As the recent significant decline in oil prices drives profit margins lower, oil and gas industry players continue to seek new ways to obtain capital to preserve liquidity and maintain growth programs. From drawing down revolving loans to keeping cash on the balance sheet to engaging in custom asset-focused carry structures, companies are examining—and executing on—a variety of diverse capitalization strategies. One such strategy that has emerged as a recent favorite for certain public companies is the issuance of preferred securities to handpicked private equity funds and similar investors in private placements exempt from the registration requirements of the Securities Act of 1933.
While non-energy public companies generally have familiarity with the basic terms of preferred issuances, fewer oil and gas companies do, largely as a result of their historical rarity in the energy space. However, with companies such as MPLX LP; NGL Energy Partners LP; American Midstream Partners, LP; Western Gas Partners, LP; Targa Resources Corp.; EnLink Midstream Partners, LP; Plains All American Pipeline, L.P., and Crestwood Equity Partners LP engaging in recent preferred issuances, such issuances have become an important tool in the oil and gas executive’s playbook.
This article briefly discusses the basic structure and terms of most private placements of preferred securities, with a focus on the most-negotiated commercial terms and their implications for the issuer and the investors.
General. Preferred securities feature both equity-like and debt-like characteristics, although issuers often resist preferred issuances that receive less than 50% equity credit from ratings agencies. In terms of equity characteristics, preferred securities generally stand “behind” debt in the capital structure, do not have a maturity date, cannot force mandatory distributions, sometimes have voting rights on an “as-converted basis,” only receive distributions as and when declared, and sometimes provide the buyer with board observer or director appointment rights. In terms of debt characteristics, preferred securities stand “in front of” other equity in the capital structure (including in distribution and, in most cases, liquidation contexts), do not have many class voting rights and have a specified distribution rate, which may include a payment-in-kind option during negotiated periods. It is these preferences over other more junior classes of equity that entice investors and give the preferred security its name.
Pricing. Pricing is one of two primary economic features of a preferred issuance, and is a feature with which both issuers and buyers struggle frequently. Preferred securities are generally priced above the current trading price of the issuer’s publicly traded common security due to their advantageous features (including distribution and, in most cases, liquidation preferences). Because the issue price is so important, however, it is often “locked in” at the term sheet stage, which can lead to varied results due to price volatility occurring during the negotiation period for definitive agreements through closing (e.g., Western Gas Partners issued preferred units in April 2016 at 2.77% less than the common unit trading price as of the closing date).
Distribution Rate. The quintessential characteristic of a preferred security is a preference on distributions made by the issuer. While distributions are not mandatory—they are paid only when declared by the issuer—they must be paid in full (together with any arrearages) prior to any distributions being paid to junior security holders. The distribution rate on a preferred security is often a specific percentage of the issue price, although this percentage is sometimes expressed as a specific dollar amount per security at the time of signing. Distribution rates are heavily negotiated and vary significantly among issuers. For example, EnLink’s preferred investors are entitled to an initial 8.5% annual distribution rate, which is scheduled to decrease to 7.5% in mid-2017, while American Midstream’s preferred investors are entitled to a nearly 11.8% annual distribution rate over the life of their security. One long-term consideration in setting the distribution rate is its impact on the time horizon over which the issuer is likely to retire the preferred securities. A lower distribution rate makes other debt or equity comparatively more expensive, which may cause the issuer to retire other capital first, while a higher distribution rate may cause the issuer to retire preferred securities before other capital.
Compounding Dividends. Another controversial issue that is often the subject of some negotiation is whether unpaid distributions on preferred securities are subject to compounding. Issuers are often very resistant to including compounding features in preferred securities, while investors frequently insist on compounding as critical to their economics (or successfully trade compounding for other economic terms). Serious negotiation of compounding is sometimes preempted, however, by ratings agencies’ apparent hesitation in giving at least 50% equity credit to preferred securities if they have compounding features.
Payment-in-Kind. Issuers are often interested in negotiating the right to pay in-kind distributions (e.g., by dividending additional preferred securities instead of cash) to preferred investors in order to maintain maximum liquidity. By contrast, preferred investors, recognizing that they have no right to force distributions, regularly want to be treated like other equity holders and paid in cash upon any declared distribution. One way in which issuers and investors often compromise on this issue is to permit (or require) in-kind distributions of additional preferred securities during a prescribed initial period, with later distributions made solely in cash. For example, each of Plains and Crestwood have the option to “PIK” their preferred security for a specified number of years.
Blocking Rights. Preferred securities often include specific blocking rights that investors view as essential to their ability to protect their investment against dilution and other adverse changes. For example, preferred securities commonly prohibit the issuance of more “senior” equity securities and place significant limitations (if not prohibitions) on the issuance of “parity” equity securities by the issuer. It is also common for the terms of preferred securities to prohibit the issuer from taking any action that adversely affects the rights, preferences or privileges of such preferred securities or amends or modifies any of their negotiated terms without the express approval of the preferred investors by majority (or higher) vote, voting separately as a class. In some cases where liquidity concerns exist, investors have secured limitations on the issuer’s ability to incur additional debt or engage in certain types of activities. While issuers commonly agree to the limitation on “senior” equity and minimal limitations on “parity” equity that are specifically targeted at preserving the integrity of the preferred securities issued, they generally resist other more significant limitations on their ability to operate their business or seek financing.
