Midstream M&A: timing may never be better, but process matters
October 2018 | SPECIAL REPORT: ENERGY & NATURAL RESOURCES
Financier Worldwide Magazine
October 2018 Issue
The midstream sector – generally involving the gathering, processing and transportation of oil & gas hydrocarbons from the wellhead to the downstream provider – is primed for continued robust M&A activity now that the oil & gas industry has stabilised and rebounded following the industry downturn from late 2014 through 2016.
Midstream M&A is compelling in the current environment due to increasing producer capex spend and exploration and production investments which, in turn, are incentivising producers to offer dedications of underlying oil & gas interests to midstream companies, minimum volume commitments and other financial incentives in midstream contracts to support the build out of new midstream systems. Successful midstream operators are able to confidently project increasing throughput volumes and pricing over time, with limited downside. Additionally, midstream asset valuations are building off a base that reset lower during the industry downturn, creating a situation where sellers are enjoying rising valuations and buyers are eager to capitalise on value creation through acquisitions.
Buyers of midstream assets may be looking to build out their geographic footprint in a particular basin, diversify their asset mix and expand the suite of services they are able to provide to their upstream customer base. Often, a buyer will have determined that acquiring an existing midstream system is more cost effective than greenfield development, or is in the best interests of the buyer for other reasons, such as the buyer is preparing for an initial public offering (IPO) and wants to reach critical scale on a particular timeline. Sellers may be looking to sell assets to focus on their core assets or de-lever their balance sheets. Sponsor-backed sellers may be focused on realising an investment in a specific time period or based on a particular return profile.
The preliminary deal process and due diligence
During due diligence review, the buyer and its advisers will review the documents and information provided by the seller under a confidentiality agreement to better understand the target business. Due diligence allows the buyer to validate the commercial assumptions underlying the business, understand any potential risks or liabilities presented by the transaction and make an informed decision as to whether it wants to proceed with the deal and on what terms.
The scope of due diligence varies from transaction to transaction and may be impacted by the size and timing of the deal, the buyer’s familiarity with the business and the buyer’s risk tolerance. Legal diligence typically includes a review of the target’s material contracts, governing documents, and real property instruments, as well as regulatory compliance, litigation, labour and employment, employee benefits, tax and intellectual property matters. Good legal diligence dovetails with the business diligence performed by the buyer’s investment bank and in-house team.
Particularly in the midstream space, it is critical to recognise potential issues early on in the deal process that will need to be addressed in the deal structure and documentation, including the location of the pipeline system, if there are processing or treatment facilities involved and whether it is an inter- or intra-state pipeline system.
A specific area of legal and commercial diligence in all midstream deals relates to potential challenges to midstream contracts by producers in light of the Sabine Oil & Gas Corp. line of cases. Midstream companies contract with producers that promise payment based on dedications of the underlying oil & gas interests. Such midstream contracts are expressly drafted to act as a covenant “running with the land” and, as such, are not supposed to be contracts that can be rejected in bankruptcy by the producer counterparty. However, in light of a growing body of case law following Sabine, such contracts may be subject to rejection in bankruptcy, or at least the threat of rejection if the contract is not renegotiated in a way favourable to the producer. Consequently, buyers should carefully review the target’s material gas gathering and processing agreements to determine the enforceability of such contracts if the counterparty to such contract were to file bankruptcy proceedings and seek to reject such a contract. Relatedly, it is a commercial diligence question whether the midstream company’s key upstream customers have alternatives to transport hydrocarbons other than through the midstream company’s system; if not, even if there is a legal risk, there is less practical risk of a challenge to the midstream contracts by producers.
