Special Series, Part 2: Getting Ready for Acquisitions and Divestments
This article is the second in a three-part series about the important role supply chain executives play in corporate mergers, acquisitions, and divestments. Part 1 examined how supply chain executives can create value and prepare assets for sale in order to maximize the value for the seller. Part 2 considers 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.
Developing a detailed supply chain management transition plan is critical to the success of any merger and acquisition (M&A) deal. Getting this into place early during an acquisition or divestiture makes the deal more secure while establishing a smoother, more cost-efficient process. In short, forward planning by supply chain professionals from both the seller and the buyer will lower the transaction risk.
With EY's Global Capital Conference Barometer reporting in October that 57 percent of companies expect to actively pursue acquisitions over the coming year (and 49 percent have more than five deals in the pipeline), we are entering a hot phase for M&A deals. It's increasingly likely, then, that supply chain professionals will be involved in such a transaction.
In the first part of this three-part series, we looked at how getting a seat at the table as early as possible in the sale process allows you to not only create more value but also simplify the transaction and reduce the potential risks associated with separation. In this second part, we highlight the specific areas that supply chain executives should focus on when planning the separation of a business unit. We also explain why these are key to driving a timely and efficient transaction, and how focusing on these details minimizes the chances of issues arising and destabilizing, or even threatening, the deal during the transition process.
Understanding operating models
Considering implications for the supply chain is an integral part of examining the asset to be divested. As you would expect, the best results occur through frequent dialogue and collaboration between seller and buyer, subject to regulatory approvals, regarding key milestones and interdependencies. Both parties should work together to identify the critical paths and the "long poles in the tent"—the important tasks that will take the longest to complete—during the process.
As a starting point, we recommend that the buyer develop a clear vision of the asset's "future" operating model. This should align with the stated transaction objectives and long-term strategy and will include the role of and any implications for employees, processes, and systems. For example, the buyer may need to determine how it will distribute products in markets where it currently does not have its own operations. Will the buyer set up its own fulfillment operations, or should it leverage a distributor? As another example, the buyer might assess how the asset could be part of a principal structure that drives both supply chain efficiencies and tax savings.
While the future state operating model represents the desired end state for the buyer, it may be unrealistic to realize this model by the close. In such cases, a transition operating model—an interim model whereby the buyer and seller have respective responsibilities for the operations of the asset—can be very helpful. For supply chain executives, development of the transition operating model is the key to achieving the desired future state operations. The three most important drivers are:
In the case of a divestiture of an entity from a parent company, the buyer must have a clear understanding of the scope of the services the parent is providing to the entity being sold. This includes services that are conveying at close as well as services that need to be established by the buyer and those that would be provided by the seller through a TSA (as detailed in Part 1 of this series). Speed-to-close can be enabled through proactively separating commingled operations such as order-to-cash (OTC), allowing the buyer to assume full control of such operations either at close or shortly thereafter. This accelerates the exit from the TSA and provides the seller with the opportunity to free up resources for use elsewhere.
A sample tile diagram representing a portion of a transition operating model is shown in Figure 1. The tile diagram is an effective means of depicting an operating model for the supply chain and other functions from the people, process, and system perspectives. We strongly advise that the seller use a construct such as this to describe the current state operating model to the buyer. They can then work together to develop the transition operating model, which depicts how systems will work during the transition period.
Once the current state model and the transition operating model have been developed, supply chain professionals can plan the path from the current state to the transition state in detail, including specific milestones for Day One, Day 100, and other key milestones identified by the seller and the buyer. Figure 2 shows how the operating model evolves over three stages and will be discussed in more detail later in this article.
Defining the separation points
In addition to tile diagrams, there are other ways to analyze separation points and handoffs from the seller to the buyer. One good example is end-to-end (E2E) flow maps, as detailed in our previous article. These describe the physical, financial, information technology (IT), and legal-entity flows from raw-material suppliers through to manufacturing and distribution and on to customer locations through various routes to market. Another method is through E2E process flows (that is, order-to-cash, procure-to-pay, and sales and operations planning), which include people, processes, and supporting systems. For a divestiture that spans multiple regions and countries, handoffs between seller and buyer may vary based on factors such as the buyer's capabilities in a given location. For certain processes, the situation may be complex, with ownership of process steps, the people involved in executing those steps, and enabling systems split between the seller and the buyer. For example, customer service representatives who take customer orders may be transferred to the buyer but continue to access the seller's order management system until the buyer establishes its own order management capability.
