If you’ve paid any attention to special situations, you’ve undoubtedly heard the term “carve out.” You’re probably also aware that these corporate actions can produce some great returns for investors.
Just how much can you make from selecting attractive carve outs?
Well, Joel Greenblatt spent much of his career digging into them and produced a CAGR north of 40%. He was so taken with special situations that he wrote a whole book on the topic, a chunk of it focused on carve outs.
In this article, I want to walk you through exactly what carve outs are, how they differ from similar special situations, and how special situation investors should approach them to maximize returns. Ready?
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Carve-Out Meaning in Business: Unpacking the Concept
Ok, let’s get right down to basics with a detailed overview of what carve outs actually are, and how they differ from similar corporate actions. We need to understand the basics before we know how to profit from these events.
What is a carveout in business? Carve out definition
A carveout is the process where a company separates a portion of its operations, assets, or subsidiaries into a distinct entity, often to sell, spin off, or operate independently. This can involve creating a new company or transferring specific assets, intellectual property, or business units while retaining core operations.
The key here with our equity carve out definition is that they are creating a distinct entity that did not exist before from operations or assets that they already had.
What is an example of a carve-out?
An example of a carveout is the 2015 separation of PayPal from eBay. eBay acquired PayPal in 2002 to facilitate payments. By 2015, eBay decided to carve out PayPal into a standalone, publicly traded company to allow both entities to focus on their core businesses.
The carveout involved separating PayPal’s payment processing operations, including its technology, customer base, and financials, from eBay’s e-commerce platform, which was highly integrated at the time. This required restructuring assets, liabilities, and contracts while ensuring both companies could operate independently.
eBay followed the carve out with spinning PayPal off to eBay shareholders as a standalone company. As a result, PayPal could pursue growth in digital payments, while eBay focused on its marketplace.
The carveout unlocked significant shareholder value, with PayPal’s market capitalization eventually surpassing eBay’s, demonstrating the strategic benefit of separating distinct business units to enhance focus and market performance.
But note that the carve out came first, and spin-off second. This is an important detail that I’ll discuss further below.
Why do companies do carve-outs?
Companies pursue carveouts to unlock value, enhance strategic focus, and improve financial performance. By separating a business unit, subsidiary, or asset into a standalone entity, companies can streamline operations, allowing each entity to focus on its core competencies. This can lead to improved efficiency, innovation, and market competitiveness.
Carveouts often aim to increase shareholder value, as the separated entity may attract a higher valuation independently, as seen in the PayPal-eBay split. They also enable capital raising through sales or IPOs, providing funds for debt reduction or reinvestment.
Additionally, carveouts can address regulatory requirements, mitigate risks, or resolve conflicts between divergent business strategies. For example, a conglomerate might carve out a non-core division to reduce complexity. However, carveouts require careful planning to manage costs, operational disruptions, and stakeholder concerns, ensuring both the parent and new entity thrive post-separation.
What are the risks of carve-out? What should investors be aware of?
Carveouts carry risks that can impact both the parent company and the new entity. This, in turn, can impact the investment returns that you may see from purchasing the company.
Operational disruption is a key risk, as separating shared resources like IT systems, supply chains, or talent can lead to inefficiencies or unexpected costs. This can impact profitability, so you always need to invest with a margin of safety to account for any slippage here.
Financial strain may arise if the carved-out entity lacks sufficient capital or revenue to operate independently. It’s critically important that management assess the capital needs of the business beforehand, and that you invest knowing that the company has the funds needed to thrive.
Market perception is critical; investors may view the carveout as a sign of distress or strategic misstep, potentially lowering stock prices. While not as common, this is indeed a risk.
Regulatory and legal challenges, such as tax implications or compliance issues, can complicate execution. Tax rules differ from jurisdiction to jurisdiction, so we can’t do them justice here.
Investors should scrutinize the carveout’s rationale, the financial health of both entities, and management’s execution track record. They should also assess the new entity’s growth potential, market conditions, and hidden liabilities to gauge whether the carveout will truly unlock value or create unforeseen risks.
