The energy trading business has seen its fair share of participant realignment over the years, as various financial institutions, utilities, and other companies have come in and out of the business, sometimes in spectacular fashion. With the impending implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“the Act”), we may be on the cusp of another great upheaval in the industry, as various participants choose to avoid some of the more burdensome provisions of the Act by exiting the business or limiting their participation, while others choose to leverage their investment in systems and regulatory knowledge through expanded operations.
As these participants come and go, they often face the issue of how to sell out of, or buy into, an existing portfolio of energy commodity trades. In some ways, these transactions are like any other acquisition or divestiture of a line of business. However, there are some unique aspects of these transactions that, if improperly navigated, can visit great misery on the buyers and/or sellers. This article describes a typical energy portfolio acquisition transaction and suggests ways to identify and avoid those potential pitfalls.
A Typical Transaction
While it is somewhat dangerous to use the adjective “typical” when describing any energy trading acquisition, there are some common elements. These transactions are almost always run, at least initially, through a large bidding process where the seller determines exactly what is being sold and how it is being packaged. Generally, the seller will be selling either the entire business (employees, systems, and contracts) or just a portfolio of contracts. Each potential bidder is allowed, at this stage, some limited due diligence to come up with a proposed bid. Once the seller evaluates all bids, it will typically choose a limited number of buyers for further negotiations. At this point, the selected bidders will have the ability to conduct additional due diligence and will likely be invited to submit detailed comments on the transaction structure and related documentation. At some point, the seller will enter into exclusive negotiations with one buyer, and the final transaction documents will be negotiated and executed.
The transaction documents will usually involve some period, after signing, for the parties to obtain all necessary government approvals and third-party consents. For transactions that include Federal Energy Regulatory Commission (FERC) regulated gas storage and transportation contracts, for example, the parties will seek a waiver of certain FERC requirements related to the transfer of such contracts. While these approvals are pending, the parties will begin the process of asking trading contract counterparties to agree to novate their trading positions to the buyer, with the actual novation contingent on closing the purchase and sale of the portfolio (a novation differs from an assignment in that it replaces the seller with the buyer as if the buyer had signed the original contract). Once all consents and approvals are obtained, the parties will establish a closing date, agree to a purchase price adjustment to reflect the change in value of the portfolio since signing, and close the transaction.
Purchase Price Adjustments
The first, and most obvious, unique issue in these transactions is that the purchase price typically floats between signing and closing. This is generally to reflect the changes in market value in the underlying commodities, but price may also be adjusted to reflect changes in counterparty creditworthiness, buyer’s funding charges, interest rates, and other factors. To avoid discovering a large disagreement in the purchase price adjustment on the day before closing, it is highly advisable for the buyer and seller to agree on a process to exchange and agree upon periodic interim adjustments between signing and closing.
Hedging the Purchase Price
In some cases, a buyer may not want to take the market risk on purchase price adjustments between signing and closing. However, it is difficult for a seller to agree to a straight, fixed price as the seller will need to hedge its risks and may not be able to recover the unwind costs on its hedges under a typical purchase and sale agreement if the closing does not occur. Therefore, if the parties do agree to shift the risk of purchase price changes to the seller, this is typically done through a separate hedge between buyer and seller. If the purchase and sale transaction does not close for any reason, the hedge would terminate, and one of the parties would owe the other party a termination payment, depending on how market prices (and other factors) have changed since signing.
Do Due Diligence
In many cases, the documentation for all contracts in an energy-trading portfolio can run into tens of thousands (if not hundreds of thousands) of pages. This makes cost-effective, thorough due diligence a near impossibility. One way that buyers might deal with this issue is to ensure that the key elements from the trading portfolio used to establish the purchase price are summarized in a separate document that is attached to the purchase and sale agreement. If, before or after closing, either party finds a mismatch between these summarized terms and the underlying trading transactions, a further purchase price adjustment would be calculated. Additionally, buyers will typically design a thoughtful due diligence plan to carefully review certain material contracts and to spot-check a sampling of less-material contracts.
