CHAPTER 4 DEALING WITH MIDSTREAM COMMITMENTS OR ACQUISITIONS AS A PRIVATE EQUITY PURCHASER
| Jurisdiction | United States |
(Apr 2018)
DEALING WITH MIDSTREAM COMMITMENTS OR ACQUISITIONS AS A PRIVATE EQUITY PURCHASER
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CHRIS HEASLEY is a senior associate with Kirkland & Ellis LLP in the oil and gas asset acquisition and divestiture practice, in Houston, TX. Chris's practice focuses on acquisitions, divestitures, and formation of joint ventures involving energy assets, with a particular emphasis on oil and gas deep-water and unconventional resources. Chris's transactional experience also includes advising clients in connection with the formation of joint ventures and complex joint development projects, farm-out and participation agreements to develop oil and gas properties, oil and gas transportation and gathering agreements, natural gas processing and fractionation agreements, and other commercial transactions.
DAVID CASTRO is a partner with Kirkland & Ellis LLP in the oil and gas asset acquisition and divestiture practice in Houston, TX. David's practice focuses on acquisitions, divestitures, and formation of joint ventures involving energy assets, with an emphasis on unconventional resources. David represents clients in connection with the purchase and sale of a broad range of assets, including upstream and midstream oil and gas assets and companies. David's transactional experience also includes advising clients in connection with the formation of joint ventures and complex energy projects, farm-out and participation agreements to develop oil and gas properties, oil and gas transportation and gathering agreements, natural gas processing and fractionation agreements, and other commercial transactions concerning the development of oil and gas properties.
I. Introduction
Private equity has played an ever-increasing role in capitalizing upstream exploration and production ("E&P") companies since the beginning of the oil price downturn in 2014. Upstream E&P is a capital intensive enterprise with spending exceeding $340 billion in 2017 alone.3 Cumulative capital expenditures on unconventional resources is expected to exceed $5.1 trillion by 2035 (averaging $200 billion per year).4 Since the downturn, capital in the oil and gas sector has remained tight, with traditional financing sources (i.e., capital markets providing both debt and equity funding and banks providing secured and unsecured loans) either inaccessible to many industry players or on such restrictive terms that companies have systematically sought out alternative funding sources.
Private equity firms have reportedly raised more than $100 billion since 2014 for investment in the oil and gas space to fill this funding void, with the bulk of the money targeted to the upstream sector. With their "dry powder" adding up, it seems likely that private equity firms will look for larger and more complex transactions in the coming years. And as the upstream acquisitions become more complex, many of these transactions will include a midstream component through the inclusion of gathering and transportation pipelines (and related infrastructure) in the conveyed "Assets" and/or by the upstream "Assets" being transferred subject to existing midstream arrangements, including acreage dedications to third party gathering systems and/or downstream transportation lines.5
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While many private equity firms have a strong bench of upstream expertise, education will likely be required on certain issues common to the midstream space.
This article is intended to discuss lessons learned by private equity firms that handle upstream acquisitions with a midstream components particularly when utilizing a newly-formed special purpose vehicle (a "SPV") to acquire the assets (e.g., a limited partnership or limited liability company organized solely for the purpose of acquiring the applicable assets with no other assets or collateral). To that end, we begin by discussing the applicable acquisition agreement before focusing on high-level financing considerations. The article concludes by reviewing key due diligence considerations. Although upstream acquisitions can be structured in any number of ways, including both at the asset or equity-level, this article focuses on asset-level transactions where record title to the underlying oil and gas assets transfers from the seller to a purchaser SPV.6
II. Acquisition Agreement Considerations
Typically, in upstream asset-level transactions, the purchaser receives only those assets described on the applicable exhibits or located within a designated geographic area (e.g., a list of counties or parishes or a map of an area where the assets are located). While the asset structure allows parties to negotiate and exclude specific liabilities, it also requires the purchaser to focus significant attention on the scope of the assets and consider how the scheduled assets relate to both the current and future development of the field. For example, if the acquisition agreement provides only for a transfer of assets located on a drilling pad or lease but compressors and other essential equipment is located off the pad or lease, then the purchaser may be required to incur significant additional expense simply to operate the existing assets.
Although the majority of time defining the scope of assets is typically spent confirming the leases and wells included in the purchaser's initial bid model are properly listed on the applicable exhibits, it is also imperative that the purchaser and its counsel review key midstream agreements and confirm that the scope of assets is sufficiently expansive to include key midstream infrastructure, to the extent owned by the seller or its affiliates.7
Besides confirming the scope of assets, there are a number of items that should be considered in the acquisition agreement that relate to midstream commitments or
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infrastructure. Although by no means comprehensive of all acquisition agreement considerations, this article addresses several items that deserve special attention.
First, this section identifies certain representations and warranties that are commonly requested by sophisticated purchasers when acquiring midstream assets and/or upstream assets subject to binding midstream agreements. Next, we discuss financial commitments and assurances held by midstream counterparts as such liabilities may inform specific provisions in the acquisition agreement relating to the SPV's obligation to absorb the related credit costs. We follow with a discussion of third party consent issues and, in connection with the denial of certain third party consents, a potential solution utilizing asset management agreements. This section concludes with a brief discussion of the regulatory considerations relating to the Hart-Scott-Rodino Act salient when acquiring midstream infrastructure.
(a) Representations and Warranties
Once the purchaser is satisfied that the scope of assets is properly defined in the acquisition agreement, the purchaser should consider the scope of its diligence and appropriate protections under the acquisition agreement, particularly when due diligence cannot be properly or practically conducted on the particular issue prior to executing the acquisition agreement.8
If the purchaser will not be entitled to a downward purchase price adjustment on account of particular issues discovered during the interim period, then the next best approach is indemnity protection. Typically, an acquisition agreement provides for indemnity for both "Retained Obligations" and breaches of the seller's representations and warranties. While both may provide post-closing protection for the purchaser,9 the seller's indemnity obligations for breach of non-fundamental reps and warranties are customarily
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subject to thresholds, deductibles and caps along with specified survival periods.10 "Retained Obligations", on the other hand, typically provide dollar one indemnity protection for the purchaser. Thus, the purchaser will commonly seek to classify known or threatened liabilities (such as existing litigation) as "Retained Obligations". However, to the extent a liability is unknown or the seller will not agree to retain a specified category of liabilities, then the purchaser should consider including a responsive representation in the agreement.11
The representations and warranties can also facilitate and focus further due diligence efforts and help the purchaser manage its risk exposure in relation to the acquisition. For example, when a seller rejects certain representations in totality or proposes a carve out that makes the representation no longer meaningful for the purchaser, the purchaser may reasonably interpret those revisions as a signal about specific areas to focus its diligence efforts between signing and closing (or prior to executing the acquisition agreement, if possible). One area where this can be particularly troubling is in connection with the typical representation that seller holds title to its surface rights or right of way sufficient to operate the system. As discussed in more detail below, given the typical volume, surface rights are often impractical (or impossible) for a purchaser to diligence the risk prior to closing and, therefore, any carve outs should be limited in nature.
In addition to indemnity protection and the potential signaling function, the accuracy of the representations and warranties also play a role in determining whether the purchaser is required to close the transaction. As a condition to the purchaser closing the acquisition agreement, it is customary for the seller to "bring down" its representations and warranties (meaning that the accuracy of the representations is confirmed as of the closing).
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However, this closing condition is nearly always limited by...
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