Midstream M&A And Hart-Scott-Rodino

With global oil prices falling more than 50% from 2014 highs, the oil and gas industry has endured a challenging period marked by oversupply concerns and significant reductions in corporate capital budgets and employee headcount. One bright spot has been the level of M&A activity in the midstream sector, which includes deals to acquire pipeline, gathering, processing and storage assets.

In this lower commodity price environment, the midstream sector has been attractive due to its characteristic fee-based contracts, which result in relatively stable, long-term cash flows and less direct exposure to commodity prices.

At a time when there is significant M&A activity in the midstream sector and a reasonable expectation that the same will continue, it is critical for market participants to understand how the premerger notification fi ling requirements of the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (HSR) and the regulations promulgated under that act may apply to their transactions.

Dropdowns

Many midstream companies are organized as MLPs, which are partnerships that are publicly traded and listed on a national securities exchange. MLPs do not pay federal income taxes, resulting in a relatively lower cost of capital, and are designed to distribute all of their available cash to their unitholders. Many midstream M&A transactions are dropdowns, where the sponsor sells assets to its affiliated MLP for cash or equity consideration. The drop-down strategy benefits the sponsor by generating liquidity for its assets and benefits the MLP by increasing cash flow available for distribution to unitholders.

Amendments to the HSR rules and reporting form implemented in 2011 require parties to certain energy transactions, particularly those involving MLPs, to report additional information where the transaction does not qualify for an exemption.

M&A trends

According to a recent report from PricewaterhouseCoopers LLP on second-quarter 2015 oil and gas industry mergers and acquisitions analysis, for the three-month period ending June 30, 2015, there were a total of 47 oil and gas deals overall (with values greater than $50 million) accounting for $38.8 billion, compared to 39 deals worth $34.5 billion in the first three months of 2015, and 65 deals worth $48.9 billion in the second quarter of 2014. Midstream M&A accounted for 44% of total deal activity by deal volume, with 21 deals accounting for $27.7 billion.

The number of deals in the midstream sector increased 110% while value increased 130% compared to second-quarter 2014. MLP dropdowns and affiliate transactions accounted for 38% of the midstream transactions, aggregating to $19.5 billion in deal value.

Several of the largest midstream M&A transactions that closed or were announced in 2015 included:

• Energy Transfer Equity LP of affiliate Regency Energy Partners LP;

• Kinder Morgan Inc. of Hiland Partners LP;

• Enterprise Products Partners LP of Oiltanking Partners LP;

• MPLX LP of MarkWest Energy Partners LP; and

• Energy Transfer Equity LP of Williams Cos. Inc.

There are several factors that would tend to suggest a continued period of elevated deal activity in the midstream sector. As an MLP is fundamentally a vehicle for investors searching for yield, the market values MLPs based on their ability to maintain and increase cash flows, rather than to generate net income. Accordingly, MLPs face constant pressure to continuously increase distributions to unitholders. The two primary avenues available to MLPs to achieve growth are first to grow organically through new construction and expansion projects and, second, acquire operating assets via M&A, which offers the quicker alternative to grow distributable cash flow.

M&A vs. organic projects

Despite the need for oil and gas transportation infrastructure in many parts of the U.S., resistance from regulators in the construction of some new pipelines—coupled with reluctance among upstream companies in the face of lower commodity prices to enter into the long-term commitments necessary for midstream companies to move forward with capital-intensive new projects—favors the trend toward M&A and away from organic projects.

Some upstream companies, desperate to raise cash in the face of falling revenue from production but seeking to retain their core production assets, have been selling ancillary midstream assets.

Many midstream companies desire to achieve both geographic, and product and service, diversification. These companies may utilize M&A to expand their footprints into additional basins. They may also acquire competitors that offer additional services with a view toward becoming a provider of a full suite of midstream services.

For example, a historically pure-play, dry-gas pipeline company might utilize M&A to gain exposure to additional products (oil and NGL) or to additional services within the natural gas product life-cycle (gathering and processing, compression and treating).

The recent plethora of IPOs of MLPs has led to a large number of midstream companies, and there remain a substantial number of private midstream companies fueled by private equity investment. This has created a competitive landscape that is ripe for consolidation. The larger MLPs will seek significant acquisitions to “move the needle,” and smaller cap MLPs whose unit prices have fallen significantly might be attractive targets.

