Corporate carve-outs: Slice and dice

Jonathan Zhu, a managing director with Bain Capital, has been familiar with Chinese data networking equipment manufacturer H3C Technologies for more than a decade and spent much of this time trying to buy some of all of the business.

As a banker with Morgan Stanley, Zhu advised on the joint venture between US-based 3Com and China's Huawei Technologies that led to the creation of H3C in 2003. In 2006, working for Bain, he was involved in a joint bid with Huawei to buy 3Com's share of the JV. 3Com was willing to pay more and took full ownership of H3C. Twelve months after that, seeing that 3Com was trading a discount to the value of H3C, Bain tried to buy 3Com with Huawei as a minority investor, but US regulators nixed the deal.

By 2011, 3Com was a subsidiary of Hewlett-Packard (HP) and H3C had been allowed to expand its sales footprint beyond China. Focused on getting its data networking equipment into the hands of more customers, several ancillary businesses that had been seeded within China were no longer so important. HP decided to sell and Bain picked up a video surveillance business, now called Uniview Technologies.

"The first time we looked at H3C they didn't have this business. The second time, when we looked at 3Com, it was at such a nascent stage we didn't include it in our underwriting. But by 2011 it had become bigger - we were impressed by the progress they had made," Zhu says. "We knew it and we knew who was managing it. We were therefore the most aggressive and active in pursuing it."

Although HP has since divested control of H3C to Tsinghua Holdings - an investment unit of Tsinghua University - corporate carve-outs by PE are relatively rare in China. It is no coincidence that the other recent deal of significant size, CDH Investments' 2014 acquisition of Fujian Nanping Nanfu Battery also involved a multinational seller: Procter & Gamble (P&G), which had previously announced plans to offload more than half of its brands in a bid to boost profitability.

Chinese corporates, by contrast, are still in acquisition mode. No market in Asia has seen the upscale-downscale seesaw that dominated the US towards the end of the last century: conglomeration in the 1960s and 1970s followed by an unpicking of these behemoths in the 1980s and 1990s as investors decreed that performance would improve if management teams focused on a narrower set of goals.

Hope springs

There are, however, signs of movement. In some markets - China and Southeast Asia - this movement is barely visible; expectations of deal flow are based on the notion that companies will eventually retreat from industries in which they are less competitive. Japan and South Korea are in a different position, with conglomerates facing a combination of regulatory and financial pressure to divest non-core assets.

PE investors have high hopes for Japan in particular, citing the government's emphasis on corporate performance. The recently enacted corporate governance code promotes greater involvement of independent directors in decision making, while the new JPX-Nikkei Index 400 assesses candidates based on criteria such as return on equity (ROE) and transparent reporting, and proxy advisory firm ISS has recommended voting out directors of companies that fail to achieve an ROE of 5%.

Operations, marketing, finance reporting went through a functional structure to different parts of the Nestle system. One of the first things we had to do was to create a structure for the business that meant everything reported up through the Peters CEO - Simon Pillar

"It is not a paradigm shift but it's a good trend," says Masamichi Yoshizawa, a partner with The Longreach Group, in reference to the corporate governance code. "Companies must engage more with outside shareholders and they can look to improve ROE through actions such as carve-outs to PE."

AVCJ Research has records of 375 buyouts in Asia - for which valuations were disclosed - worth $200 million since 2000. About 30% of these could be described as corporate carve-outs, and four in five of these involved businesses in Australia, Japan and South Korea.

The two largest were both announced within the last 12 months: the $6.3 billion acquisition of General Electric's Australia and New Zealand consumer finance business by KKR, Deutsche Bank and Varde Partners; and Hahn & Co's purchase of a majority stake in Korea-based Halle Visteon Climate Control from Visteon Corp for $2.5 billion.

Needless to say, in more developed markets divestments are a larger contributor to private equity deal flow. According to a survey released by EY earlier this year, 45% of corporate respondents had recently divested or placed a business on a watch list. Over half expect an increase in the number of strategic sellers over the next 12 months. The primary drivers are a unit's weak competitive position, an asset being deemed non-core, and concerns about shareholder activism.

Even with a willing seller, carve-outs can present various complications. When Pacific Equity Partners (PEP) acquired Australia-based Peters Ice Cream from Nestle in 2012 (it has since sold the business to R&R of the UK), separating subsidiary from parent took 12 months. The private equity firm had to install new IT and reporting systems and find replacements for the management team members returning to Nestle. It also had to change the way in which the company was managed.

"Operations, marketing, finance reporting went through a functional structure to different parts of the Nestle system. One of the first things we had to do was to create a structure for the business that meant everything reported up through the Peters CEO," says Simon Pillar, managing director at PEP. "It was a very positive thing. People came in on a Monday morning knowing exactly what they were doing, how much they'd sold last week, and how much money they were making."

