Divestitures and carve-outs in the oil and gas industry - Deloitte

Positioning for survival and opportunity
Divestitures and carve-outs in the oil and
gas industry
Whatever the
situation, companies
considering a
divestiture or carveout
can benefit from
considering a number
of key issues
An uptick in M&A activity in late 2009 suggests to us that repositioning has become the
watchword for a growing number of companies in oil and gas and related businesses.
Several integrated multinational oil companies have announced their intent to divest
businesses and assets to redirect capital spending toward exploration and production.
Some independent oil and gas companies have announced their intent to sell noncore
domestic, international, and offshore portfolios to streamline their operations, and several
oilfield service companies have announced plans to exit certain business lines or countries.
Such companies are shedding assets and carving out parts of their business for a variety of
reasons. Strong cash flows from rising prices and demand for services over the past several
years have caused many companies to expand in all directions. Now, pricing pressures are
forcing some to rethink these expansive strategies as revenue falls. Tight credit conditions
are choking off capital needed to operate and expand. Technology advances are offering
new exploration horizons for companies ready and able to pursue high-potential but
expensive plays. Anticipated carbon and renewable energy legislation is dampening the
strategic view of refining, processing and other businesses.
Willing buyers, including private equity investors, are showing strong interest. However,
sellers may find it challenging in this environment to offload businesses with heavy capital
demands, in volatile markets or facing significant structural changes as a result of new
rules and regulations.
Whatever the situation, companies considering a divestiture or carve-out can benefit from
considering a number of key issues likely to arise as the transaction progresses, as well as
effective practices for deal planning and execution.
M&A Industry Advantage Series
Oil & Gas

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Areas of interest to buyers
One of many financial accounting issues that frequently will arise in a carve-out
is treatment of corporate allocations. This will vary depending on the traditional
structure of the seller. For example, a seller may choose to leave allocations, such as
human resources, accounting, and treasury, in the reported financial results because
they may be representative of the actual standalone costs for those functions
prospectively. Other times, the seller may feel that the financial picture may be more
meaningful by removing the allocation amounts and disclosing to the buyer the
types of functions that are not included in the business.
To be well prepared for when prospective buyers knock at your door, consider the
following accounting information that buyers generally want to see:
• Transfer pricing
• Intercompany receivables and payables
• Shared services and corporate allocations.
• Acquisitions and divestitures
• Restructuring reserves
• Capital spending, dry hole costs and asset impairments
• Foreign exchange
• Derivative financial instruments
• Pensions and post-retirement benefits
• Self insurance experience and payments to captive insurance companies
• Stock options and deferred compensation
A major consideration in the complexity of a carve-out is the impact of international
activities. International operations – which often include a mix of carve-out and
legal entity sales (e.g., stock deals) – tend to be more complicated and require
focused effort on the part of buyer and seller. In countries where a company has
a smaller footprint, the business may not have sufficient post-divestiture scale
to operate on a standalone basis and a buyer may need to consider a different
approach to operating in that locale. It is important that both parties understand
country-specific requirements and work with local country operational and tax
specialists and personnel. Also, the buyer will need certain information, such as
details around operating and payroll tax compliance to support uninterrupted postacquisition
tax planning and reporting.
M&A Industry Advantage Series — Divestitures and carve-outs in the oil and gas industry
Deciding what to sell and at what price
In some cases, such as a strategic realignment, the
process of choosing what to dispose of can be fairly
straightforward. Assets that no longer fit with your
company’s core business become prime candidates.
Other factors can play an important role when decisions
are not so clear cut; for example, when cost containment
is the prime motivation. In such cases, you may want to
prioritize assets for disposition based on factors such as
the growth potential, capital requirements, industry realignment
issues and other risk considerations.
Also view the assets you are considering for sale from the
perspective of potential buyers. Which assets are likely to
be most attractive to them?
Finally, determine how valuable the assets are to you.
What is your walk-away price?

