The "not-so-new" oil and gas investor

By its nature, the oil and gas industry requires substantial capital at various stages of the asset life cycle. Now, arguably more so than ever before, finance from private equity (PE) funds is being seen as one of the most likely sources of capital for organic and inorganic development in the sector.

The drop in the oil price since 2014 coincided with a number of PE funds indicating that they will focus on investment in the sector. A significant amount of press coverage in recent times has focused on PE funds as a new investor in the oil and gas sector (particularly the upstream sector), however, this is not strictly true.

This article provides an overview of the current landscape of PE investment in the oil and gas sector. It begins by highlighting certain key developments in investment in the sector over the past two decades. It then sets out an introduction to some of the key features of PE transactions, before analysing, at a high level, a number of legal and commercial considerations that are relevant for PE investment in the oil and gas sector.

Key developments

Over the past two decades, large PE funds have increased their participation in the oil and gas sector. Blackstone’s and Warburg Pincus’s investment in the independent exploration company Kosmos Energy in the early 2000s, for example, was a particularly notable transaction. The deal involved a significant initial commitment of US$300m and a further US$500m in 2008 to enable Kosmos to accelerate its exploration efforts in West Africa. The investment paid a remarkable dividend when Kosmos discovered the Jubilee field off the coast of Ghana in 2007, one of the most important discoveries in West Africa’s history. In 2011, Kosmos listed its shares on the New York Stock Exchange. While such “pure exploration plays” are quite rare in the PE sphere due to the level of risk involved, it demonstrates the upsides on offer to PE in the industry.

Since then, investment has ramped up substantially. Research by EY into PE investments in oil and gas found that in 2014, PE oil and gas deals around the globe amounted to US$38.6bn. Furthermore, whilst there was a slow start to 2015, the rest of the year saw activity that was very much in line with previous years, and the first quarter of 2016 has seen deals worth $7.6bn. While a large proportion of this investment has been in unconventional oil and gas assets (particularly in the US shale industry), funds have begun to emerge with a forward-looking focus on investing specifically in North Sea oil and gas assets.

There are several factors that have driven this pivot towards North Sea investment, with one obvious factor being the oil price. As the price of oil fell from its peak in 2014, companies have come under increasing pressure to divest non-core assets in an attempt to cut costs and maintain dividends. The result has been to increase the availability of assets in the region and reduce the number of purchasers competing for those assets.

A second factor is the rise in the number of companies or assets under stress due to a combination of the fall in energy prices and the financial crisis. Funding from banks and the capital markets has largely dried up for these companies, and therefore the need for them to raise capital quickly has left a void which is beginning to be filled by PE. It is also an attractive opportunity for PE funds who focus on increasing value and margins by way of efficient asset management.

In parallel with these situations playing out, we have seen the establishment of, and investment by, a number of funds in North Sea oil and gas. These include the reported US$500m commitment by Blackstone and Bluewater to newly formed company Siccar Point Energy, which has a specific focus on the North Sea; Carlyle and CVC coming together to establish Neptune Oil & Gas, an entity being led by the former chief executive of Centrica, Sam Laidlaw; and Kerogen Capital who have invested in Zennor Petroleum (formerly MPX UK) and Hurricane Energy.

More broadly, L1 Energy was established as part of the international investment group LetterOne Group and is led by Lord Browne, the former CEO of BP. This has been funded by Russian billionaire Mikhail Fridman with the objective of acquiring a portfolio of currently undervalued oil assets. L1 Energy has also made it clear that it is particularly interested in assets in the North Sea and Europe and, to that end, it made a number of acquisitions in the last two to three years including those of RWE Dea and E.ON’s Norwegian assets.

Types of private equity investment

“Private equity” is an umbrella term that captures many forms of private investment into entities (here referred to as “targets” or the “target”) that are not listed on a recognised stock exchange.
 