Other areas of diligence may also be important to the negotiation of the acquisition, based on the specific facts and circumstances of the deal. For example, if a significant amount of capital expenditure is expected to be incurred, but not paid, between signing the acquisition agreement and closing the transaction, then such capital expenditure should be accounted for directly in the acquisition agreement and in the valuation used to determine the base purchase price. In midstream deals, the working capital adjustment to the purchase price, the mechanism whereby the purchase price is adjusted upward if actual working capital exceeds the agreed target amount, or downward if actual working capital is less than the agreed target amount, is often a source of considerable diligence and negotiation to ensure the parties have a clear understanding and agreement prior to signing the acquisition agreement of what items will be accounted for in the calculation of working capital for purposes of determining the purchase price.
The acquisition agreement
The acquisition agreement is the primary document of the M&A transaction and provides for the parties’ obligations, both before and after the closing of the transaction. The acquisition agreement will typically include: (i) a description of exactly what is being purchased and sold (and whether any assets are excluded from the sale or any liabilities will be retained by the seller), and the purchase price the buyer will pay in exchange for the target; (ii) adjustments to the purchase price for working capital, debt, cash, seller transaction expenses, change of control amounts and rollover amounts, as applicable; (iii) rights of the parties to terminate the acquisition; (iv) conditions to closing, which may include execution at the closing of ancillary agreements, such as a transition services agreement, pursuant to which the seller agrees to provide transition operating services for a period of time following closing; (v) representations and warranties of the seller, both concerning itself and the target; (vi) representations and warranties of the buyer; (vii) post-closing covenants and agreements of the parties; and (viii) indemnification rights and other remedies.
Two of the most heavily negotiated sections of the acquisition agreement are the representations and warranties (R&W), the negotiation of which is underpinned by the buyer’s legal and business diligence, and indemnification rights, subject to the caveat that such sections are often less meaningful in transactions involving representation and warranty insurance.
The customary approach to allocating risk between the buyer and the seller once a transaction has closed is for the seller to stand behind and indemnify the buyer for damages resulting from breaches of R&W, typically via a portion of the purchase price being escrowed or held back by the buyer. However, sellers’ desire to walk away from the transaction with the full benefit of the purchase price and minimal future liabilities, and buyers’ willingness to rely on third-party insurance in place of a seller indemnity, has led to the use of R&W insurance in midstream M&A deals. Such policies are currently available from leading insurers for approximately three cents per dollar of insurance purchased.
In a typical buyer policy, the insurer will cover a certain portion of damages, for example 10 percent of the purchase price, subject to an approximately 1 percent deductible (or ‘retention’) amount borne by the buyer. In a competitive sell-side auction process, the willingness to use a buyer policy can greatly enhance the buyer’s proposal from the seller’s perspective. For example, if a buyer purchases an insurance policy, a buyer will likely agree to a substantially lower indemnification escrow amount or none at all, which guarantees the seller can walk away at closing with all or substantially all of the purchase price and, if applicable, distribute such purchase price out to its parent or sponsor. In certain circumstances, sellers may be willing to indemnify the buyer for some or all matters excluded by an insurance policy or within the policy retention. Sellers may also agree to make a more fulsome set of R&W if a portion or all of their representation and warranty-related indemnification obligations are covered by insurance, although sellers still need to have a factual and knowledgeable basis for each representation being made regarding the target’s business.
As buyers and sellers of midstream businesses consider M&A transactions, they should ensure they understand the proper process for completing a successful transaction. Comprehensive diligence, identifying critical issues early in negotiations, carefully drafting the acquisition agreement to capture the full value of the target business and also addressing the potential risks of the target business, structuring the acquisition in a way that is competitive to the seller but gives the buyer adequate recourse and otherwise having the most knowledgeable and diligent counsel advising on a midstream acquisition, will substantially improve a midstream buyer or seller’s odds of a successful, value-creating outcome.
Kevin Crews is a partner and William Eiland is an associate at Kirkland & Ellis LLP. Mr Crews can be contacted on +1 (214) 972 1662 or by email: firstname.lastname@example.org. Mr Eiland can be contacted on +1 (214) 972 1680 or by email: email@example.com.
© Financier Worldwide
Kevin Crews and William Eiland
Kirkland & Ellis LLP