Lease considerations in the M&A context

In the wake of a series of announcements regarding the closure of the operations of several Canadian retailers as well as the withdrawal of US retailers from the Canadian market, questions are being asked regarding the potential impact on the landlords of the numerous store locations affected. This is not surprising given that a retailer’s entry into or expansion strategy within Canada routinely involves the assumption of various existing leases. The consequences of the recent closure announcements will, no doubt, be felt across the Canadian commercial real estate market and retail scene for years to come, as landlords scramble to fill vacant sites, in some cases representing very large footprints. Further, in instances where a departing retailer was the anchor tenant, the closure of operations may also impact the traffic flow to other retailers in the same shopping centres. The negative financial impact on landlords, however, may not be the same across the board: some landlords may have obtained financial covenants to backstop the departing tenant’s lease obligations. 

Assessing the lease implications of retail closures may be instructive in the M&A context, particularly insofar as they raise a number of other lease considerations that landlords and parties to asset purchase and sale transactions should be aware of in asset purchase and sale transactions where leases are being assigned and assumed. Specifically, most commercial leases will require landlords’ prior written consent to an assignment and provide that the original tenant/assignor will not be released from its covenant, notwithstanding any assignment.

From a landlord’s perspective, while the terms of a lease may require that such consent not be unreasonably withheld, delayed or conditioned (or some combination thereof) and otherwise provide criteria for approval, landlords will want to be satisfied with the financial strength and operating history of the proposed assignee and drill down on the corporate structure to ensure that the proposed assignee providing the covenant has the means to meet the lease obligations, or that a sufficient guarantee/indemnity is obtained, with the above scenario a prime example as to why. This becomes even more important to landlords if the existing tenant is requesting a release.

Often, while the parties in an asset purchase and sale transaction turn their minds to the requirement for landlords’ consent to the assignment of leases and include such as a closing condition, sometimes sellers fail to turn their mind to the fact that they (as well as any guarantor/indemnifier) may not be released from the leases by the landlord upon such assignment and the potential implications, namely continued liability after the assignee has taken over the premises, particularly if the tenant/assignor entity is an operating company with other assets not included in the transaction. While an indemnity from the assignee may be obtained to temper this risk, an indemnity too is only and strong as its covenanter. In such circumstances sellers may want to require releases and/or a replacement covenant from the purchaser/assignee satisfactory to the landlords as a condition precedent to closing.

From a purchaser/assignee perspective, in addition to wanting to include express provisions in an asset purchase agreement for landlords’ consent to lease assignments, other important closing deliverables/conditions include landlord estoppels, notices of key leases being registered on title to the subject properties and non disturbance agreements being obtained from landlords’ secured creditors. A discussion of the importance of the foregoing will be the subject of a subsequent post to this blog.

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Locking the box: an emerging tool to avoid post-closing negotiations

In Canada, private M&A transactions have long followed a familiar structure: the parties settle on a “cash free, debt free” price, which then must be adjusted post-closing to account for the target’s actual cash, debt and working capital (or other measures such as net assets) in an effort to reach the true “equity value” of the business. Calculating and settling these post-closing adjustments to the purchase price can frequently take many months and is one of the main causes of acrimony between buyers and sellers.

In light of these frustrations, it is perhaps unsurprising that one recent trend that has been gaining momentum—particularly in the UK and EU—is the use of “locked box” pricing to generate greater deal certainty.

What is a locked box?

A locked box transaction at its most basic is a fixed-price deal. Under a locked box structure, the purchase price is set at signing and is calculated based on a recent balance sheet at a pre-signing date (the Reference Date). Cash, debt and working capital as at the date of the Reference Date are therefore known by the parties at the time of signing, and will often have been subject to independent audit review. Accordingly, there is no need for drawn out debate over which accounting policies and procedures are to be followed in calculating the post-completion adjustment, or with respect to the process by which those adjustments are to be reviewed (and potentially disputed).

From the Reference Date onwards—i.e. once the “box is locked”—the buyer effectively takes on the economic risk of the target business. The profits or losses made on the target business go to the buyers’ benefit or detriment. To compensate sellers for the opportunity cost of transferring their economic interest in the business at the Reference Date without being paid until closing, locked box transactions typically include an interest charge on the purchase price during the interim period.