What are the benefits of a carve-out?
Carveouts offer several benefits for companies and stakeholders. These benefits are one of the reasons so many investors are drawn to investing in firms undergoing carve outs in the first place.
- Enhanced Focus: Separating a business unit allows both the parent company and the new entity to concentrate on their core operations, strategies, and markets, improving efficiency and innovation.
- Value Creation: Carveouts can unlock hidden value, as the separated entity may achieve a higher market valuation independently, as seen in cases like PayPal’s spin-off from eBay.
- Capital Raising: Selling or spinning off a unit generates cash, which the parent company can use to pay down debt, fund growth, or return to shareholders.
- Strategic Flexibility: The parent company can shed non-core or underperforming assets, streamlining operations and aligning with long-term goals.
- Attracting Investment: A standalone entity may appeal to investors seeking focused opportunities, potentially drawing specialized capital or partnerships.
- Regulatory Compliance: Carveouts can address antitrust or regulatory issues by separating conflicting operations.
What this all comes down to is the same thing Braveheart was shouting about, freedom. Freedom to pursue different strategic objectives, freedom to reward management in a more effective way, freedom to fine-tune operations… and much of this can’t be done without creating the new entity.
These benefits, when executed well, enhance competitiveness and shareholder value. The more you can reward management for improved profitability, and the more control over making that happen that you can give them, the better the company and the stock should do.
What is the difference between a split off and a carve-out?
A carve-out and a split-off are both corporate restructuring strategies, but differ in execution and outcome. In essence, a carve out means creating the new business entity, while a split off refers to an event where shareholders exchange shares in the parent for shares in the new entity.
In a carve-out, a company creates a new, independent entity from a business unit, often selling a portion of shares through an IPO while retaining some control. For example, eBay carved out PayPal, which became a separate public company.
In a split-off, the parent company distributes shares of a subsidiary to its shareholders in exchange for their parent company shares, fully divesting the subsidiary without raising new capital. Split-offs, like AT&T’s split-off of WarnerMedia, focus on redistributing ownership to streamline operations.
Carve-Out vs Spin-Off: Comparing Corporate Strategies
A lot of investors confuse the concept of carve out with the concept of spin off. While they’re closely related, and one usually follows the other, they are distinct and have specific implications for investors wanting to pursue each strategy.
What is the difference between a spin-off and a carve-out?
A carve-out involves a company separating a business unit into a new, independent entity, often (but not necessarily) selling a minority stake through an IPO while retaining partial ownership. For example, eBay’s carve-out of PayPal created a separate public company.
In contrast, a spin-off is when a parent divests of a subsidiary (in whole or in part, known as a partial spinoff) by distributing all shares to existing shareholders, raising no new capital. An example is Abbott Laboratories’ spin-off of AbbVie, where shareholders received AbbVie stock.
Firms pursuing carve-outs focus on unlocking value through creating more independent operating entities first and foremost, and partial sales or a divestiture may (ok, usually) follow. Firms pursuing spin-offs aim for complete separation, enhancing strategic focus for both entities. Each strategy has distinct financial and operational implications.
What is the difference between spin-off and carve-out IPO?
A carve-out IPO involves a company selling a minority stake of a business unit through an initial public offering, creating a separate entity, and receiving funds in the process. A spin-off involves a parent company divesting of a subsidiary by distributing at least some shares to existing shareholders without raising new capital as part of the process. Carve-out IPOs generate cash for the parent while spin-offs don’t.
Carve out vs spin off pros and cons
Remember that a carve out meaning in business, is just that the parent forms a new operating entity, and does not necessarily have to divest itself of that entity. So, the obvious major benefit of a carve out versus a spinoff is just flexibility. The parent doing the carving out has the flexibility of doing what it wants with its new entity, which includes a possible spinoff.
The negative side of carve outs versus a spin-off (for indecisive management) is just the large number of possible paths forward once that new entity is created. Complex execution also risks disruptions, high costs, or regulatory issues. The new entity may struggle with debt, and unclear rationales can lower stock prices.
