Carve-Outs in Finance: Strategy, Process, and Implications

Carve-Outs in the world of finance offer a unique approach to restructuring a business. This financial maneuver involves a parent company selling a minority interest in one of its subsidiaries to external investors. The goal is not to part ways with the subsidiary entirely but to relinquish a degree of control while retaining an equity stake. Let’s delve deeper into this intriguing financial concept and explore its key aspects.

In a carve-out, the parent company initiates the process by selling a portion of its subsidiary’s shares to the public through an initial public offering (IPO). This action effectively transforms the subsidiary into a self-sustaining entity. Moreover, it introduces a new set of shareholders to the subsidiary. In many cases, a carve-out is a precursor to a full spin-off of the subsidiary to the parent company’s shareholders.

For this future spin-off to be tax-free, it must meet the 80% control requirement. This means that no more than 20% of the subsidiary’s stock can be offered in an IPO.1 2

One of the fundamental aspects of a carve-out is that it separates a subsidiary or business unit from its parent company, establishing it as an independent entity. This newly formed organization has its own board of directors and financial statements. However, the parent company typically retains a controlling interest in the new company and provides strategic support and resources to ensure its success. Unlike a spin-off, a carve-out often results in a cash inflow to the parent company.

A corporation may opt for a carve-out strategy instead of a complete divestiture for various reasons. Regulators consider these reasons when approving or denying such a restructuring. At times, a business unit is deeply integrated into the parent company’s operations, making it challenging to sell the unit outright while keeping it financially viable. Potential investors must also consider the consequences of the original company severing all ties with the carve-out and the underlying motivations that led to the carve-out in the first place.

In financial terms, an equity carve-out involves a business selling shares in one of its units. While the ultimate goal may be full divestiture, this might not occur for several years. The equity carve-out allows the company to receive immediate cash for the shares it sells. This approach is favored when the company believes that finding a single buyer for the entire business unit is challenging or when the company wishes to maintain some level of control over the unit.

Another divestment strategy is the spin-off. In this scenario, the company transforms a business unit into its own standalone company. Instead of publicly selling shares in the business unit, the company distributes shares to its existing investors. The business unit that is spun off becomes an independent company with its own set of shareholders, while the original company’s shareholders now hold shares in two distinct entities. The parent company typically does not receive any immediate cash benefit from a spin-off, and it may still retain an equity stake in the new company. To qualify for tax benefits regarding the final ownership structure, the parent company must cede 80% or more of its control.

A carve-out involves a parent company selling a portion of its subsidiary’s shares to the public while retaining some control, whereas a spin-off turns a business unit into its own separate company, with shares typically distributed to existing investors. In a carve-out, new shareholders are introduced, while in a spin-off, existing shareholders receive shares in the new entity.

Companies may choose carve-outs over full divestitures for several reasons, such as the deep integration of a business unit into their core operations. Carve-outs can also unlock value in segments that don’t align with a company’s core activities. Regulators consider these factors when approving such restructuring.

To qualify for tax-free status in a future spin-off, the parent company must relinquish 80% or more of its control over the subsidiary during the initial carve-out. This ensures that the subsidiary is truly operating as an independent entity.