Finding the right fit. Public monetization options for upstream companies
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- Moris Wilkerson
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1 Finding the right fit Public monetization options for upstream companies
2 Traditional corporate IPOs have been pillars of the US capital market since the late 1700s, across all industries. St
3 ructures Since the inception of the first known initial public offering (IPO) of shares during the Roman Republic, one of the most common and well-known forms of accessing capital in the public market has been through a traditional IPO of corporate stock. Traditional corporate IPOs have indeed been pillars of the US capital market since the late 1700s, across all industries. The traditional corporate IPO has also evolved over time into more complex capital and offering structures, including the Up-C structure, which has generated interest from the exploration and production (E&P) sector in recent years. Furthermore, yield-based structures, such as the master limited partnership (MLP) structure and, more recently, the yield-driven company structure, have been efficient vehicles to raise equity and have been strong performers for investors. Since the debut of the US MLP structure in the early 1980s, a significant number of MLPs have been introduced to the market, with more than 120 currently trading today. MLPs can provide access to capital for companies that generate qualifying income at a lower cost of capital while providing investors a higher-than-typical yield. An E&P company that is looking to go public will likely tailor its IPO and capital structure based on a number of factors, including, but not limited to, the following: (i) the nature of the business to be taken public; (ii) value creation; (iii) growth vs. yield focus; (iv) stability of cash flows; (v) governance and control; (vi) market acceptance and demand; (vii) tax cost to sponsor; (viii) acquisition currency; (ix) levels of tax; and (x) employee incentives. Finding the right fit the right structure to access the public markets often requires detailed tax and economic modeling and a thorough evaluation of alternatives (including evaluating and thoughtfully considering strategic goals, growth expectations, and commercial, economic and tax considerations). Which structure is the right structure depends on varying factors. The traditional corporate IPO has evolved over time into more complex capital and offering structures. The MLP IPO An MLP is a publicly traded limited partnership, or a limited liability company, which pairs the tax benefits of a partnership with the capital-raising capability and liquidity of a public company. MLPs typically consist of (a) a general partner, who manages the operations of the partnership and often holds a minor percentage (e.g., between 0 and 2%) of the outstanding MLP units and may own incentive distributions rights (IDRs), and (b) limited partners, who provide capital and hold most of the ownership but have limited influence over the MLP s operations. As a general rule, MLPs do not pay US federal income taxes; conversely, partners each include their own distributive share of the MLP s items of income, gain, loss, deduction and credit when computing their own individual US federal income tax. As a result of the flow-through nature of the structure and the market requirement for the MLP to distribute all available cash (which is defined in the MLP s operating or partnership agreement), cash flow is often increased. In order to maintain MLP qualification (and thus maintain the single level of taxation for US federal income tax purposes), at least 90% of the MLP s gross income must be qualifying income that is, derived from certain activities in natural resources, real estate or commodities, among others. There are two primary types of MLPs: traditional MLPs and variable-pay MLPs. In a traditional structure, the MLP discloses an intention to make minimum quarterly distributions of cash (MQDs) to unitholders. The amount of the MQDs factors into a broader distribution arrangement, which ultimately impacts the dollar-per-unit threshold at which (and in what amount) the MLP sponsor(s) receive IDRs with IDRs effectively representing the right to a disproportionately higher share of available cash above certain thresholds. In a traditional MLP, different types of ownership interests generally exist namely, the general partner interest, the IDRs, common units and subordinated units (which are retained by the sponsor and convertible according to certain events and/or the passage of time). Additionally, the sponsor controls the MLP through its ownership of the MLP s general partner. Finding the right fit 1
4 Strategic Under the variable-pay structure (which is also colloquially referred to as a variable MLP or a variable distribution MLP ), the public owners are not promised any MQD, and, conversely, the MLP sponsor does not receive IDRs. Consequently, both the sponsor and the public owners typically share pro rata in the upside (and downside) of operations. Variable-pay MLPs often take the form of a limited liability company (as opposed to a limited partnership). Certainly, the pressure on MLPs (regardless of whether the MLP is a traditional MLP or a variable MLP) to keep distributions high (and growing) may not always be ideal for E&P companies that need to consistently reinvest cash to keep drilling wells. However, for companies with investments in mature reserves with long remaining lives as opposed to looming significant, capitalintensive drilling programs an MLP may be the best strategic move. In fact, successful