Spin-offs can fully divest subsidiaries, enhancing focus and simplifying the parent’s business. While no cash is raised, divesting of a dissimilar business can remove the conglomerate discount that the company may face. A loss of synergies or market volatility can hurt share prices, however.
What is the difference between an equity carve out and a divestiture?
An equity carve-out involves a parent company creating a new operating entity out of assets or business operations already part of a large business unit. A divestiture, on the other hand, is the removal of ownership of a division through the sale or spin off of the division. This removes parental ownership over the division. They’re quite different. Though at least a partial divestiture often follows a carve-out.
Equity Carve-Out Process: How long do carve outs take?
When it comes down to it, all carve outs are a little different, and that means that the timeline for each carve out can vary substantially. I’m talking 6 months to 2 years – quite a spread. How and why they differ, though, comes down to the time it takes to complete each step in the carve out process.
- Planning (1-3 months) involves identifying the business unit, assessing its standalone viability, and defining strategic goals (e.g., operational focus or future sale preparation).
- Structuring and Due Diligence (3-6 months) entails separating assets, liabilities, and shared resources like IT or HR, ensuring legal and financial independence. If an IPO is pursued, regulatory approvals from bodies like the SEC and compliance with tax laws add 2-6 months.
- Execution (3-12 months) creates the new entity, which may remain wholly owned or involve a minority stake sale.
- Transition (3-12 months) stabilizes operations, addressing dependencies. Even without divestiture, the process requires meticulous planning to avoid disruptions.
Delays can arise from regulatory hurdles, market conditions, or operational complexities, requiring meticulous planning to minimize disruptions.
How Can Investors Profit From Carve Outs?
Investors can profit from corporate carve outs by capitalizing on the unique opportunities they present, but success requires careful analysis and strategic timing.
First and foremost, remember that a carve out just refers to the creation of a new entity. Carve outs do not always involve the parent divesting of all or a part of the new entity. However, when a company does divest, the carve out company could hit the market as a spinco, which provides similar opportunities.
With that in mind…
Purchase the Newly Carved Out Entity Post-Divestiture
Carve-outs often create undervalued entities with strong growth potential. For example, when eBay carved out PayPal in 2015, PayPal’s stock soared as it focused on the booming digital payments market, eventually surpassing eBay’s market capitalization.
Investors can profit by purchasing shares of the new entity during its IPO or early trading if it demonstrates strong fundamentals, such as robust revenue streams, a clear growth strategy, or a niche market position. However, investors must assess the new entity’s financial health, management team, and competitive landscape, as some carve-outs struggle with high debt or operational challenges post-separation.
Sometimes the new entity is simply revealed as a significant bargain by the numbers. Even if there are no apparent growth prospects and the firm seems to be a mundane business, a low multiple soon after going public can signal an investment opportunity.
Typically, these sorts of bargains are created by investors selling after a spin off, for example, so look for opportunity within the first month. Investors in the parent may not be interested in owning the spinco, and disinterest increases if the distribution is tiny relative to the parent company or in a different industry, and increases the likelihood of selling the stock, pushing the price down.
Capitalizing on Parent Company Gains After the Carve Out
Investing in the parent can be a smart move, whether the firm divests of the new subsidiary or not.
In cases where they do divest, the parent company may see a stock price increase post-carve-out due to streamlined operations or capital influx from selling the subsidiary. If the parent was able to get cash for a poorly performing division, that could boost overall profitability, and the parent could use that cash to invest in its higher ROI business.
Carveouts That Create Arbitrage Opportunities Due to Spinoff
If the parent divests of the carved out entity in the form of a spin-off, that can create some enticing opportunities.
In spin-offs, shareholders of the parent company receive shares in the new entity proportional to their holdings. Investors can profit by buying the parent’s stock before the spin-off announcement when it’s undervalued, then selling either the parent or new entity’s shares post-separation based on market performance.
