Private Equity March 2020 Update

Private Equity Investment in Oil and Gas through DrillCo Transactions By Michael Brewster

Navigating Blockchain and Data Privacy By Daniel Murray and Courtney Rogers Perrin

Data Privacy Concerns in Private Equity By Craig Cox and Daniel Murray

Private Equity Fund Investment in Qualified Small Business Stock – An Introduction to Section 1202’s Benefits By Scott Dolson

SURPRISE! You may be liable for union pension plan withdrawal liability. By Michael Bindner

Credit Financing: Adjusted EBITDA Cheat Sheet By Aaron Turner

Introduction to Private Equity’s Acquisition of Medical Groups By Brian Higgins and Tom Anthony Private Equity Investment in Oil and Gas through DrillCo Transactions By Michael Brewster

As a result of tighter capital markets, Operators like the use of DrillCo interest in the assets through the traditional financing for upstream oil arrangements because, if structured assignment that it receives. and gas operations, such as drilling, properly, DrillCos preserve cash flow A DrillCo is typically used in areas where is increasingly difficult to obtain. and avoid balance sheet liabilities. For the geological formations have proven Borrowers face increasingly stringent an operator with limited access to capital to be productive and where the geology lending standards, and lenders are ever that is holding acreage with development has been developed. Because of the prior cognizant of the inherent risk of upstream potential, a DrillCo transaction presents production and the tested geology, there oil and gas development, especially in an attractive mechanism by which the is a reduced risk profile associated with a low-price environment. Upstream oil operator can develop its acreage. Instead development. For the operator, an area and gas operators often need to employ of using its own cash, an operator relies like this creates many possible drilling alternative financing vehicles, which can on the investor’s funds to increase locations that will likely produce reliable be advantageous. production and enhance the value of cash flow. However, the operator may not the acreage. Utilizing this strategy, the During the last few years, a transaction have the capital to develop all of these operator is more likely to obtain favorable structure called a “DrillCo” has emerged, possible locations. As a result, areas like terms in an ultimate sale, a public which is a term used to describe a drilling this are attractive to both operators and offering or a refinancing. In addition, joint venture arrangement. In a DrillCo investors, with the downside being that a DrillCo enables drilling activities to transaction, an investor agrees to fund a large amount of capital is required to commence, which can also provide the all or a significant portion of the drilling develop this inventory of drilling locations. operator with the capital necessary to costs for a certain number of wells in maintain its leases prior to the expiration exchange for a percentage interest in of the primary term. the oil and gas lease or the well, which is called a working interest. The drilling Private equity groups favor DrillCo CONTACT THE AUTHOR costs that the working interest owner arrangements for a variety of reasons. For a more in-depth discussion funds include a portion of the costs First, a DrillCo allows the private equity regarding DrillCo transactions, associated with the exploration, drilling group to invest a substantial amount contact Mike Brewster of Frost and production of a well. of capital in a single transaction while Brown Todd’s Private Equity utilizing an efficient and effective In a DrillCo transaction, an operator Industry team. means of investing. With a DrillCo contributes acreage, and the private transaction, the investor looks for an equity investor contributes cash to cover established operator with a proven most of or all the costs associated with acreage position, a track record of success drilling oil wells. In exchange for putting and well production, which minimizes up the capital, the investor earns and is the investment risk. The investor can assigned a working interest in the wells minimize the geological and operational drilled. In typical DrillCo transactions, risks by investing in drilling prospects the working interest assigned to the that have been identified, tested, and Mike Brewster investor is subject to partial reversion to proven. Finally, investors prefer DrillCo Managing Associate | Pittsburgh the operator once the investor achieves a arrangements because they offer greater 412.513.4322 predetermined internal rate of return on protection in the event of a bankruptcy, [email protected] its investment, called an IRR Hurdle. because the investor owns a real property Navigating Blockchain and Data Privacy By Daniel Murray and Courtney Rogers Perrin