The form of investment chosen is largely dependent on the type of assets that the target holds, the life-stage that the target is at, and the degree of risk that the investor is willing to take. The main forms of PE investment include the following:

• leveraged buy-outs (LBos) – a transaction is financed by a mixture of debt and equity. LBOs are typically used to acquire a majority controlling interest in a target and seek to make a profit by increasing the capital value of a target and through financial leverage. The target that is bought out tends to be well established with stable cash flows, which are used to fund the interest and principal on the debt used to finance the acquisition;
• venture capital – equity finance is provided to a potentially high-growth target that is embarking on a new venture, which can either be the commencement of the target’s activities as a whole or where it is expanding into a new area. The equity investor usually takes a minority stake. Returns are often generated through the development of new technologies and embryonic projects that have not been executed before;
• growth funds – like venture capital, these investments are usually made in order to acquire a minority stake in a target. The differentiator between growth funds and venture capital is that growth funds focus on more mature targets that are seeking to expand or increase efficiency, so the investment is seen as somewhat less risky; and
• infrastructure funds and direct investors – investors in longer-term stable and public projects; for example, oil and gas pipelines and storage. This provides an investment opportunity for institutional investors who are seeking a low-risk return over a number of years.

An investor’s objectives and risk appetite can therefore be carefully aligned with the type of equity investment pursued and the type of activities that the target deals with. For example, an investor seeking high returns may wish to invest in a venture capital fund which might pursue unconventional projects, which tend to use relatively untested methods and technologies but can potentially achieve high returns. On the other hand, an investment in conventional projects will likely involve a more established target and be more capital-intensive, making it an appropriate investment for an LBO fund.

Structure of an oil and gas private equity investment

There are a number of features that distinguish PE investment from other forms of investment. One key feature is the fact that a PE fund is managed by a manager who decides what to invest the funds in, and the manager may also, in some instances, take a stake in the investments they choose in order to retain some of the risk of the investment, which is reassuring to the private investors.

The PE fund may also partner with a specialist management team to make the investment. Given that the oil and gas industry is such a specialised sector, the PE fund will be particularly reliant on the expertise of the management team that it partners with.

Particular legal and commercial considerations for oil and gas PE investments

Having regard to the various types of investment that can be made in the oil and gas sector, there are several legal and commercial factors that are often considered as part of an investment decision.

Legal structure and risk
Whether the PE fund joins forces with a management team or otherwise, in most cases a special purpose vehicle (SPV) will be incorporated to acquire the target assets, and it is this SPV that the PE fund will acquire equity in. In some instances, the structure will also include a newly incorporated subsidiary of the SPV, with the investors subscribing for shares at the SPV level  and external debt finance being provided to the subsidiary, which will then make the acquisition of target assets. This is beneficial to the investor for a number of reasons, including the fact that the investor can be reassured that they are investing in an entity which will (usually) not have any historic liabilities. This means that due diligence can be limited to the target assets only. Secondly, separate legal personality is established with the SPV being distinct from the PE fund and management, usually with the aim of shielding the PE fund and management from the liabilities of the SPV (and  its subsidiaries) through the principle of limited liability.

However, in the UK, investors need to be aware of the statutory liability regime that applies in relation to the decommissioning of oil and gas installations and pipelines under the Petroleum Act 1998. Broadly speaking, that regime makes all licensees jointly and severally liable for decommissioning of those installations and pipelines, and also extends that liability to associated companies of licensees and certain other persons. Given this potentially significant liability, careful consideration must be paid to the structuring of the investment from the outset to ensure that the PE fund is sufficiently disassociated from the SPV within the legal structure and does not exercise enough control to bring it within the ambit of this regime. However, this issue needs to be balanced against the competing concern for the PE fund to have enough control to be able to effectively monitor its investment and steer the company’s activities in an appropriate strategic direction.

Choosing a management team
The management team is crucial to any investment being a success. The investors will conduct significant due diligence to ensure that the management team has the appropriate skills and experience of running entities that correspond with the targets that the fund is looking to acquire and driving future growth in line with the PE fund’s strategy.

Investors will also want to consider the proposed strategy of the management team. The investors will have some say in the overall strategy of the target, but it will, under supervision, be the management team that takes this forward and implements it.

Protection of investment and jurisdiction of the SPV
The jurisdiction of the SPV used  as the acquisition/investment vehicle is an important factor for the PE fund to consider to ensure that the fiscal and regulatory regimes in place are going to complement the objectives of the investment.