Benefits & key considerations

The most obvious benefit of using a locked box structure is that it provides certainty of price for both buyer and seller at the time of signing. Long popular for this reason among financial/private equity sellers, it is also increasingly favoured in the corporate world for allowing sellers to avoid the potential disputes that arise with the calculation of post-closing adjustments under the traditional approach. In an auction scenario, the ability to offer a fixed purchase price payable on completion can offer a significant competitive advantage for buyers. If asked for by sellers in the same context, it can also greatly simplify the process of comparing competing offers.

Yet while the locked box can drive value by providing simplicity of process and cost certainty, any buyer utilizing such a structure should be careful. With no ability to test and dispute a target’s reference balance sheet after the purchase price has been set, a purchaser must be comfortable that the balance sheet it is committing to is reliable. Thus, not only should a buyer ensure that it has comprehensively diligenced the reference balance sheet before committing to a price, it should also require that the reference balance sheet be sufficiently supported by appropriate warranties.

A further key task for buyers using this transaction structure is to ensure that the box is in fact “locked”. The concept behind a locked box is that between the Reference Date and closing, any changes in working capital will be mirrored by equal movement in net debt. However, for this to work, it is essential that no value “leaks” from the target business back to the seller during the interim period.

Therefore, buyers will need to ensure that, apart from leakage that is expressly negotiated (e.g., payments for management bonuses or target transaction costs) or otherwise permitted (e.g., transactions with affiliates on arm’s-length terms), no payments have been made that could benefit the seller. Thus, the seller will typically be required to undertake that, for instance, no distributions, dividends, payments or returns can be made to the seller or that no shareholder loans may be repaid, with recourse to be had if these provisions are violated. Where the target business is highly integrated into the operations of the seller’s larger corporate group, the task of “locking the box” can be quite difficult and may require a line item by line item review of which cash flows are arms’ length/ordinary course and which need to be subject to restrictions.

A final consideration is that locked boxes also do not normally provide the buyer with protection from ordinary course changes in the value of the business. Because buyers take on the economic risk and reward of the business following the reference date, a seller will not bring current the majority all warranties at closing thereby leaving the buyer with fewer rights of withdrawal. As a result, the structure may not be appropriate where the target business is of a seasonal or otherwise highly variable nature or where the interim period between the Reference Date and closing will be overly long.

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The effects of lower oil prices in 2015

A recent report by the Royal Bank of Canada reveals that lower oil prices may result in cuts to business investment in the oil and gas industry which may have a chilling effect on the M&A activity in this Canada’s important sector of economy.

Oil prices started to decline in June 2014. In the last six months, WTI crude benchmark had fallen from above US$100 to below US$50 a barrel; a drop of more than 50%. While historically OPEC would support the falling oil price, this time it refused to do so trying to preserve its market share by putting pressure on the competitors producing oil from US shale deposits, the Alberta oil sands and offshore projects.

RBC warned that reductions to oil-production investment are “more certain to occur” than the positive, counteracting forces of lower-priced crude. It is, therefore, expected that for deals involving oil and gas assets there will be a pause in M&A activity that will continue through at least the first part of 2015. During this pause buyers will wait to see if prices keep falling before committing to acquisitions, while sellers will try to avoid selling at the bottom of the cycle.

There are certainly players looking to invest their money in the sector. For example, AltaGas has recently announced that it plans to double its asset base over the next five years. Likewise, in December, Veresen announced the formation of Veresen Midstream with KKR and a $5 billion midstream expansion for Encana and Mitsubishi.

Overall, the RBC report said lower oil prices will have significant (negative) impacts on budgets in oil-producing provinces. But it argues these provinces—Alberta, Saskatchewan and Newfoundland and Labrador—have seen big increases in revenues from price increases in recent years, putting them on relatively strong footing to absorb the shocks of a prolonged decline. Other provinces, meanwhile, are seeing benefits from the low crude prices in the form of cheap gasoline and the falling Canadian dollar, which is creating a better climate for their manufacturers and exporters.

The RBC analysis pointed to a combined effect of three “offsetting positive outcomes” from low-priced oil: a boost for the US economy; the lower Canadian dollar’s benefit to exporters selling to the stronger US market; and more spending by Canadians thanks to cheaper fuel.

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Despite lower valuations in natural resources, M&A activity is up in Africa

The international market is betting on Africa’s growth. Major international players, including Kohlberg Kravis Roberts and Carlyle, have entered the African market, and others such as Blackstone have expressed interest in doing so in the near future.

