One financial consideration often overlooked during the planning phase of a strategic divestiture is that of stranded cost. This silent killer cost analysis should be conducted during any divestiture.
What Are Stranded Costs in M&A Activities?
Stranded costs are recurring operating expenses allocated to a particular segment which remain with the seller after the business unit has been fully divested. Information Systems and associated infrastructure often comprise an enterprise’s largest portion of stranded cost.
The Significance of Stranded Costs
Businesses pursue growth through a number of different strategies, both organically and through Mergers & Acquisitions (M&A). With M&A activity near all-time highs and demand for fundamentally sound businesses forecasted to remain strong, sellers are enjoying historically high exit multiples. But in their rush to cash in on these valuations, they sometimes find themselves stuck with onerous recurring costs that can run into the millions of dollars per year despite putting thoughtful TSAs in place.
One financial consideration during the planning phase of a strategic divestiture is that of stranded cost.
Consider a B2B product company with two distinct business units, BU-A and BU-B. BU-A develops high margin offerings, rooted in intellectual property and on the forefront of the market. Conversely, BU-B manufactures commoditized products at lower margins and with fewer opportunities for top-line growth. To free up capital and other resources for investment in BU-A, executive leadership may decide to sell BU-B to a strategic or financial buyer, or spin it into a new stand-alone entity.
During separation planning, each individual function should perform stranded cost analysis and develop action plans to achieve post-separation Run targets. Primary focus areas within IT include:
- Applications
- Infrastructure & Depreciation
- EUS (End-User Services)
- Resources
- Transformation Initiatives
- Commercial Agreements with suppliers
Find out more on how our M&A experts can help you perform a stranded costs analysis by getting in touch today.
Where to Perform Stranded Costs Analyses
Application Licensing & Support
Depending on one’s IT operating model and technology requirements, application cost may account for the largest portion of IT’s stranded cost. Bottom-up analysis of the application portfolio, associated support and licensing agreements, and contract renewal timelines is required to accurately forecast stranded application costs. For example, if the portfolio is heavily slanted toward named user, subscription style licensing agreements, stranded cost will be minimized. Conversely, if a high percentage of applications leverage pooled licenses, the company can expect to retain much of the allocated cost. The majority of license costs often reside with a subset of application providers, e.g. ERP software and its related ecosystem, so analysis can be performed relatively quickly to estimate the overall stranded impact.
Application support is another area that needs to be examined. The separation of applications shared by multiple business units will result in greater stranded cost than dedicated applications, which should transfer with minimal impact beyond any incurred, one-time fees. Support models vary from dedicated support cost per application to “pooled support” models where the company pays a flat fee for reduced service levels on a collection of applications. License costs are typically more easily actioned than support costs, and one can expect to reduce license costs by approximately 50-80% of the allocation as compared to 20-50% of support costs.
Infrastructure & Depreciation
Hosting (servers and storage used to run applications) comprises another category of potentially stranded cost. Servers can be analyzed similar to the way in which we view applications. The cost of a server that supports one or more dedicated (single BU) applications will transfer with the sale. A server that hosts co-mingled applications between business units will need to be cloned, and the seller will continue to incur the cost of the retained hardware. Shared servers need to be evaluated for application specificity and transfer disposition to forecast any stranded impact. For a hosting environment that leverages shared servers, a significant portion of the segment’s allocated hosting cost may be stranded if action is not taken to consolidate the post-transaction infrastructure landscape.
The primary driver for network-related stranded cost is sites, and similar to previous categories, whether they are dedicated or shared between business units. If a site is dedicated, all network costs should transfer to the buyer. If a site is shared, and the divested BU vacates the site, the network must stay in place. If 50% of the cost of that site’s network was allocated to the divested BU, that 50% will be stranded if action is not taken to reduce network capacity. Thorough analysis of sites and their post-TSA disposition is required to estimate stranded costs attributable to the corporate network.
D&A (Depreciation & Amortization) expense may be allocated across segments based upon the location of Capital Assets held within the portfolio. For assets managed by dedicated, local sites, D&A expenses should transfer to the buyer. For centrally located and managed assets, associated D&A expenses may become stranded if the corresponding capability is not analyzed for a possible reduction in operating capacity. In the above example, if no action is taken to reduce the infrastructure footprint post-separation, depreciation expense for those network-related assets will remain flat, and the portion previously allocated to the divested segment will become stranded.
Resources, Initiatives & End-User Support
EUS costs are more directly tied to personnel, and therefore a higher percentage of the allocation should transfer with the sale. The cost per user for service desk and PC support will likely increase following a reduction in purchasing power, and overhead charges will remain in place. Additionally, shared IT resources who are allocated to multiple business units will need to be actioned or re-allocated following the deal. Investment in transformation initiatives is necessary to both continually modernize the environment (hardware refresh) and to enable new capabilities (analytics, threat intelligence, etc.). Each active and planned project in the portfolio needs to be reviewed to determine whether the scope of the project can be reduced to offset the cost allocated to the divested BU. For example, the seller wants to implement a manufacturing application with a price tag of $5.0m, $2.5m to each BU. If BU-B is removed from scope, the price may not come all the way down to $2.5m for BU-A. If the resulting implementation cost sits at $3.5m, $1.0m will be stranded.
Understand the Bottom Line With Liberty Advisor Group
One of the primary benefits of divesting a line of business is the ability to refocus spending on strategic priorities. To plan effectively, a thorough stranded costs analysis is required in each of the primary focus areas to understand the post-deal environment and to identify opportunities to optimize expenses. The chart below shows that without proper diligence and the development and execution of a stranded cost action plan, 30% or more of the divested segment’s allocation may serve as a financial headwind for years to come.
No two companies or transactions are the same. Therefore, it is absolutely necessary to combine a comprehensive understanding of one’s IT cost structure with the specifics of the deal to accurately forecast stranded costs. We have partnered with numerous clients throughout the M&A deal cycle to assess the pre- and post-separation IT landscape and recommend operational improvements to achieve maximum benefit. If your business is considering inorganic growth initiatives, contact us so that we can exchange ideas gleaned from decades of collective experience in the complex world of M&A. We wish you all the best and we hope to hear from you soon!
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About Liberty Advisor Group
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