Blockchains are becoming more prominent Right to “Delete” in cryptocurrencies like Bitcoin, supply Data privacy laws sometimes provide consumers a right to delete data. This poses a challenging feat when the data may reside on chain applications, and more. Two typical millions of computers around the world, the blockchain may have features of blockchains are transparency and no managing central authority, and it may have been built to be immutability. immutable. Helpfully, pseudonymization of the data can reduce some of the compliance requirements associated with deletion. Under pseudonymization, a piece of data can only identify a Despite the money flowing into this consumer when combined with additional data. technology, there are several legal challenges, including the application of data privacy laws. Controllers v. Processors Data privacy laws often distinguish parties that collect and Here are some issues to keep in mind. control data from parties that simply hold the data temporarily to complete some analysis. In the land of blockchain, the blockchain itself—particularly if it’s a private blockchain—is likely the controller. That raises the compliance requirements. Who has jurisdiction? There are no clear borders when it comes to data privacy or Right to Transfer blockchain. Data privacy laws can cover a state (California Like the right to delete, a right to transfer implies that consumers Consumer Privacy Act) or a group of countries (General Data can control their data and move it at will. But in blockchain this Protection Regulation “GDPR” in the European Union). And may not be possible. Again, as with the right to delete, blockchains these laws often apply to a subject citizen, regardless of that will want to implement data pseudonymization to avoid the most citizen’s physical location. Meanwhile, public (or distributed) onerous requirements of data privacy laws. blockchains may reside on computers scattered around the world. Private blockchains may reside at a centralized location. But even Chief Compliance Officer – CCO then, if multiple countries can use that private blockchain, then GDPR requires companies to name a chief compliance officer in each country’s data privacy laws may apply. some cases. But even if GDPR is not applicable, most companies Courts have just begun to address the jurisdictional issues. In the will need a specialist to monitor its data privacy activities and United States, courts are looking at previous case law on websites. possible compliance issues. Because data subjects often reside in Although it’s difficult, best practice would be to comply with each multiple countries, companies can quickly become subject to local law applicable to your blockchain, including server location, multiple data privacy laws. With or without a data protection consumer citizenship, and consumer location. To avoid a specific officer, blockchains should document their efforts to comply with data privacy law, blockchains will likely have to prohibit users and GDPR and other laws. servers from that locale. This could mean blocking all U.S. IP addresses, for example. Data Privacy Concerns in Private Equity By Craig Cox and Daniel Murray