The 2014 edition of Mergermarket’s Deal Drivers Africa report shows that Africa, like the Middle East, is home to increased deal-making.More than half of the survey respondents expect this trend to continue and deal-making to increase significantly in the next 12 months. The volume of deals increased 7% year-on-year (YoY) in the first nine months of 2014, and M&A activity between African countries quadrupled.

Natural resources no longer leading the charge

The news is not all positive. Several West African countries were hit by Ebola, leading to a downturn in M&A activity. Also, deals in 2014 were smaller than in 2013.  he lower deal value can be attributed partly to the fact that investors focused on deals outside of South Africa, which is the country in which deal values are largest. Also, valuations in the natural resource sector are down as compared to the prosperous mid-2000s, when Chinese companies led the way into the African commodity market.

The lack of interest from China corresponds with a decline in both volume (25% YoY) and value (79% YoY) of deals in the natural resource sector. Zambia and Nigeria were both negatively impacted by this trend. Nigeria was also unable to export crude oil to the United States due to the shale boom.

New developments

And yet, Nigeria is emerging as a new hub of activity, as it surpassed South Africa as the continent’s largest economy in 2014. Together, activity in the two countries made up almost 60% of total domestic deal value. On a regional level, East Africa is developing a reputation for hosting fair value targets with the potential for regional expansion.

In terms of sectors, inbound deal value in the financial and telecommunications, media, and technology sectors surpassed energy, mining, and utilities. Telecommunications, media, and technology activity jumped 53%, and value increased an impressive 471%.  Private equity activity was also on the rise in 2014, albeit at a slower rate:  buyout volume rose 11% and value grew 7%.

When asked to predict which sectors would see the greatest increase over the next 12 months, 26% of the respondents to Mergermarket’s survey picked energy, mining, and utilities.  The report concluded that opportunities in Africa’s power generation sector are emerging quickly because electrification remains a large obstacle in many promising markets.

Challenges and opportunities

Concerns over transparency and changes in the regulatory environment continue to threaten deal-making on the continent.  Many countries remain challenging environments for doing business, and investors face issues such as opaque tax regulations, complications for repatriating profits, and difficulty in extracting value from investments in an acceptable timeframe.

However, the prospects are improving. It is crucial to keep in mind the diversity across the continent because the investment landscape varies significantly between countries, not just regions.  For example, countries such as Uganda, Kenya, and South Africa are attempting to promote institutional investment through regulatory reform.  Another promising market is Mozambique, which will likely offer new opportunities because of its government’s commitment to developing its large natural gas reserves.

Many deal-makers are already capitalizing on these opportunities, creating a positive trend for M&A in Africa.

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Supreme Court clarifies test for merger review in Canada

Lays waste to Commissioner’s case on efficiencies, but serves as reminder of hazards of internal documents

On January 23, 2015, the Supreme Court of Canada (SCC) released its much-anticipated decision in Tervita Corp. v Canada (Commissioner of Competition). In 2011, the Commissioner of Competition (Commissioner) challenged Tervita Corp.’s merger with a potential competitor, Complete Environmental Inc., and in 2012 the Competition Tribunal (Tribunal) ruled in favour of the Commissioner and ordered Tervita to divest itself of the assets it had acquired. The Federal Court of Appeal (FCA) upheld that decision. In its first ruling on the Competition Act’s merger review provisions in more than 20 years, the SCC allowed Tervita’s appeal and overturned the earlier decisions.

The decision largely validated the Commissioner’s analytical approach, but raised fault with the Commissioner’s failure to adduce evidence of the identified anti-competitive effects. Section 96 of the Competition Act provides that no order can be made in respect of a merger where the merger is likely to result in gains in efficiency that will be greater than, and will offset, the anti-competitive effects of the prevention of competition that are likely to result from the merger. Because of the Commissioner’s failure to quantify the anti-competitive effects, the fact Tervita had demonstrated even “marginal” efficiency gains was enough to succeed with the section 96 defence.

There are several key lessons from the case: 

  • the Commissioner will, in appropriate cases, challenge mergers or acquisitions he believes are likely to prevent competition;
  • the analysis and evaluation of potential efficiency gains will take on a greater role in strategic mergers where a lessening or prevention of competition is possible;
  • small mergers that do not exceed the pre-merger notification thresholds are not immune from scrutiny; and
  • a robust competition compliance program that includes training on how employees communicate can help minimize competition law-related risks.

