C. Spencer Johnson III
King & Spalding LLP
Atlanta
Archie Fallon
King & Spalding LLP
Houston
The precipitous drop in crude oil prices since June 2014 has left many growth-stage upstream oil and gas companies requiring new equity investment in order to fund exploration of shale play prospects and existing drilling programs.
In many instances, lenders are having difficult conversations with distressed companies about strategies to restore compliance with credit facility financial covenants through drilling program curtailment, recapitalization, and asset sales. At the same time, the public capital markets have closed for many of these companies.
While some companies have turned to institutional funds that specialize in providing capital to fund growth opportunities in challenged industries or to distressed companies, there may be recapitalization alternatives for companies already sponsored by a private equity fund without the need for placement fees or third-party costs. Those companies may find that large institutional limited partners of the sponsoring private equity fund have a strategic interest in making a direct investment alongside the sponsor’s fund in order to obtain additional exposure to the company and the shale plays or plays where it operates.
Further, the sponsor may have access to third parties interested in recapitalization opportunities.
In this type of offering, if the company is issuing new securities to both the private equity fund and to a population of the fund’s limited partners or third party investors making a concurrent investment alongside, but outside the fund, these investors are commonly said to be "co-investing" with the fund.
This article provides analysis of key benefits of a co-investment transaction and also identifies three key issues to consider.
From the private equity sponsor’s perspective, a co-investment transaction can provide strategic capital–from rescue capital to growth capital–for a portfolio company without necessarily ceding control over the governance of the company to one or more new investors.
This option may be particularly attractive to the sponsor once its fund that made the original investment in the company no longer has remaining capital commitments or has reached a geographic concentration limit. For example, a fund may be organized so that not more than 30% of its capital commitments are invested in companies operating within the Eagle Ford shale formation (or a subset of counties therein).
In some cases, the private equity sponsor can earn management fees and carried interest for organizing and managing the additional investment outside the fund.
The sponsor may limit co-investment opportunities to limited partners who have made minimum capital commitments to its sponsored fund (so-called "most favored nations" investors). Accordingly, the sponsor may use co-investment opportunities to incentivize larger capital commitments to its funds, which may be particularly attractive to investors when M&A markets involving shale producers are active and transactions are difficult to source.
From the company’s perspective, if existing limited partners of the fund co-invest alongside the fund, the company can potentially close the capital round faster than if the company raised capital from new investors unfamiliar with the company’s assets and strategy for developing those assets. For companies involved in exploration and production, this execution speed is always an important factor.
Further, in a co-investment transaction, the company may potentially access capital ultimately managed by the same private equity sponsor (though perhaps managed outside of the sponsor’s existing fund); consequently, the company can avoid a change of control and related disruptions to the business.
These disruptions may include preferential rights associated with leased properties or joint operating arrangements, consents and fees from lender groups and the time-consuming process of renegotiating a new governance structure.
Pre-emptive rights checked
The terms of applicable pre-emptive rights represent a key consideration in any potential co-investment transaction as they often dictate how and to whom the securities may be sold. Co-investment transactions may require pre-emptive rights analysis at multiple levels. Before the operating company issues new securities to a group of co-investors, the company’s organizational documents will dictate whether the company’s existing equity holders are entitled to the first right to fund the company’s capital needs (or else waive their respective rights and be diluted). The private equity sponsor’s limited partnership agreement or other similar organizational agreement may separately dictate that if a portfolio company of the private equity sponsor requires financing above and beyond the sponsor’s capital commitment to the company, the general partner will give all or certain limited partners of the sponsor the opportunity to fund the required capital before third-party investors fund the required capital.
In addition, if the initial terms of an offering change during the negotiation of the investment, the pre-emptive rights could "re-load", requiring the company and the sponsor to again offer pre-emptive rights on the basis of the new offering terms. There could be exceptions to these pre-emptive rights, including if the company decides to hire an investment bank or placement agent, to raise the required capital.
