Carve-eat Emptor: Beware the Fallacy of Division
According to industry sources,[1] carve-out transactions have increased in frequency in the post-pandemic M&A market. This trend has accelerated in 2024 and early 2025. The recent slowdown of deal activity due to macroeconomic and geopolitical factors and the specter of heightened regulatory scrutiny of M&A activity (e.g., proposed expanded horizontal merger guidelines and increased DOJ and FTC enforcement actions[2]) may be contributing factors to the recent rise in interest for carve-out deals. BlueChip can confirm from our own experience there has been an increase in carve-out submissions received during 2024 and through the first month of 2025.
Private equity and strategic buyers have found carve-outs can be a good way to realize the value of a large enterprise, assuming they have picked the right division or business unit. But there are many areas auditors and other due diligence providers need to examine when assessing the financial performance of a potential carve-out business, such as other business units not a part of the transaction perimeter.
In most carve-out transactions in the M&A middle market, a financial advisor will be commissioned to perform a quality-of-earnings analysis. Although the same is true for non-carve-out transactions, there are significant differences between reporting assets and liabilities, comprehensive income, cash flows, and related financial statement disclosures for a standalone entity versus a business unit within that entity. As KPMG notes, “pre-transaction, the proposed carve-out business is not a legal group or even a stand-alone division. Its operations, revenues and costs depend on a host of shared services and service level agreements with parent — provided functions, such as IT, HR, legal, procurement and marketing. Unbundling these relationships and defining the parameters of a transaction requires significant judgment.”[3] This observation, while true, does not go far enough. It takes considerable coordination among internal and external financial personnel and management to have, as a few Deloitte executives put it, “a rational and systematic method for allocating selling, general, and administrative expenses.”[4]
It is also important to consider the materiality of potential financial misstatements. Four partners and two managing directors at Deloitte wrote a report memorialized and published in the Wall Street Journal some years back called A Guide to Carve-Out Transactions. In that study, the Deloitte team analyzed the contrasting effects of materiality between carve-out and non-carve out transactions, saying that since “the materiality thresholds related to the carve-out financial statements will likely be lower than those related to the consolidated parent entity, management may need to assess the carve-out entity’s accounts and balances more closely than the parent’s own. The parent entity’s historical corrected or uncorrected misstatements and disclosures related to the carve-out entity that were previously considered immaterial to the parent’s financial statements would need to be reconsidered on the basis of materiality thresholds applicable to the carve-out financial statements.”
Another key consideration in conducting due diligence of a carve-out business is intercompany accounting. It is not uncommon for business units within a large corporate group to have misallocated certain revenues and/or expenses to other business units within the same enterprise. This cannot automatically be attributed to fraudulent activity. If several business units exist within various entities of the same enterprise, it is hardly surprising that certain accounting errors may arise given the complexities associated with having multiple inter and intra company accounts. One mistake can lead to many more, especially in accounting.
In addition to the financial statements of the target carve-out division, the accounting function of the other divisions and ultimate enterprise should not be neglected as to fall into the fallacy of division or composition. What is true for the parts is not always true for the whole, and what is true for the whole is not always true of its parts.
BlueChip has underwritten numerous carve-out transactions and seen claims on several of these transactions. These claims have usually arisen from deals involving a strategic buyer and a strategic seller, which makes sense given historically more carve-outs would be strategic to strategic, with private equity firms only recently getting more involved in such deals. Most claims have been of a third-party nature, though the highest severity losses have come from first-party claims. Consistent with results across the broader portfolio, the most frequently cited breached representations include financial statements, undisclosed liabilities, litigation, IP and tax.
Notably, BlueChip’s insurer partners paid out a full limits loss on a $25M RWI policy involving a complex carve-out transaction. This claim involved the alleged misallocation of revenues and expenses across disparate business units, only some of which were included within the transaction perimeter. BlueChip has experienced similar claims on other carve-out deals, including the alleged misallocation of certain employees across business segments. These experiences highlight the complexity of carve-out transactions and the risks inherent in separating a closely integrated business.
In summary, carve-out transactions can be a highly effective way for a selling company to unlock value and raise cash to invest in its core operations while providing the buyer with a sizable platform to focus upon and grow. An experienced buyer must beware of the different risks and nuances involved in analyzing what the carved-out business really looks like once separated from its former parent.
[1] Carve-out is Context – Transformation is the real opportunity | Alvarez & Marsal | Management Consulting | Professional Services (alvarezandmarsal.com) (“We are already seeing an increase in transactions involving carve-outs of assets from large corporates where sellers are looking to crystallize value and improve liquidity.”, Sept 2020); Carve-Out Deals are Thriving in Post-COVID Economy | Marcum LLP | Accountants and Advisors (“According to data from Dealogic, the first half of 2021 saw $281.1 billion in carve-out deals transacted in the U.S. alone, an impressive 197% increase year over year”, Jan 2022); setting-carve-success.pdf (kpmg.com) (“There has been a significant increase in activist shareholders’ demands to divest noncore and underperforming business units.”, 2022); PE Market Poised To ‘Unclog’ In 2024, Hopeful Attorneys Say – Law360 (“The tricky environment has given way to an increasing amount of carve-outs and other complicated deal structures such as sponsor-to-sponsor minority interest deals, explained Marni Lerner, co-head of Simpson Thacher & Bartlett LLP’s private equity mergers and acquisitions practice.”, Jan 2024)
[2] DOJ and FTC Release Revised Merger Guidelines (natlawreview.com)
[3] Page 10 of KPMG International’s Dissecting public carve-outs: What are the dynamics of a successful transaction? dissecting-public-carve-outs.pdf (kpmg.com)
[4] https://deloitte.wsj.com/riskandcompliance/a-guide-to-carve-out-transactions-01662474677
