CHAPTER 11 EQUITY FINANCINGS -- SELECTED ISSUES IN STRUCTURING AND NEGOTIATING PRIVATE EQUITY INVESTMENTS IN OIL AND GAS COMPANIES
| Jurisdiction | United States |
(May 2006)
EQUITY FINANCINGS -- SELECTED ISSUES IN STRUCTURING AND NEGOTIATING PRIVATE EQUITY INVESTMENTS IN OIL AND GAS COMPANIES
Thompson & Knight LLP
Dallas, Texas
JEFFREY A. ZLOTKY
Jeffrey Zlotky is a partner in Thompson & Knight LLP's Corporate and Securities practice group in their Dallas, Texas office. His practice includes the representation of private equity funds, public corporations and master limited partnerships, financial institutions and other qualified investors in connection with domestic and international transactions. He has extensive experience in the structuring, organization, and capitalization of private equity funds on behalf of sponsors and investors. Also, Mr. Zlotky is adept at the formal organizations of corporations, partnerships, and limited liability structures.
Mr. Zlotky is a member of the Firm's Management Committee. He is listed in Corporate Counsel's Best Lawyers (Corporate, Mergers and Acquisitions, and Securities Law); 2004, The Best Lawyers in America (Corporate, Mergers and Acquisitions, and Securities Law); 2001-present, Texas Super Lawyers, Texas Monthly; 2003-2005, and Best Lawyers in Dallas, D Magazine; 2005.
He earned his J.D. at the University of Texas School of Law in 1985 and his A.B. at Princeton University in 1982.
Table of Contents
1.01 Introduction
1.02 Investor Requirements
[1] Formation of Entities versus Investments in Discreet Projects
[2] Unrelated Business Taxable Income (UBTI)
[3] ERISA Considerations
1.03 Considerations Affecting Choice of Entity Decisions
[1] Management's Carried Interest
[a] Corporations
[i] Preferred Stock
[ii] Common Stock and Use of Promissory Notes
[iii] Incentive Stock Plans
[b] Flow Through Vehicles
[2] Taxation of Corporations and Flow Through Vehicles
[3] Additional Tax Matters Regarding Flow Through Vehicles
[4] Monetization Events for Corporations and Flow Through Entities
[a] Corporate Transactions
[b] Flow Through Entity Transactions
[5] Alternatives to Formation of Entities
[a] Net Profits Interests
[b] Participating Loans
1.04 Significant Documentation Issues for Investors and Issuers
[1] Governance of the Entity
[a] Board Composition
[b] Approval of Major Decisions
[c] Special Concerns Over the Exercise of Limited Partner Rights
[2] Capitalization
[a] Required Capital Contributions
[b] Failure to Make Required Capital Contributions
[c] Voluntary Additional Capital Requirements
[3] Transferability of Securities
[4] Exit Strategies
[a] Drag Along and Tag Along Rights
[b] Forced Sale Provisions
[c] Buy/Sell Provisions
[d] Registration Rights
[5] Other Provisions; Ancillary Documents
1.05 Conclusion
1.01 INTRODUCTION
The oil and gas industry has always had an intensive need for capital to fund the exploration and production of oil and gas. The industry has traditionally sought a wide variety of sources to provide this capital, including internally generated cash flow, industry participants, public capital markets, bank and mezzanine debt and private sources of equity.
Given the relatively low return on capital deployed in the oil and gas industry during most of the previous decade (particularly as compared to investment opportunities in other sectors of the economy), many private sources of equity capital shunned the entire asset class. Institutional investors such as insurance companies and pension plans that had traditionally made direct private investments with management teams or specific assets curtailed or abandoned their direct investment programs. These institutional investors and other investors that were interested in investment exposure to the oil and gas industry instead chose to commit capital to private equity funds organized for the specific purpose of making investments in companies engaged in the oil and gas business.