Degrees of separation

Working with management to identify better ways in which to run a company - and providing economic incentives for reaching agreed targets - is integral to the private equity carve-out. If the asset in question is an unloved Asia division of a multinational with disillusioned management, much can be achieved in this area. However, it depends on how and for how long the asset is considered by the parent to be non-core. This is well exemplified by two transactions involving Navis Capital Partners.

The first is Thai chicken producer Golden Foods Siam (GFS), which was a division of UK-based Grampian Country Foods until the parent was acquired by Dutch conglomerate VION Food Group in 2008. VION did not buy Grampian because it wanted exposure to Thailand, and in the wake of the global financial crisis, the parent was reluctant to invest in the business. Within a year it was sold to Navis.

The second is Linatex, a Malaysian rubber manufacturer owned by UK-listed Elementis. "It was a good company but had been non-core for a long time and the parent was milking it for cash," says Nick Bloy, managing partner at Navis. "Requests for investment in capital expenditure were only approved if it could be repaid in 12 months. The very definition of capex is that it takes longer than a year to repay. That sense of being squeezed to pay the corporate dividend is corrosive on a management team that has ambition."

Elementis eventually bowed to pressure from an activist shareholder and sold Linotex to Navis for $30.8 million in 2005. The private equity firm sold it five years later for $172.5 million.

In both cases, Navis found out from local management that a divestment could happen. It approached Elementis about Linotex and was invited to participate in an auction process for GFS on the basis of its previous experience in Thailand's poultry space with duck producer Bangkok Ranch.

Familiarity with the target business and management team can give a private equity firm the edge in a competitive process or even remove the need for an auction. For example, the CDH team had first backed Nanfu 15 years earlier, building up a majority ownership position before selling to Gillette, Duracell's parent, which was struggling to penetrate the Chinese market.

P&G subsequently bought Gillette but CDH stayed in touch with Nanfu's management. Thomas Lanyi, a director with the PE firm, told AVCJ last year that initial discussions with P&G were "pretty high level with us letting P&G dictate the direction." However, once the focus narrowed, CDH knew it could work with the Nanfu management. There was no competitive process and the PE firm paid close to $600 million for P&G's entire 78.8% stake in the business.

Personal connections were equally important in a second China carve-out by Bain, completed last year, also on a proprietary basis. The private equity firm had been looking at leasing businesses as part of deal-sourcing efforts within financial services and so was aware of Lionbridge. The team had previously created industrial equipment manufacturer Zoomlion's leasing division and then spun out as an independent, securing China CITIC Construction Corporation (CCCC) as a sponsor.

Recognizing that Lionbridge had nothing to do with any of its other operations, and reluctant to continue providing the guarantees required by banks as a condition of meeting the business' financial needs, CCCC decided to sell. A Bain executive heard about the planned divestment through a university classmate who knew the Lionbridge CEO. The combination of access to management and a prior understanding of the opportunity set in this space led to a deal.

Diplomacy first

It is vital that a prospective private equity buyer get comfortable with the management team of a non-core subsidiary, but careful diplomacy is required in terms of formal and informal approaches made to management and parent.

"You have to approach it with a fairly strict ethical framework," says Navis' Bloy. "You need to get to know management but you may also want information that the corporate parent would regard as confidential. If management team is very much in favor of a buyout they may not appreciate they are overstepping the mark in terms of what information they can share. This is more likely to get you disqualified from a process than present an advantage."

In the US there tends to be a key manager of the division or CEO of the company who has a lot of leeway to make the decision. In Japan it is more consensus-oriented and you really have to communicate with and build your case with a large group of people - David Gross-Loh

Indeed, many parent groups, particularly those that are listed, would be deeply unhappy to discover that a subsidiary has engaged in informal negotiations with private equity. They may fear being presented with a fait accompli when there is a broader duty to shareholders to conduct an objective, price discovery process, perhaps followed by a fully-fledged auction.

In situations that meet all fiduciary requirements and interaction takes place with the parent's blessing, management can still influence the process - perhaps just through body language during negotiations. The level of influence varies according to the corporate culture of the market.

"In the US there tends to be a key manager of the division or CEO of the company who has a lot of leeway to make the decision," says David Gross-Loh, a managing director with Bain. "In Japan it is more consensus-oriented and you really have to communicate with and build your case with a large group of people. It's more of an informal process conducted one-on-one with the key people rather than going to the whole board and the board votes on it."

The center of gravity in Japan has shifted such that the parent, which five years ago might have offered a non-core subsidiary a choice between remaining under the corporate umbrella and improving profitability, being acquired by private equity or being acquired by a competitor, is no longer willing to continue providing support.

Even though the prospect of working with private equity and retaining a degree of independence might be preferable to absorption by a rival, Longreach's Yoshizawa says it is rare for a management teams to actively seek out private equity. Those that do are often frustrated at their parent group's reluctance to invest in overseas expansion, which for many companies is essential to preserving competitive advantage.

