Positioning for survival and opportunity Divestitures and carve-outs in the oil and gas industry Whatever the situation, companies considering a divestiture or carveout can benefit from considering a number of key issues An uptick in M&A activity in late 2009 suggests to us that repositioning has become the watchword for a growing number of companies in oil and gas and related businesses. Several integrated multinational oil companies have announced their intent to divest businesses and assets to redirect capital spending toward exploration and production. Some independent oil and gas companies have announced their intent to sell noncore domestic, international, and offshore portfolios to streamline their operations, and several oilfield service companies have announced plans to exit certain business lines or countries. Such companies are shedding assets and carving out parts of their business for a variety of reasons. Strong cash flows from rising prices and demand for services over the past several years have caused many companies to expand in all directions. Now, pricing pressures are forcing some to rethink these expansive strategies as revenue falls. Tight credit conditions are choking off capital needed to operate and expand. Technology advances are offering new exploration horizons for companies ready and able to pursue high-potential but expensive plays. Anticipated carbon and renewable energy legislation is dampening the strategic view of refining, processing and other businesses. Willing buyers, including private equity investors, are showing strong interest. However, sellers may find it challenging in this environment to offload businesses with heavy capital demands, in volatile markets or facing significant structural changes as a result of new rules and regulations. Whatever the situation, companies considering a divestiture or carve-out can benefit from considering a number of key issues likely to arise as the transaction progresses, as well as effective practices for deal planning and execution. M&A Industry Advantage Series Oil & Gas
Areas of interest to buyers One of many financial accounting issues that frequently will arise in a carve-out is treatment of corporate allocations. This will vary depending on the traditional structure of the seller. For example, a seller may choose to leave allocations, such as human resources, accounting, and treasury, in the reported financial results because they may be representative of the actual standalone costs for those functions prospectively. Other times, the seller may feel that the financial picture may be more meaningful by removing the allocation amounts and disclosing to the buyer the types of functions that are not included in the business. To be well prepared for when prospective buyers knock at your door, consider the following accounting information that buyers generally want to see: Transfer pricing Intercompany receivables and payables Shared services and corporate allocations. Acquisitions and divestitures Restructuring reserves Capital spending, dry hole costs and asset impairments Foreign exchange Derivative financial instruments Pensions and post-retirement benefits Self insurance experience and payments to captive insurance companies Stock options and deferred compensation Deciding what to sell and at what price In some cases, such as a strategic realignment, the process of choosing what to dispose of can be fairly straightforward. Assets that no longer fit with your company s core business become prime candidates. Other factors can play an important role when decisions are not so clear cut; for example, when cost containment is the prime motivation. In such cases, you may want to prioritize assets for disposition based on factors such as the growth potential, capital requirements, industry realignment issues and other risk considerations. Also view the assets you are considering for sale from the perspective of potential buyers. Which assets are likely to be most attractive to them? Finally, determine how valuable the assets are to you. What is your walk-away price? A major consideration in the complexity of a carve-out is the impact of international activities. International operations which often include a mix of carve-out and legal entity sales (e.g., stock deals) tend to be more complicated and require focused effort on the part of buyer and seller. In countries where a company has a smaller footprint, the business may not have sufficient post-divestiture scale to operate on a standalone basis and a buyer may need to consider a different approach to operating in that locale. It is important that both parties understand country-specific requirements and work with local country operational and tax specialists and personnel. Also, the buyer will need certain information, such as details around operating and payroll tax compliance to support uninterrupted postacquisition tax planning and reporting. 2 M&A Industry Advantage Series Divestitures and carve-outs in the oil and gas industry
