Taking upstream companies public

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TRADITIONAL CORPORATE IPO

A traditional, corporate IPO is the most common and well-known form of accessing public capital. In its most basic sense, a sponsor company would transfer assets to a newly formed corporation, and that corporation would file an S-1 Registration Statement with the Securities and Exchange Commission (SEC) and ultimately issue stock to the public. If the sponsor entity currently holds assets in an arrangement that is classified as a partnership for US federal income tax purposes, further consideration should be given to the method of conversion (and timing) to a corporation in preparation for an IPO (e.g., assets-over, assets-up, interests-over, formless conversion, etc.).

The traditional corporate structure generally results in two levels of tax (double taxation) - the corporation pays tax on its earnings, and the shareholders generally pay tax on distributions (dividends) received from the corporation. Further, investors in a traditional, publicly-traded corporation would receive a Form 1099 - which can result in broader investment interest from tax-exempt investors and non-US investors (who generally prefer corporate investments for US federal income tax reasons). Similarly, institutional investors have historically preferred corporate investments for the same reasons, although the MLP investor base has evolved over time to include an increased percentage of institutional investors.

For many E&P companies, the traditional corporate IPO makes the most sense, even in the current market. Since the valuation of these companies is generally based on EBITDA (and not forecasted distributions to shareholders), the company is generally free to use available cash to fund drilling programs or make other accretive investments or improvements to new or existing assets.

THE UP C IPO

Another option is called the Up C, which is a variation of the traditional corporate IPO. Depending on the underlying facts and tax posture of the relevant parties, an Up C IPO may be a tax-efficient alternative to a traditional corporate IPO. Similar to a traditional corporate IPO but unlike an MLP, the structure does not include a market obligation to grow distributions over time. Several E&P companies have used this structure over the past three years, and it is expected to grow in popularity.

Under the Up C structure, the sponsor company creates a subsidiary holding company (either a limited liability company or a limited partnership, often referred to as OpCo), which owns the operating assets and is flow-through (either disregarded as an entity for US federal income tax purposes or classified as a partnership) for US federal income tax purposes. The sponsor then contributes nominal consideration to a newly formed corporation (referred to as PubCo, which is eventually taken public) in exchange for high-vote, low-value shares (sometimes referred to as "golden shares"). With the high-vote, low-value shares, the sponsor retains control over PubCo. PubCo then files an S-1 Registration Statement with the SEC and offers stock to the public in an IPO. As in a traditional corporate IPO, investors would receive Forms 1099 (as opposed to a Schedule K-1, as an investor would typically receive in an MLP).

After PubCo's IPO, the offering proceeds are typically contributed to OpCo in exchange for an interest therein. In connection with the overall offering, sponsor, OpCo, and PubCo often enter into both an exchange agreement and a tax receivable agreement (TRA). Under the exchange agreement, the sponsor often has the right to exchange its OpCo interests for PubCo shares of common stock (which would ultimately provide sponsor with liquidity if sponsor then sold the PubCo shares on the secondary market). When sponsor exchanges OpCo interests for PubCo shares, a couple of interesting results transpire - first, the transaction is fully taxable to sponsor, and second, PubCo receives a tax basis "step up" in the interests in OpCo (which trickles down to the underlying OpCo assets) that PubCo receives in the exchange.

However, the story does not end there. In connection with the exchange, the agreements typically provide that the sponsor receives 85% (although the percentage could be higher or lower, as agreed upon by the parties) of the tax benefit the step up provides to PubCo. Each year, PubCo will perform a "with and without" calculation - a tax calculation to determine what the "tax benefit" of the step up to PubCo was in connection with the exchange. At the end of each year, PubCo would then pay the agreed upon percentage (85% in this example) back to sponsor, which would be taxable to sponsor upon receipt.

The "tax benefit" payment could be beneficial to sponsor's with both appreciated assets and assets that will be in a tax-paying position. If sponsor has appreciated assets (i.e., where the fair market value exceeds the tax basis of such assets), PubCo would generally receive a higher "step up" in connection with the exchange - which could ultimately result in a higher "tax benefit" payment under the TRA.

Similarly, if the assets held under OpCo would generally produce positive taxable income, the "with and without" calculation could also yield positive results to sponsor. Conversely, if PubCo is not in a tax-paying position (either because of deductions, net operating losses, credits, etc.), then the "tax benefit" payment may be significantly delayed, which would reduce the net present value of the payments. Stated differently, if PubCo is not in a tax-paying position, there is no tax benefit to the step up since PubCo's tax liability would be $0 under both the "with" and "without" prongs of the calculation.