Background and analysis

For additional details on the background of the transaction, the decisions of the lower courts, and the SCC’s analysis, please see our more detailed update here.

SCC decision

The SCC’s decision focused on the following two main issues: 

What is the proper test to determine when a merger results in a substantial prevention of competition?

The SCC upheld the Tribunal’s decision that the merger would likely result in a substantial prevention of competition. The Tribunal correctly identified Complete as the potential competitor. As well, it properly used the forward-looking “but for” analysis to determine that, absent the merger, Complete would have entered the relevant market in a manner sufficient to compete with Tervita. As a result, the SCC held that the merger was likely to substantially prevent competition. 

What is the proper approach to the efficiency defence?

The SCC found that Tervita was able to prove quantifiable “overhead” efficiency gains resulting from combining administrative and operating functions of the merging parties. Although these efficiencies were “marginal,” they nonetheless met the “greater than and offset” requirement under section 96 because there were no quantifiable or qualitative anti-competitive effects proven by the Commissioner. As a result, the SCC held that the efficiency defence applied and allowed Tervita’s appeal, resulting in the divestiture order being set aside and the Commissioner’s application under section 92 being dismissed.


In a statement issued following the decision, the Commissioner “welcomed” the decision, “embraced the clarity” it offered in respect of applying the merger review provisions, and was “pleased” the SCC endorsed the decisions of the Tribunal and FCA on the question of whether the merger substantially prevented competition. 

One can expect the Bureau will continue to apply its theory of prevention of competition as warranted in future cases.  One can also expect the Commissioner will ensure that where the efficiencies defence is likely to be invoked, he will present evidence of the identified anti-competitive effects. As such, it is likely that the Commissioner will seek more detailed economic data from merging parties through the supplementary information request process and that Bureau economists will be busy crunching the numbers to support the merger case teams.

The case also serves as a reminder that the Bureau will not shy away from reviewing mergers that are below the pre-merger notification thresholds in the Act. As stated by the former Commissioner, Melanie Aitken, “Volume of commerce is not the only factor we consider when reviewing mergers – we are willing to take on cases where competition is being denied, regardless of size.” Merging parties must be cognizant of this fact and not stop their competition analysis after reviewing the notification thresholds.

The evidentiary record in this case proved problematic to Tervita. The Tribunal relied upon internal documentation from Tervita and Complete to conclude that Complete’s bioremediation business would fail and Complete’s eventual entrance into the secure landfill market in northeastern British Columbia would cause financial hardship on Tervita and result in a reduction in prices charged to customers in this market.

Merging parties must be cognizant that the Bureau will seek all relevant internal documentation to bolster its case. As such, this is a valuable reminder that companies should have in place a competition law compliance program that includes training on the scope of the Bureau’s investigative powers and the importance of exercising caution when drafting reports about potential transactions.

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Branding: no longer an afterthought

Tax savings, legal implications, and financial prosperity are typically at the forefront of corporate decision-making, yet almost 70% of mergers and acquisitions fail to generate long-term value for shareholders. According to a report published by Lippincott, failure to consider branding in the due diligence process or during post-merger integration activities will eventually shortchange shareholders. Throughout the high pressure bidding phase, it is easy for executives to focus on short-term indicators without considering the post-transaction impact of branding on a company’s strategic objectives. Lippincott’s report provides companies with three main guidelines:

1. Determine value by analyzing how the brands will impact demand

When valuing the assets of a company, due diligence requires more than a mere balance-sheet approach to quantify the static dollar value of a brand.  If a buyer simply accepts as true the figures provided by the seller, the buyer risks overpaying for an asset which, in the future, may result in a significant write-down or place constraints on business strategies going forward. Brands are volatile and can easily lose their appeal. It is critical to analyze how the brand will shift customer demand and the brand’s ability to drive business objectives after the transaction concludes. Lippincott suggests that due diligence requires answering the following questions:

  • Considering the market as a whole, do customers prefer this brand over others?
  • What premium are customers paying for the brand? Has this changed over time?
  • If the brand was to exit the market, how would this impact buying behaviour?
  • How much of the brand’s value is derived from distribution channels and product features?
  • If the company was to abandon the brand, what are the associated risks and benefits? Would it be possible to transfer brand equity from one brand to another? How easily could this be done?

