Over the past two years, public oil and gas companies’ stock prices reacted to an environment of instability not recently felt in the booming industry. This time, investors concerned with their brokerage accounts and retirement funds were not the only ones closely watching prices. Private equity funds closely tuned in as well, as they considered past and future exit opportunities.
While the price of oil has fluctuated over the years based on demand, new technology, natural disasters, geopolitics and general market conditions, few private equity firms historically invested billions of dollars in upstream, midstream and downstream assets. The private equity boom of the 2000s injected substantial funds into the market. Investors during that time may have experienced gradual fluctuations interspersed with a few outliers, but the market presented itself as generally stable. However, the market’s recent erratic nature presents a challenge to private equity firms seeking to exit their investments.
After three to five years, most private equity firms are interested in monetizing their investments. That monetization can come in a variety of forms, the most common being (i) a sale to a public company, (ii) a sale to a private company, and (iii) a combination with another party to create a larger company. Once popular, IPOs are less frequently used, given the state of public markets and expenses incurred in going public.
Selling to a public company has significant advantages as an exit option, since public companies have access to capital and can afford a large purchase price. Public companies can also combine cash with publicly tradeable stock that – while not as liquid as cash – is a relatively liquid form of consideration with potential to increase in value over time.
However, with recent rapid stock price swings, and with boards of public companies requiring more cash to be held on the balance sheet, a public transaction is no longer as appealing. Additionally, private equity sellers have little taste for risking a steep decline in stock prices while they wait for lock-up and holding periods to expire. Further, sellers are not receiving the aggressive purchase prices seen in years past when public companies had access to more cash.
Sale to a Private Company
A private equity seller might also consider a sale to another private company, which may or may not be owned by another private equity firm (maybe even a competitor). Private company buyers will not have access to publicly traded securities to include in their purchase price, but they will have the same access to debt and equity financing if cash is not plentiful. However, the same debt and equity financing sources a private company might consider may also have their money tied up in public investments subject to the same price fluctuations. In that circumstance, a circular problem emerges where a company is interested in a private sale to avoid the problems with the public market but the financing available in the private sale is still dependent on the public market.
Combination and Cost Minimization
Another exit option is combining portfolio companies, or adopting another strategy that minimizes overall costs to the private equity fund. In addition to portfolio combination, some examples of cost-minimization include limiting capital spend and operating the current assets in a manner to create cash-flow as opposed to building the assets out to create future sale value. All of these strategies can help the private equity funds’ balance sheet, but are less likely to generate the kind of returns to which the funds and their limited partners may expect. An added complication is the reaction to such a combination in the market and among potential management team members that the private equity fund may want to engage in the future.
To combat the complications mentioned above as the price of oil continues to fluctuate and to protect the deal value achieved (even if not as high as desired), private equity sellers might consider the following in their transactions:
Consider whether your investment banker would be willing to put together a financing package for buyers on the front-end of the process. If you are able to show potential buyers that there is at least one financing package available, potential buyers may be more optimistic and receptive to higher purchase prices.
No Financing Conditions
Sellers should not permit any financing conditions. Since seller will have to remove itself from the market while it waits for a potential buyer to secure financing, seller could miss out on a different deal and general market conditions could worsen. When the market is already fluctuating so much and the public markets are impacting public and private sales, a seller should expect some sort of compensation for accepting such risk.
Reps and Warranties Insurance
Sellers should limit their post-closing exposure and indemnification obligations by requiring purchasers to acquire reps and warranties insurance. Reps and warranties insurance can cover almost all operating reps and special policies can be purchased for fundamental reps, tax matters and environmental matters for a premium (that may be modest when compared to potential future liability). It has also expanded and is available for not only the midstream and services industries but also exploration and production activities. The market is also moving toward a no-seller liability model where post-closing obligations are very minimal. This blog covers reps and warranties insurance in more detail here.
Broader Registration Rights
If a public company deal is made, sellers should consider increasing the flexibility of their registration rights (in number, how often registration can be requested, when registration can be requested, who will pay fees, and what type of secondary offering will the registrant assist with and permit). Sellers will need to take advantage of a good market as soon as it is available with as few restrictions on registration as possible.
If a private equity seller does not want to combine two or more of its own portfolio companies, it might consider combining with a separate private equity fund’s portfolio company. The new company could minimize capital spend and also reduce general and administrative expenses for both funds, while potentially creating a larger company that would be primed for a sale when market conditions stabilize. Challenges to this approach include marrying the correct synergies and ensuring the appropriate personnel from both ventures are retained.
Wait and See
If the market conditions are not right, some private equity sellers may try to cash-flow the business and survive on production or fees until the market turns around. While this strategy may work for the short-term, eventually the fund’s limited partners will want to ensure that their investments are being put to work in the most advantageous way possible and look for larger returns.
With the public markets in flux, it is not surprising that M&A activity, especially in the oil and gas sector, has slowed. There are some steps that sellers can take to protect themselves and limit exposure, but the same huge returns realized by investors just a couple of years ago will likely be rare until the public market stabilizes.