Identifying the business early in the process
It’s not unusual for a company to embark on a divestiture
without completely understanding or defining what
is actually being sold. What activities and services are
involved? Which people will be going with the business?
What property, equipment, and plants will pass on to the
buyer?
Sometimes sorting out the business activities, people,
and physical property – isn’t so easy. For an integrated
operation, identifying where and how to separate
the business can involve a number of challenges as
product flows from the wellhead through pipeline and
transportation systems to processing, refining, marketing,
and distribution organizations before ultimately being sold
to a third-party customer. International businesses can
be particularly tricky when the business relies heavily on
shared services in each country within which it operates
and with differing levels of support depending upon the
scale of the business and the parent company in each
country. Operations typically involve an array of personnel
that need to be considered for inclusion including
engineers, geologists, field personnel, operations, safety,
area managers and back office support.
All of these issues should be addressed from an operational
standpoint, as well as in financial terms (see sidebar, “Areas
of interest to buyers”). Providing a potential buyer with
an accurate picture of the accounting, tax, and financial
dimensions of the deal will hinge on having a clear view of
the business.
Conducting “sell-side due diligence”
A seller’s credibility in a divestiture or carve-out can
translate directly into higher or lower deal value. The fewer
the uncertainties about the accuracy and reliability of
information being provided, the more willing the buyer will
be to pay full consideration, or a premium.
Seller credibility is never higher than when the buyer first
receives information on what’s being offered for sale. From
then on, any discrepancy or other unpleasant surprise
uncovered through buyer due diligence will likely reduce
that credibility and, as a consequence, the buyer’s trust
and willingness to pay what the seller is expecting.
Time is money in a divestiture.
Company leaders are eager to
complete the deal to realize the
anticipated financial benefits, as
well as control the cost of the
bankers, lawyers, and accountants
that support the transaction
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Therefore, it’s imperative that you prevent surprises from
occurring down the line. To do that, you must have
confidence in the information you’re providing from the
very start. The revenues, costs, and profits, and business
description you initially provide — likely at a summary level
— must hold up throughout the buyer’s examination of
the operation.
It’s also important to have ready explanations for unusual
events or incidents, such as a temporary business
interruption, customer issue, or event at an affiliated
business that caused a negative financial impact. Your
management team should be able to provide an accurate
account of what happened and how it was resolved.
The business identified for disposition may have many
interdependencies, common customers, and other
relationships with the businesses being retained by the
seller. It is important to have a clear view of how these
relationships have influenced the business operations,
procurement and marketing, profitability, and cash flows of
the business and how those may change post-separation.
Conducting “sell-side diligence” before the sales process
starts can help you anticipate issues a buyer may raise
and develop responses that help reinforce your credibility
(see sidebar, “Key focus areas of sell-side due diligence”).
Location of tax basis and structural nuances can assist
in tax planning to help maximize after-tax proceeds.
And it can help you better understand the impact of the
transaction on the parts of your business you’re not selling.
Structuring the transaction
Finding common ground in deal pricing is an ongoing
challenge for buyers and sellers. Periods of economic
weakness intensify the challenge, as bid/ask spreads
tend to expand and buyers hold the upper hand in
deal negotiations. Earnouts and other purchase price
contingency adjustments may be used to help close the
buyer/seller value gap.
M&A Industry Advantage Series — Divestitures and carve-outs in the oil and gas industry
Earnouts can help sellers realize the value they desire, and
help buyers manage their purchase price risk by sharing
some of that risk – and potential value realization – with
the seller. In earnout arrangements, the buyer and seller
agree to make a portion of the purchase price contingent
upon the target company, subsidiary or division meeting
certain future performance targets post-closing. Other
contingency adjustments may deal with risks in a specific
set of contracts or other specific business issue and may be
tied directly to the settlement of that issue.
One of the first questions that sellers struggle with in
structuring an earnout feature in a transaction is what
the purchase price will be for the risk of the contingent
arrangement. Agreeing to the appropriate performance
targets or milestones is the most time consuming part
of earnout negotiations, as it establishes the basis for
determining whether and under what circumstances
the contingency may be in the money post-closing. Not
defining the performance targets in detail is one of the
most common causes of post-closing disputes.

