Tax Executives Institute: Current Trends in Capital Market Transactions

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1 Tax Executives Institute: Current Trends in Capital Market Transactions February 22, 2017 Chris Lallo EYU Aparna Talluri Koneru The way we develop our people

2 Oil and gas industry overview Page 2

3 Spot oil and gas prices US$/bbl Sep- 12 Dec- 12 Mar- 13 Jun-13 Sep- 13 Dec- 13 Mar- 14 Jun-14 Sep- 14 Dec- 14 Mar- 15 Jun-15 Sep- 15 Dec- 15 Mar- 16 Jun-16 Sep- 16 Dec- 16 US$/million BTUs $120 Oil (NYMEX WTI) Gas (NYMEX Henry Hub) $6 $100 $5 $80 $4 $60 $3 $40 $2 $20 $1 Since mid-2014, oil and gas prices have declined significantly Prices have been steadily increasing in 2016 Page 3 Source: S&P Capital IQ

4 Recent upstream M&A activity Deal value (US$ billion) Deal count (includes deals w/o reported value $40 $35 $30 Transaction Value Total Deals $29.5 $ $25 $20 $15 $10 $19.0 $12.8 $23.1 $8.4 $7.9 $8.6 $10.1 $14.2 $19.7 $ $5 $0 $1.0 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q Upstream M&A volumes collapsed following commodity price declines in 2014 Higher 2016 activity primarily reflects Permian Basin-focused transactions Page 4 Source: Multiple sources including S&P Capital IQ and public press releases.

5 Transaction value ($US billion) Overall industry M&A activity Deal Count (includes deals w/o reported value) $80 Upstream/E&P Oilfield Equipment & Services Midstream Downstream Total Deals 160 $ $ $ $40 80 $30 60 $20 40 $10 20 $0 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 0 Page 5 Source: Multiple sources including S&P Capital IQ and public press releases.

6 Sector performance Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 40% 30% 20% S&P 500 Oilfield Services (OSX) Midstream (AMZ) Upstream (Dow Jones E&P) 10% 0% -10% -20% -30% -40% -50% -60% Since mid-2015, all oil and gas sectors have underperformed the overall market Page 6 Source: S&P Capital IQ

7 2017 outlook Value over volume strategy Discipline around capital spending Portfolio optimization Companies are no longer prepared to pursue production growth at any cost The low oil price has driven transformation in the industry. Companies have reduced costs, cut spending and removed inefficiency. There will be opportunities to acquire assets at the bottom of the cycle, but quality and price will be equally important considerations. Companies will look to increase their exposure to premium areas where they currently participate. Companies will remain disciplined around capital spending and the projects selected for development There will be interest in whether companies intend to raise spending in tandem with higher oil prices. However, oil price gains may be capped by the expected growth in US shale/lto production. New megaprojects will be conspicuously few in number. Only megaprojects where costs have been reduced through operators own improvements and changed market conditions will get the green light. Portfolio optimization will remain a top theme in 2017: Companies are trying to manage their portfolio OPEC s deal to limit output has shifted market sentiment. The five oil majors announced upstream acquisitions totaling US$5.7b in December This is more than the combined value of all upstream acquisitions made by these companies in the other 11 months of the year. Page 7

8 Capital market transactions Page 8

9 Unlocking value Page 9

10 Options for unlocking value Disparities in private market valuation are leading companies to look at public markets to access growth capital and/or alternative growth platforms. Unlocking value Portfolio/ organization restructuring Corporate IPO MLP REIT Asset sale Traditional US vs. non-us Domestic control? Debt issuance/ restructuring Strategic JV YieldCo Up-C* Formation/transact with existing Royalty trusts Publicly traded *In an Up-C structure, a newly formed corporation is the entity undertaking the IPO and sits above an existing limited liability company. Page 10

11 Certain public monetization alternatives Page 11

12 Traditional initial public offering A traditional corporate IPO is the most common and well-known form of accessing public capital. The traditional corporate structure generally results in two levels of tax (double taxation) the public corporation pays tax on its earnings, and the shareholders generally pay tax on distributions received from the public corporation. Traditional IPOs are well recognized and accepted in the public market. Typical corporate IPO organizational structure Historic Shareholders 100-X% X% Public Company Public Operating Subsidiaries Page 12