Tax efficiency is likely to be the biggest driver here. However, from a legal perspective, the PE fund will likely prefer the SPV to be incorporated in a jurisdiction that has a bilateral investment treaty in place with the country where the relevant assets are located, particularly when investing in emerging markets.

Degree of control retained by the Investors
Although a significant degree of trust will be placed in the management team, the PE fund will likely want to retain levels of control over the business. This is usually provided for in an investment agreement between the PE fund and the management team which will, among other things, set out a number of reserved matters which the PE fund will need to agree on, in addition to the board, before a final decision can be made.

The PE fund will usually expect to have the right, under the terms of the investment agreement, to appoint directors to the board.

Level of investment
As mentioned above, the objectives and attitude of the PE fund will influence the type of investment, including how much equity they choose to provide. Depending on the attractiveness of the assets concerned, the PE fund may also want to ensure that it has the option to make further investments if the opportunity arises.

If the PE fund is investing in an upstream oil and gas company, the activities of that target will likely require further capital over time, for instance, to invest in further exploration in a particular region. The  PE fund may not want to invest in all of these opportunities, but may want to be presented with the option to do so in preference to bringing in a new third party investor. This can be achieved by providing for pre-emption rights in respect of new equity or shareholder debt in the investment agreement.

The parties may alternatively prefer to make it clear from the outset what circumstances will trigger further investment. In such cases, the investment agreement can establish a “line of equity” whereby if the target company or assets achieve prescribed goals or criteria, the PE fund will be committed to taking a further stake or providing additional capital. If this is the case, related issues will need to be dealt with so that the line of equity can be implemented smoothly. For instance, the constitution of the SPV will need to permit increases in capital. The constitution or investment agreement will also need to deal with the consequences (if any) of an increased equity stake held by the PE fund, whether the management team will have a corresponding obligation to take up further equity, and what procedure will be followed if either party defaults on such obligations.

Where the management team defaults on this obligation (if it exists) or chooses not to provide additional capital, the PE fund will likely require an option in the investment agreement to facilitate taking up the managers’ share as well. This can be achieved in two ways: first, the PE fund could include a right to unilaterally provide further equity and proportionately dilute the equity held by the managers. However, this is likely to be unattractive or, at the very least, a disincentive to the managers. Alternatively, the PE fund could be compensated with a preference instead of further equity, so that its investment ranks above that of the managers in a liquidation.

Degree of risk in oil and gas activities
The  PE fund may be reluctant to invest in an oil and gas target with extensive future minimum commitments to fulfil. As demonstrated by the oil price in the last two years, oil and gas companies may need to have the flexibility to be able to adapt their activities to prevailing market conditions. To achieve this, the target should have freedom to select the type of projects it can expend its capital on. The investment agreement may also support this by setting out a monetary threshold of decisions above which the PE fund must agree in advance, so that it can control how concentrated the target’s expenditure is on a particular type of activity and indirectly support diversification.

In some scenarios, the PE fund may want to obtain a right of syndication in the investment agreement. This could be particularly important, for instance, where the PE fund wants to reduce its exposure to the risks associated with activities that the target is involved in, particularly if it believes that it is no longer likely to
see a satisfactory return on its investment. A right of syndication would, in such circumstances, allow the PE fund to reduce all or part of its investment by transferring it to another entity in a syndicate group which would likely be identified by the investment agreement. Importantly, this ensures that the PE fund can remain flexible and can initiate a transfer in order to invest the proceeds in a more attractive opportunity.

Method of exit
The ultimate aim of any  PE investment is likely to be to achieve a successful and profitable exit. This means that, even from the outset, investors will have to consider what type of exit option they want to put in place. Exit strategies include an initial public offering, secondary buyout (where the same management team partners with a new PE fund) and a trade sale.

Conclusion

PE investment in the oil and gas sector is not new and it is clear from the activity we have seen in 2016 that it is likely to continue. What is new is the geography and the scale of investment in the upstream sector which PE is focused on. In the current environment, PE can  potentially provide a new source of capital to the industry where other options are not currently open.

It is important that parties early on in any investment recognise the key issues, particularly those that are bespoke to the sector, and focus on agreeing those terms early to avoid any mismatch in expectations later on.