Private equity investment surges in midstream market

Elizabeth McGinley, Bracewell & Giuliani LLP, New York

As increasing volumes of shale gas and oil are extracted across the United States, there is a critical need for midstream infrastructure to transport and store such production. It is estimated that the cost to develop the necessary midstream infrastructure in the US could reach $200 billion. Accordingly, there is a tremendous demand for capital to fund infrastructure development.

Fortunately, the pool of private capital to be invested in oil and gas midstream assets is also growing. Many investors that previously had a general interest in US shale gas and oil assets are now sharpening their focus and are seeking more specific investment opportunities in midstream assets. New funds dedicated solely to investment in midstream infrastructure have been formed and are gaining popularity. In addition, many private funds that have broadly invested in shale gas and oil assets recently have sought to increase the percentage of their portfolio invested in midstream assets.

Accordingly, the combination of the high demand for midstream asset development and private funds' increasing interest in midstream assets has led to a dramatic increase in private fund investment in midstream infrastructure in the past year. The trend is expected to continue at least through 2013.

Investments in midstream assets can provide investors with exposure to the shale gas and oil market, but with less volatility than direct investment in exploration and production, making them well suited for private fund investment. When properly structured, midstream investments can provide a steady return for five to 15 years, the typical private fund investment horizon.

Private fund investment in midstream assets may take many forms including debt, equity in a joint venture, or a sale-leaseback arrangement. The form of investment is driven, in part, by the US federal income tax consequences to various types of private fund investors. Private fund investors include US taxable investors, US tax-exempt investors, and foreign investors.

Domestic tax-exempt investors generally are not subject to federal income tax on investment income such as interest, dividends, or gains from investment assets, unless the investment was acquired with the proceeds of debt financing. Such investors are, however, subject to federal income tax on unrelated business taxable income, or UBTI, which generally is income from a trade or business unrelated to the organization's tax-exempt purpose.

Accordingly, tax-exempt investors in a private fund generally are not subject to federal income tax on returns earned through debt or corporate equity financing to develop midstream assets, but they are subject to federal income tax on returns from an investment in a joint venture structured as an interest in a pass-through entity, generally, a limited partnership, or limited liability company that does not elect to be treated as a corporation. This is because the partners or members in such joint venture are treated as engaged in the business activities of the partnership or LLC.

Similarly, if a foreign investor is treated as engaged in a US trade or business, its effectively connected income, or ECI, will be subject to US income tax at regular graduated rates and the foreign investor will be required to file US tax returns. A foreign investor will be treated as engaged in a US trade or business if it is a partner in a partnership or a member in an LLC that does not elect to be treated as a corporation engaged in a US trade or business.

In addition, foreign investors are subject to US federal income tax on gains on the sale of US real property interests. US real property interests include both interests in land and permanent structures as well as equity in a US real property holding corporation, generally, a corporation with 50% or more of the value of its assets attributable to US real property interests, subject to certain exclusions. The proceeds from the sale of such interests by foreign investors also are subject to US tax withholding.

However, foreign investors generally can receive US source interest, dividends, and gains on investments without being treated as engaged in a trade or business in the United States. The interest or dividend income may be subject to US withholding tax, but the receipt of such income does not require foreign investors to file a US tax return.

Funds with tax-exempt investors that want to avoid UBTI or foreign investors that want to avoid ECI are not precluded from making investments that generate such income. Instead, funds can cause the tax-exempt or foreign holders to hold the investment through a US corporation. The corporation is subject to federal income tax on its earnings and remits the net earnings to shareholders in the form of dividends or gain on the sale of stock, which generally are neither UBTI nor ECI.

Debt financing for midstream asset development generally is attractive to all types of fund investors as well as developers seeking cash to build and operate midstream assets. Debt financing yields interest income to investors which generally is not UBTI to tax-exempt investors or ECI to foreign investors, and may be paid to certain foreign investors without US withholding. Further, issuers of debt usually may deduct the interest expense for federal income tax purposes. However, debt financing typically provides a fixed return and does not provide creditors the right to share in the profits of the issuer that an equity investment provides.

The Ryckman Creek Gas Storage Facility is connected to five interstate pipelines, including Kern River, Questar, Overthrust Pipeline, Ruby Pipeline and Northwest Pipeline, all of which also connect to the Opal Hub located just north of Ryckman Creek. Photo courtesy of Peregrine Midstream Partners

The Ryckman Creek Gas Storage Facility is connected to five interstate pipelines, including Kern River, Questar, Overthrust Pipeline, Ruby Pipeline and Northwest Pipeline, all of which also connect to the Opal Hub located just north of Ryckman Creek. Photo courtesy of Peregrine Midstream Partners

One of the most common forms of equity investment for midstream asset development, particularly the development of gathering systems, is the partnership joint venture. Typically, a partner engaged in either the upstream business with a need to develop midstream infrastructure to transport its production or in the development of midstream assets for use by third parties forms a partnership joint venture with a private fund willing to commit capital to the project. The developer may or may not contribute assets such as existing gathering system assets, assets created in the pre-development process or cash, and the private fund contributes cash to fund the development. Often an affiliate of the developer will provide the development and construction services to the joint venture.