Privacy, data security and data ownership Note what laws apply and what further issues are increasingly relevant for consent is needed. If the acquisition is buyers in M&A transactions. This confidential, consent from customers will CONTACT THE AUTHORS may result from the industry involved, have to wait until the deal is completed. For a more in-depth discussion the importance of data as a company regarding the blockchain and data asset, the use of data in the company’s Contracts with Vendors privacy, contact Craig Cox, Daniel marketing and sales, or because the Also relevant are contracts with suppliers Murray, or Courtney Rogers Perrin company’s operations involve regulated that may collect or store data on behalf of Frost Brown Todd’s Private data. Applicable laws include GDPR in of the company, as well as any contracts Equity Industry team. Europe, CCPA for California, HIPAA the company may have to collect, process for the United States, and PIPEDA for or store customer data for. Buyers Canada. should investigate a target’s security procedures and history of breaches. Data issues should be a primary concern Does the company use third parties for buyers, both when conducting due to perform security or vulnerability diligence into a target company and when assessments or data audits? How does the documenting the sale with appropriate company manage its network and data? representations and warranties and Remember that one vendor is the data indemnity provisions. Failure to properly Craig Cox room provider. The parties will want Member | Dallas address these issues in an acquisition to ensure that the data room provider could subject the buyer to private causes 214.580.5855 complies with applicable law. Certain [email protected] of action from customers and other data may need to be protected from individuals and to action from regulators. disclosure during the acquisition process. Pseudonymization or anonymization of Due Diligence Concerns personal data may be necessary. Disclosure requests should address several key areas. Buyers need to understand a Reps & Warranties target’s treatment of regulated data such Representations and warranties can as health data, financial data, customer determine the target’s compliance and personal data, and data related to minors. track record under applicable laws. This Buyers should learn how companies includes having the target confirm that Daniel Murray interact with both customers and vendors. they have established policies to comply Managing Associate | Dallas with applicable data privacy and security 214.580.5853 Contracts with Data Subjects laws and best practices. Also, confirm any [email protected] Buyers need to understand a company’s security breaches, audits, or governmental privacy policies and contractual investigations relating to data privacy and obligations related to customers. What security that involve the target. Buyers kind of consent has been obtained from should require the target to identify every customers? Does the consent cover the jurisdiction for which the target possesses types of activities that the buyer will protected data. engage in? The results of these analyses may impact the valuation of any deal. Indemnification Remember, even if customer data isn’t Do your best to apportion risk of data Courtney Rogers Perrin at issue, data privacy laws may apply to privacy non-compliance. However, some Managing Associate | Nashville employee data. laws, such as GDPR, may limit the extent 615.251.5592 Post-acquisition, buyers may need to which apportionment can remove [email protected] to provide notification to, or obtain risk to either party. Seek appropriate additional consents from, data subjects. insurance coverage when possible. Private Equity Fund Investment in Qualified Small Business Stock – An Introduction to Section 1202’s Benefits By Scott Dolson Section 1202 of the Internal Revenue A critical point from a planning innerworkings of Section 1202. Given Code provides for a potential exclusion standpoint is that Section 1202 the challenges associated with structuring from federal income tax of 100% of gain doesn’t limit its scope to investment in investments in QSBS and documenting from the sale of qualified small business corporations engaged in de novo start- Section 1202 eligibility, we recommend stock (QSBS), including alternative up activities. There is nothing in the that PEGs identify tax advisors who have minimum tax, the 3.8% net investment language of Section 1202 that restricts an extensive experience working specifically income tax and often state income issuer of QSBS from acquiring equity or with Sections 1202 and 1045. taxes. If a private equity group’s (PEG) assets of a qualified small business. This fund with 20 owners acquires QSBS of interpretation of Section 1202 opens the XYZ Corp, each of the 20 owners has a door to investment in QSBS by PEGs in potential gain exclusion from the sale of connection with their M&A investment CONTACT THE AUTHOR the QSBS of at least $10 million. activities. For more information, contact Scott Dolson of Frost Brown Todd’s QSBS can only be issued by a C An issuer of QSBS to a PEG could be a Private Equity Industry team. corporation. This fact used to be a major corporation organized to roll up assets or reason why Section 1202 was ignored equity of a target company, or it could be by many advisors since its enactment in the equivalent of a “blocker corporation” 1993. But with corporate tax rate reduced organized to hold an equity interest in a from 35% to 21%, operating as a C target company. The target company itself corporation has become more attractive, might be a pass-thru entity such as an particularly when the rate reduction is LLC (taxed as a partnership) or a greater combined with Section 1202’s benefits. than 50% owned corporate subsidiary. With careful attention to Section 1202’s Scott Dolson While some venture capitalists have workings, it should be possible in most Member | Louisville structured their investments to take cases to structure an acquisition that 502.568.0203 advantage of Section 1202, its potential accomplishes both the issuance of QSBS [email protected] has not been fully explored by many (including avoiding the redemption issue) PEGs. Under the right circumstances, to the PEG and the tax-free rollover of Section 1202 can deliver dramatic tax target company equity or assets by target savings for a PEG’s investors. management.

The PEG business model of buying and Where a target company would cause selling businesses makes PEG investments the corporation issuing QSBS to fail natural candidates for including the Section 1202’s $50 million size of issuance of QSBS in the transaction issuing corporation limitation, possible structure. The difficult task is molding solutions might include first forming a traditional leveraged buy-out (LBO) a C corporation to issue QSBS to the transaction into a structure that permits PEG, followed later by the corporation’s both an investment by the PEG fund in acquisition of target company assets or QSBS and a tax-free rollover of target equity, or the formation of two or more company equity by the management corporations issuing QSBS and acquiring team. The holding period requirement assets or equity of the target company. may exclude some PEG investments from Section 1202 planning, but the holding In spite of the potential for extraordinary period for at least some PEG and family tax savings, many otherwise experienced office investments exceeds five years. tax advisors are unfamiliar with the

frostbrowntodd.com | Private Equity SURPRISE! You may be liable for union pension plan withdrawal liability. By Michael Bindner