13 Traditional initial public offering Historically, IPOs are a desirable form of accessing public capital for a variety of reasons/circumstances: Insufficient qualifying income traditional public company is not subject to any qualifying income or qualifying asset tests Long-term capital expenditure needs Desire to reinvest or grow through acquisition, as opposed to distributing out profits Global investor base Value based on prospective earnings growth (as opposed to a cash yield-based valuation) If currently in partnership form, consider method of conversion (and timing) to corporation in preparation of IPO (e.g., assetsover, assets-up, interests-over, formless). Typical corporate IPO organizational structure Historic Shareholders 100-X% X% Public Company Operating Subsidiaries Public Page 13

14 Up-C structure The Up-C structure which offers tax benefits to pre-ipo investors and sponsors likely will expand among companies. In using this structure, the public company (PubCo) typically owns a substantial equity interest in a subsidiary holding company (Holdings), which owns the operating assets. Historic Members Typical Up-C organizational structure 100% Class B Shares Majority voting power Non-economic interest Tax Receivable Agreement 100% Class A Shares Minority voting power 100% economic interest Public The equity interests in Holdings not held by PubCo are typically owned by the pre-ipo investors, which may consist of individual investors, private equity funds or others. 100% Class B Units Exchange Right 100% Class A Units Sole Managing Member PubCo Holdings LLC Operating Subsidiaries Page 14

15 Up-C structure (cont.) The pre-ipo investors in Holdings have the right to exchange their Holdings equity interests for shares in PubCo, at which point PubCo gets a stepped-up tax basis in the Holdings equity interests (which results in tax savings to PubCo through additional depreciation and amortization) and the pre- IPO investors are taxed on any gain recognized as a result of the exchange. The pre-ipo investors and PubCo may enter into a tax receivable agreement pursuant to which PubCo would pay the pre-ipo investors a portion (typically 75% to 85%) of the tax benefits realized from the basis stepup resulting from the exchanges. In 2013, the following energy companies went public using a so-called Up-C structure: Athlon Energy Inc.; Frank s International N.V.; Jones Energy, Inc.; Plains GP Holdings, L.P. Historic Members 100% Class B Units Exchange Right Holdings LLC Typical Up-C organizational structure 100% Class B Shares Majority voting power Non-economic interest 100% Class A Units Sole Managing Member Tax Receivable Agreement PubCo Operating Subsidiaries 100% Class A Shares Minority voting power 100% economic interest Public Page 15

16 Yield Co structure A Yield Co owns assets that are typically not MLP-able assets. In 2013, a new type of vehicle went public with a story very similar to an MLP but without possessing assets that would qualify for pass-through tax treatment. Like MLPs, Yield Co and similar companies are positioning themselves as vehicles for investors seeking stable and growing dividend income from a diversified portfolio of lower-risk high-quality assets. More of these types of vehicles are in the planning stages. As an example, NRG Yield, Inc. (NYSE:NYLD), a company that owns, operates and acquires contracted renewable and conventional generation and thermal infrastructure assets, which are not MLPable assets, went public as a Yield Co in July of Typical Yield Co organizational structure Sponsor 100% Class B Units 100-X% Economic Interest Class B Common Stock 100-X% Voting Interest and 0% Economic Interest Yield Co Inc. Yield LLC Operating Subsidiaries Public Class A Common Stock X% Voting Interest and 100% Economic Interest Sole Managing Member 100% Class A Units X% Economic Interest Page 16

17 Master Limited Partnerships (MLPs) An MLP is a partnership or limited liability company that is traded on a stock exchange. In contrast to corporations, partnerships generally do not pay federal income tax at the entity level. However, publicly traded partnerships are taxed as corporations unless 90% of the gross income is qualifying income. MLPs typically pay out all of their available cash (essentially cash receipts less cash expenses and reserves) on a quarterly basis (partnership agreement requirement; not legal requirement). One of the hallmarks of the traditional MLP has been the relative stability in its quarterly distribution payments (e.g., its minimum quarterly distributions (MQDs)); the primary goal of most MLPs has been to maintain or grow distributions every quarter. Typical MLP organizational structure Sponsor GP 2%/LP/IDR MLP LLC 100% Assets LP Public Page 17