Basic application

Under the HSR Act and rules, parties to acquisitions of assets, voting securities and equity interests in non-corporate entities (e.g., limited liability companies, partnerships) that meet certain jurisdictional dollar thresholds, are required to file premerger notification forms with the Federal Trade Commission (FTC) and the Department of Justice and observe a waiting period—usually 30 days—before they are permitted to consummate the transaction.

There are two basic jurisdictional thresholds. The size-of-persons threshold is satisfied where there is a person on one side of the transaction with $152.5 million or more in total assets or annual net sales, and a person on the other side with $15.3 million or more in total assets or annual net sales. The size-of-transaction threshold is met if the value of the transaction exceeds $76.3 million. Transactions valued in excess of $305.1 million meet the jurisdictional threshold regardless of the size of the persons.

Transactions meeting these thresholds are reportable unless there is an applicable exemption.

Parties failing to notify an HSR reportable transaction may be subject to civil penalties and enforcement actions. The civil penalties, which can amount to up to $16,000 per day for each day the parties are in violation, can be levied against both companies and individuals.

Exemptions

There are a number of exemptions under the HSR Act and rules that can apply to acquisitions of midstream assets or entities that hold such assets. First, acquisitions of equity interests in non-corporate entities such as MLPs or limited liability companies holding midstream assets are reportable only if—as a result of the acquisition—the acquiring person will hold a 50% or greater interest in the non-corporate entity. A 50% interest is defined under the HSR rules as having the right to 50% or more the non-corporate entity’s profits or 50% or more of the entity’s assets upon dissolution.

All acquisitions resulting in the acquiring person holding less than a 50% interest are exempt regardless of dollar value. In addition, rules exempting the acquisition of certain real property have been applied to midstream assets in the past. HSR Rule 802.5 exempts the acquisition of “investment rental property assets,” which is real property that will be rented to entities not included within the acquiring person except for the sole purpose of maintaining, managing or supervising the operation of the real property, and will be held solely for rental or investment purposes. In the past, this exemption was available for acquisitions of pipelines so long as the pipeline transportation services were provided only to third parties, such as upstream companies.

HSR Rule 802.2(h) exempts an acquisition of retail rental space (including shopping centers) or warehouses and assets incidental to the ownership of retail rental space or warehouses. In the past, the warehouse exemption was available for acquisitions of oil and gas terminals and storage facilities where the facilities would be used to provide storage of oil and gas to third parties, such as upstream companies.

The FTC’s Premerger Notification Office (PNO) new position regarding the availability of the Rule 802.5 and 802.2(h) exemptions with respect to midstream assets is discussed below.

Additionally, under Rule 802.65, an acquisition of a controlling interest in a non-corporate entity is exempt from HSR filing requirements if (a) the acquiring person is contributing only cash to the non-corporate entity, (b) for the purpose of providing financing and (c) the terms of the financing are such that the acquiring person no longer will control the entity after it realizes

a preferred return. In recent years, it has become increasingly common for financial investors to contribute funds to entities that hold renewable energy projects, including solar power and wind projects, under terms that meet the requirements of this rule and in theory this rule could be applied to acquisitions of midstream assets as well.

Thus, parties to such investments should consider whether their transaction qualifies for the Rule 802.65 exemption.

A global industry

In an increasingly global energy industry, it is more likely that both U.S. and non-U.S. companies will be acquiring energy-related assets and entities located outside the U.S. Even if the parties to such transactions that meet the act’s jurisdictional thresholds cannot take advantage of the exemptions discussed above, such acquisitions may qualify for one or more HSR exemptions relating to foreign commerce.

In general, the acquisition of assets located outside the U.S. is exempt so long as the non-U.S. assets being acquired from the same acquired person did not account for aggregate sales in or into the U.S. of more than $76.3 million in the acquired person’s most recent fiscal year.

A similar rule applies to acquisitions of voting securities in non-U.S. corporations. Where a non-U.S. person acquires a non-controlling (less than 50%) voting securities interest in a non-U.S. corporate issuer, the transaction is exempt. Where a non-U.S. person acquires a controlling interest in a non-U.S. corporation, or a U.S. person acquires any voting securities interest in a non-U.S. corporation, the acquisition is exempt unless the target entity, including any of its controlled subsidiaries, holds assets located in the U.S. with a current fair market value of more than $76.3 million, or had sales in or into the U.S. of more than $76.3 million in its most recent fiscal year.

