ABA Business Law Section Fall Meeting September 13, 2018

Transcription

1 ABA Business Law Section Fall Meeting September 13, 2018 Private Equity Investments in the International Oil and Gas Sector: A Comparative Analysis of U.S., U.K. and Norwegian Practices Energy Business Committee Bradley Ashkin, Julie D Avignon, Ben Hudy, Matt Anstead, Pavithra Mani Materials Summary Abstract In recent years, a worldwide decline in commodity prices has led to a deficit of traditional financing options for many companies operating in the oil and gas sector. Over the past few years, oil prices have risen from 2016 lows and the industry is undergoing a partial recovery, particularly in the United States where production has begun substantially growing. With the industry s partial recovery, new opportunities for private equity investment are becoming available, with many investors undertaking nontraditional investment strategies to fulfil the needs of oil and gas companies at all stages of the business life cycle. In many instances, private equity is filling the gap created by a departure of traditional financing sources from the energy sector. Increasingly, private markets are being relied upon to provide the capital needed for start-ups, restructurings, buy-outs, and various other investment purposes, as required in the evolving price environment for the oil and gas sector. Private markets have been growing rapidly over the past decade with growth rates consistently higher than 8% and assets under management swelling to exceed $5 trillion in This high level of investment flow into private markets is partly a consequence of the decreasing attractiveness of public markets, due to excessive regulation and operating requirements for public companies. In years prior, investment by private equity in the energy sector was relatively limited, in part due to a traditional investment horizon of 5-7 years, but also as a result of the downturn in oil and gas commodity prices. However, in more recent years, new entrants and large investment flows into private funds has resulted in an increasing scope of investment strategies being utilized by private equity funds. These funds are expanding into different target markets with nontraditional investment horizons, often seeking out multi-strategy and long-term investments. The net result of this upsurge in private equity funding and a widening scope of investment strategies has led to increased liquidity being made available to oil and gas companies, particularly in the United States, but also increasingly in European countries. Moreover, private equity firms are able to utilize measures to reduce investment risk inherent in the oil and gas industry by investing in mature basins and by undertaking alternative investment strategies, such as co-investing. Overall, these trends are leading to increased investment flows into the oil and gas sector. Changes in political regimes have also resulted in changing flows of private equity investment across jurisdictions. Global political headwinds remain a challenge for investors in the oil and gas industry in some locations and an advantage others. In the U.S., the election of a Republican President provided a tailwind for the oil and gas industry, and consequently, investment has been increasingly flowing into US oil and gas companies. Conversely, investment in and by energy-focused funds in other jurisdictions has remained relatively flat in other jurisdictions v2

2 - 2 - As well as providing a high-level overview of the commodity cycle, private markets, and political impacts on oil and gas transaction volumes, the program will review common structures employed by US, UK, and Norwegian private equity firms investing in international oil and gas assets. The panel will identify trends in the investment strategies being employed by private equity investors, and discuss the types of funds participating in the market. A particular focus will be placed on comparing and contrasting private equity strategies being utilized to generate return on investment in oil & gas assets. Furthermore, in structuring private equity funds and investments, tax mitigation, including on the repatriation of funds, is often a critical consideration. Therefore, key issues for efficient tax structuring will be identified and an overview of common private equity tax structures will be provided. The impact of various OECD tax reform measures will be examined, including such items as treaty shopping and the measures being taken by the OECD to mitigate tax abuse. In addition, the panel will discuss recent changes to the US tax code and the potential consequences for private equity structuring v2

3 Private Equity Investments in the International Oil and Gas Sector: A Comparative Analysis of U.S., U.K. and Norwegian Practices

4 1 Commodity Cycle and Capital Raising

5 Commodity Cycle Downturn WTI Prices / 2

6 Commodity Cycle Downturn US Production / 3

7 Commodity Cycle Downturn US Production Source: Houlihan Lokey; Oil & Gas Industry Update Q / 4

8 Reserves Replacement Ratio For Conventional Reservoirs Historic Low Unsustainable? 180% 160% 140% 120% 100% 80% 60% 40% 20% 0% Sources: Pareto Securities Equity Research / 5

9 US Independents Have (Finally) Returned to Profitability Sources: S&P Capital IQ, / 6

10 Global OFS A Muted Recovery Sources: Spears & Associates / 7

11 OFS Growth In North America, Not International Sources: Spears Oilfield Market Report / 8

12 North America Some OFS Segments Outperform Sources: Spears Oilfield Market Report / 9

13 Frac Job 1978 (and China Today) Sources: Spears & Associates / 10

14 Frac job stages on 3 wells in the STACK Sources: Spears & Associates / 11

15 # of deals M&A Tracks Large OFS Profitability Still A Buyers Market Whilst International Weakness Persists Q Q Q Q Q Q Q Q Q Q Q # OFS M&A Deals Q Q Q Large OFS Combined EBITDA Q Q Q Q Q Q Q ,000 8,000 6,000 4,000 2,000 - Large OFS EBITDA (USD Billion) Sources: Capital IQ, EV Analysis / 12

