent more likely to generate a sale price above expectations.
Source: EY, "Global Corporate Divestment Study," 2016
Having a separation plan enables the seller to influence the terms of separation and long-term partnership. Divesting brick-and-mortar manufacturing plants and global-reaching supply chain systems, including people, technology, and regulations, requires significant attention to detail. Providing the buyer with a transition and separation plan can make the deal more efficient and can ease potential anxiety about assets that are not possible to fully separate before the transaction. Below are two types of services that the seller may agree to provide to the buyer for a limited time so that the buyer has adequate time to establish (stand up) its own capabilities or absorb transferred operations into its own business. The separation plan should take into consideration the scope of these services; note that the seller may offer one or both.
Transition service agreements (TSAs). TSAs cover a multitude of back-office services that the seller may offer to the buyer at a predetermined price for an agreed period, until the buyer can stand up those operations. TSAs may contain some markup to cover the exceptional costs associated with providing services to a third party.
Logistics is a good example of when commingled operations, which drive efficiency during normal times, can be troublesome in separating a business. During the past 10 to 15 years, it has become common practice for large companies to reduce overhead by leveraging a shared-service organization for managing logistics. The shared-service organization is part of the seller's business; it centralizes activities such as logistics or procurement that can be offered to multiple business units in order to increase scale and efficiency. The organization's core services typically include:
- Customer service
- Transportation management and sourcing
- Trade compliance
The seller delivers TSA services in accordance with a service-level agreement (SLA). In the case of a corporate buyer, there may be less need for TSAs because the buyer may have its own assets and capabilities that can help it to absorb the new business. For a PE buyer, the TSA may have to be more comprehensive and longer in duration to provide the buyer with adequate time to set up its own capabilities. The services are usually limited to executional functions, such as fulfilling customer orders; typically the seller is not interested in offering the buyer such strategic functions as sourcing logistics services. To reduce the cost impact, the seller typically provides these services at the same service levels and with the same reporting used for its own internal customers.
Transition manufacturing agreements (TMAs) and reverse TMAs (rTMAs). The transfer of physical assets may take longer than the anticipated sign-to-close period; a transition manufacturing agreement may speed the closing. A TMA sets out terms under which the parties will provide each other with services when manufacturing equipment is conveyed to the buyer but the facility itself remains with the seller. For example, the buyer might purchase raw materials and the seller's plant would provide services under a TMA. An rTMA is used when a conveyed site manufactures non-conveyed products, in which case the buyer must continue supplying them to the seller.
Because a TMA or an rTMA can last several years, it's helpful to keep the following key objectives in mind:
1. Know the workings of your operations. Lay out the product, physical, financial, informational, and legal flow.
2. Secure a fair and equitable price that compensates the seller for services and motivates the buyer to transfer ownership in a timely manner. Understand the detailed costs, including allocated costs, and build in sensitivity for volume fluctuations.
3. Establish governance that is robust, simple, and fairly represents both sides' interests in execution for continued product supply. Clearly define accountability, roles, and responsibilities for the various levels within the organization.
4. Reduce the risk to both parties with specific contractual language.
5. Establish an exit strategy. Align on exit timelines and proactively educate and enable the buyer to achieve manufacturing transfer.
The parties should take care to agree on workable terms. Contractual language in the TMA can be a source of dispute that strains the partnership. Definitions (such as for cost calculations), subjective areas (for example, order timing and forecasts), treatment of errors, and consistency all need to be ironed out prior to signing an agreement. A specific example is "net working capital." Agreeing on a calculation method (for example, Generally Accepted Accounting Principles applied on a consistent basis), how assets and liabilities will be defined, and even an example of how benefits and losses would be calculated during the partnership will all play a key role in preventing disputes.
Supply chain and the divestment process
Because they face the possibility of an acquisition or divestment at any time, supply chain professionals need to prepare for these challenging situations now. They play a critical role in the transaction process by helping their companies take advantage of enormous opportunities to optimize value. Buyers, too, should appreciate the supply chain's role in helping to reveal whether the acquisition target is likely to be a good fit at an appropriate price.
By being involved in the divestment process early on, supply chain executives can take steps that increase an asset's sale price and lower the risk associated with a divestment. With a more comprehensive understanding of the processes and techniques that enable growth and reduce complexity and cost, the parties will be more efficient and create less uncertainty during the divestment.
1. EY analysis of the last five years of Standard & Poor's transaction-related data, as of August 15, 2016.
Authors' note: This article contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Member firms of the global EY organization cannot accept responsibility for loss to any person relying on this article.
As they implement strategies for creating value and improving an asset's sale price, supply chain executives may want to keep in mind the following "guiding principles," which can help to ensure the success of their transactions:
Think like a buyer. The key to capturing divestment value is to examine the business from the buyer's perspective. The seller needs to develop a "value story"—the seller's point of view regarding intrinsic value and improvement opportunities associated with the asset. The seller articulates the value story to potential buyers so that a buyer will understand the full value of the asset. As part of the value story, the seller will explain its key assumptions on how the asset will be separated.
For example, each pillar of the SCOR model (Plan, Source, Make, Deliver, and Return) should be evaluated for performance improvement, risk mitigation, and complexity reduction, with the understanding that each pillar may have an intrinsic value to the buyer that is different from the value to the seller. Private equity buyers focus on free cash flow because they generally use leverage to purchase assets and always consider the asset's debt-servicing capability. By contrast, strategic buyers focus primarily on EBITDA because they need the earnings.
Show the buyer work-in-progress. A prospective buyer is more likely to pay a higher price for the asset if the seller can demonstrate that it has already implemented a value-creation program that will be sustainable after the divestment. To increase the sale price, the seller should provide the buyer with a "road map" showing value-creation initiatives it has begun, such as plant rationalization, operational improvements, and revenue enhancement or restructuring actions. The seller could provide evidence of future value by showing that it has engaged in a program to, for example, reduce working capital or increase overall equipment effectiveness. Supplying a supporting business case and demonstrating improvements to operational metrics will help to show that a higher price is merited.
Prioritize improvements based on time available. The opportunity to increase value depends on the time horizon prior to presenting the asset for sale. If that period is 12 or more months, then large-scale initiatives like network optimization and operating-model changes can drive significant value. If the time horizon is shorter, then there may still be "quick-hit" opportunities, such as working-capital optimization or reducing total landed cost. At the very least, the buyer will value four to six months of focused improvements that can be reflected in quarterly financials. Figure 4 illustrates this time-versus-value concept.
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