Identifying the business early in the process It s not unusual for a company to embark on a divestiture without completely understanding or defining what is actually being sold. What activities and services are involved? Which people will be going with the business? What property, equipment, and plants will pass on to the buyer? Sometimes sorting out the business activities, people, and physical property isn t so easy. For an integrated operation, identifying where and how to separate the business can involve a number of challenges as product flows from the wellhead through pipeline and transportation systems to processing, refining, marketing, and distribution organizations before ultimately being sold to a third-party customer. International businesses can be particularly tricky when the business relies heavily on shared services in each country within which it operates and with differing levels of support depending upon the scale of the business and the parent company in each country. Operations typically involve an array of personnel that need to be considered for inclusion including engineers, geologists, field personnel, operations, safety, area managers and back office support. All of these issues should be addressed from an operational standpoint, as well as in financial terms (see sidebar, Areas of interest to buyers ). Providing a potential buyer with an accurate picture of the accounting, tax, and financial dimensions of the deal will hinge on having a clear view of the business. Conducting sell-side due diligence A seller s credibility in a divestiture or carve-out can translate directly into higher or lower deal value. The fewer the uncertainties about the accuracy and reliability of information being provided, the more willing the buyer will be to pay full consideration, or a premium. Seller credibility is never higher than when the buyer first receives information on what s being offered for sale. From then on, any discrepancy or other unpleasant surprise uncovered through buyer due diligence will likely reduce that credibility and, as a consequence, the buyer s trust and willingness to pay what the seller is expecting. Time is money in a divestiture. Company leaders are eager to complete the deal to realize the anticipated financial benefits, as well as control the cost of the bankers, lawyers, and accountants that support the transaction M&A Industry Advantage Series Divestitures and carve-outs in the oil and gas industry 3
Therefore, it s imperative that you prevent surprises from occurring down the line. To do that, you must have confidence in the information you re providing from the very start. The revenues, costs, and profits, and business description you initially provide likely at a summary level must hold up throughout the buyer s examination of the operation. It s also important to have ready explanations for unusual events or incidents, such as a temporary business interruption, customer issue, or event at an affiliated business that caused a negative financial impact. Your management team should be able to provide an accurate account of what happened and how it was resolved. The business identified for disposition may have many interdependencies, common customers, and other relationships with the businesses being retained by the seller. It is important to have a clear view of how these relationships have influenced the business operations, procurement and marketing, profitability, and cash flows of the business and how those may change post-separation. Conducting sell-side diligence before the sales process starts can help you anticipate issues a buyer may raise and develop responses that help reinforce your credibility (see sidebar, Key focus areas of sell-side due diligence ). Location of tax basis and structural nuances can assist in tax planning to help maximize after-tax proceeds. And it can help you better understand the impact of the transaction on the parts of your business you re not selling. Structuring the transaction Finding common ground in deal pricing is an ongoing challenge for buyers and sellers. Periods of economic weakness intensify the challenge, as bid/ask spreads tend to expand and buyers hold the upper hand in deal negotiations. Earnouts and other purchase price contingency adjustments may be used to help close the buyer/seller value gap. Earnouts can help sellers realize the value they desire, and help buyers manage their purchase price risk by sharing some of that risk and potential value realization with the seller. In earnout arrangements, the buyer and seller agree to make a portion of the purchase price contingent upon the target company, subsidiary or division meeting certain future performance targets post-closing. Other contingency adjustments may deal with risks in a specific set of contracts or other specific business issue and may be tied directly to the settlement of that issue. One of the first questions that sellers struggle with in structuring an earnout feature in a transaction is what the purchase price will be for the risk of the contingent arrangement. Agreeing to the appropriate performance targets or milestones is the most time consuming part of earnout negotiations, as it establishes the basis for determining whether and under what circumstances the contingency may be in the money post-closing. Not defining the performance targets in detail is one of the most common causes of post-closing disputes. 4 M&A Industry Advantage Series Divestitures and carve-outs in the oil and gas industry
Key focus areas of sell-side due diligence Understand intra-company transactions, allocated costs, shared services, and your plans for providing support post-acquisition and during transition. Evaluate the quality of earnings and identify non-recurring items for which management may want to consider adjusting the financial information. Analyze the trend of working capital required by the carve-out business in order to develop a target working capital amount and mechanism in the purchase and sale agreement. Understand the assumptions in your forecasts and the bridge of detailed data from actual results to forecast information. Evaluate the cost structure for fixed versus variable costs, capital expenditure requirements, and the relevance of certain general and administrative activities to the carve-out business. Understand employee and union issues and related costs or exposures and segregation of benefit plan liabilities and assets. Identify all shared assets and facilities. Gauge the ability to separate and/or continue customer