CHAPTER 5 DUE DILIGENCE FROM INVESTOR|FINANCING PERSPECTIVE
| Jurisdiction | United States |
(May 2011)
DUE DILIGENCE FROM INVESTOR/FINANCING PERSPECTIVE
Jolisa M. Dobbs
Thompson & Knight LLP
Dallas, Texas
BRIAN MINYARD is with the firm of Thompson & Knight LLP in Dallas. His practice focuses on commercial finance and general corporate law, emphasizing structuring, negotiation, and documentation of a variety of business transactions. His experience includes secured and unsecured credit facilities and other specialized financing transactions, acquisitions, and general corporate matters.
JOLISA MELTON DOBBS is a Partner at Thompson & Knight LLP in Dallas. Her practice focuses on oil and gas transactions. She counsels clients in the areas of acquisitions and dispositions of properties; oil and gas secured lending; and acquisitions and dispositions of natural resources companies. She works in close contact with the Firm's Finance and Corporate and Securities Practice Groups. Ms. Dobbs also has expertise in oil and gas title due diligence in acquisitions of properties, and she regularly advises clients regarding exploration and production activities, including preparation of agreements and COPAS issues. She also advises mineral owners on leasing. Ms. Dobbs is an active member and prior scholarship recipient of the Rocky Mountain Mineral Law Foundation. She is also a frequent speaker and writer on various oil, gas, and energy topics, including "Keeping it Fast by Merging Around Consents to Assign," published in the State Bar of Texas Oil, Gas, and Energy Resources Law Section Report, and "The Purchase and Sale Agreement - The Seller's View," presented at a Rocky Mountain Mineral Law Foundation Special Institute.
1. INTRODUCTION.
A. The Financial Crisis and its effects on investment diligence.
The financial crisis that began in 2007 is widely acknowledged to be the worst financial markets disruption since the Great Depression.1 The roots of the crisis have been attributed to everything from the development of exotic financial products like sub-prime mortgage backed securities and complex financial derivatives and credit insurance instruments, to the deregulation of financial markets around the world, to public policy initiatives distorting otherwise healthy market forces. The effects of the crisis, however, are far less subject to debate. When participants in the financial markets ceased to believe their counterparties were credit-worthy, the financial system began to freeze and the ability of all market actors to access the capital markets became extremely limited.
Market participants had good reason to be suspicious of their counterparties - the International Monetary Fund estimated that large western banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009.2 These institutions kept their individual losses and exposures a closely guarded secret to prevent "runs" on their banks or trading against their positions by their competitors in the markets that would further increase their losses. Since no participant felt confident that they understood the financial health of their trading partners, banks and other institutions simply quit lending money - either among themselves or to other businesses - the risk of loss was too high and the banks wanted to maintain what cash they had to off-set possible future losses. When institutions like Lehman Brothers and AIG failed spectacularly, no financial institution could predict who might be next.
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The sources of liquidity dried up for most companies as the capital markets ceased to function correctly. This led to either further failures and bankruptcies of leveraged companies or, in the case of energy companies, to companies that were faced with a land-rich/cash-poor situation. At the same time as the financial markets seized, it became clear that the global economy was in a recession. The decaying financial condition of market participants given both a financial markets crisis and a general economic recession led to still more failures, and the cycle fed upon itself. Of particular concern to the energy industry was the deflation of the commodity price bubble in late 2008, which led to rapid declines in energy prices. Shrinking borrowing bases and declining stock prices with little resort to the equity and debt markets (so readily available in years past) provided few opportunities to improve a company's balance sheet.
The credit market crisis and general decline in overall economic conditions had massive effects throughout the global economy, but the impact on banks and financial institutions in particular has been quite pronounced. This differential in sensitivity to the financial crisis results from a number of structural issues related to banking, including the regulated nature of many lenders, the ability of equity investment entities to place limits on the ability of their investors to recall investment capital, and the differing risk profiles of the target investments to begin with (lenders being far more sensitive to any one individual deal underperforming).
As a result, our experience has been that equity investors, while they may be more cautious in making individual investment decisions in the current environment, have not materially changed the way that they approach the diligence process. As the equity investment process is generally relationship driven, both before and after the recent capital markets disruption, there is less need to change the conduct of due diligence. Although equity investment experienced an overall reduction in activity due to the recent financial crisis, when the "right deal" did come along, the title and property diligence underlying the investment remained materially similar to the type of diligence performed prior to such financial crisis.
A portion of the reduction in equity transactions involving the purchase of assets resulted in the shift of the market from a "seller's market" to a "buyer's market" as the price of natural gas and oil slipped and the funds to finance such acquisitions dried up. Investors with ready cash looking to invest their money in an area away from the capital markets were in a prime spot for investing in oil and gas properties - be it through an equity position in a newly formed entity, through the sale of project units or a similar private placement type investment, or through the joining of only a handful of capital investors in the newly formed entity. In a seller's market, buyers are more likely to assume a variety of risks including the assumption of environmental liabilities (both pre- and post-effective date), shorter indemnifications or seller's representations survival periods, and even assumption of some risk for pre-effective date ownership or operation liability. Equity investors and sellers quite frequently failed to reach a middle ground in 2009 to reflect a shift in such risk allocation.
This was especially true for monetizations. With the credit markets unavailable, some companies looked to monetizations to continue the development of their properties and raise cash for other operations to be performed by the company. In a typical monetization, the assets of the company are sold to a newly formed special purpose entity in which both the company and
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the equity investor are owners. The seller may also retain a small undivided share in the properties outside of this newly formed special purpose entity. In a monetization, the selling entity will typically increase its partnership (or other entity type) ownership percentage upon the equity investor receiving a targeted return on investment.
Lenders should generally follow the same strategy in good times and bad, but this is often not the case. While the nature of the information a lender may want to know about a potential borrower should not change depending on the economic cycle, in practice, lenders often undertake less diligence during good economic times and arguably over-perform diligence reviews in more difficult times. This behavior relates to (i) the fungible nature of debt capital - lenders begin to compete on price and perceptions of client service (and an extensive diligence process is conducive to neither), (ii) declines in the lender's other loans creating pressure on the regulatory metrics of the lender's own financial health which causes the lender to become hypersensitive to potential risks and (iii) shifting power within the lender's organization, which results in relatively more power in the hands of the credit officers, which are incentivized to minimize losses, as opposed to the relationship managers, who are incentivized to close investments and acquire assets. These changes relate to the overall comfort level of the lender with risks and therefore produce changes in how lenders approach due diligence and what they expect to get out of the process.
B. Differences between debt investments and equity investments.
Lenders and equity investors obviously have different expectations with respect to the appropriate level of risk of their investments and are also faced with differing economic assumptions that must be met in order to guarantee an anticipated rate of return on this investment. They therefore often have differing goals when conducting diligence reviews prior to investing. These differences can even manifest themselves when the subject of the diligence reviewed is effectively the same.
a. Debt investment diligence expectations.
Debt investments are structured to achieve relatively low risk in return for a lower investment return when compared to an equity investment. The debt investment is a highly structured relationship between the lender and the company3 during the term of the investment.
To provide the required protection, the documentation governing a debt investment will restrict the ability of the company to take actions that...
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