Before making big purchases like buying a house or a car, we check different websites, scan reviews, talk to different agents to negotiate the best deal possible. In fact, for something as simple as online clothes shopping, we read the reviews by other buyers and shoppers of the website to ensure we are getting value for our money.
It may seem like we are merely protecting ourselves from risk, but such acts are considered due diligence tasks. If people are so cautious about regular transactions in their everyday lives, then we can grasp how meticulous lawyers have to be in mergers and acquisition (M&A) deals; involving large organisations with several moving parts.
M&A transactions happen when an independent company decides to purchase or merge with either part of or a whole other independent company. These transactions are structured; as either stock purchase agreements (SPA) involving the sale of a company’s shares or asset purchase agreements (APA) involving the sale of certain business assets. The due diligence process aims to weigh the cost or value of the purchase against its perceived risks, obligations and liability, and provide guidance on how the buyer can mitigate such risks.
Energy Sector
The energy sector is highly regulated so, there is an increased focus on legal due diligence when structuring an M&A transaction. One of the foremost tasks of this kind of due diligence is investigating pending litigation or arbitration against the target company. Regulatory compliance (like environmental impact assessment approvals, licensing obligations), corporate structure, employment contracts, material contracts will also need review in a due diligence exercise.
Things are not different in Nigeria. In fact, in most cases, there will be visits to sector regulators like the Department of Petroleum Resources (DPR) for oil and gas transactions and the Nigerian Electricity Regulatory Commission (NERC) for electric power deals. With queries at relevant agencies i.e land registry and Corporate Affairs Commission (CAC), depending on the target company.
Components in an Energy Due Diligence Process
In an asset purchase transaction, the focus will be on the assets and liabilities transferred to the buyer or held by the seller. Though parties can be creative with their negotiations based on their freedom of contract, some standard checks often occur including:
Investigating title to oil and gas assets: there will be a search at the land registry to ascertain the type of property interests held by the target company
Environmental checks: based on the nature of activities in the energy sector, a functional project is likely to have at least some environmental issues. In some cases, the buyer retains the services of a third-party inspector with oil and gas expertise to visit the assets during the review period to identify and value environmental defects.
Review of commercial agreements: to determine the value of certain assets, vital commercial contracts in the midstream chain covering processing, transportation, and storage activities must undergo review.
Review of income-generating agreements in the power sector: a typical power transaction due diligence structure involves; the review of power purchase agreements, distribution agreements, engineering agreements, maintenance agreements and regulatory permits. This reflects the profitability of the target company.
Regulatory approvals: energy M&A transactions typically require approval from one or more regulators. For transparency and guidance, transfer restrictions that require government authorisations are placed on such transactions. The government’s consent is needed where it is represented by the national oil company, either in joint venture contracts or to divest assets. Some other regulatory queries include;
-Whether the target company is compliant with the contractual framework in the energy industry?
-Whether they adhere to the local content, decommissioning and financing obligations (royalty payments)
The ‘R’ Factor
Risk management is one of the pillars of due diligence. It comes after identifying the potential risks involved in this transaction. The final step is to devise solutions to mitigate those risks. Due diligence relies on disclosure from the seller trying to get the best deal for his assets, so the onus is on the buyer to assess the substance of the assets. Contractual protection provided by the sellers in M&A transactions includes express risk allocation, third party guarantees, indemnities and warranties.
Some risk mitigation strategies;
Indemnity: a promise by a seller in a purchase deal to reimburse the buyer for any loss he suffers due to the risks caused by the seller is an indemnity. Indemnities cover specific company or asset-related risks within certain periods like tax liabilities, litigation and environmental claims.
Warranty: a warranty guarantees the condition and circumstance of the subject matter of the transaction. Where a warranty is false and leads to the buyer suffering loss, the seller is liable to compensate the buyer with damages and return him to his pre-loss position. However, this is conditional on the buyer’s ability to prove loss due to the breach. Sellers try to limit warranties mostly in areas they have little to no control over i.e natural resources.
The Future
The energy sector is experiencing a rise in energy M&A activities around the world. This is because of many reasons including, capital growth and expansion, post-COVID-19 recovery and entry to new markets. The purpose of the due diligence exercise is to assess the target company, adjust the valuation and understand the risks. Though a buyer cannot discover every possible risk, uncertainties can be supplemented with some of the remedies mentioned. Do you think the increase in energy M&A transactions will extend to renewable energy?
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