and supplier contracts and arrangements. Estimate potential loss of intercompany sales and other business secured by parent relationship. Identify tax contingencies and ability to push down debt into divested businesses. Executing the transition The speed with which divestitures and carve-outs take place can result in the buyer not having the infrastructure necessary to take over operations quickly. In such cases the buyer and seller can enter into a transition services agreement, or TSA, in which the seller continues to provide operational support for a period of time. Careful attention should be given to how the TSA will be structured and executed, as well as the conditions and timetable for its dissolution. Performance metrics and must have timelines are also critical components to any well-crafted TSA. Anticipating post-deal considerations Once you have sold off assets, how will you know whether you ve realized the benefits you expected from the transaction? Give consideration to setting metrics and benchmarks for post-deal performance. M&A Industry Advantage Series Divestitures and carve-outs in the oil and gas industry 5
Employing effective practices Taking some key steps can help lay the foundation for deal success. Here are three suggestions to consider as you prepare a business for sale or a function for carve-out: Appoint a full-time project champion outside of the business As noted above, carving out a portion of the enterprise to be sold will affect a variety of functional responsibilities and employee groups within the organization. Because of the breadth and weight of issues that inevitably will arise, it is imperative that someone with sufficient stature and authority lead the process. The divestiture will require different parts of the company to work together in new ways and in some cases buy into decisions they don t view as being in their best interest. The executive put in charge will usually be a member of the corporate team. He or she should have standing and authority within the company to effectively manage inevitable cross-functional conflicts. At the same time, the transaction needs to have board-level support and clearly defined accountability for the board, CEO and executives in charge of the deal. Prior to launching a divestiture strategy, leadership must clearly outline the overarching M&A strategy and communication plans to maintain executive alignment. Commit to precision and detailed follow-through on tasks Time is money in a divestiture. Company leaders are eager to complete the deal to realize the anticipated financial benefits, as well as control the cost of the bankers, lawyers, and accountants that support the transaction. But shortcuts ultimately create more issues than they solve. Taking the time to do things right the first time can be difficult, but it is critical to having a clean process and to maintaining credibility with the buyer. For example, you should have a complete view of the financial information before disclosing any data to a buyer. All of the historical financial information that you re going to provide should be gathered, analyzed, and assembled in a data room at the outset, even if you re only going to provide a small portion of it to a broad group of potential buyers in the initial steps of the transaction. You want to avoid sharing information early that ends up being contradicted or contested later in a more detailed portion of the process. Being well prepared and spending the time and effort to have precise information upfront can translate into credibility and value. Focus on the people aspect of a carve-out Clearly defining the separation strategy and how employees will be affected by the carve-out is complex. However, in order to maintain momentum and effectively execute the transaction, the seller s internal communication and people strategies should not be overlooked. While traditional divestitures can be somewhat straightforward when it comes to which employees remain and which are transitioned with the divested organization, carve-outs are more complex. Uncertainty regarding employees futures can significantly decrease productivity, so a clear view of the carve-out s impact on the organization is critical to maintaining business as usual. 6 M&A Industry Advantage Series Divestitures and carve-outs in the oil and gas industry
Understanding the value of auditable carve-out financial statements A buyer s financing plans or disclosure requirements may compel the seller to develop full, audited financial statements for the carve-out business. It s important for both parties to understand that the numbers included in these auditable statements may not in fact, probably should not agree with the numbers that come out of the due diligence process. Why? A number of accounting issues can arise in preparing the adjustments required for these two different types of financial statements, and these need to be addressed in detail to substantiate the amounts subject to external audit. The seller should be able to provide statements that will reflect the accounting and disclosures necessary for an audit that otherwise might be seen as a last minute surprise by a potential buyer. Achieving your deal goals Market dynamics and economic conditions are causing oil and gas and related midstream, downstream, and service companies to seize their most promising opportunities and rightsize their operations. This repositioning often dictates the divestiture or carve-out of some existing operations. By considering the issues outlined above and adopting effective M&A practices, sellers can increase the likelihood of achieving deal goals. M&A Industry Advantage Series Divestitures and carve-outs in the oil and gas industry 7
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