Investors have shown an inordinate amount of attention to the midstream sector over the past 12 months as energy companies try to figure out how to pull additional oil and gas production out of unconventional plays and bring them to market. The ongoing attention has spurred renewed interest in mergers and acquisitions, and for the first time in recent memory, an old-fashioned takeover fight broke out as two midstream players vie for the acquisition of a third midstream company.

At stake is who will acquire Houston-based Southern Union Co., a natural gas gathering and processing company with more than 20,000 miles of gathering and transportation pipelines, 7.4 billion cubic feet (Bcf) per day of transport capacity and 87 Bcf of storage. Southern Union’s assets will help form the largest network of natural gas pipelines and processing facilities in North America for the company that ultimately buys it.

The assets are attractive enough to draw multiple rounds of offers from two different bidders, and analysts say there could be other potential bidders watching from the sidelines. Each offer was a little more attractive to Southern Union Co shareholders than the previous and, at press time, it was still not clear who would win the company.

First offer

Dallas-based Energy Transfer Equity LP struck first, in mid-June, when its executives announced that the company agreed to acquire Southern Union for $7.9 billion in an all-stock transaction. The deal included some $4.2 billion in equity, or $33 per share, and the assumption of $3.7 billion in Southern Union debt.

Under the terms of the initial agreement between Energy Transfer and Southern Union, stockholders of Southern Union would exchange their shares for newly-issued Series B Units of Energy Transfer with a value of $33 per share, or about $4.2 billion. At the time of the announcement, $33 was nearly a 17% premium to the price of Southern Union’s previous closing price.

The agreement provided for a complex scheme by which Series B unitholders would be able to redeem their shares for $33 in cash or a specific number of Energy Transfer Equities. Southern Union shareholders and regulators still need to approve the offer and it’s no longer clear that this will occur.

“The acquisition of Southern Union will give Energy Transfer a larger, more competitive interstate and midstream platform and will add demand-driven pipeline assets to our portfolio.” —Kelcy Warren, chairman, Energy Transfer Equity LP

If the deal does close, the combined footprint of Energy Transfer and Southern Union would include more than 44,000 miles of pipelines and about 30.7 Bcf per day of capacity. When the initial announcement was made, executives from both companies took turns praising the deal, stressing how good it was for their respective shareholders.

“Our financial position will remain strong with more stable cash flows, a solid liquidity position, a high quality base of long-term customers and continued flexibility to raise capital,” says Martin Salinas, chief financial officer of Energy Transfer Partners.

Other executives also gushed: “The acquisition of Southern Union will give Energy Transfer a larger, more competitive interstate and midstream platform and will add demand-driven pipeline assets to our portfolio,” Energy Transfer Equity’s chairman Kelcy Warren said in a press conference announcing the results, while noting that the acquisition would increase Energy Transfer’s cash flow profile and allow it to save $100 million a year in commercial and operational synergies.

Understandably, Southern Union executives were happy with the arrangement, professing that the deal would give its shareholders multiple options for a solid return.

“We are thrilled with the opportunities the transaction with Energy Transfer creates. Under our management, we have grown Southern Union from a value of approximately $125 million to about $8 billion. The combination with Energy Transfer is the right next step for the company’s growth and delivers significant value for our shareholders,” says George L. Lindemann, chairman and chief executive of Southern Union.

“Our proposal provides significantly greater value to all Southern Union shareholders than they would receive from Energy Transfer.” —Alan Armstrong, president and chief executive, Williams Cos.

Second suitor

Analysts initially lauded the deal, saying it was a fair price for both sides. Southern Union’s stock rose about 17% the day of the announcement, to just above $33 per share for a few days, an affirmation that investors generally agreed with the price assessment.

Yet, a few days later, Tulsa-based Williams Cos. Inc. shocked the midstream industry with an unsolicited $39 all-cash offer for all of Southern Union shares. The normally sleepy pipeline industry was shaken by the unexpected takeover attempt, driven by market perception that assets which move hydrocarbons to market are sorely needed right now. The total value of Williams’ bid was assessed at $8.7 billion, compared with Energy Transfer’s bid of $7.9 billion.

“Our proposal provides significantly greater value to all Southern Union shareholders than they would receive from Energy Transfer,” contends Williams’s president and chief executive. Like the Energy Transfer offer, Williams would assume $3.7 billion in Southern Union debt. The big question now in the minds of many investors and market analysts is whether Williams can make good on an all-cash offer worth $4.86 billion. To that end, Barclay’s Capital and Citi, acting as financial advisors to Williams, have announced that they are “highly confident” Williams will be able to make the purchase price. Carl Kirst, an analyst for BMO Capital Markets, says the announcement was tantamount to an endorsement of the bid and an agreement to finance it.