For non-U.S. non-corporate entities, a similar but somewhat different exemption is available if the current fair market value of any assets held by the entity located in the U.S. does not exceed $76.3 million, and aggregate U.S. sales associated with any non-U.S. assets held by the entity does not exceed $76.3 million. If the value of the U.S. assets does not exceed $76.3 million, but the non-U.S. assets are not exempt, the parties should add the value of the U.S. and non-U.S. assets to determine whether the combined value exceeds the $76.3 million threshold, in which case the exemption is not available.

In transactions involving the acquisition of both U.S. and non-U.S. assets or entities, it may be helpful for the parties first to assess whether the U.S. part of the transaction alone is valued in excess of $76.3 million, and if not, then determine whether the non-U.S. part is exempt. If it is, the transaction is not reportable; as discussed above, if the non-U.S. part is not exempt, the parties then should determine whether the value of the U.S. and non-U.S. parts together exceed the $76.3 million threshold.

Rule 802.3 specifically exempts acquisitions of carbon-based reserves and rights on reserves. However, due to the limitations on such rules, they have little if any application to midstream assets.

New interpretations

In July 2015, the PNO staff provided new interpretations for the application of HSR Rules 802.5 and 802.2(h). The new interpretations have the practical effect of reducing the availability of these two exemptions as they relate to midstream M&A. While the PNO released a detailed interpretation of HSR Rule 802.5 with accompanying examples, the guidance regarding Rule 802.2(h) did not provide similar detail.

Under the PNO’s new position, in order to qualify for the Rule 802.5 investment rental property exemption, “the buyer must intend to profit from the investment in the real estate, not from the business conducted on the property.”

Under the PNO’s new interpretation, if the buyer proposes to acquire natural gas pipelines that it will use to provide midstream transportation services to third parties, the transaction is not exempt under Rule 802.5. The PNO gives the following specific example related to pipelines:

An example

“X” proposes to acquire from “Y” substantially all of the assets relating to a gas gathering and compression system, comprised of four pipelines and two compressor stations, which are currently used to provide transportation services to natural gas producers. The business conducted on the property is midstream transportation services. “X” will use the assets to provide midstream transportation services. This is not an exempt acquisition of investment rental property unless the buyer and seller are only landlords.

Here’s how that scenario could work: “Y” holds the gas gathering and compression system, which it leases to third-party “C,” and “C” operates the midstream transportation services business. “Y” only receives rental income from “C” and is not engaged in the transportation services business conducted on the property. If “X” seeks to acquire the pipelines, does not operate other pipelines, and only continues to lease the pipelines to “C,” this is an exempt acquisition of investment rental property.

The FTC website posted a brief statement regarding Rule 802.2(h), stating that “[u]pon further consideration of prior interpretations by the PNO, the warehouse exemption, 802.2(h), will not be available for oil/gas storage facilities.”

Based on this development, a likely conclusion is that the 802.2(h) exemption would not be available for a prototypical outright sale of oil and gas storage facilities where the buyer will provide storage services to third parties following the closing of the transaction.

Additional obligations

In 2011, the FTC implemented changes to the HSR Act reporting form and regulations that were designed to obtain additional information in filings made by both private equity funds and MLPs. The effect of these new rules can be illustrated with the following, simplified example:

Assume GP is the general partner and holds a 5% interest in both MLP1 and MLP2, each of which owns natural gas pipelines. MLP1 now plans to acquire another natural gas pipeline in a transaction reportable under the HSR Act. Under the old rules, MLP1 was not required to report anything about MLP2’s pipeline holdings, even if they competed directly with the pipeline MLP1 now is planning to acquire. Under the new rules, GP and MLP2 are considered to be “associates” of MLP1, and MLP1 must include information in its HSR Act filing regarding any entity in which GP or MLP2 holds a 5% or greater equity interest that operates in the same industry as the assets or company being acquired by MLP1.

In this example, that would include information regarding MLP2’s pipelines, including the geographic areas in which they operate. As this example shows, an MLP that is managed by a general partner that also manages one or more other MLPs, and is engaged in a transaction reportable under the HSR Act, needs to identify both relevant associate relationships and the resulting information it may need to report regarding those relationships.