Some sponsors permit only investors meeting "most-favored-nations" criteria to participate in co-investment transactions.
Terms of new securities sold
The terms of new securities issued by a portfolio company to co-investors will depend upon a number of factors, including the strategic need for the capital to fund new projects, the company’s production profile, reserve reports, and historical and projected earnings.
Co-investors making investments in companies perceived to have riskier asset portfolios (e.g., significant 2P or 3P reserves) often seek terms that simulate debt instruments through preferred equity securities that are senior to the common equity in the company.
For example, co-investors may require regular, mandatory distributions of cash flow before any cash flow is available for distributions to common equity holders, at least until the co-investors reach an agreed rate of return.
Companies needing flexibility around mandatory cash distributions will seek the right to defer and have accrued such distributions as well as to pay such accrued distributions in kind.
In order to provide additional upside to these preferred securities, co-investors typically require some incremental common equity or asset-linked component (or "kicker") affording continuing participation in the company’s or the underlying asset’s economic performance once the hurdle is met.
There are different ways to structure a kicker, but one structure is to issue warrants to the co-investor that are exercisable during a given period of time for common equity in the company. Co-investors often also seek to enhance their return by acquiring an interest free from the costs of production in new wells funded by their investment.
These kinds of interests are often structured as overriding royalty interests. As part of the process for acquiring such interests, the co-investors must diligence the title to the relevant assets held by the company from which the override derives, including any existing encumbrances or preferential rights of third parties that could be triggered upon the issuance of such an interest.
Investor rights vary
Co-investors often will negotiate their investors’ rights package in a manner similar to any non-control investment, seeking restrictions on the controlling investors adversely modifying the co-investors’ economic and other rights, exit protections and some level of governance visibility.
The protection of economic and other rights typically come in the form of covenants and consent rights running in favor of the co-investor. To protect their core economics, co-investors will typically seek a covenant from the company restricting the issuance of new securities that out rank the new securities sold to the co-investors, either in terms of liquidation distributions or cash flow distributions.
Additional examples of these provisions include anti-dilution protection through pre-emptive rights in successive securities offerings, and covenants from the company on the size and scope of properties secured by new indebtedness. These covenants also typically include a right for the co-investor to exit at the same time and in the same manner as the sponsor’s fund invested in the company. At the asset level, investors would seek restrictions on the company’s disposition of interests in production (e.g., overriding royalties) to third parties. It is of critical importance in structuring these covenants that the company take into account its level of flexibility for future capital transactions and operating parameters in order to successfully run the business.
The requested governance rights of co-investors will vary based on the strategic need for the capital. Investors who view themselves as rescuing the company in general negotiate for more rights. Generally, co-investors seek to have a representative on the company’s governing body, either one with the right to vote or who is an observer. In addition, like any investor, co-investors will require periodic reports that contain financial statements of the company, reserve and well production information and management analysis of the asset development plan. It would be unusual for co-investors to seek control over operational decisions of the company, which are reserved to management and the company’s governing body, however, investors that perceive a need for their capital that would otherwise go unfulfilled are likely to push for specific consent rights over major decisions. These major decisions may range from approving a new drilling program or acquiring significant new acreage to entering long term production marketing contracts. Importantly, the scope and extent of the governance rights should be negotiated on a basis that takes into account potential change in control or other comparable relationships of the company, including commercial arrangements and debt documents.
As private equity sponsors and their portfolio companies operating in shale plays and elsewhere seek capital during a challenging price environmental, they may find that the sponsor’s institutional investors have interest in directly investing in portfolio companies alongside the sponsor’s fund.
Sponsors can co-invest with these institutional investors to avoid potentially more expensive third-party capital, keep control over the portfolio company and avoid a long diligence process with a new investor not familiar with the business. In negotiating these arrangements, the sponsor should be mindful of existing relationships and contractual arrangements that may place limits on the scope of the rights granted to the co-investors.
The authors