2. Link brand strategy with business strategy

Whether the business strategy behind the merger or acquisition is to expand geographic scope, target a broader customer segment, or eliminate a competitor, a company must consider whether its business strategy is at odds with its brand strategy.  If the company’s vision involves migrating to a single brand, it is recommended that the company evaluate the “brand factor” when assessing the sustainability of a brand and its value to the organization in the future. The brand portfolio’s vision should be communicated throughout various levels of the organization to provide clarity to employees and other stakeholders.

3. Design and implement a brand transition plan

When well-known brands migrate to a new brand, companies have an opportunity to capitalize on the publicity surrounding the M&A process to transition to the new branding. By leveraging media attention, a company is able to accelerate the transition process both within an organization and externally. Internally, employees will identify with the new combined entity; questioning old practices and procedures. Externally, a company can leverage the free publicity as a marketing tool if it chooses to immediately adopt the new brand.

Assessments of a company’s brand during the diligence process and after the transaction concludes should no longer be an afterthought but a critical component of decision-making. A basic assessment of brand reputation, awareness, and image for the purposes of financial statement asset valuations will compromise long-term shareholder value. Thought should be given to how the brand will impact demand, customer preferences, brand premiums, consumer buying behaviours, brand equity, the interplay between business strategies and brand strategies, and the brand’s transition process. 

The author would like to thank Victoria Riley, articling student, for her assistance in preparing this legal update.

Acquisitions of freight carriers and other commercial vehicle operators: the road to regulatory compliance

Transport by road is a major and developed industry in Canada and the United States. The acquisition of a freight carrier – a commercial vehicle operator – may trigger varying levels of regulatory registration and compliance requirements, depending on how the transaction is structured. The same concerns will often arise in acquisitions of entities that are not freight carriers, but operate a commercial vehicle as part of their business. The regulatory framework applicable to commercial vehicle operators can be surprisingly complex and should be taken into account when acquisitions are contemplated.

Generally, freight carriers have three basic types of regulatory requirements that apply to a fleet, all of which are set out in more detail below. Of note, it is likely that target entities other than carriers that operate commercial vehicles as part of their business will be most concerned with the second type of regulatory requirements – safety certification – especially if the commercial vehicles are operated exclusively within the province in which they are, or will be, registered.

The first type of registration requirement is registration of commercial vehicles themselves. Registration of commercial vehicles is a provincial responsibility. However, provincial legislation and regulations have been harmonized to a great extent in order to allow freight carriers to have their vehicles plated in a Canadian jurisdiction and travel without additional registration or permitting requirements into other Canadian (or United States) jurisdictions. All Canadian provinces and 48 of the United States are member jurisdictions of the International Registration Plan (the IRP). The IRP program provides for plating of vehicles and payment of registration fees in a single “base” jurisdiction, based on fleet distances operated in various jurisdictions. This type of registration is referred to as “prorate”. Generally, a carrier will have an “account” for the purposes of the IRP program, to which it can add new commercial freight vehicles when these are purchased. Operators other than carriers may consider “local” non-prorate registration. In share purchase transactions, the registration requirements are simplified as commercial vehicles are already owned and registered by the entity being acquired. Where vehicles are being transferred, the registration requirements can present more of a challenge, as registration may take time.

The second type of registration requirements pertain to safety certification of the operator. While administered provincially, the area of commercial vehicle safety has been largely streamlined across the provinces over the last decade. Provincial safety certification programs follow the requirements of the National Safety Code. Across the provinces, the name of the safety certificate itself can vary. In Ontario, the Commercial Vehicle Operator’s Registration is the equivalent, while in Quebec, a Registration Identification Number will correspond to a National Safety Code number. Generally, safety certificates issued by the “base” province of the operator (that is, where the vehicle is registered) will be recognized by other provinces where the vehicle is operated. Once an operator entity obtains a safety certificate, it will be assigned a profile that reflects its ongoing safety compliance ratings. Safety certifications need to be considered in the context of an acquisition of a carrier or other operator of commercial vehicles. Even in share purchase transactions where the target entity already holds a safety certificate, certain changes to a corporate entity holding such a certificate will trigger notice requirements in certain provinces.

The third type of regulatory requirements normally applies to inter-provincial and international freight carriers. These types of operators are required to obtain an International Fuel Tax Agreement (IFTA) number. This requirement is triggered by, among other things, the physical characteristics of the commercial vehicles operated (weight and number of axels). Notably, registration of a new IFTA number can take a significant amount of time. For example, obtaining an IFTA number in British Columbia may take up to 21 days.