By carefully tracing the steps in flows and processes, it becomes easier to identify key handoffs between the seller and buyer and the changes required to support the transition operating model. It is recommended to conduct country-level workshops where all parties involved (seller, buyer and transferred resources as appropriate) map end-to-end flows and processes to confirm responsibility for each step. Jointly developing process flows that will be in effect during the TSA period helps to prevent confusion and document a clear delineation of responsibility. Prior to these sessions, the seller may not completely understand the buyer's capabilities or intentions, so in preparation for those initial discussions, the seller should evaluate back-up options. Having understood the current operations, the seller can then define flows and process with regard to a best-case and alternate-case scenario.
Below are four key areas for transition planning on which supply chain executives from both the seller and the buyer should focus at this stage.
PLAN: Typically, a buyer takes over both the order and inventory planning processes. A seller's transition planning scenario can include all technology, processes, and people that will be owned by the buyer from Day One. If revenue recognition is important for the buyer, then so is ownership of the demand management process. In the event the buyer does not have the capability or capacity for this, the alternative should include a time-bound, transaction-based service the seller would provide the buyer. In a carve-out, this requires statistical analysis, forecasting, and demand management as well as a clear understanding of forecast expectations by category to inform systems planning as part of the TSA.
SOURCE: For sourcing, the assignment of contracts and ownership of procure-to-pay (P2P) could transfer to the buyer. In the event the buyer needs a transition plan or the seller would prefer to keep some volume synergies, an option for providing procurement services as part of that plan should be explored. Depending on the operations, the volume of contracts, purchase orders, and procurement activities to be transferred could be significant. The seller should evaluate options that benefit a complete transfer versus transition support to enable a quick close. In cases where this is a significant issue, on change of control the seller can work with the supplier to renegotiate for ease of transition rather than setting up a TSA.
MAKE: Special consideration should be given to the manufacturing assets. A manufacturing plant's transition should be considered in conjunction with quality, engineering, environmental health and safety regulations (including registrations and licensing), working capital required, and speed of product or manufacturing transfer. A buyer needs to understand the products that are being transferred with the asset, the timelines to close, and the manufacturing assets and facilities that are being transferred to determine whether it should negotiate a long-term supply agreement (LTSA) or a short-term TMA. It should also activate long-lead capital expenditure (CAPEX) items ahead of time, and particular care should be taken to understand country-specific work-council and labor-transfer regulations to achieve a smooth transfer on Day One. A buyer must understand the implications of in-progress capital projects to determine whether it or the seller will close the project before transition and, similarly, familiarize itself with future and recently launched products to plan adequate capacity and inventory buffer due to the high degree of forecast variation.
DELIVER/RETURN: The sales and distribution model employed after the close is of paramount importance—the decision made has significant supply chain, financial, tax and IT implications. For example, there are a number of models that can be used wherever the seller provides order fulfillment, including disclosed agency, undisclosed agency, commissionaire, and others.
In an undisclosed agency model, for a given market, the seller continues to fulfill customer orders as if it still owned the business, providing revenue minus agreed fees to the buyer as part of a monthly reconciliation process. In general, this model creates less disruption during the order-to-cash process. In an undisclosed agency model, the seller continues to fulfill orders without advising customers that it is doing so on behalf of the buyer, giving the appearance that the business is still owned by the seller. In some countries, however, this model may not be feasible due to regulatory requirements. In this situation, a disclosed agency model, in which customers are made aware that the seller is acting as an agency for the buyer, is often used. (See the illustrative example in Figure 3.) Consequently, it may be necessary to update invoices and shipping documents with appropriate disclaimers, the name of the buyer's legal entity, and other information, which creates the need for information system updates. With either model, the seller might be required to implement changes such as physically segregating inventory within the warehouse or obtaining special licenses to act as a distributor.
In some cases, the seller may prefer to leverage a distributor to serve the market because regulators don't permit an agency model to be used. In addition, for smaller markets, the time and resources required for the seller to provide TSA order fulfillment services on behalf of the buyer can be disproportionately high. In either of these cases, to reduce transition risk and cost, the seller should consider transitioning the market to a distributor prior to close. In this case, the third-party distributor purchases products and owns the direct relationship with customers in the market. At close, the commercial agreement between the seller and the distributor will be reassigned to the buyer.
Another consideration is that, should the seller agree to take customer orders on behalf of the buyer, both the seller and the customers may need to make updates to electronic data interchange (EDI) systems to reflect the buyer as the new selling entity. Conversely, if the buyer takes over order fulfillment on Day One, it must ascertain whether it has common customers with the seller, how to update master data, and how it will train customer service representatives. The buyer may need to set up new transportation lanes and also address the issue of trade compliance; for example, it may have to become the importer of record. If a new distribution center is required, the buyer may choose to leverage a third-party logistics provider to stand up these operations to accelerate implementation and avoid having to establish its own operations. Other areas that supply chain professionals should address as part of the comprehensive settlement may include who has responsibility for managing returns, depending on when the product was originally sold, and whether the buyer should take possession of historical sales-transaction information to support future returns.
