Your account already exists. Please login first to continue managing your settings.
Inorganic growth is an important goal for many companies. But like growth through the drill bit, transaction risks need to be managed.
It might surprise some that Houston ranked second only to New York City for M&A deal value during the first nine months of 2011, according to the Houston Chronicle. To be sure, this was a notable achievement considering that US metropolitan areas such as Chicago and Boston have a significantly higher presence of venture capitalists, private equity firms, and hedge funds whose business models essentially consist of buying and selling companies.
But to those in E&P, Houston's emergence as a hotbed for M&A activity was far from unexpected. Since their primary assets (i.e., reserves) are a dwindling resource with a finite value, E&P companies are under constant pressure to acquire and exploit reserves or buy other E&P companies when they cannot replace reserves organically. Fortunately, their historically strong balance sheets and cash positions allowed them to make deals last year, even as many other industries and locales were forced to retrench.
Understanding key transaction risks and negotiating and structuring the transaction to mitigate them are critical to a successful deal. After all, a single M&A transaction can alter a company's future significantly. The challenge is that most companies are operationally focused and typically do not have sufficient M&A experience at the executive level or the infrastructure needed to acquire and integrate companies effectively. With so many E&P company earnings and reserve restatements stemming from acquisitions in recent years, it is clear that the industry is not immune to this challenge.
With that in mind, it is a good idea for E&P executives to examine key transaction considerations that are unique to their companies and have the potential to negatively impact capital deployment and/or cash flows if not properly measured and factored in. Grant Thornton's Energy Transaction Advisory Services group helps companies assess E&P transaction risks. Executives should consider a number of essential items within these categories when conducting due diligence.
Transaction risk assessment
There are five overarching categories for assessing transaction risk. Reserve and production characteristics. Concerns here include:
Reinvestment. Concerns here include:
Operating and capital efficiency. Concerns here include:
Non-E&P operations. The major concern here is the potential for significant liabilities related to other businesses (e.g., midstream, distribution, or refining/marketing) with different risk profiles, such as an out-of-the- money trading book from aggressive marketing/trading activity or environmental liabilities from refineries and chemical plants.
In addition to looking at these items while conducting their due diligence, E&P companies should consider factors that fall outside these broader categories. Following are some of the questions clients should answer: Does the asset base, as currently leveraged, generate adequate return on capital invested? If not, what are the scenarios to optimize investment? What are the strategic synergies that can be created by the transaction under consideration, and how are they expected to impact the overall value chain? Are hedging programs in place to protect against commodity price exposures? Are there any joint venture or royalty issues, counterparty risks, or off-balance sheet financing contingencies?
The challenge, of course, is finding the best way to perform financial and operational due diligence in today's environment of limited or stretched corporate development budgets. Companies can build out their corporate development departments, engage experienced transaction advisory professionals to leverage their internal team, or elect to do both. Whatever approach a company takes with respect to due diligence, the rewards for conducting it will be clear: The company will not only make more informed decisions but also perform its fiduciary duties for its investors and lenders in an optimal way.