Expect a Novation Process
Most energy trading contracts do not allow assignment without consent of the counterparty. Therefore, as part of the sale process, each counterparty in the portfolio will likely need to agree to accept the transfer of trades to the buyer. This is typically done by having the buyer, seller, and counterparty sign, before closing, a novation agreement where the trades will transfer to the buyer upon notice that the closing has occurred. From a legal perspective, because this is a novation rather than a simple assignment, the seller is completely off the hook for the trades once the transfer occurs (if it had been only an assignment, the seller would be responsible if the buyer did not perform going forward). The novation agreement will also likely include certain amendments to the transactions being transferred. In some cases, these are purely mechanical amendments to address the change from the seller to the buyer. In other cases, these changes may be addressing issues the buyer discovered in its novation process.
It is important to bear in mind that the number of counterparties to be novated can run into the hundreds, or even thousands, in a very large transaction. As such, the novation process may end up taking considerable legal and operational manpower over a period of weeks and may require a great deal of coordination between the buyer and the seller. Ideally, the purchase and sale agreement will contain detailed procedures that the parties can begin implementing immediately after closing.
Dealing With Non-Novated Counterparties
If the portfolio includes a large group of counterparties, neither the buyer nor the seller wants to wait to close until 100% of all counterparties have agreed to novate. However, the seller, who may be exiting the business, does not want to be in the business of serving a handful of recalcitrant counterparties going forward. Therefore, the parties typically agree to close even if less than 100% of the counterparties have agreed to novate, but agree that market risk and, to the extent practicable, servicing obligations of the non-novated counterparties will transfer to the buyer as of closing.
This is accomplished through a back-to-back arrangement that is sometimes called a “mirror transaction” or “total return swap transaction.” Under such a transaction structure, the buyer would agree to perform the seller’s obligations under each underlying trade that has not yet novated to the buyer. This is typically documented as a confirmation under an International Swaps and Derivatives Association (ISDA) master agreement and is intended to create a separate transaction between the buyer and the seller that “mirrors” the roles in the underlying trade.
However, because the buyer is not facing the counterparty directly (except possibly as the seller’s agent), the seller typically retains all counterparty performance and payment risk. As the mirror transaction creates independent credit exposure between seller and buyer, this credit exposure will likely require margining between the seller and the buyer (subject to any agreed unsecured thresholds). The parties will usually continue seeking novation of any mirrored trades post-closing and, if novation is secured at a later date, the related mirror trade will terminate at no cost.
Juggle Transition Issues
Depending on the complexity of the transactions being transferred, and the extent to which the buyer is acquiring systems and personnel from the seller, a great deal of pre-closing and post-closing cooperation may be required to ensure that the buyer is able to properly perform on novated transactions upon closing (and begin servicing any “mirror transactions,” as described above).
Before closing occurs, the buyer may want to embed personnel with the seller’s scheduling and operations groups to begin learning the intricacies of daily operations, though any such arrangements will need to be carefully constructed to avoid raising regulatory or compliance issues.
Transition around closing can be particularly difficult, as the parties will need to cooperate closely with one another and with third-party service providers (like independent system operators and pipeline operators) to ensure that responsibility for commodity flow transfers from the seller to the buyer at the appropriate time. This can be complicated for transactions that involve both gas and power physical transactions, as power typically schedules on a calendar-day basis, while gas typically schedules on a “gas day” basis, starting at 9 a.m. Central time each day.
Buying and selling any business is complicated and requires careful structuring and cooperation between the buyer and seller. In the energy trading business, the risks of “getting it wrong” can be magnified by the real-time nature of the underlying markets and volatility of market prices. Ultimately, the pain involved in a large energy trading portfolio acquisition will be inversely proportional to the level of advance planning and attention to detail involved. If the parties remain mindful of the unique nature of the assets involved, the transaction will seem simple in hindsight.