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Four cross-border carve-out trends private equity firms need to know

With intense domestic competition in the US and elsewhere, cross-border carve-out deals have become an increasingly important strategy for private equity firms looking to develop their portfolio.

Global M&A activity shattered records in 2021. Overall carve-out deals also spiked to a four-year high. Despite the increase in popularity, however, cross-border carve-outs remain challenging to execute due to their complexity relative to domestic carve-outs. To effectively prepare for a cross-border carve-out deal, PE managers should understand the following four trends.

Government slowdowns due to Covid

Even in ideal circumstances, executing a carve-out deal is a complex undertaking, and requires review and approval from local authorities in various areas. Governmental agencies across the world have suffered persistent staffing issues due to Covid, resulting in delays for a variety of basic functions such as apostille services. What may have taken days pre-pandemic can now take months. 

It’s important that private equity firms have realistic expectations about timing and build in a buffer for potential delays. Underestimating timing for steps in the process like establishing a bank account or even just obtaining official documents could result in potentially serious consequences, such as missed payrolls for acquired employees.

In some cases, private equity firms and their carve-out advisers are finding creative workarounds to delays. For instance, in the case of apostille service slowdowns, one potential solution is to change the ownership of the parent company to countries where apostille requirements can be fulfilled in less time. Some countries allow these services to be provided virtually, which could be the difference between meeting the closing date or facing penalties for a missed deadline.

Increased caution around shelf companies

Legal entity establishment is one of the most critical – and time-consuming – steps in the carve-out process. The typical entity establishment process can take more time and resources than PE firms often expect. Because of this, shelf companies have been used in cross-border carve-out deals to bypass the establishment of new legal entities in the host country and speed up timelines. Shelf companies are existing fully compliant entities which can be purchased “off the shelf” by the buyer. These companies are structured to facilitate an efficient transfer of ownership, allowing business activities to begin much sooner by avoiding the regulatory and compliance issues that come with the formation of a new business entity.

However, two factors have led to decreased use of shelf companies. Risk-conscious private equity buyers have started to shy away from shelf companies that have been used for other purposes. These types of entities could have liabilities or other prior activity that might adversely affect the buyer, such as outstanding loans. Rather than risk uncovering liabilities down the line, some PE buyers are opting to only purchase virgin shelf companies – ones that haven’t been used for other purchases – or avoid this route altogether. 

Additionally, shelf companies have become a less appealing route as international and domestic regulatory bodies push for stricter Know Your Client (KYC) requirements. Shelf companies are usually set up with a bank account, and some jurisdictions frown on – or simply won’t allow – moving a bank account to a new owner. Even where a transfer of ownership is viable, the process is lengthened as the new owner must comply with all KYC requirements. 

Although transferring ownership via shelf company is more time-consuming than it used to be, in some cases it could still be a faster path to ownership than establishing an entirely new legal entity. PE firms considering a cross-border carve-out deal should still explore this option but look to purchase virgin shelf companies and prepare for a slightly longer timeline due to KYC requirements.

Directorship services in entity setup

When establishing a new legal entity as part of a cross-border carve-out deal, more PE firms are using third-party directorship services to meet residency requirement and manage personal risk. 

In most jurisdictions, establishing an entity requires having an in-country resident director or a non-resident director. In addition to ensuring compliance with residency requirements, a third-party director will often have specific jurisdictional knowledge that can be useful in navigating other local rules and regulations. In the past, PE firms might tap an employee to act as an interim director during entity formation. However, doing so runs the risk of personal liability to the director. The director is responsible for the entity and any business activity and may be held liable for legal ramifications affecting the carved-out unit – for instance, late or inaccurate tax filings. A US-based director could have a liability in a foreign country due to a temporary directorship and never know about it.

In response, private equity firms are increasingly turning to third-party directorship services during entity setup to protect against personal liability. Once the entity is fully operational, directorship typically transitions from third-party directors to the new company directors. 

Rise of outsourced compliance services

Compliance is always top of mind for savvy investors, and it’s a particularly salient consideration when expanding into new jurisdictions. The challenge of navigating local rules calls for a high level of management resources and jurisdictional expertise. For that reason, many private equity firms are turning to third-party firms that can ensure carved-out business units remain compliant after the entity is stood up.

With a complex deal like a cross-border carve-out, there are many points in the process where compliance is critical. For instance, in some jurisdictions, firms need to submit monthly nil VAT filings after the legal entity is established and before the acquisition closes. Even requirements around statutory reporting and payroll will vary greatly by jurisdiction. 

Many companies will start to consider outsourced compliance services when expanding into new jurisdictions, where less local expertise or fewer in-house resources could be the difference between successful business operations and non-compliance. By outsourcing compliance services, companies and their owners benefit from additional resources, local expertise and often saved costs.

As cross-border carve-out deals continue to rise in popularity, it’s likely that we’ll see more PE firms using third-party services to navigate jurisdictional differences and minimise risk in the process. For private equity firms considering a cross-border carve-out deal, staying informed of trends can help ensure the necessary planning and due diligence takes place. With adequate preparation and expertise, private equity firms will be well-positioned for a successful investment that pays off.

For further reading, download our Comprehensive Guide to Cross-Border M&A.

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