18 Master Limited Partnerships (MLPs) (cont.) Typically, half of the LP interests are subordinated units retained by the sponsor. During the subordination period (typically three years), the subordinated units do not receive distributions until the common units receive the minimum quarterly distribution (MQD) The sponsor retains incentive distribution rights (IDRs) that receive an increasing percentage (typically 13%, 23% and 48%) of distributions after the MQD and certain target distribution levels have been satisfied. Consider structural alternatives synthetic, baseload and other alternatives to achieve cash flow stability. In distressed situations, partners may get hit with CODI in connection with indebtedness. Typical MLP organizational structure Sponsor Public GP 2%/LP/IDR LP MLP LLC 100% Assets Page 18

19 Capital raise comparison Page 19

20 Capital raising option comparison Pros Asset sale Immediate liquidity Execution timeline/efficient Debt Ability to obtain cash and fund capital needs without losing control of strategic asset Execution timeline/efficient Transaction with existing MLP Strong M&A market with higher multiple on sale Potential to receive material upfront cash If units are received in exchange, potential for a tax-deferred transaction Cons Market conditions Loss of control of strategic asset Multiple depends on buyer/asset Taxable Covenant restrictions Obligation to repay/economic consequences Rate variability Loss of control of strategic asset Size of asset base may limit potential buyers Taxable if cash is received (although opportunities may exist) Page 20

21 Capital raising option comparison Pros MLP IPO Constructive/positive MLP IPO market Retain control of strategic asset Potential to create growth vehicle with lower cost of capital than parent Control timing/amount of cash flow to parent Valuation at attractive multiples Strategic JV Financial JV Potential for strong industrial logic Sharing of synergies with partners Robust interest Opportunities for tax deferral Deep investor base, dependent on value stream Ability to extract cash up-front for ongoing growth Cons Ability to size correctly to attract investor attention Complexity/reporting and governance Increased demand for management time and resources Growth potentially limited by market Timing Execution complexity Complexity of operations/ownership Loss of some control Little, if any, synergy value Complexity Capital costs Page 21

22 Capital raising option comparison Private MLP Pros Cons Market depth Ability to extract cash up-front or ongoing growth Up-C Retain control of strategic asset Creation of growth vehicle Access to public markets Control timing/amount of cash flow to parent Tax receivable agreement Global investor base IPO Retain control of strategic asset Creation of growth vehicle Access to public markets Global investor base Expensive form of capital Loss of some control Complexity/reporting Increased demand for management time and resources Governance Complexity/reporting Increased demand for management time and resources Governance Page 22

23 Capital raising option comparison REIT formation Pros No corporate-level tax Retain control of strategic asset Creation of growth vehicle/public market access Global investor base Valuation multiple Yield Co Retain control of strategic asset Creation of growth vehicle Access to public markets Global investor base Improved valuation multiple Cons Must satisfy income, asset, ownership and distribution tests Potential for built-in gains tax at formation Complex tax reporting/investor issues Increased demand for management time and resources Governance Predictable cash and distributions Stability/length of cash flow/contracts Complexity/reporting Increased demand for management time and resources Governance Page 23

24 Tax reform overview Page 24

25 Key Trump tax policy proposals: corporate tax CURRENT TRUMP Top corporate tax rate (now 35%) 15%* Taxation of future foreign earnings (now worldwide) Mandatory tax, untaxed foreign earnings 10% Immediate worldwide taxation, repeal of deferral Inversions Expensing R&D (now 20% credit or alternative credit of 14% based on three-year average) Other business provisions Lowering taxes is the only way to prevent inversions Immediate expensing for new business investments. No interest deductibility for manufacturers who expense Retain research credit Eliminates most corporate tax expenditures Page 25 *May apply to pass-through businesses.

26 Key Trump tax policy proposals: corporate tax CURRENT Individual tax rates (now 10%, 15%, 25%, 28%, 33%, 35%, 39.6%) Capital gains rate (now 23.8% for long-term capital gains) Qualified dividends rate Carried interest (now capital gains) Estate tax (now 40%, $5.43m exemption) Individual credits TRUMP 12%, 25%, 33% 15%; 20% (3.8% net investment income tax (NIIT)) repealed 15%; 20% (3.8% NIIT repealed) Ordinary income Repealed. Step-up in basis disallowed for capital gains of estates over $10 million. Capital gains held until death subject to tax (first $10 million tax-free) New deduction for childcare costs Charitable contributions (now capped at 50% of adjusted gross income) Subject to itemized deductions cap Page 26