For example, when Abbott Laboratories spun off AbbVie in 2013, both entities saw significant gains as AbbVie’s pharmaceutical focus attracted growth investors. Timing is critical, as spin-off announcements often cause short-term volatility.
Short-Term Trading on Market Inefficiencies Caused By Carve Outs
Equity carve outs can lead to mispricing due to market uncertainty or limited initial analyst coverage of the new entity. Savvy investors can exploit these inefficiencies by buying undervalued shares early or shorting overvalued ones, though this carries higher risk. Monitoring trading volumes and sentiment on platforms like X can provide real-time insights into market perceptions.
You also have to take advantage of the situation early, which is why free email services such as our Morning Brew special situations newsletter helps. By receiving notifications and being aware of carve outs before they happen, you can quickly take advantage of market inefficiencies.
Capitalize on Carve Outs that Create Long-Term Growth Potential
Carve-outs often unlock value by allowing the new entity to pursue specialized strategies. For instance, Ferrari’s 2015 carve-out from Fiat Chrysler enabled it to thrive as a luxury brand, rewarding long-term investors.
Identifying carve-outs in high-growth sectors, like technology or healthcare, can yield significant returns if the entity scales successfully. This is the “buy growth on the cheap” strategy.
By strategically investing in either the new entity or the parent company, exploiting short-term mispricings, or holding for long-term growth, investors can profit from carve-outs. However, success hinges on understanding the specific dynamics of each deal and managing inherent risks.
Your Pocket Guide to Carve-Outs: Key Takeaways that Special Situations Investors Have to Know to Profit from Carve Outs
Special situation investors targeting carve-outs can profit by understanding these 10 key takeaways:
- Rationale Matters: Analyze why the carve-out is happening (e.g., unlocking value, raising capital). A clear strategic purpose, like eBay’s PayPal carve-out, signals potential upside.
- Evaluate the New Entity: Assess the carved-out unit’s financial health, growth potential, and competitive position. Strong fundamentals increase profitability chances.
- Parent Company Impact: Examine how the carve-out affects the parent’s balance sheet and focus. A streamlined parent, like post-PayPal eBay, may yield gains.
- Market Mispricing: Carve-outs often face initial undervaluation due to limited analyst coverage. Buy early if the new entity is undervalued.
- Operational Risks: Watch for disruptions from shared resource separation (e.g., IT, HR). Poor execution can erode value.
- Debt and Liabilities: Check the new entity’s debt load and hidden liabilities, as high leverage can hinder performance.
- Management Quality: Strong leadership in both entities is critical. Research the track record of executives running the carve-out.
- Regulatory and Tax Issues: Ensure compliance with SEC or tax regulations, as delays or penalties can impact returns.
- Market Sentiment: Monitor platforms like X for real-time investor sentiment to gauge market reception and timing.
- Long-Term Potential: Focus on carve-outs in high-growth sectors (e.g., tech, healthcare). Ferrari’s carve-out from Fiat Chrysler thrived due to its luxury niche.
To Profit, conduct thorough due diligence using financial reports and industry trends. Time purchases during IPO dips or post-carve-out volatility. Balance risks like operational hiccups against potential rewards from undervalued shares or parent company gains. And, most importantly, always demand far more value than you pay.
How Do You Find Carve Outs to Invest In?
Now that you’re up to speed, how do you find a steady stream of carve outs to research and possibly invest in?
The obvious place is in the financial pages, such as The Wall Street Journal or The Financial Times. You can also search for these on social media, or with a Bloomberg terminal, but quite frankly, all of this takes a lot of time and effort.
The best way to track new equity carve outs is to sign up for a service alerting you to newly announced events. Even better if it’s free.
That’s why I created our free Event Driven Daily Morning Brew. Each month, we send our subscribers a full list of all the special situations that we’ve uncovered over the prior 30 days. Rather than going out to try to find carve outs, you can simply open your email inbox to review a list of the latest deals.
Enter your email in the box below because we’ll save you a huge amount of time and effort trying to find these deals by yourself.
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