16 Private Energy Fundraising Subsector / 13

17 PE Dry Powder By Region Source: EY Private Equity Capital Briefing April 2018 / 14

18 Global PE Dry Powder Source: Preqin Ltd. / 15

19 2 Transaction Trends

20 Transactions - Upstream Source: EY analysis of data from Derrick Petroleum Services / 17

21 Transactions - Midstream Source: EY analysis of data from Derrick Petroleum Services / 18

22 Transactions - Downstream Source: EY analysis of data from Derrick Petroleum Services / 19

23 Transactions Oilfield Services Source: EY analysis of data from Derrick Petroleum Services / 20

24 Private Equity Global Oil & Gas / 21

25 Private Equity Canadian Oil & Gas / 22

26 Private Equity US Oil & Gas / 23

27 Private Equity Europe Oil & Gas / 24

28 Private Equity United Kingdom Oil & Gas / 25

29 Private Equity Norway Oil & Gas / 26

30 3 Tax Structures

31 Key Tax Structuring Considerations Jurisdiction of the investment tax regime in the jurisdiction of investment, which impacts nature of the investment (e.g., equity only, combination equity and debt) and potential tax leakage under that tax regime whether dispositions of equity in the portfolio company are subject to taxation in that jurisdiction (e.g., under FIRPTA or a similar regime) whether that jurisdiction has tax treaties with other relevant countries Countries of residence of the PE investors Taxation of gains (e.g. on exit), dividends and interest Whether those countries have tax treaties with other relevant countries Types of investors taxable investors (e.g., individuals, corporations), tax-exempt investors (e.g., pension plans, endowments, charities and other tax-exempts), other funds (i.e., in fund of funds contexts) Whether any co-investors will participate in the investment Size of the investment and flexibility to dictate structuring Investment and exit strategy of the PE fund / 28

32 Key Tax Structuring Decisions Type of investment vehicles Preference for fiscally transparent (i.e., tax flow-through) entities to mitigate tax leakage to the extent possible For example, partnerships are often used as the investment vehicle The underlying investment is often in a corporate entity, which is typically a taxable entity (subject to available losses and deductions from its business operations) Parallel investment vehicles parallel investment limited partnerships ( LPs ) are frequently used to segregate different types of investors (e.g. based on jurisdiction of residence and/or taxable/tax-exempt status) Structuring carried interests Carried interests can be structured in different ways depending on the type of investment entity and terms of the carry Blocker entities above-the-line blockers: typically used where a blocker is needed in respect of one or more particular investors (e.g., to block types of income for the fund, or to establish a blocker in a particular jurisdiction through which certain investors will invest) below-the-line blockers: where a blocker is needed for the fund as a whole (e.g., to block types of income, such as ECI or UBTI) / 29

33 Common PE Investment Structures Common to form aggregator entity for various investors Frequently PE investments are made through a foreign LP PE fund sponsor owns the General Partner PE fund sponsor s promote may be structured in one of various manners Use of blocker entity may be under increased scrutiny now due to focus of OECD and many of its member countries on treaty shopping and introduction of the multilateral instrument An acquisition company may be formed to acquire the portfolio company in order to establish cross-border stated capital up to the investment amount (potentially followed by a merger with the portfolio company) / 30

34 Common PE Investment Structures PE Sponsor Parallel investment LPs are frequently used to segregate different types of investors (e.g. based on jurisdiction of residence and/or taxable/tax-exempt status) Parallel investment LPs invest in the portfolio company Canadian Investors Special Units Special Units US Investors Special Units International Investors Exit strategy would involve the sale of the portfolio company shares by the three parallel investment LPs Regular Units Regular Units Regular Units Provided the LP is a flow-through for tax purposes in its relevant jurisdiction, the LP is not subject to tax on the gain triggered on the sale of the portfolio company shares Canadian LP GP Unit GP US LP GP Unit GP International LP GP GP Unit The various investors would report their respective share of such gain and be taxed accordingly in their home jurisdiction The jurisdiction in which the Portfolio Company is based may also impose tax on the gain Shares Shares Shares Portfolio Company The general partners ( GPs ) would be entitled to a management distribution The units of the LPs held by the PE Sponsor would entitle it to its carried interest distribution / 31

35 Key U.S. Tax Provisions Business Tax Rate Cost Recovery and Immediate Expensing International Provisions Employee Compensation Interest Expense Net Operating Loss Industry Specific Provisions / 32