Conversion/Redemption. Preferred securities need not be convertible or redeemable, but because investors often prioritize liquidity and issuers often prioritize flexibility, each of which is served by such terms, conversion and redemption have become customary terms of preferred issuances. Other than conversions or redemptions in connection with changes of control, which generally occur at a premium and are further described below, investors and issuers often negotiate for bi-directional options to convert after a certain period of time. Commonly, investors also preserve the option to convert or to force redemption immediately prior to any liquidation, dissolution or winding up of the issuer. While not universal, it is common for investors to agree to volume thresholds and frequency limitations in return for an option to convert less than all preferred securities they own. It is also common for any issuer option to require conversion/redemption of all outstanding preferred securities (so as not to treat investors disparately) and to require a current trading price and trading volume over certain thresholds (so as to compensate investors for the loss of the economic benefits of the preferred security upon conversion/redemption). Investors, in particular, are often very focused on issues involving conversion/redemption because such issues pertain not only to investors’ ability to liquidate their investment, but also to the preservation of the preferential terms for which they have negotiated so heavily.
Change of Control. Investors are often wary of risks associated with an issuer change of control, and are typically successful at negotiating certain protections in such events. Because changes of control can have multiple permutations, such protections often assume various forms, depending on the specific circumstances of the change of control transaction. For example, in the case where the issuer is acquired by a third party, investors often attempt to negotiate certain rights, such as an option to require the third party acquirer either to provide it with a substantially similar preferred security or to redeem the preferred securities at a specified premium. As another example, where the issuer merges with a subsidiary of an acquirer and survives the merger, investors regularly attempt to negotiate other rights, including an option to retain the outstanding preferred security without changes or to convert into common equity at a conversion rate superior to the otherwise general conversion rate described above. Given the long-term implications of these provisions, it is not surprising that issuers and investors spend significant time carefully drafting these provisions, which often reflect the particular views of the transaction participants. By way of example, Targa’s preferred issuance and NGL’s preferred issuance had significantly different change of control provisions that were customized to the particular issuer and investors.
Board Representation/Observer Rights. Another commercial item often central to preferred issuances is whether the investors are entitled to any board representation or observer rights in connection with their investment in the preferred security. Board representation/observer rights are essentially a matter of access and information, although investors will sometimes trade such rights for better pricing or other terms. This issue is resolved disparately across various precedent transactions, including (i) no board representation or observer rights, (ii) board observer rights only, (iii) one or more directorships initially dedicated to preferred investors and (iv) one or more directorships dedicated to preferred investors only upon the occurrence of certain trigger events, such as failures to pay dividends for a certain number of periods. In large part, the outcome of negotiations depends on the percentage of the issuer’s total equity that the investors will hold; a smaller percentage (as in the MPLX issuance) likely correlates to fewer (or no) representation/observer rights; a larger percentage (as in the EnLink issuance) often correlates to greater rights. Board representation can have a significant impact on investors, in that the amount of material non-public information they will receive without such access is minimal, while significantly greater with board representation.
Registration Rights. Registration rights are significant elements of most preferred issuances, the details of which are—unfortunately—often left unaddressed until latter stages of negotiation. Registration rights sit at the crossroads of competing interests—investors want certainty of liquidity and flexibility of exit, while issuers are often focused on avoiding disruption to their business, precedent-setting and flexibility of financing. Five primary elements characterize most preferred registration rights: (i) which securities are registrable, the preferred security itself or the common equity into which it is convertible, (ii) by when will the issuer be required, or when can the investors require the issuer, to register the subject equity, (iii) whether the issuer will be required to pay specified liquidated damages in connection with any delay in successfully completing or maintaining registration, (iv) which investors will have “piggyback” rights to participate in a primary equity offering by the issuer or registered secondary offerings by other equity holders and (v) which investors will have the right to require the issuer to engage underwriters to conduct an underwritten public offering of such investors’ securities. Registration rights vary widely among preferred issuances depending on the particular concerns of the investors.
When contemplating an issuance of preferred securities, both investors and issuers should carefully consider the many key terms of such issuance and their impact upon the more-obvious commercial terms of the potential transaction. When structured correctly, preferred securities can provide significant benefits to both investors and issuers that are often more advantageous than other transactions, such as the issuance of common stock, the incurrence of debt or engaging in other more custom structures.
Tim Langenkamp is a corporate and securities law partner in the Houston office of Sidley Austin LLP with an emphasis on capital markets transactions in the energy industry.
Tim Chandler is a private equity and mergers and acquisitions senior associate in the Houston office of Sidley Austin LLP with an emphasis on transactions in the energy industry.
Ryan Scofield is a private equity and mergers and acquisitions associate in the Dallas office of Sidley Austin LLP with an emphasis on transactions in the energy industry.