Finally, acquirors need to consider special vehicle requirements and permitting that can vary across the provinces. For example, maximum prescribed vehicle weight, permitting for over-sized vehicles, or requirements associated with operating long combination vehicles in Alberta.

Doing business in Canada: M&A considerations

canadian-flag-on-buildingCanada is a top destination for foreign companies and investors attracted to our wealth of natural resources, stable and sound political and financial systems, and world-class infrastructure. While Canada is an open economy and welcoming of foreign investment, there are issues that corporations and investors should keep in mind when doing business in Canada. Norton Rose Fulbright’s guide, Doing Business in Canada, provides a general overview of the principal corporate, tax and other legal considerations that would be of interest to foreign businesses wishing to establish or acquire a business in Canada.

Of particular interest in the M&A context, the chapter on competition and Foreign Investment Laws addresses sections of the federal Competition Act relevant to an acquirer of an existing Canadian business. The Competition Act sets out a framework to promote and maintain fair competition and applies to Canadians and non-Canadians alike.The Competition Act prohibits certain anti-competitive business practices and also provides the Commissioner of Competition, who heads the Competition Bureau, with the ability to review merger activity in Canada. Where the Commissioner believes a transaction is likely to prevent or lessen competition substantially, he may challenge the transaction before the Competition Tribunal, an independent quasi-judicial body.

There are two parts of the Competition Act that apply to the acquisition of an existing Canadian business which any investor must consider:

  • the pre-merger notification provisions in Part IX of the Competition Act; and
  • the substantive merger provisions in Part VIII.

Of note is that the above provisions apply independently. Thus even if a transaction is not subject to mandatory pre-merger notification provisions in Part IX, a transaction may nonetheless be subject to the substantive merger provisions in Part VIII of the Competition Act. The chapter on competition and Foreign Investment Laws speaks to both of these provisions in detail, and also considers related practical considerations, as well as issues in respect of confidentiality and the regulation of anti-competitive practices. The chapter also considers the applicability of the Investment Canada Act in M&A transactions and, more specifically, what constitutes a reviewable or notifiable transaction thereunder.

It is vital to consider competition and foreign investment laws and best practices early on in any deal making process. In addition to offering a convenient primer on the principal competition and foreign investment laws relevant to doing a deal in Canada, Norton Rose Fulbright’s guide, Doing Business in Canada, also sets out the corporate, tax and other legal considerations relevant to ensuring that a Canadian deal is executed in a successful timely and efficient manner.

A new reality: living with lower oil prices

The below is an excerpt taken from a bulletin published on the Norton Rose Fulbright (United States) website earlier this month. Please click here to read the entire bulletin, which also includes an overview of managing contractor and counterparty exposure, proactively reviewing and renegotiating contractual arrangements, mitigating the risk of contractor exposure in construction projects, shareholder activism, communication and public relations, and political risk.


Following a prolonged period of high oil prices, the world must adjust to a ‘new normal’. Opinion as to where the average spot price will hover following the current volatility varies but the consensus is that oil prices will remain considerably lower than they were pre-June for the foreseeable future.

Where does this leave oil companies, many of whom modelled their new exploration and production (E&P) projects around oil prices of US$90-100 bbl? What are the wider ramifications of the lower oil prices – on the web of oil services companies, suppliers and related infrastructure – and how can oil companies mitigate the effect that lower oil prices may have on both themselves and those with whom they do business?

This briefing sets out some of the strategies and options that E&P companies (as opposed to petrochemical or refining companies, banks or oil service providers) might think about as the market adjusts to a new normal, and highlights some key issues to consider.

When, not if

Effective hedging means that many oil companies may not feel the effect of lower oil prices until 2016-2017. However, most economists maintain that the economic climate has undoubtedly and irrevocably changed for the next few years and oil companies would be wise to review at what point they are likely to be exposed.

This would be a good time to review financial models and agree a strategy to manage the business should oil prices breach certain thresholds.

Portfolio management

Many oil companies may decide to reduce their overall capital expenditure load. This may emanate in an overall cut in expenditure budget, or a strategic change in direction away from capital-intensive, high risk and technically challenging drilling projects towards improving margins and generating maximum value from existing operating projects through step-outs and neighbouring structure exploration.

If there is a case for divesting assets, then a well-structured, targeted and timely divestment plan will be essential for generating maximum value. Oil companies looking to raise capital and drive shareholder value will be separating core from non-core assets, and/or divesting underperforming or non-core assets in order to put capital to use more efficiently elsewhere.