upstream MLPs (both traditional and variable-pay MLPs) are often focused on properties with low decline rates and/or significant sponsor-retained assets (with a high ratio of provided developed producing reserves) both to maintain distributions and to communicate a growth story to the market. Traditional corporate IPO A traditional corporate IPO is the most common and wellknown form of accessing public capital. In its most basic sense, a sponsor company would transfer assets to a newly formed corporation, and that corporation would file an S-1 Registration Statement with the Securities and Exchange Commission (SEC) and ultimately issue stock to the public. If the sponsor entity currently holds assets in an arrangement that is classified as a partnership for US federal income tax purposes, further consideration should be given to the method of conversion (and timing) to a corporation in preparation for an IPO (e.g., assets-over, assets-up, interests-over or formless conversion). The traditional corporate structure generally results in two levels of tax (double taxation): the corporation pays tax on its earnings, and the shareholders generally pay tax on distributions (dividends) received from the corporation. Further, investors in a traditional, publicly traded corporation would receive a Form 1099, which can result in broader investment interest from tax-exempt investors and non-us investors (who generally prefer corporate investments for US federal income tax reasons). Similarly, institutional investors have historically preferred corporate investments for the same reasons, although the MLP investor base has evolved over time to include an increased percentage of institutional investors. For many E&P companies, the traditional corporate IPO makes the most sense, even in the current market. Since the valuation of these companies is generally based on earnings before interest, taxes, depreciation and amortization (EBITDA) (and not forecasted distributions to shareholders), the company is generally free to use available cash to fund drilling programs or make other accretive investments or improvements to new or existing assets. Further, corporate stock (including preferred stock) can be an incredibly flexible transaction currency for use in a variety of tax-deferred transactions. Additionally, public companies have a number of well-established means of compensating their employees with equity, including incentive and nonqualified stock options, restricted stock and restricted stock units. The Up-C IPO Another option is called the Up-C, which is a variation of the traditional corporate IPO. Depending on the underlying facts and tax posture of the relevant parties, an Up-C IPO may be a taxefficient alternative to a traditional corporate IPO, and, similar to a traditional corporate IPO but unlike an MLP, the structure does not include a market obligation to grow distributions over time. 2 Finding the right fit
5 fit Several E&P companies have used this structure over the past three years, and it is expected to grow in popularity. Under the Up-C structure, the sponsor company creates a subsidiary holding company (either a limited liability company or a limited partnership, often referred to as OpCo), which owns the operating assets and is flow-through (either disregarded as an entity for US federal income tax purposes or classified as a partnership) for US federal income tax purposes. The sponsor then contributes nominal consideration to a newly formed corporation (referred to as PubCo, which is eventually taken public) in exchange for high-vote, low-value shares (sometimes referred to as golden shares ). With the high-vote, low-value shares, the sponsor retains control over PubCo. PubCo then files an S-1 Registration Statement with the SEC and offers stock to the public in an IPO. As in a traditional corporate IPO, investors would receive Forms 1099 (as opposed to a Schedule K-1, as an investor would typically receive in an MLP). After PubCo s IPO, the offering proceeds are typically contributed to OpCo in exchange for an interest therein. In connection with the overall offering, the sponsor, OpCo and PubCo often enter into both an exchange agreement and a tax receivable agreement (TRA). Under the exchange agreement, the sponsor often has the right to exchange its OpCo interests for PubCo shares of common stock (which would ultimately provide the sponsor with liquidity if the sponsor then sold the PubCo shares on the secondary market). When the sponsor exchanges OpCo interests for PubCo shares, a couple of interesting results transpire: first, the transaction is fully taxable to sponsor, and second, PubCo receives a tax-basis step-up in the interests in OpCo (which trickle down to the underlying OpCo assets) that PubCo receives in the exchange. However, the story does not end there. In connection with the exchange, the agreements typically provide that the sponsor receives 85% (although the percentage could be higher or lower, Finding the right fit 3