36 Corporate Tax Rate Business Tax Rates Maximum corporate tax rate: 21% - Effective for tax years beginning after 2017 Key Provision Could significantly impact valuation and purchase price adjustments for deals now in the pipeline. Corporate blockers would be less expensive to use, although the ability to lever them could become more limited due to the new limitations on interest deductibility, discussed below. Private equity firms will need to quickly assess the impact these changes could have on the cash flows of their U.S. portfolio companies, and consequently, their valuations of these portfolio companies. / 33

37 Business Tax Rates Pass-Through Businesses Key Provision New 20% deduction would apply to certain pass-through business income of U.S. individuals from businesses operated as sole proprietorships, partnerships, LLCs and S corporations. When coupled with the reduction of the top individual tax rate to 37%, this deduction would effectively yield a top 29.6% rate for the taxpayer Given the new 21% corporate tax rate, the double tax disadvantage of operating a U.S. business as a corporation and paying out dividends will shrink compared to the current spread, especially for business income ineligible for the pass-through deduction. Flow through structures maintain advantage in allowing subsequent buyers to refresh basis particularly during the period of immediate expensing of depreciable property. / 34

38 Interest Expense Key Provision The Act generally caps net business interest expense deductions at 30% of adjusted taxable income (ATI). - ATI is roughly equivalent to tax basis EBITDA, but decreases to EBIT for tax years beginning after December 31, 2021, which will make this limitation more severe. Lower U.S. corporate rate, coupled with the more severe 30% EBIT limitation will reduce and in some instances eliminate tax rate arbitrage between many jurisdictions, though repayment of debt principal may still allow for more efficient return of earnings where dividend distributions would be subject to withholding tax. New rules generally apply to all debt and thus put inbound buyers on a more equal footing with domestic buyers in relation to leverage used in transactions. / 35

39 Cost Recovery and Immediate Expensing Key Provision Businesses would be able to immediately deduct the cost of certain property, other than structures, acquired and used between September 27, 2017, and January 1, For property placed in service between December 31, 2022, and January 1, 2027, the percentage that can be immediately deducted is phased down by 20% per year. Unlike prior bonus depreciation regimes, the provision does not require this to be first use of the acquired asset but simply the first use by the acquiring taxpayer. This is a timing benefit of accelerated deductions that would not help all companies; those with significant tax attributes (e.g., NOL c/f) likely would see little benefit. Private equity buyers focused on after-tax cash flows in the early years may find it valuable. / 36

40 Net Operating Losses Key Provision Net operating loss (NOL) deductions arising in tax years beginning after 2017 would be limited to 80% of taxable income. Most NOL carrybacks would be repealed, which could reduce the tax value of transaction expenses, such as investment banker fees, compensatory payments and debt payoff costs. NOLs generated in tax years beginning after 2017 would be carried forward indefinitely. / 37

41 Net Operating Losses Impact/Consequences The 80% limit would slow the ability to use the NOL carryforward in post-closing years and cause cash taxes to be due earlier in an investment s lifecycle. This limit, along with the interest limitation noted above, also may lead highly leveraged companies that generate significant interest expense to become taxpayers more quickly after debt is paid off or revenues increase. / 38

42 Relevant Tax Reform for PE Investment - Canada Recent changes to the treatment of Canadian exploration expenses Oil & gas exploration expenses incurred in Canada in general, fully (i.e. 100%) deductible in the year incurred In contrast, oil & gas development expenses (i.e. for existing discoveries) only deductible at 30% per year (on a declining balance basis) As of 2019, only oil & gas exploration expenses for unsuccessful discoveries will qualify for full deductibility Oil & gas exploration expenses related to any successful discoveries will only qualify for 30% per year deductibility Results in an extended horizon for oil and gas companies to deduct credits for exploration activities GST changes for investment limited partnerships Recent changes to Canada s good and services tax rules General partners will now be deemed to have provided a supply to the partnership equal to the fair market value of the management and administrative services provided to the partnership The rules only apply to partnerships that invest in shares or other financial instruments and not to operating partnerships that hold business assets directly The fair market value concept introduces significant uncertainty The tax rate is generally 5%-15% depending on the jurisdiction of the investors Investment limited partnerships are not eligible for a credit for such tax, which means any such tax is a sunk cost / 39

