Surging oil and gas output is driving heated demand for midstream assets and capacity in the Permian Basin, which is the top U.S. oil field. With midstream operators in the Permian ramping up capital spending to build out networks to move production to market, and private-equity firms holding record levels of capital looking for deals, we could see a marked increase in midstream mergers and acquisitions (M&A) in 2018.
If the upstream space is a leading indicator, M&A activity in the midstream could be significant.
The Permian Basin holds 60 billion barrels (Bbbl) to 70 Bbbl of untapped oil, according to IHS Markit. In 2017, there were 39 upstream deals in the Permian with a total transaction value of $30.3 billion. The lower production costs of the Permian, relative to other onshore basins, have led to deal mania in the Permian, or “Permania.” Rig activity is robust. Production is growing. Deals are on the rise.
Mind the date
Amid this flurry of activity, it is important for buyers to pay special attention to the structure of their transactions. One important issue midstream investors should consider when leading deals is the concept of an effective date, which can have important tax and cash flow implications.
The effective-date concept essentially transfers the economics of the business from seller to buyer at a date before the deal’s closing date. The concept is used to effectuate a reimbursement from buyer to seller for the seller’s growth capital dollars spent after the effective date. All customary purchase price adjustments, such as net working capital or indebtedness, are measured as of the effective date.
Factors to weigh include:
Leakage—As the effective date and signing date differ, the concept of leakage should be included in the purchase agreement to protect the buyer from value leakage between the effective date and close date. For example, the seller should not be permitted to pay a dividend out of the company after the effective date without reimbursement to the buyer. In PwC’s experience, a robust leakage definition might include:
- Any dividend or distribution of profits or assets declared, or paid by the company;
- Any payments made or agreed to be made by the company to any seller or any other return of capital;
- Any payments made to sellers for the direct or indirect benefit of any of them by the company;
- Any guarantee, indemnity or security provided by the company in respect of the obligations of sellers;
- The waiver, release, deferral or discount by the company of any amount owed to the company by sellers;
- The payment of any item by the company that would otherwise be indemnified by the sellers at or after closing;
- The agreement or understanding by the company to do any of the matters set out above; and
- Any fees, costs or tax becoming payable by the company and/or any of its subsidiaries as a consequence of any of the above four.
Working capital considerations—When establishing a target net working capital amount, the historical net working capital amounts should be adjusted to remove capex payables so that the target setting is not influenced by them. Then, these payables would be included in the calculation of net working capital as of the effective date. It is important to understand the accounting procedures, processes and systems in place to accrue for capex to ensure all unpaid pre-effective date capex are properly accrued for on the effective date balance sheet.
To the extent that the effective date precedes the signing date, the purchase agreement could eliminate the working capital mechanism entirely by including the economic substance of an adjustment directly into the purchase price. This concept is similar to “locked box” closing mechanisms that are popular in European M&A markets.
Target capex—To reduce the likelihood of pre-effective date capex moving into the post-effective date period, we recommend establishing a target threshold or range capital spend amount with a purchase price adjustment for any underspend in the pre-effective date period.
Tax—While an effective-date mechanic seeks to transfer the economics prior to closing, the tax implications remain with the seller until close. Accordingly, in the case of a corporation, the corporate tax footprint continues, and in the case of pass-throughs, interim operating results are passed through to the sellers or sole proprietor.
As a result, a separate set of issues arise in effective date deals. For one, the buyer will want tax control (or at least negative covenants with regard to tax elections, asset/cash distributions, etc.) in order to manage the business and tax profile transferred at closing. In addition, to the extent of pass-throughs, the interim tax-related activities will need to be “trued-up” on closing as the seller will bear the tax costs via allocations of income, expenses, gains and losses (with potential outside basis implications). These factors increase the complexity of the closing day true-up mechanics.
New construction—As midstream companies scramble to build transportation and storage infrastructure to support the increased production in the Permian, some of these newbuilds will not have any operations associated with them. Thus, they may function only as a cost center with little or no revenues and a limited balance sheet. Therefore, it may be difficult to generate meaningful financial information. It’s important, then, to consider how to value these.
Fully considering how an effective date impacts a deal’s economics is crucial, especially at a time when there is a shortage of takeaway capacity and capital outlays are significant, and when after a long downturn U.S. onshore fields are gearing up for several years of sustained growth to help meet global demand.
There will likely be more midstream deals in the Permian, given its geographic proximity to refineries on the U.S. Gulf Coast and producers in the basin who are increasingly orienting themselves to export crude.
The authors are with PwC. Rob McCeney is an energy and infrastructure deals partner, Darin Siders is an infrastructure deals partner specializing in M&A taxes and Kyle West is an energy deals director.
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