6 Long-term as agreed upon by the parties) of the tax benefit that the stepup provides to PubCo (remember, PubCo receives a step-up in tax basis in connection with the sponsor s exchange of OpCo for PubCo interests at no cost to PubCo). Each year, PubCo will perform a with and without calculation a tax calculation to determine what the tax benefit of the step-up to PubCo was in connection with the exchange. At the end of each year, PubCo would then pay to sponsor 85% (in this example) back to the sponsor (which would be taxable to the sponsor upon receipt). The tax benefit payment could be beneficial to the sponsor s with both appreciated assets and assets that will be in a tax-paying position. If the sponsor has appreciated assets (i.e., where the fair market value exceeds the tax basis of such assets), PubCo would generally receive a higher step-up in connection with the exchange which could ultimately result in a higher tax benefit payment under the TRA. Similarly, if the assets held under OpCo would generally produce positive taxable income, the with and without calculation could also yield positive results to the sponsor. Conversely, if PubCo is not in a tax-paying position (either because of deductions, net operating losses, credits, or other reasons), then the tax benefit payment may be significantly delayed (which would reduce the net present value of the payments). Stated differently, if PubCo is not in a taxpaying position, there is no tax benefit to the step-up (as PubCo s tax liability would be $0 under both the with and without prongs of the calculation). For an E&P company with a scheduled drilling program or significant capital expenditures on the horizon, it is critical to properly model out the tax consequences (and benefits of the TRA payment) to determine the value of putting the Up-C structure in place. This structure can be appealing to a sponsor looking to monetize a portion of its business through a public exit since the exchange agreement provides the sponsor with liquidity at the time of the exchange (i.e., shares of a publicly traded entity), while the tax receivable agreement effectively cash-shields a portion of the sponsor s gain resulting from exit. Although similar to the earnings of a traditional public corporation, a PubCo s earnings are subject to two levels of tax (i.e., at both the PubCo and the shareholder levels), the sponsor (or sponsors), through its retained interest, may obtain the benefit (if any) of the flow-through status of OpCo for tax purposes, including that it may be able to offset its allocable share of income with operating losses from other operations. Finding the right fit Each structure has its benefits, but the unique characteristics of the company will guide the State what the decision is about. Income derived by E&P companies (those that own an interest in reserves and subsequently explore and develop those reserves) will oftentimes fall under the definition of qualifying income for MLP purposes, but market pressures for continued growth and distributions of available cash need to be thoughtfully considered. The potentially higher market multiples that MLP IPOs might attract compared to a corporate IPO will often play a role in the decision-making process. Other E&P companies looking to raise public capital may determine that the distribution profile of an MLP opposes the core demands of their business model and opt for a more traditional capital structure through a corporate IPO. The traditional corporate IPO is easy to understand and is generally well accepted in the market. Although the valuation multiples 4 Finding the right fit
7 strategy that are typically associated with a traditional corporate IPO may be lower than an MLP IPO, aligning the capital structure with the needs of the business may provide greater value in the long run, particularly for a sponsor that is not looking for a quick exit. Although the distribution structure and valuation multiples using the Up-C structure are similar to a traditional corporate IPO, the Up-C structure can be particularly beneficial to a sponsor that is seeking to wholly or partially monetize assets, while maximizing after-tax cash flows; however, a significant amount of additional complexity arises from a tax and accounting perspective that may be challenging for a company with a lot of assets to monetize (e.g., yearly computation of the tax benefit the with and without calculation). Ultimately, the decision often comes down to both (a) the longterm, strategic direction of the company (e.g., reinvestment versus distribution of cash flows) and (b) the outputs of detailed tax and economic modeling to determine the net present value of the cash flows resulting from each structure. Experience counts EY has experience in helping senior executives understand the benefits and challenges that these structures offer. Our team can help you understand the complexities of each structure and make a well-informed strategic decision one that can helpyour management team increase value and stimulate growth in the years to come. Finding the right fit 5
8 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member organizations of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. How EY s Global Oil & Gas Sector can help your business The oil and gas sector is constantly changing. Increasingly uncertain energy policies, geopolitical complexities, cost management and climate change all present significant challenges. EY s Global Oil & Gas Sector supports a global network of more than 10,000 oil and gas professionals with extensive experience in providing assurance, tax, transaction and advisory services across the upstream, midstream, downstream and oil field subsectors. The Sector team works to anticipate market trends, execute the mobility of our global resources and articulate points of view on relevant sector issues. With our deep sector focus, we can help your organization drive down costs and compete more effectively EYGM Limited. All Rights Reserved. EYG No. DW _SW ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com/oilandgas/mlp Contact us Greg Matlock MLP Leader Ernst & Young LLP greg.matlock@ey.com Connect with us Visit us on LinkedIn Follow us on See us on YouTube
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