With the separation points now defined, it's time to focus on detailed transition planning. The transition operating model is the main vehicle, and thorough planning and execution by supply chain executives on both sides of the deal is the key to a successful close. The steps will vary, depending on the deal structure—whether it's a stock, asset sale, joint venture, or a spin-off. For example, during an asset sale, the buyer needs to create and operationalize legal entities (discussed in more detail below) prior to closing if it doesn't have a footprint in the countries involved. Depending upon the size and scope of the deal, appropriate legal and regulatory licenses may be required for a successful close. This may take several years depending upon the country. In such scenarios, Day One plans should incorporate the possibility of phased country closings:
The setup of the legal entity will be critical on the path to the close, especially if the deal is structured as an asset sale. In this situation, it's vital that the buyer have a legal presence prior to close in order to absorb incoming assets, including people, contracts, and infrastructure in that country. If the buyer doesn't have such a presence, it must establish one ahead of time. Depending on the country, this can take several months.
The buyer must capitalize the new entity and set up appropriate bank accounts, such as payroll and accounts receivable, as well as a tax identification number and (when applicable) a value-added tax (VAT) account to establish a smooth flow of products and funds post-close. Additionally, depending upon the country's requirements, it must include this financial information on externally facing documents such as invoices and delivery notes in order to maintain business continuity after the close.
Business licenses, registrations, certifications, and the like are tied to whichever legal entity the operations are assigned to. In a world where tax efficiencies are a priority, legal entities are often commingled. Prior to the deal, the seller should make every effort to separate such requirements, especially product registrations. These registrations could then be segregated into a new, stand-alone legal entity for ease of separation.
It is also important that the seller plan for and staff the required supply chain resources for post-close support. For example, in the event the deal requires a TMA, the seller should plan for key manufacturing management staff to transition to the buyer. This would entail the seller identifying and providing capable staff resources to meet the obligations defined in the TMA. It's in the buyer's best interest to verify that the seller acts diligently on this issue; any lapse could cause a customer-facing revenue-loss situation.
The aforementioned E2E product-flow map should be used to prevent any disruption in product flow on Day One. Particular attention should be paid to markets that account for the most revenue and, consequently, where any product-flow disruption would have the greatest impact. We suggest using a scorecard to track readiness preparations during the sign-to-close phase. The scorecard aligns with typical product flow and confirms all requirements are in place, such as the establishment of import and distribution licenses, the assignment of appropriate freight terms on all lanes, changes to customer-facing documents, communication of changes to customers and logistics service providers, and setup of new distribution facilities by the buyer, to name just a few examples.
Should the sale involve a product transfer, the buyer and seller may need to develop a specific, related transition service plan, such as an information technology (IT) TSA, alongside the product-transfer plan. If manufacturing equipment is being relocated to the buyer's premises, the supply chain team will also need to build up a stock of inventory to meet market demand while certain production lines are inactive during the transition.
In order to accelerate speed-to-close and minimize the need for post-close support, we recommend that the seller proactively initiate the separation of commingled operations early in the deal cycle. Prior to the close the seller would set up a stand-alone enterprise resource planning (ERP) instance hosted on a third-party, cloud-based environment. This ERP instance would be configured to support key business processes that are currently used by the divesting entity. Upon close, the instance will be transferred to the buyer to support the divesting entity from that point onward. This will minimize any TSAs as well as eliminate the buyer dependencies required for TSA exit that are seen in traditional divestitures.
Depending upon the deal's timelines, buyer considerations, and the time required to set up a separate ERP instance, the above strategy will significantly reduce, if not completely eliminate, post-close support. For example, in a recent US $1 billion-plus carve-out of a large consumer goods company, the buyer desired rapid separation of commingled activities related to finance, distribution, and other operations. Challenges included implementing a new market-participation model (direct-to-distributor) and consolidation of ERP systems into a single instance, among others. The seller was able to set up a separate cloud-based ERP instance to simplify the business-process landscape and achieve full separation of the divesting entity by 10 months after the close, as compared to multiyear timescales for comparable transactions.
Cutover and inventory planning
In the weeks prior to close, a key focus for supply chain professionals from both sides should be "cutover" planning for the discrete activities that must be well choreographed in order to effect a seamless transition. Sometimes financial considerations aimed at achieving a clean closing of the books dictate supply chain decisions. For example, executives may need to suspend intercompany and external shipments several days prior to close so that financials can be reconciled prior to transfer of the business from seller to buyer. The suspension of shipments can have significant impacts for customers and for product integrity. Clear communication is therefore key, and the seller may need to advise customers to place advance orders to guard against disruption. There must also be consideration for products with near-term expiration dates that are not shipped to customers in a timely fashion.