The unexpected offer was initially embarrassing for Southern Union executives, who appeared to have undervalued their own assets. Remarks from the previously-gushing executives grew scarce and the only additional statements about the deal came through cryptically-worded pronouncements filed with regulators.

“Our financial position will remain strong with more stable cash flows, a solid liquidity position, a high quality base of long-term customers and continued flexibility to raise capital.” —Martin Salinas, chief financial officer, Energy Transfer Partners

Exit packages

As analysts pored over the details of the two proposals, it became clear that Energy Transfer’s offer included some expensive executive perks that benefit some shareholders more than others.

For example, Southern Union’s Lindemann and president Herschmann signed non-compete agreements and consulting agreements with Energy Transfer with $50 million going to each over five years.

The existence of non-compete and consulting agreements are common in mergers, but the size of these commitments surprised the analysts, particularly given their most recent compensation. In 2010, salary and bonuses for Lindemann was $7.7 million, while Herschmann received about $7.3 million, according to proxy statements filed with the SEC.

As the two competing offers attracted attention in the mainstream media, Energy Transfer met quietly with Southern Union shareholders to gauge their reaction to the two offers on the table. Energy Transfer’s Warren called their feedback, “concerning and informative.”

“We learned that many Southern Union shareholders could not own a Series B preferred. In addition, we found that few shareholders felt they would ever receive Energy Transfer units. They would either be cashed out or receive the Series B preferred dividend,” he says. The feedback from shareholders, as well as the unexpected offer from Williams, forced Energy Transfer back to the drawing board to come up with a better offer.

Energy Transfer made an amended merger agreement, which became public two and a half weeks after the original one, valued at $8.9 billion, including the assumption of $3.8 billion in debt. Under the terms of the revised agreement, Southern Union shareholders can receive $40 per share or 0.903 Energy Transfer shares for every one of their own. Energy Transfer will allot up to 60% of its aggregate offer in cash. The offer beat Williams’ offer and gave investors the option to hold a stake in a master limited partnership. Also, Southern Union’s top two executives announced they would forego their consulting and non-compete agreements.

Analysts generally agreed the offers were getting better with each successive round. Energy Transfer’s revised amendment represents a premium of more than 42% above the price of Southern Union stock on the day before the original merger agreement was made.

“We have listened to Southern Union shareholders and are providing a superior yet simpler transaction, including a significant cash component with the opportunity to benefit from Energy Transfer’s upside through the ownership of common units,” Warren says. “We believe this structure provides everything the shareholders need.” There is enough demand for Energy Transfer Equity shares that those who want cash will have it.

“It’s a proxy fight, pure and simple. In the end, the law requires that you go with the highest bid.” —Charles Elson, law professor and director, University of Delaware’s Weinberg Center for Corporate Governance

The smell test

Along with the revised offer, Energy Transfer announced it will drop down Southern Union’s 50% interest in Citrus Corp., which owns the Florida Gas Transmission pipeline system, to its subsidiary, Energy Transfer Partners, in exchange for $1.9 billion in cash. The drop down of Citrus to Energy Transfer Partners allows Energy Transfer Equity to deleverage its balance sheet upon closing and provides it with an interest in one of the best pipeline systems in the U.S., Warren says.

Kirst says he considers Energy Transfer’s original offer a fair one and endorsed it when it was initially announced. BMO Capital Market’s 12-month outlook for the price of Southern Union, immediately prior to the announcement, was $34 per share. When Energy Transfer offered equity worth $33 per share plus 8.25% annual dividends, the present value was between $34 and $35 per share.

“This, to us, passes the smell test,” says Kirst. “It’s not like Energy Transfer was stealing Southern Union. The Energy Transfer deal for Southern Union was a solid deal for Southern Union shareholders in a vacuum, but I do think the deal from Williams is better,” he says.

Williams’s all-cash offer of $39 per share was better for its simplicity and higher price. The amended offer from Energy Transfer beat that, forcing Williams to make another offer worth $9.4 billion all cash offer. The second offer from Williams was worth $44 per share in cash.

Southern Union shareholders had some legitimate reasons to be skeptical of Energy Transfer’s initial bid, but its revised offer alleviates all of those concerns, Kirst says. The amended agreement creates a more equitable treatment for Southern Union shareholders who opt for cash and those who choose to take Energy Transfer shares. Also, the amended offer is easier to understand with no possibility of being called at a price below conversion. The revised offer also removed the contentious corporate perks. Taken together, all of these characteristics make the latest offer the best so far, Kirst says. But the fight might not be finished, and Williams could easily make another attempt at winning over Southern Union shareholders.