For an E&P company with a scheduled drilling program or significant capital expenditures on the horizon, it is critical to properly model out the tax consequences (and benefits of the TRA payment) to determine the value of putting the Up C structure in place.

THE MLP IPO

An MLP is a publicly-traded limited partnership, or a limited liability company, which pairs the tax benefits of a partnership with the capital-raise capability and liquidity of a public company. MLPs typically consist of (a) a general partner, who manages the operations of the partnership and often holds a minor percentage (e.g., between 0% and 2%) of the outstanding MLP units and may own incentive distributions rights (IDRs), and (b) limited partners, who provide capital and hold most of the ownership, but have limited influence over the MLP's operations.

As a general rule, MLPs do not pay US federal income taxes; conversely, each partner includes its distributive share of the MLP's items of income, gain, loss, deduction, and credit when computing the partner's US federal income tax. As a result of the flow-through nature of the structure and the market requirement for the MLP to distribute all "available cash" (which is defined in the MLP's operating or partnership agreement), cash flow is often increased. In order to maintain MLP qualification (and thus maintain the single level of taxation for US federal income tax purposes), at least 90% of the MLP's gross income must be "qualifying income" - that is, derived from certain activities in natural resources, real estate or commodities, among others.

There are two primary types of MLPs - "traditional" MLPs and "variable pay" MLPs.

In a traditional structure, the MLP discloses an intention to make minimum quarterly distributions of cash (MQDs) to unitholders. The amount of the MQDs factors into a broader distribution arrangement, which ultimately impacts the dollar-per-unit threshold at which (and in what amount) the MLP sponsor(s) receive IDRs - with IDRs effectively representing the right to a disproportionately higher share of available cash above certain thresholds.

In a traditional MLP, different types of ownership interests generally exist - namely the general partner interest, the IDRs, common units, and subordinated units (which are retained by the sponsor and convertible according to certain events and/or the passage of time). Additionally, the sponsor "controls" the MLP through its ownership of the MLP's general partner.

Under the "variable pay" structure (which is also colloquially referred to as a "variable MLP" or a "variable distribution MLP"), the public owners are not promised any MQD, and, conversely, the MLP sponsor does not receive IDRs. Consequently, both the sponsor and the public owners typically share pro rata in the upside (and downside) of operations. Variable pay MLPs often take the form of a limited liability company as opposed to a limited partnership.

Regardless of structure, the pressure on MLPs to keep distributions high and growing may not always be ideal for E&P companies that need to consistently reinvest cash to keep drilling wells. However, for companies with investments in mature reserves with long remaining lives - as opposed to looming significant, capital intensive drilling programs - an MLP may be the best strategic move. In fact, successful upstream MLPs are often focused on properties with low decline rates and/or significant sponsor-retained assets (with a high ratio of proved developed producing reserves) to both maintain distributions and to communicate a growth story to the market.

WHICH APPROACH IS RIGHT?

Each of the three broad categories of public structures for E&P companies (the traditional corporate IPO, the Up C IPO, and the MLP) can have significant benefits to both sponsors and the public. Determining which one (or none) is the right structure for an E&P company often requires a thoughtful analysis of the company's long-term, strategic focus, as well as detailed tax and economic modeling to illustrate the pros and cons of each structure.

The fundamental strategic question that executives need to answer is, "do we want to reinvest cash in our business, or distribute it to shareholders/unitholders?" Accessing the yield-driven investment market can provide significant benefits - often resulting in significant valuation uplift due to the increased value the investor base places on yield-based vehicles with little to no entity level taxation. However, it requires a fundamental corporate directive to continue to grow the business and distribute earnings. For E&P companies that are comfortable with the yield-based structure, an MLP (or other yield-based structure) could be the right answer to raise equity and grow the business.

Where the long-term, strategic goal of the E&P company is focused on reinvestment and/or improvement of existing assets, or where the company would prefer to have increased flexibility in determining its capital structure, the corporate IPO (either the traditional corporate IPO or the Up C structure) may be ideal. For companies with aggressive and complex future drilling programs and/or management teams that would prefer to reinvest cash flow as opposed to distributing such cash flow on a current basis, the traditional corporate IPO or Up C may be preferable.

As described above, determining which corporate alternative may be more beneficial often requires detailed tax modeling to determine the net present value of the TRA payments and whether that benefit is significant enough to warrant the increased complexity of the structure (e.g., the yearly requirement of the "with and without" calculation).

ABOUT THE AUTHOR

Greg Matlock is the MLP leader for Ernst & Young LLP in the US. The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.