Key analysis steps

Regardless of the deal format (auction, negotiated acquisition, hostile offer, etc.), companies should make an early determination of available exemptions and whether a filing is required under the HSR Act. There are many energy-related transactions that, while potentially reportable under the HSR Act, may qualify for one or more energy-related or more general exemptions from the HSR Act’s reporting requirements.

Parties to transactions of the types discussed above should confer with counsel to determine whether their transaction is exempt, ensure that the transaction does not fall within an exception to the relevant exemption and, particularly if an MLP is involved, for guidance in identifying any associate relationships. For an interactive presentation, Mayer Brown LLP has created quick and practical HSR guidance on its website at www. mayerbrown.com/files/uploads/Documents/ PDFs/2015/February/Navigating_HSR_2015.pdf.

The key basic steps for HSR analysis in the context of midstream M&A transactions are as follows:

1. Determine whether the size-of-transaction test has been met.

a. For acquisitions of voting securities (e.g., the acquisition of the stock of a pipeline corporation), the Size-of-Transaction test is based on

(i) the value of the voting securities that will be acquired; plus (ii) the value of any voting securities of the same corporation that the acquirer already owns.

b. For acquisitions of assets (e.g., the direct acquisition of a fleet of natural gas compression units), the size-of-transaction test is based on (i) the value of the assets that will be acquired; plus

(ii) the value of any assets acquired from the same person within the last 180 days.

c. For acquisitions of non-corporate entities (e.g., the acquisition of MLP units or the limited liability company interests in a pipeline joint venture), the size-of-transaction test is based on (i) the value of the non-corporate interests that will be acquired; plus

(ii) the value of any non-corporate interests of the same entity that the acquirer already owns. As noted above, only acquisitions of non-corporate interests resulting in the acquiring person holding 50% or more of a non-corporate entity are reportable.

If the size-of-transaction is $76.3 million or less, no fi ling is required. If the Size-of-Transaction test exceeds $305.1 million, a filing is required unless an exemption applies. If the Size-of-Transaction is less than or equal to $305.1 million and more than $76.3 million, the parties must analyze the transaction under the Size-of-Persons test under steps (2) and (3) below.

2. Identify the acquiring and acquired persons (the “ultimate parent entity”) of each party.

The first step in determining the size-of-persons is to identify the “acquiring person” and the “acquired person.” Under the act, the obligation to report depends on the size of the “persons” involved. “Person” is defined in Rule 801.1(a)(1) and is the “ultimate parent entity” of the buyer or seller.

The ultimate parent entity is the company, individual or other entity that controls a party to the transaction and is not itself controlled by anyone else. Identifying the ultimate parent entity involves tracing the chain of “control,” a term defined in Rule 801.1(b). In the MLP context, the ultimate parent entity will usually be the sponsor that controls the MLP and its general partner. In a private transaction, the ultimate parent entity of the seller might be the private equity sponsor, or the majority partner in a joint venture company.

3. Determine whether the Size-of-Persons test has been met.

Once the acquiring and acquired persons have been properly identified, the size-of-persons test can be applied. The size-of-persons test requires a determination of whether, based on the applicable person’s fully consolidated financials,

a. The person on one side of the transaction has $152.5 million or more in total assets or annual net sales, and

b. The person on the other side of the transaction has $15.3 million or more in total assets or annual net sales.

4. Determine whether any exemptions are available.

If the size-of-persons test is met and the transaction is valued at more than $76.3 million, or if the size-of-transaction test exceeds $305.1 million, an HSR fi ling is required unless an exemption applies. In light of the narrowing of the Rule 802.5 and 802.2(h) exemptions discussed above, parties should consider that prototypical third party sale transactions involving single asset pipelines or storage facilities are less likely to qualify for exemptions.

As noted on the FTC’s website, companies with questions on the application of 802.2(h) to a type of facility, asset and/or service can contact the PNO. The same is true for questions regarding the application of Rule 802.5.

5. If an HSR fi ling is required and an MLP is involved in the transaction, identify and report associate relationships.

As consolidation continues in the midstream sector, additional entities are likely to be brought under the umbrella of a common sponsor. In a situation where a single sponsor has interests in multiple MLPs, reporting companies need to identify and report associate relationships appropriately.