43 Relevant Tax Reform for PE Investment Treaty Shopping and the Multilateral Instrument Several bilateral tax treaties provide important exemptions or reductions that would otherwise be imposed by source states (e.g. on dividends, interests, or gains from dispositions of certain properties) Canada s tax treaties provide an exemption from the tax on capital gains arising on shares of active Canadian resource companies (e.g. Canada s treaty with Luxembourg and the Netherlands) Accordingly, use of Lux. and Dutch holding entities in oil and gas investment structures is common The OECD launched a Base Erosion and Profits Sharing (BEPS) project a few years ago included an action item on tax treaty abuse and treaty shopping. Countries have anti-avoidance rules in their domestic law, but that is frequently considered insufficient Unlike the US treaties, most other treaties do not contain a limitation on benefits ( LOB ) clause or similar provision The OECD prepared a multilateral instrument to address treaty abuse and other matters. Establishes a minimum standard to prevent treaty abuse through implementation of a principal (non-tax) purpose test and/or an LOB style clause To alter an existing treaty, both countries must be a signatory and have the MLI entered into force As of July 2018, over 80 countries had signed the MLI (including Canada and Norway) although it has only entered into force in a handful of countries so far (UK, on October 10, 2018). The US has not signed. The MLI is expected to have a profound impact on tax structuring, particularly in oil and gas investments. / 40

44 Deal Impact of Tax Reform on Executive Comp. Payments to outgoing executives following a merger or acquisition may cost some companies millions more under the new tax law. Historically, the majority of post-termination payments were deductible. However, any payments in excess of $1 million may now be non-deductible, so companies need to understand the impact of US tax reform when considering their next deal - Lance Forman Partner, PwC New rules resulting from US tax reform (IRC Section 162(m)) effectively eliminated a public company s ability to deduct annual compensation paid to top executives in excess of $1 million. The exemption, which previously allowed qualified performance-based pay (e.g., annual bonus and performancebased restricted stock units) to be exempt from this $1 million limitation, has been removed. The definition of covered employees which previously was defined as the CEO and the 3 next highest paid executives, has been expanded to include the CFO (i.e., now CEO, CFO and the 3 next highest paid). Further, the covered employee status is made permanent. Private companies with publicly registered debt and foreign companies with publicly traded ADRs are now also subject to the $1 million limitation. As the after-tax cost of executive compensation will increase following tax reform, companies will need to take appropriate steps to adapt their programs and corresponding administration in order to preserve compensation related tax deductions. Source: PwC Deals US Oil & Gas Deals insights second quarter 2018 / 41

45 Speakers Julie D Avignon Julie D Avignon is a partner in the Tax Group. Her practice focuses on providing tax advice in connection with mergers and acquisitions, corporate reorganizations, equity investments, flow-through share transactions and financings. Julie has extensive experience working with Canadian and international clients, public and private entities, resource sector clients and private equity firms. Julie has particular expertise in resource and energy taxation, including with respect to Canadian and international oil and gas, mining, and pipeline projects. Ben Hudy Ben Hudy is a partner in the Capital Markets and Mergers & Acquisitions Groups. His practice focuses on securities, corporate finance, mergers and acquisitions, joint ventures and other co-ownership structures and general corporate and commercial matters. Ben acts for public and private issuers, both domestic and international, as well as investment dealers and private equity investors on a broad range of matters including public and private offerings of equity and debt securities, takeover bid and plan of arrangement transactions, asset and share purchase and sale transactions, corporate reorganizations and debt restructurings. Brad Ashkin Bradley Ashkin is an associate in the Corporate Group whose broad transactional practice focuses primarily on mergers and acquisitions and corporate finance and securities. He regularly acts for Canadian and international clients with interests in oil and gas, finance and infrastructure. Bradley has acted on acquisitions and dispositions (both friendly and unsolicited) of public companies, and for buyers and sellers of private businesses and individual assets. He also acts for private equity sponsors and management teams on funding energy startups and has represented issuers and investors on public and private financings and complex commercial arrangements. Stikeman Elliott LLP / 42

46 Speakers Matt Anstead Matt Anstead is a Partner with EV Private Equity (EVPE) in Houston. He currently serves as Non-Executive Director on the board of three oilfield services companies in Canada, USA and UK. Matt is involved in all aspects of EVPE s business, including origination, transaction execution, stewardship and investor relations. Prior to EVPE, Matt worked for Simmons & Co, Booz Allen & Hamilton, Wood MacKenzie and Schlumberger. Matt holds a Masters in Mechanical Engineering from Imperial College London and an MBA from London Business School. Pavi Mani Pavi Mani is a mergers and acquisitions tax partner. Pavi has over 18 years of experience assisting private equity and multinational clients with tax structuring, due diligence, tax modeling and other U.S and cross border deal related matters. Pavi has extensive experience leading large renewable energy, oil & gas, power and utilities and infrastructure deals. She has led large US and global Yieldco IPO structuring. She also has significant experience with leading tax equity and yieldco tax modeling and diligence on tax equity structures and other project financing structures in the renewable energy space. Additional areas of tax specialization include spin-offs, tax-free reorganizations, post-deal restructuring, NOL planning, section 382 analysis, stock basis studies, partnership structures and bankruptcy planning and workouts. Pavi is a Certified Public Accountant and holds a masters degree in accounting and a masters degree in taxation, both from the University of Illinois at Urbana Champaign. Stikeman Elliott LLP / 43