During the current decade, there has been an unprecedented growth in the amount of capital that has been committed by investors to private equity funds. Some private equity funds have exclusively invested in the energy sector, while other private equity funds that have a more general investment mandate have also made significant investments in the oil and gas area. One industry publication estimated that as of July 2005 the top fifteen providers of private capital in the energy industry had between them around $15 to $20 billion available for investment in the energy sector.1 High commodity prices had the affect of generating even more interest in making investments in the oil and gas industry. These "billions of private equity dollars pouring into the upstream energy space"2 represent an unprecedented amount of private equity capital available to oil and gas companies.
This paper addresses the issues that issuers and investors--particularly private equity funds--face when they are structuring and negotiating investments in the oil and gas industry. It will highlight the legal requirements imposed upon private equity funds by their respective investors, including tax and ERISA requirements. The paper will discuss the impact that these requirements have on the manner in which private equity funds structure their investments in their portfolio companies, including the effect that these issues have on choice of entity for the transaction. Regardless of the manner in which an investment is structured, investors and issuers face a wide variety of issues when it comes to documenting their understanding. This paper also discusses several of the significant issues
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that arise in the course of preparing the organizational documents of a portfolio company and provides some specific drafting suggestions for investors and issuers.
1.02 INVESTOR REQUIREMENTS
Due to the variety of requirements imposed upon private equity funds in response to the needs of their investor base, the private equity funds in turn have requirements that they impose upon the portfolio companies in which they invest. An understanding of the basis for these requirements helps to explain the underlying rationale for various structural considerations and the attendant affect that these have on negotiating documentation for a transaction.
[1] Formation of Entities versus Investments in Discreet Projects
The vast majority of private equity funds strongly prefer to back a management team that will devote its entire efforts to the building of a single enterprise. For this reason, the private equity funds seek to make investments in entities rather than discreet projects. They increasingly seek to give their backing to seasoned management teams in the hope that the experienced teams can recreate past successes. The fact that the teams have experience and a track record gives investors more confidence in the manner in which the management team will handle the variety of issues that will affect the portfolio company and its assets during the course of its existence. It allows investors to mitigate risk by choosing management teams whose experience in the industry demonstrates an ability to create value regardless of the current level of commodity prices, the nature of the geological issues affecting the underlying assets or whether the assets are in a "hot play."3 This is contrasted with some very successful natural resources funds, which have an their fundamental purpose the acquisition, production and exploitation of properties, which funds often use the devices of net profits interests and production payments when they acquire properties.
[2] Unrelated Business Taxable Income (UBTI)
One of the most important legal requirements affecting private equity funds stems from the fact that a significant portion of the capital committed to them by their investors is drawn from tax exempt entities, which include university endowments, foundations and pension plans. As a result, the private equity funds often strive to avoid or minimize the incurrence of "unrelated business taxable income" or UBTI.4 UBTI is defined as the gross income of an organization from any trade or business, the conduct of which is not substantially related to the exercise or performance by such organization of its tax-exempt purpose, less any deduction directly connected with the carrying on of such trade or business.5 Certain types of "passive" income, including dividends, interest, annuities, royalties, capital gains, and rents from real property and from personal property leased with real property, are excluded from UBTI.6 In the oil and gas context, the income and gain that would arise from the
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ownership of preferred stock or common stock and the receipt of dividends thereon are considered passive income excluded from UBTI. The ownership of an interest in a partnership or limited liability company that owns royalties and overriding royalties, as well as the direct ownership of royalty interests, are considered passive income that is excluded from UBTI. The scant authority in this area indicates that net profits interests also will be treated as royalties excluded from UBTI to the extent that the net profits interest owner is not personally liable for its share of operating or other expenses.7 Income from production payments taxed as mortgage loans also is excluded from UBTI. In contrast, the income allocable to investors from their ownership of a flow through entity that owns working interests is considered active business income subject to UBTI.8
In addition to the foregoing qualitative test with regard to the source of the income, there is another manner in which an investment can generate UBTI for an owner. Income will also be taxed as UBTI if the income is "debt-financed income" under Section 514 of the Internal Revenue Code. Debt-financed property is defined as any property held to produce income and with respect to which there is an...
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