In countries where the buyer already has established operations, subject to regulatory approvals, it may need to take possession of inventory prior to close in order to begin fulfilling customer orders starting on Day One. In this case, cutover planning must include plans to transfer inventory from the buyer's distribution center (DC) to the seller's. If there is a relatively small amount to transfer, we suggest the transfer be accomplished over a weekend, outside of business hours, to avoid complications. However, if there is a significant amount of inventory to transfer, then careful planning is required to avoid degradation of order-fill rates for the seller prior to close. Typical considerations include understanding demand at a stock-keeping-unit (SKU) level, sequencing the SKUs being transferred (clearing out very slow-moving inventory first), redirecting production output to the buyer's distribution center to bypass the seller's DC, incremental warehousing labor and transportation requirements, and side agreements to address inventory title and liability. In addition, prior to transfer, the buyer and seller must agree on a means to confirm an accurate count of the inventory being transferred, which ultimately impacts the overall financial figures.
Looking ahead: Integration planning
While much of the focus during the sign-to-close phase is on separation planning, it's imperative that the buyer also take a longer-term view toward integration planning to achieve the desired future state operating model. Meeting synergy goals and providing continuity in the customer experience are top priorities during this process. Supply chain executives need to be cognizant of the value proposition associated with the deal, and the buyer should formulate preliminary integration plans that protect the most important assets it acquires. For example, understanding the existing channels and routes to market for the business being acquired will help to establish that the future model will maintain expected customer service levels while avoiding potential problems with conflicts related to the buyer's existing channels (for example, overlaps in distributor territories, direct sales to customers already served through distributors, and so forth).
A company's digital agenda is an increasingly important consideration, too. If the buyer is developing omnichannel capabilities, then it should consider how to integrate the asset so newly acquired product lines can be ordered, fulfilled, and returned across various channels; this may include order fulfillment from existing distribution centers, from stores, or through drop shipments from vendors. In addition, it's important to be aware of new products so the future state supply chain can support upcoming launches and help to support revenue objectives. The future state supply chain should also support the targeted manufacturing model, whether it is make-to-stock, make-to-order, or a hybrid of the two. Lastly, there is frequently an expectation that synergies between the new asset and the buyer's existing assets will lead to operational cost savings. For global companies, we suggest the buyer consider incorporating its purchase into a new or existing tax-effective supply chain structure to drive both supply chain efficiency and tax savings. It is the responsibility of the buyer's supply chain executives to help achieve these benefits (one of the topics we will explore in more depth in Part 3 of our series).
Due care and diligence
The transition process involves a complex series of issues, any one of which could throw a divesture off schedule, causing significant revenue losses for both parties, if it is not carried out with due care and diligence. Careful planning by supply chain professionals during the sign-to-close phase will reduce the risk of this problem and helps to accelerate the transition. At the same time, close interaction between the seller and the buyer, including review and consideration of end-to-end product flows and supply chain processes, supports development of the transition plan around which the whole process is centered.
Special attention should be given to activities with long lead times, including the establishment of new legal entities by the buyer, which can have implications for the supply chain. It's also important not to overlook communication with key stakeholders, including customers, suppliers, and third-party service providers. The buyer must be particularly attentive to key assets and capabilities acquired during the deal so as to not undermine the value of the newly acquired entity. Protecting these will stabilize their purchase and create improved returns.
The views expressed herein are those of the authors and do not necessarily reflect the views of Ernst & Young LLP.
Merger and acquisition (M&A) deals have a set of specific terms referring to key elements and events during the transaction process. Below are some of the most important ones referenced in this article:
Sign—Milestone at which an agreement is signed between the seller and the buyer for the transaction to occur, assuming certain conditions are met
Close—Milestone at which the deal is completed, with the buyer taking ownership of the asset and the seller receiving agreed compensation in return
Sign-to-close—Phase between the sign and the close, during which the two parties work together to establish smooth operational transfer of various elements of the asset being sold
Day One—First day of operational control of the asset under the buyer
Day 100—Interim milestone by which time the buyer aims to have made progress on standing up (implementing and having operational) various operations
Transition services agreement (TSA)—Covers a multitude of back-office services the seller may offer to the buyer for an agreed period at a predetermined price, until the buyer can stand up those operations
Transition manufacturing agreement (TMA)—Sets out terms under which the seller will provide the buyer with manufacturing services when manufacturing equipment is conveyed to the buyer, but prior to the buyer having full capabilities to perform manufacturing itself
Principal closing countries—Countries where assets are transferred to the buyer on Day One (generally the business's biggest markets)
Non-principal closing countries—Countries where assets are not transferred on Day One (typically smaller countries that contribute a lower percentage of overall revenues)