Alternative sources of finance

In a period of lower oil prices it will almost inevitably become more difficult for companies to raise development capital. Ultimately, lenders will look to the long term sales contracts that underpin a project and the credit of the counterparty to ensure that there is long term and adequate cash flow available for debt service. Given that the price agreed under many off-take and long term sales agreements is often determined according to industry price indices, a period of lower oil prices will inevitably have an impact on a company’s ability to generate revenue, and so attract finance.

E&P companies seeking finance may need to explore alternative sources of finance to fully fund the development and operation of their projects, and in a tightening bank market, there is likely to be an increasingly reliance on these alternative sources of finance.

Alternative finance approaches are growing in number and scale. Understanding how these different financing tools work and interact together is essential to navigate the sometimes challenging intercreditor issues. This is particularly relevant given the likelihood of a new investor base with different investment appetites and requirements. Regulatory frameworks may also have an impact on the availability of options.

Some of the options for oil companies seeking finance include:

1.     Private equity

Management teams seeking capital to realise or accelerate development projects are seeing increasing interest from private equity funds. For private equity funds – particularly the increasing number with dedicated energy funds – a period of lower oil prices is an opportunity to acquire and develop assets with attractive valuations. Private equity funds are playing a growing role in mature producing fields, high-impact exploration and facilities, and we anticipate significant activity in PE investments as energy producers look to sell assets and bridge cash shortfalls.

2.     Commodity and royalty streaming

This source of finance is likely to become more prevalent in the oil sector if it becomes difficult to raise capital through the equity and debt markets. Streaming finance is raised by selling a right to a commodity in exchange for an up-front payment.

3.     Offtaker financing

Downstream oil purchasers can be a good source of additional finance if they are prepared to make an equity investment in or provide straight commercial debt to a project. The most common form of off-taker financing is a combination of:

  • An advance payment for future production (a prepayment) which is amortised against deliveries, and
  • A discount to market price under the offtake agreement.

4.     Trading house development finance

Trading houses with growing balance sheets are increasingly financing select developments and acquisitions, in order to access offtake and financial return opportunities.

We are seeing a growing interest in the use of convertible bonds to finance development of discovered reserves, with all physical offtake committed at a discount to benchmark prices. Committed physical offtake allows for longer term trading positions to be taken to gain a further margin.

5.     Equipment and tied-finance

Manufacturers of oil services equipment often provide financing to development projects to finance the purchase of their own equipment and therefore enhance their own sales volumes. Equipment manufacturers have established lending arms in order to participate alongside (and on the same terms as) senior lenders in providing senior secured debt of sometimes up to an additional 100% value of the equipment for the project. Contractors may also provide capital for services, or trading services for equity; in some cases they may also provide capital alongside a private equity fund.

6.     Export credit agencies

Multilaterals and export credit agencies are increasingly involved in mega-projects in the energy sector, and their involvement in a project can be persuasive for commercial lenders.

The export credit agencies of countries in which plant or equipment necessary in the project will be sourced can provide credit support guarantees to the commercial lenders, thereby substantially reducing the risk (and pricing) of the financing of the project. Each ECA has its own requirements and criteria to satisfy in order for their participation.

7.     Development finance institutions

Multilateral and development finance institutions may be willing to fund part of the project development costs, especially where there is a direct development benefit to the country where the project is based. Each development finance institution has its own set of criteria, usually including environmental and sustainability requirements, in order for the project to be eligible to receive such funding.

8.     Completion support

Completion support is often used in project finance transactions to provide the banks with additional protection. It allows the banks recourse to the sponsor for any financial contribution in excess of the agreed initial equity contribution. It can take many forms, but in each case the sponsor provides the banks with recourse by guaranteeing that the project will be completed by an agreed date.

The requirement for completion support reflects the level of risk associated with the pre-completion phase of a project. Completion support provides support during this phase and so helps offset the risk that the banks will not be repaid.

9.     Convertible bonds

Convertible bonds are a form of hybrid security that gives investors the right to convert their bonds into shares of the issuer (or sometimes into shares of another company) during a specific period and at a specified conversion price, usually at a premium to the current market share price of the shares at the time of pricing. On conversion new shares are issued to the convertible bondholders as consideration for the redemption of the convertible bonds. Convertible bonds are a comparatively cheap method of funding, since the annual servicing costs are generally lower than those for plain vanilla bonds because the coupon paid to investors is lower or even zero.