When a participating employer stops determined by Internal Revenue Service operating entity and were provided a contributing to, or no longer has an regulations, are jointly and severally direct economic benefit that an ordinary obligation under a collective bargaining liable for the withdrawal liability if the passive investor would not derive. The agreement (CBA) to contribute to, an participating employer does not pay the courts applied what is referred to as the underfunded multiemployer (union) liability. “investment plus” test (i.e., the owner pension plan, the employer may be is more than just a passive investor) in liable for “withdrawal liability” even Successor Employer Liability making the determination that the Sun though it always paid its required annual A purchaser of assets generally does not Capital funds were “trades or businesses.” contributions to the pension plan. acquire a seller’s liabilities, but some Fortunately for the funds, the U.S. First Withdrawal liability can be triggered federal courts have found a buyer of assets Circuit Court of Appeals, in a decision when an employer has a significant liable for the seller’s withdrawal liability as issued in November, 2019, held that union workforce reduction (a partial a successor business. Successor businesses because (1) neither Sun Capital fund withdrawal), a complete union workforce to entities which are assessed withdrawal owned at least 80% of the operating reduction (a complete withdrawal), or liability have been found liable for unpaid entity and (2) the two funds were a withdrawal of all employers from the withdrawal liability if they: determined not to be in an implied pension plan (a mass withdrawal). partnership with each other, the two ∙ had notice of the liability and funds were not considered in common ∙ The employer is primarily responsible continued the business of the control with the operating entity and thus for paying the withdrawal liability, but predecessor entity (typically referred to not responsible for the operating entity’s other businesses which have common as a “continuity of operations”) after withdrawal liability. ownership with the employer will also be purchasing the assets of such entity. liable. Shareholders of an incorporated business, partners in a partnership, or an Liability of Private Equity CONTACT THE AUTHOR alter ego or successor business may also be Investors responsible for withdrawal liability if the A private equity fund that is under For a more information contact participating employer does not pay the common control with an operating entity Michael Bindner of Frost Brown withdrawal liability to the pension plan. (sometimes referred to as a “portfolio Todd’s Private Equity Industry team. company”) can be responsible for The following is an explanation of the withdrawal liability that is originally potential liability of certain entities, other assessed to the operating entity if the than the employer, when the participating private equity fund’s involvement in the employer becomes insolvent and can’t pay operating entity is sufficiently active as to the withdrawal liability. render the private equity fund a “trade or business” (i.e., not a passive investor). Liability of Commonly Owned Businesses In the Sun Capital Partners cases, Michael Bindner All entities which are considered under federal courts determined that two Sun Counsel | Indianapolis common control (i.e., a parent-subsidiary Capital funds were not merely “passive 317.237.3863 group or a brother-sister group), as investors,” but “trades or businesses” [email protected] because they operated and managed the Credit Financing: Adjusted EBITDA Cheat Sheet By Aaron Turner

In its simplest form, Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) forms the Negotiation of EBITDA add-backs often include basis for some type of leverage ratio discussions around the following add-back types: financial covenant, and those covenant levels are derived from the operating ∙ Losses from interest rate hedging agreements. entity’s historical financial information ∙ Financing fees and other amounts arising in connection with incurring as well as the projections provided by indebtedness. the private equity sponsor, borrower, ∙ Restructuring charges and projected savings/synergies in connection financial advisor or similar representative. with a restructuring. EBITDA serves many other functions as well in these types of facilities—for ∙ Management and advisory fees and indemnities and expenses under example, in loan pricing and incurrence- sponsor management agreements. based restrictive covenant exceptions. ∙ Other extraordinary, nonrecurring or unusual losses or expenses (e.g., arising from transactions, integrations, transitions, facility opening, The negotiation by borrowers and lenders consolidation, relocation and expansion costs). concerning the definition of EBITDA in cash flow-based credit facilities is ∙ Costs of employee benefit plans or management and board stock fundamental to the size of the default option plans, to the extent such plans are funded with contributed risk of the applicable loan. Sponsors and capital or equity proceeds. borrowers, certainly, and even lenders, ∙ Cash receipts in respect of previously excluded non-cash gains. in many cases, have some interest in ∙ Losses on sales of securitization assets. mitigating loan default risk by creating ∙ a leverage calculation that is a market- The excess of GAAP rent expense over cash rent expense. accepted approximation of the borrower’s ∙ Fees, costs and expenses arising in connection with a transaction consistent operating cash flows. In permitted by the financing documentation. addition, especially for highly leveraged ∙ Proceeds of business interruption insurance for the applicable period. deals, regulated lenders have an interest ∙ Litigation expenses. in creating a thoughtful definition of EBITDA that, within such lender’s ∙ All other non-cash charges. underwriting and risk policies, avoids ∙ Add-backs included in the borrower’s projections. unnecessarily painting an overly leveraged picture of the lender’s loan portfolio and Each of these add-back types (and many others not listed) have their other consequences of regulatory “red own nuances and level of market acceptance to consider. EBITDA flag” loans. is only one definition in agreements that are often in excess of 150 pages of highly complex terms and provisions, and both lender and This article is a brief reminder (for all borrower/sponsor sides rely on strong representation from outside market participants to consider when counsel to navigate credit documentation. negotiating the EBITDA definition in credit facilities) of the general types of EBITDA add-backs that are often included in middle-market, cashflow- based credit facilities, particularly those with private equity sponsor influence. CONTACT THE AUTHOR The general objective of credit facility For a more in-depth discussion Aaron Turner regarding the merits of different EBITDA is to add back to net income Member | Dallas EBITDA-related contract the interest, taxes, depreciation and 214.580.5858 provisions, contact Aaron amortization, as well as to addback [email protected] Turner of Frost Brown Todd’s certain other non-cash, extraordinary and Private Equity Industry team. transaction-related items deducted from earnings when determining net income. Introduction to Private Equity’s Acquisition of Medical Groups By Brian Higgins and Tom Anthony