Key focus areas of sell-side due diligence
• Understand intra-company transactions, allocated costs, shared services, and
your plans for providing support post-acquisition and during transition.
• Evaluate the quality of earnings and identify “non-recurring” items for which
management may want to consider adjusting the financial information.
• Analyze the trend of working capital required by the carve-out business in order
to develop a target working capital amount and mechanism in the purchase and
sale agreement.
• Understand the assumptions in your forecasts and the bridge of detailed data
from actual results to forecast information.
• Evaluate the cost structure for fixed versus variable costs, capital expenditure
requirements, and the relevance of certain general and administrative activities
to the carve-out business.
• Understand employee and union issues and related costs or exposures and
segregation of benefit plan liabilities and assets.
• Identify all shared assets and facilities.
• Gauge the ability to separate and/or continue customer and supplier contracts
and arrangements.
• Estimate potential loss of intercompany sales and other business secured by
parent relationship.
• Identify tax contingencies and ability to “push down” debt into divested
businesses.
Executing the transition
The speed with which divestitures and carve-outs take place can result in the buyer not
having the infrastructure necessary to take over operations quickly. In such cases the
buyer and seller can enter into a transition services agreement, or TSA, in which the seller
continues to provide operational support for a period of time. Careful attention should
be given to how the TSA will be structured and executed, as well as the conditions and
timetable for its dissolution. Performance metrics and “must have” timelines are also
critical components to any well-crafted TSA.
Anticipating post-deal considerations
Once you have sold off assets, how will you know whether you’ve realized the benefits
you expected from the transaction? Give consideration to setting metrics and benchmarks
for post-deal performance.
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Employing effective practices
Taking some key steps can help lay the foundation for deal
success. Here are three suggestions to consider as you
prepare a business for sale or a function for carve-out:
Appoint a full-time project champion outside of
the business
As noted above, carving out a portion of the enterprise
to be sold will affect a variety of functional responsibilities
and employee groups within the organization. Because
of the breadth and weight of issues that inevitably will
arise, it is imperative that someone with sufficient stature
and authority lead the process. The divestiture will require
different parts of the company to work together in new
ways and in some cases buy into decisions they don’t view
as being in their best interest.
The executive put in charge will usually be a member
of the corporate team. He or she should have standing
and authority within the company to effectively manage
inevitable cross-functional conflicts. At the same time, the
transaction needs to have board-level support and clearly
defined accountability for the board, CEO and executives in
charge of the deal. Prior to launching a divestiture strategy,
leadership must clearly outline the overarching M&A
strategy and communication plans to maintain executive
alignment.
Focus on the people aspect of a carve-out
Clearly defining the separation strategy and how
employees will be affected by the carve-out is complex.
However, in order to maintain momentum and effectively
execute the transaction, the seller’s internal communication
and people strategies should not be overlooked.
While traditional divestitures can be somewhat
straightforward when it comes to which employees
remain and which are transitioned with the divested
organization, carve-outs are more complex. Uncertainty
regarding employees’ futures can significantly decrease
productivity, so a clear view of the carve-out’s impact on
the organization is critical to maintaining business as usual.
M&A Industry Advantage Series — Divestitures and carve-outs in the oil and gas industry
Commit to precision and detailed follow-through
on tasks
Time is money in a divestiture. Company leaders are eager
to complete the deal to realize the anticipated financial
benefits, as well as control the cost of the bankers, lawyers,
and accountants that support the transaction.
But shortcuts ultimately create more issues than they solve.
Taking the time to do things right the first time can be
difficult, but it is critical to having a clean process and to
maintaining credibility with the buyer.
For example, you should have a complete view of the
financial information before disclosing any data to a buyer.
All of the historical financial information that you’re going
to provide should be gathered, analyzed, and assembled
in a data room at the outset, even if you’re only going to
provide a small portion of it to a broad group of potential
buyers in the initial steps of the transaction.
You want to avoid sharing information early that ends up
being contradicted or contested later in a more detailed
portion of the process. Being well prepared and spending
the time and effort to have precise information upfront can
translate into credibility and value.

Understanding the value of auditable carve-out financial statements
A buyer’s financing plans or disclosure requirements may compel the seller to develop full,
audited financial statements for the carve-out business. It’s important for both parties to
understand that the numbers included in these auditable statements may not – in fact,
probably should not – agree with the numbers that come out of the due diligence process.
Why? A number of accounting issues can arise in preparing the adjustments required for
these two different types of financial statements, and these need to be addressed in detail
to substantiate the amounts subject to external audit. The seller should be able to provide
statements that will reflect the accounting and disclosures necessary for an audit that
otherwise might be seen as a last minute surprise by a potential buyer.
Achieving your deal goals
Market dynamics and economic conditions are causing oil and gas and related midstream,
downstream, and service companies to seize their most promising opportunities and rightsize
their operations. This repositioning often dictates the divestiture or carve-out of some
existing operations. By considering the issues outlined above and adopting effective M&A
practices, sellers can increase the likelihood of achieving deal goals.
M&A Industry Advantage Series — Divestitures and carve-outs in the oil and gas industry 7

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