The issuer benefits from being paid upfront for shares which are to be issued in the future. This may be of particular value where an issuer is reluctant to seek funding directly through the equity markets because it feels that its shares are currently undervalued.

Care should also be taken by the borrowing entity that it is not exposing itself to unacceptable risk by accepting significant investment across a range of products from a single investor or a group of investors.

Restructuring and insolvency

If market conditions have such an adverse impact on trading conditions that continuing operations ceases to be feasible, restructuring should be considered at an early stage.

It is important to develop a restructuring plan and to consider a standstill agreement, not least to ensure that the directors avoid the severe penalties imposed in most jurisdictions for trading while insolvent. The restructuring plan may include proposals for repaying creditors, seeking additional funding or security collection with respect to debtors; restructuring or preserving assets for sale. It should also propose financing solutions, such as permitted transfers of assets, share pledges and guarantees, borrowing of super senior tranches, shareholder loans and convertible shares.

Concluding comments

History demonstrates that the oil sector is capable of enormous volatility, and can generally withstand the swings in pricing and demand flows. How long the current period of low prices will last is a source of constant speculation, and any resulting ‘momentum investing’ may make price changes even more pronounced. Investment decisions relating to projects where production is envisaged for 5-10 years hence clearly should not be taken on the basis of current prices.

The current climate may also present opportunities for E&P companies (and their investors). Private equity funds have billions of dollars of energy capital to deploy to experienced management teams with strong underlying assets, and as noted in the Political Risk section which can be accessed in the full version of the bulletin, governments’ enthusiasm for continued foreign investment during more challenging times can result in a more attractive energy investment regime. There are a range of options available for those seeking alternative financing solutions, and wherever E&P companies sit on the oil price cost curve, now is the time to review portfolios and revisit service and marketing contacts.

Commodity price declines present M&A opportunities for well-capitalized industry players or private equity firms

It is not uncommon to see acquisition opportunities arise at the bottom of a commodity price cycle, as low prices put pressure on companies to sell assets at revised down prices, in order to raise cash to fund projects or offset revenues lost to low commodity prices. Low oil and gas prices therefore promise to make 2015 a year in which well-capitalized players find opportunities to invest or grow in the oil and gas industry.

The stunning decline in oil prices since June of 2014 has been precipitated by a number of factors. On the supply side, unprecedented levels of US oil production and OPEC’s refusal to curb its member states’ production levels have resulted in a glut of supply; and on the demand side, weak global economic activity, increased climate change and energy efficiency initiatives, and movement to alternative energy sources are all factors playing into consumption levels failing to keep pace with the high levels of oil production. And although overshadowed by the oil price media frenzy, natural gas prices have been subject to a similarly striking downward trend in recent months, hitting a 28-month low in January of 2015, after a mild December throughout much of North America left natural gas reserves at unexpectedly high levels and investors pessimistic about the ability to achieve significant profit gains in the last few months of winter.

While the causes of the downturn in commodity prices seem capable of being identified with some level of precision, it is far from clear that an end to these price falls can be pinpointed with anything close to a similar level of certainty. Indeed, as one witnesses the successive upending of market analysts’ projections about the ‘final’ price bottom having been reached, it seems clear that the only thing that one can safely conclude is that the ultimate price floor is anyone’s best guess.

In this context, the critical question for companies contemplating whether to buy or sell in this industry may become less a matter of “if” to act, and more a question of “when”. Well-capitalized companies and private equity firms will have good reason to aggressively pursue opportunities to consolidate with, or acquire the assets of, smaller firms with weak balance sheets. Conversely, many of these undercapitalized firms will be reluctant to sell in this market, and are likely to hold out as long as possible in hopes of a price recovery.  But as daily industry news reports are making clear, it is likely that a good number of firms will ultimately have no choice but to merge or sell at discounted or distressed prices, particularly if prices continue their decline and destroy firms’ ability to borrow funds or raise capital. Companies that do have to do a ‘deal of necessity’ in these circumstances may push for a share transaction structure in order to preserve their ability to participate in any upside when markets improve.

In sum, today’s bearish market conditions are tough but not without their upside for the right industry players. Companies and private equity firms with sizeable cash reserves can rightly be expected to pursue opportunities to acquire strategic assets, achieve economies of scale or realize operational efficiencies in the context of a buyers’ market.