Private equity’s expansion into healthcare effectively means that the only owners sold to the MSO and then leased back to has proliferated in the past decade, with of a medical group can be state-licensed the medical group for a fee. In addition to over 181 private equity deals for all types physicians. Further, many states also this leaseback arrangement of hard assets, of physician practices in 2018 alone, prohibit physicians from splitting the the MSO may provide management according to a Modern Healthcare. fees generated from their medical services services to the medical group for a fee. Most recently, private equity firms have with others. Generally, these prohibitions These management services usually been interested in investing in specialty arose to protect patients from individuals consist of the back-office functions practices like orthopedic, gastroenterology or companies that are not licensed of the medical group, like billing and and urology practices. These private physicians from making medical decisions collections matters, office administration, equity firms buy in for a quick return on which may be influenced by making a and information technology services. The investment, typically selling their stake profit at the expense of patients’ best leaseback of the assets and management in the medical group within 3-5 years, healthcare interests. services provided by the MSO to the most often to another private equity firm. medical group are typically embodied Medical groups may find these deals These types of prohibitions make it in a long-term (sometimes 15-40 years), attractive because it is both lucrative for very difficult for a private equity firm heavily negotiated management services the physicians and also can allow them to buy-in directly to a medical group. agreement. to focus more on patient care and keep Thus, private equity firms interested costs down for their patients and practice. in the healthcare space need to find a To patients getting care at a medical While private equity acquisitions of different vehicle by which to generate group that has an arrangement medical groups can result in positives for revenue from a medical group. This with an MSO, their experience is private equity firms and medical groups, vehicle is typically a management services no different while in the physician’s the upfront structuring of these private organization (the “MSO”), which is a office. If anything, the stakeholders equity deals with medical groups involves separate legal entity created by the private in the arrangement hope the patients’ careful planning to avoid the risks posed equity firm to own and manage all the experience has improved. Our law firm by a variety of legal concerns. non-medical or business aspects of the has deep experience advising clients on medical group. To generate revenue for healthcare acquisitions and would be For example, many states prohibit the the MSO, the medical group’s assets— happy to counsel anyone interested in a “corporate practice of medicine,” which chairs, medical equipment, gauze—are private equity healthcare deal.

CONTACT THE AUTHORS Brian Higgins Tom Anthony Please contact Brian Higgins or Senior Associate Member Tom Anthony of Frost Brown Cincinnati Cincinnati Todd’s Private Equity Industry 513.651.6839 513.651.6191 team for more information. [email protected] [email protected] About Frost Brown Todd A full-service law firm with more than 525 attorneys in multiple states, Frost Brown Todd offers that rare blend of local market knowledge and world-class problem solving. Our attorneys work together across disciplines and across the map to support a diverse client base, including some of the world’s best-known companies as well as numerous startups, government entities, and social-sector organizations. Whether we’re crafting deals or compliance solutions that are above reproach, or intervening in high-stakes commercial disputes, we’re driven to exceed expectations and deliver value by working creatively, meticulously and passionately.

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