27 Key Trump tax policy proposals: individual tax CURRENT Mortgage interest (now deduction on first $1m) Other itemized deductions Life ins. build-up (now not incl. in income) TRUMP Subject to itemized deductions cap Caps deductions at $100,000 for single filers and $200,000 for married filers Included in income for high earners Page 27

28 House tax reform task force blueprint: highlights CURRENT Corporate tax rate 20% Business income pass-through tax rate Taxation of future foreign earnings Taxation of accumulated foreign earnings Border adjustability Interest expense HOUSE REFORM 25% Territorial, 100% exemption for dividends paid from foreign subsidiaries 8.75% for cash/cash equivalents, 3.5% otherwise 100% expensing Not deductible on a net basis Corporate tax preferences Generally eliminated, except for R&D credit/lifo Page 28

29 House tax reform task force blueprint: highlights CURRENT HOUSE REFORM Individual tax rates 12%, 25%, 33% Investment income 50% deduction, basic rates of 6%, 12.5%, and 16.5% Individual deductions Alternative minimum tax (AMT) /Estate tax Eliminated except for mortgage interest, charitable contributions/ standard deduction increased Repealed Page 29

30 Questions Page 30

31 Bios Page 31

32 Christopher J. Lallo Christopher J. Lallo Partner Transaction Advisory Services Transaction Tax Tel: Mobile: Fax: Function in EY Chris Lallo joined the Houston office of Ernst & Young LLP in 2008 and currently leads the Transaction Tax Practice for the Southwest Area. He was formerly a partner at Fulbright & Jaworski LLP. His practice is focused on both domestic and international tax matters with broad-based experience in the area of tax planning related to domestic and crossborder mergers and acquisitions, including taxable and nontaxable transactions, cross-border investments, financing structures, withholding issues, capital market transactions and securities offerings. He is also a past Chair of the Tax Section of the Houston Bar Association. Professional Experience and Clients Significant experience in advising domestic and international energy companies in connection with upstream, midstream, downstream and oilfield service company transactions. Significant experience in mining and other transactions in the natural resources sector. Represents buyers and sellers of public and private organizations in various types of transactions, including cross-border transactions, taxable and nontaxable stock and asset transactions. Represents clients in connection with tax issues related to acquisition financing structures and debt restructuring transactions. Has worked on a significant number of large inbound oil and gas transactions and has advised numerous clients on tax issues associated with inbound investment structures. Has written numerous articles and is a frequent public speaker at professional conferences. Counseled clients in private equity transactions. Represents investors and companies that have been acquired by private equity funds, providing tax counsel on acquisitions and divestures. Provides counsel on tax matters for both domestic and foreign funds. Counseled clients in international tax planning. Represents clients in connection with global structure planning and business transactions from a tax perspective. Clients include both U.S. and foreign based multinational businesses. Education/Certifications Bachelor of Business Administration degree in Accounting from Texas A&M University. Doctrine of Jurisprudence from The University of Texas School of Law. Certified Public Accountant in Texas. Licensed Attorney in Texas. Page 32

33 Aparna T. Koneru Aparna T. Koneru Manager - Transaction Advisory Services Transaction Tax Tel: Fax: aparna.koneru@ey.com Function in EY Aparna is a manager in Ernst & Young s Houston office in the Transaction Advisory Services Transaction Tax group. Aparna s primary responsibilities include transaction tax structuring, tax due diligence, and post-transaction implementation for clients. Aparna advises her clients in connection with upstream, midstream and oilfield service company transactions. Education/Certifications Doctrine of Jurisprudence from The University of Texas School of Law. Licensed Attorney in Texas. Professional Experience and Clients Aparna has knowledge and experience with U.S. international tax matters, including cross-border mergers and acquisitions, taxable and nontaxable transactions, cross-border investments, and tax-efficient financing structures. Aparna represents both U.S. and foreign-based multinational corporations and has advised numerous clients on tax issues associated with inbound investment structures. Aparna represents private equity funds, and portfolio companies that have been acquired by private equity funds. She provides tax counsel on acquisitions and divestures. She also provides assistance on tax issues related to acquisition financing structures and debt restructuring transactions. Page 33

34 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 firms 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 Center 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 Center supports a global network of more than 10,000 oil and gas professionals with extensive experience providing assurance, tax, transaction and advisory services across the upstream, midstream, downstream and oil field sub-sectors. The center works to anticipate market trends, execute the mobility of our global resources and articulate points of view on relevant key 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 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.