Once the midstream assets are constructed, the partnership joint venture contracts with either the developer partner or third parties to transport oil or gas through the system. The profits of the joint venture may be divided between the developer and the fund at a fixed rate or the allocation may vary over time as certain return hurdles are achieved. Routine operational control normally is delegated by the partnership joint venture to the developer partner pursuant to a management services agreement with major management decisions made by the partners with voting rights in proportion to their percentage ownership of the venture.

To optimize the investment for the fund, the shipping contracts can be structured to minimize production risk and create a relatively steady return. First, the gathering system contracts can be structured as "take or pay arrangements." This mitigates production risk as there is a minimum fee that applies even if volumes transported through the system drop below certain threshold amounts. So, the fund's exposure to decreases in production due to a decline in gas or oil prices or other market factors is reduced.

Second, fees can be structured to increase if development costs exceed a designated level or to pass through certain variable operating costs to the shipper. The shipping contracts also may require the shipper to commit to spend a specified amount on drilling in the region or dedicate production from all wells in the area to help ensure a minimum level of production will be transported through the system and generate a predicable gathering fee.

Finally, because private funds prefer to have a defined investment horizon, the partnership agreement can specify certain events that would trigger the fund's right to exit the partnership. The agreement can provide for a put right or redemption arrangement so that, upon the achievement of certain economic goals, a specific date or certain events, such as a voting deadlock, the private fund can liquidate its investment.

The partnership joint venture structure provides federal income tax advantages for taxable domestic investors, including a single level of federal income tax on earnings. Joint ventures conducted in limited partnerships or LLCs that do not elect to be treated as a corporation are not subject to federal income tax, instead the partnership income is allocated to the partners and the domestic taxable partners are subject to federal income tax on their share of the earnings.

Such partners also may be able to use losses generated by the joint venture to offset taxable income, subject to certain limitations. However, operating income from the joint venture would be UBTI to tax-exempt investors and ECI to foreign investors. Thus, funds may be required to form a corporation to hold the investment on behalf of such investors. The income from the joint venture then could be subject to two levels of tax, once at the corporate level and again if the dividends paid to foreign investors are subject to withholding.

Alternatively, private funds can enter a midstream development joint venture in the form of preferred stock in a midstream subsidiary corporation. This structure may be preferred by oil and gas producers organized as corporations that hold their midstream assets in consolidated subsidiary corporations. If the subsidiary is owned at least 80% by its parent corporation, the income and losses of the consolidated group of corporations can be aggregated to determine the taxable income of the group and dividends from the subsidiary are excluded from the income of its parent corporation.

Preferred stock that has a fixed return and does not provide the holder a right to vote may not be treated as stock for purposes of determining whether the 80% ownership test is met, thus such preferred stock of the subsidiary constituting more than 20% of the value of the subsidiary could be issued without causing the subsidiary to cease to be consolidated with its affiliated corporations.

Dividends on the preferred stock generally are not treated as UBTI or ECI to tax-exempt or foreign holders. However, the midstream subsidiary may be treated as a US real property holding company, and thus gain on sale of the stock by a foreign investor would be subject to federal income tax. Accordingly, the fund may form a taxable corporation to hold the stock on behalf of foreign investors, which reduces the after-tax return.

A midstream asset developer also may seek capital to develop new midstream assets by monetizing existing midstream assets. This can be achieved through a sale-leaseback arrangement. Generally, the developer sells existing assets to a buyer and the buyer leases the midstream assets back to the developer, earning a stable return over the life of the lease. The developer raises capital for additional development and retains use of its existing midstream assets. Typically, the developer also continues to manage and operate the assets pursuant to a service contract with the buyer.

For federal income tax purposes, these arrangements may be respected as a sale of the property and a lease to the seller, or they may be treated as loans. Generally, the analysis is based upon which party is properly treated as the owner of the assets for federal income tax purposes. A primary factor that supports treating the buyer as the owner of the property is that the buyer has a significant interest in the leased property when the lease terminates. That is, at the end of the lease term, the property has a significant residual value and remaining useful life. The issuance of an option by the buyer to the developer to repurchase the leased property for a de minimis amount at the end of the lease term that is likely to be exercised can cause the buyer to be treated as having no residual interest in the property and thus not properly treated as the owner of the property for federal income tax purposes.

If the buyer is properly treated as the owner of the assets, the buyer will earn rental income offset by depreciation, and such income may be treated as active business income subject to federal income tax if earned directly by tax-exempt or foreign investors. Thus, it may be necessary for the fund to form a corporation to hold the property interest on behalf of the tax-exempt or foreign investors.

If the buyer is not properly treated as the owner of the assets for federal income tax purposes, the arrangement may be treated as a loan from the buyer to the developer, with any return on the cash advanced treated as interest. Such interest income generally would not be taxable to tax-exempt investors and may be remitted to certain foreign investors without federal tax withholding.

These alternative transactions are just some of the options private investment funds and midstream developers seeking capital have to structure financing transactions. The best form for any development project must be determined based upon many factors including the desired economic return, tolerance for risk and variability of return, desire for operational or voting control as well as the federal income tax consequences to the ultimate investors. OGFJ

About the author

Elizabeth McGinley  

Elizabeth McGinley is a partner and head of the tax practice at Bracewell and Giuliani LLP. She represents a variety of clients in the oil and gas and electric power industries, including private funds investing in oil and gas exploration, production, and infrastructure, and is based in New York.

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