“Energy Transfer now has put together a transaction which is easy to understand and is more easily comparable to the other bidder. All of this clarity does make it easier for a third bidder to enter the race. The stakes are a lot easier to follow now.” —Tim Buford, partner, BDO USA LLP

“Anytime you have a proxy battle, this is going to get messy. I don’t see how we leave this without a lawsuit being filed somewhere,” Kirst says. “It may not necessarily stop something from happening one way or the other, but at some point you are going to have a disgruntled party who is going to seek a settlement in the courts.”

The market price for Southern Union stock, meanwhile, has risen with each successive offer. In the days after the announcement of Energy Transfer’s price, the market price for Southern Union shares rose abruptly to a range between $33 and $34 dollars. Since Williams made its bid, the value has fluctuated between $39 and $40 a share. After Energy Transfer’s amended offer, its price surged past $40.

Tax advantage

Tim Buford, a partner at BDO USA LLP, agrees the latest offer from Energy Transfer trumps the one from Williams. “The current best offer is from Energy Transfer,” he says. “ETE now has put together a transaction which is easy to understand and is more easily comparable to the other bidder. All of this clarity does make it easier for a third bidder to enter the race. The stakes are a lot easier to follow now.”

Energy Transfer should have no trouble carrying through with its latest offer, Buford says. The pass-through tax status of a master limited partnership is also expected to draw at least some of the Southern Union shareholders. In fact, senior executives at Southern Union have already pledged 14% of their votes to the latest offer and agreed to take Energy Transfer shares.

Profits in Citrus, for example, are currently taxed twice—once at the corporate level and again at the shareholder level. If the merger goes through with Citrus shares, they will only be taxed once, a tax advantage for owning master limited partnership shares, Buford explains. Williams offer was all cash, so its offer did not include the tax benefits benefit of an MLP.

“Southern Union must be pretty confident that no more than 60% of the shareholders will ask for cash,” he say, and notes that the higher offer from Energy Transfer gives the two top executives at Southern Union approximately the same value they would have received from the initial offer with the executive perks.

Another tax advantage of the offer from Energy Transfer is that Southern Union assets can become a feeder for a master limited partnership. Energy Transfer Partner, a subsidiary of ETE, retains the right of first refusal for all Southern Union assets, Buford says.

“Anytime you have a proxy battle, this is going to get messy. I don’t see how we leave this without a lawsuit being filed somewhere.”– Carl Kirst, analyst, BMO Capital Markets

Proxy fight

So why the continuously competing offers, if an initial agreement has been struck? The disagreement boils down to an old-fashioned proxy fight, says Charles Elson, a law professor and director of the University of Delaware’s Weinberg Center for Corporate Governance. Generally, the initial agreement between two merging companies is considered a binding contract on both parties, but there is always a fiduciary-duty clause that requires the target company to act in the best interest of its shareholders. If a better offer comes along before the deal closes, management is generally required by law to accept the other offer, Elson says.

“It’s a proxy fight, pure and simple,” he says. “In the end, the law requires that you go with the highest bid.” It’s hard to predict who will win the fight or how long it will take, but Elson says these disputes generally take a few months to play out. In some cases, they can take as long as a year. The complexity of the Energy Transfer bid allows much room for debate about which bid is worth more, and Elson says the issue will ultimately be decided in a lawsuit. “It will go to the courts. There will be lawsuits. There always are.”

Meanwhile, the perks originally offered to Southern Union senior executives would have been hard to defend in a lawsuit, he says. “From the shareholder’s standpoint, that’s a little problematic. The question is: Is that money that should have gone to shareholders in the offer? It’s obviously given to the executives to ensure their cooperation in the sale of the business. But is that effectively money that belongs to the investors? And that typically will be criticized by investors? It will be a point of argument for the other offer.”

Stay tuned

In Elson’s opinion, although the legal status of Energy Transfer Partners as a pass-through tax entity enhances the value of its bid, it’s hard to put a dollar amount on the value of the tax savings from that offer. “Both sides will argue over the value of the tax savings,” he says.

Elson says he is unsure who will win this dispute, but the court system will likely decide who makes the best offer. “It’s hard to make predictions. Generally, anyone who offers you more money and more cash wins.”

The offer from Williams, an all-cash offer for $39 per share (and later by $44 per share), by comparison, is simple. “That’s probably why they did it. They want the business. The other offer is complicated and has those executive parachutes that most investors find problematic. Why should the former executives walk off with that type of money, particularly from their shareholders?” he asks.

If Southern Union management does ultimately go with the offer from Williams, its agreement with Energy Transfer makes it expensive. That agreement contains a breakup fee if either side fails to abide by its terms. The breakup fee rose from $92.5 million in the first agreement to $162.5 million in the second.

All the analysts agree that the outcome of the deals is still hard to predict. Energy Transfer may make a counter offer to Williams, a third bidder may enter the scene, or Southern Union could go with one of the two offers it has on the table now. “We’re just going to have to sit back and watch this,” Elson says.