Exploring Equity Carve-Outs As a Strategic Investment Move

Key Takeaways

• The premise behind carve outs is that two companies or entities may be worth more separately than together.

• There are times in which the carve out is the parent company of a troubled business unit that the new buyer can improve via operational or financial support.

• Acquiring an asset that may still have strong ties to its parent company can be complex when it comes to potential value assessment.

In general, financial buyers such as private equity funds are most attracted to carve-out investment opportunities since the businesses involved are usually solid and managed well. But what is “carve out?” Here it is and how it works.   

What is Carve Out?

An equity carve out is a process whereby, for strategic or financial reasons, a company turns a subsidiary or division into a standalone company and sells shares to an outside investor or investors.

The strategy is commonly employed to capitalize on a business unit that is separate from its core competency. While the parent company usually continues to hold a majority stake, the new entity has its own board, corporate strategy, and financial statements.

There are times in which the carve out is the parent company of a troubled business unit that the new buyer can improve via operational or financial support. In some cases, the existing management will gather the capital to buy the unit itself, triggering a leveraged buyout.

Carve outs are more common among technology and fast-moving conglomerates that dip in and out of their industry segments as their corporate strategy changes.

Note, too, that while a carve-out is distinct from a divestiture, the action is sometimes the first in a series of moves over time by the parent company to leave the business.

Moreover, a carve out can be an entire business unit as well as a portfolio of assets or specific assets.       

How a Carve Out Works

One prominent example of a carve out illustrates how they work.  In 1994, American Express would spin off its banking unit Lehman Bros to establish a new entity owned by Lehman employees and Amex shareholders. Core business benefits included travel, signature charge cards, corporate services, and financial planning and were marketed under the American Express brand name.

Further, American Express poured more than $1 billion in capital into Lehman to financially back the new company. While the former parent had no directors on the Lehman board, it still received a share of future profits.  

How Do Carve Outs Create Value?

The premise behind carve outs is that two companies or entities may be worth more separately than together.

In one example, while a high-end retailer and a deep discounter may both sell a number of the same goods, their business models are nearly opposite. Values created by the carve out include:

• Strategic alliances. The carved-out entity discovers that its independence promotes the creation of strategic partnerships.
• More customers and suppliers. The new entity’s independence garners heightened access to new customers and suppliers previously blocked due to commercial conflicts of interest.
• Separate funding. With a balance sheet free of debts and capital costs that are different from those of its parent, the new entity finds it easier to arrange funding independently.

Difference Between Carve Out and Spin Off

There is a relatively new form of carve out called “spin off,” in which an entirely new independent entity emerges from the parent company.

The chief difference between carve out and spin off is that in an equity carve out, the parent company divest a portion of its stake in the new entity, which is subsequently sold through an initial public offering. With a spinoff, though, existing shareholders get shares of the new subsidiary.

Why to Consider Carve Out in Mergers and Acquisitions

If the buyer is able to add revenue sans the need for additional infrastructure or HR to serve the new business, a merger or acquisition can produce substantial cost savings and operational synergies. In fact, a carve-out acquisition could be a favorable way to create value, despite the risks.

How to Do Carve Out Due Diligence

Acquiring an asset that may still have strong ties to its parent company can be complex when it comes to potential value assessment. Due diligence can help with the understanding of the scope and nature of the carved-out business, understanding the financial information germane to the deal, and evaluating any entanglements between the carved-out unit and other parts of the parent company’s operations. 

When is an Equity Carve Out Not a Good Idea

Carving out even minute stakes in business units or subsidiaries will likely ultimately result in complete separation. Companies that do not plan for this stand a good chance of erasing shareholder value.

Carve Outs, Real Estate, and Diversification

In commercial real estate, so-named “bad boy” carve outs are employed in non-recourse loans, in which the sole way banks can recoup lost yield and investment due to default is through the property and the income it generates. With a carve out, the borrower is not personally responsible in the case of default, but investors are protected if the borrower is a “bad boy” –conducts themselves poorly. An example of such conduct would be the submission of fraudulent financial statements.

Real estate overall remains a popular investment. After all, the benefits of such investments can include protection from inflation and other volatility, the potential for property appreciation, passive income, possible tax benefits, and the building of capital.  

While there are a number of ways to invest in real estate, one is through the leading investment platform Yieldstreet, which offers as secondary income “alternative” investments – asset classes other than stocks, bonds, and cash. Since 2015, such private-market investing has delivered a net annualized return of 9.7%. That is compared to 6.5% for a portfolio of stocks and bonds. 

The platform, on which nearly $4 billion has been invested to date, offers the broadest selection of asset classes available. In addition to art, transportation, private credit, structured notes, and more, Yieldstreet has private and commercial opportunities in real estate.

Investing in real estate also serves another essential purpose – diversification. As an alternative asset class, adding real estate to one’s holdings can mitigate overall portfolio risk and even improve returns. In fact, diversification – a portfolio that comprises varying asset types – is essential to long-term investing success. 

Portfolio Diversification and Alternative Investments 

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Carve outs can create value for businesses and can be helpful with mergers and acquisitions and offer investment opportunities for PE funds, which can diversify investment portfolios. Remember, another way to diversify is through real estate.