In this respect, the private equity offering must amount to more than just an escape route. While there may be clear cost savings or efficiencies a PE firm can easily realize post-acquisition, there has to be a strategic rationale for getting involved, not least because the management of the subsidiary or the legacy-wary parent insist on it.

"We've had situations where we have been able to reap quite significant procurement benefits very quickly and this has been surprising - for example, you would expect multinationals to be efficient in their purchasing," says PEP's Pillar. "But you can't create long-term value by taking low-hanging fruit. There has to be strategic upside."

The partnership approach

PEP went through this process in partnership with a corporate when it took a 50% stake in the Australasia hygiene products business of Sweden-headquartered SCA. The parent recognized the division required significant capex and wanted a partner to share the burden. PEP also provided local expertise and the business listed last year, allowing the PE firm to make a full exit.

This approach remains a rarity in Australasia, but elsewhere in the region - particularly if the seller is an Asia-based group - there is often an interest in retaining a minority stake in the divested asset. Situations vary, but in most cases the parent recognizes that a private equity investor can deliver growth that would not be achievable if driven in-house and wants to participate in the upside.

In China, HP held on to 20% of H3C. In Southeast Asia, when CVC Capital Partners bought a majority stake in Matahari Department Store, the asset was restructured as a joint venture between the PE firm and the seller, the Riady family-controlled Lippo Group. CVC's value proposition was that it could help professionalize Matahari and the Indonesia-based business has since gone public. It trades at four times the valuation at which CVC bought in and the PE firm has now sold down most of its stake.

Partnership was also a key factor in two Japan deals involving KKR and Bain, respectively. KKR bought a majority stake in Panasonic Healthcare in 2013, having convinced parent company Panasonic Corporation - which was to retain 20% of the business - that it could help drive growth through cross-border M&A. Last month the company agreed the bolt-on acquisition of Bayer's diabetes care business.

Bain, meanwhile, purchased of a 50% interest in Jupiter Shop Channel from Sumitomo Corp. in 2012 - a entirely bilateral deal that followed years of discussions with the Japanese corporate about a range of businesses.

"They had identified Jupiter Shop as a business they wanted to get off the balance sheet, but at the same time they wanted to grow it, particularly in the internet area. We showed them some work we'd done with retail and media companies in the US and they were impressed," Gross-Loh says. "This was more of a partnership decision on their part."

 

SIDEBAR - Toolbox: Finding value in carve-outs

Kerry Foods did want to sell Pinnacle, or at least not at that particular time. The Ireland-based conglomerate had decided its Australasia-focused bakery business required a significant capital expenditure program and it wanted local management to focus on executing it. An auction would be a distraction; it could come later.

Nevertheless, Pacific Equity Partners (PEP) convinced Kerry to do business, agreeing a buyout of Pinnacle earlier this year. There was no auction. "We had to persuade them that we could assess the value of what was going to come out of the capex program, which was underway but had not yet started to deliver. And we persuaded them that our process would not be distracting for management," says Simon Pillar, managing director at PEP.

Kerry is relatively unusual in that it recognized Pinnacle was non-core but committed to the capex program with a view to realizing a higher valuation for the asset when the time came to divest. Stephen Lomas, Asia Pacific divestiture advisory services leader at EY, observes that all corporates should think about divestments as a way of raising capital for investments in other parts of their business. And in this respect, there is much they can learn from private equity.

"When a PE firm buys a business it is already planning to divest it at a profit - that is the business model," he says. "Corporates should look at what private equity does to enhance value. If they want to sell an asset in 2-3 years' time, isn't there something they can do now to get a better price later on?"

In addition to increasing revenue by investing in the non-core business - which some parent groups may struggle to justify - corporates can make operational improvements to reduce costs and also take working capital out of the business in order to boost the economic return on the sale. Further measures include optimizing legal and tax structures and treating divisions targeted for divestment as stand-alone entities.

"In these situations, what creates the opportunity to do something a bit more proprietary is a function of the complexity of the transaction," adds Pillar. "In the case of Griffin's Foods and Tegel [bought from Danone and Heinz, respectively], they were stand-alone businesses. This meant separation from the mother ship was relatively straightforward."

It is unclear to what extent corporates can replicate elements of the management buyout model that underpins many divestments: empowering a management team to make decisions and rewarding them for making the rights ones, based on a combination of efficient governance, performance-based incentives and accountability.

"Many big companies culturally do not have an entrepreneurial spirit. A spin-off unleashes it because you turn executives who are unloved in the corporate structure into shareholders and you can have a burst of alpha creation activity," says Nick Bloy, managing partner at Navis Capital Partners. "It is very hard within a corporate structure to say to a non-core business, ‘We are empowering you to create some value, good luck guys.'"

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• Topics
• Greater China
• Southeast Asia
• GPs
• Buyouts
• China
• Southeast Asia
• buyout
• KKR
• Hahn & Co
• Pacific Equity Partners
• Navis Management
• Bain Capital Asia