A Legal Guide to Power Generation Mergers and Acquisitions

Posted on 4th Sep 2019

A myriad of issues come into play when parties execute power industry mergers and acquisitions. Part 2 of this two-part series looks at the issues involved with acquisition agreements, and some of the more highly negotiated provisions.

Professionals who participate in mergers and acquisitions (M&A) involving operating electric power generation assets must be well-versed in a wide variety of business and legal issues unique to the power generation industry. There are many details involved in the evaluation and negotiation of M&A transactions for operating projects, including key considerations such as potential regulatory approvals, that should be identified at the outset of a potential transaction.

In Part 2 of this two-part series—Part 1 ran in the November 2018 issue of POWER—we will dissect the anatomy of a typical acquisition agreement used in power M&A transactions and some of the provisions that are most often negotiated.

The Parties Involved

Seemingly straightforward, one of the key components to a transaction is determining the proper entities to be parties to the acquisition agreement.

Buyer and Seller. Clearly, the seller (the entity that directly owns the equity interests or assets to be sold) and the buyer (the entity that will directly acquire those equity interests or assets) must be parties to the agreement.

Acquired Companies. In many stock transactions, the acquired companies are also parties to the acquisition agreement (Figure 1). The acquired companies make representations and warranties about their businesses, and undertake to perform covenants during the interim period between signing and closing of the transaction. The buyer will want to ensure that the seller cannot look to the acquired companies for post-closing indemnification or contribution, so that the buyer is not in effect seeking recourse from its own subsidiaries once the deal closes.

1. Stock transactions. CenterPoint Energy’s $6 billion deal to buy Indiana gas utility Vectren was brokered after CenterPoint said it would pay $72 in cash for each share of Vectren stock, and assume all of Vectren’s outstanding net debt, with Vectren becoming a CenterPoint company. Vectren’s assets include the A.B. Brown Generating Station in Evansville, Indiana, which burns both coal and natural gas. Vectren plans to close those units and build a new gas-fired power plant at the site. Courtesy: Wikimedia Commons

Guarantors. One of the most heavily negotiated aspects of a transaction is what parent entities or other credit support, if any, will backstop the obligations of the buyer and the seller. The buyer may be a special purpose entity formed solely for the purposes of the acquisition, and the seller will want some assurances that a creditworthy parent company will be available to pay the purchase price and/or any termination fee payable to the seller. The seller may be a holding company that does not own any other assets besides the project or portfolio being sold in the transaction, and the buyer will want some assurances that a creditworthy parent company will be available to satisfy any post-closing obligations (including indemnification) once the seller has distributed the sale proceeds to its owners and holds no other assets that would be available to satisfy those obligations.

Defined Terms

Below are several defined terms that are likely to be encountered and subject to negotiation in a power M&A acquisition agreement.

Knowledge. The acquisition agreement will often contain a definition for “Knowledge” that qualifies certain of the seller’s representations and warranties, such that, to prove a breach, the buyer would have to prove that the seller possessed the requisite “Knowledge” of the inaccuracy of the relevant representation and warranty. While sellers will seek a strict actual knowledge standard (without any duty of investigation), buyers often seek a duty of reasonable inquiry, or potentially a constructive knowledge standard (what the seller should have known). The “Knowledge” definition is often limited to a discrete universe of the seller’s individuals, and the buyer will want to ensure that the list encompasses individuals that would actually be in a position to know whether or not a representation and warranty is accurate, such as plant managers, asset managers, and environmental personnel.

Good Utility Practices. The acquisition agreement will often contain a definition for “Good Utility Practices,” “Prudent Operating Practices,” or some similar term that attempts to set forth an objective reasonable operator standard for purposes of representations and warranties concerning the seller’s historical operations of the project and covenants concerning the seller’s operations of the project during the interim period prior to the closing. “Good Utility Practice” means, with respect to the project, the practices, methods, and acts generally engaged in or approved by a significant portion of the independent electric power industry in the U.S. for similarly situated facilities during a particular period, or any of such practices, methods, and acts, which, in the exercise of reasonable judgment in light of the facts known at the time a decision is made, would be expected to accomplish the desired result in a manner consistent with applicable law, safety, and good business practices.

Material Adverse Effect (MAE). In most acquisition agreements, it is typical to encounter a material adverse effect or “MAE” definition, which serves as a qualifier on negotiated representations and warranties, and also as a condition to the buyer’s obligation to close the transaction, either by way of a standalone closing condition or by operation of the closing bring-down of the seller’s representation and warranties. The structure of the MAE definition most typically consists of 2 prongs: a material adverse effect on the acquired companies (often phrased in terms of the “business, assets, operations, or condition, financial or otherwise,” of the acquired companies, and occasionally referring to the “prospects” of the acquired companies in order to encompass a forward-looking component) and a material adverse effect on the seller’s ability to consummate the transaction. The first prong is usually subject to a negotiated litany of eventualities that are exceptions, and thus, are not to be considered in determining whether an MAE has occurred. Below are some examples of power M&A-specific exceptions:

A seller’s auction form will likely contain the above and numerous other exceptions. While most buyers can live with some exceptions, typically macro-economic factors that do not disproportionately affect the projects to be acquired, a buyer should be wary of attempts to shift project or transaction specific risk to the buyer.

For example, buyers might resist references to “national” electricity markets when the transaction involves a single facility where the regional market would be much more pertinent. Practitioners should also be aware that courts have held that the purpose of MAE clauses is to protect the buyer against the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally significant manner. Thus, buyers should not assume that the MAE provisions will be triggered by short-term issues, even if material. In addition, buyers should not assume that by successfully negotiating for the deletion of the seller’s proposed MAE exceptions, the substance of those exceptions will necessarily constitute the MAE— the underlying facts must still constitute an MAE in the first place in order to qualify.

Asset and Liability Descriptions. If the transaction is structured as an asset purchase, there will be increased focus on the assets (Figure 2) and liabilities that will be transferred to the buyer or retained by the seller. At a high level, the seller’s form will often seek for the buyer to generally assume all liabilities in connection with the projects, subject to limited exceptions for liabilities the seller will expressly retain. The buyer’s preference will often be the inverse, with the buyer disclaiming and the seller retaining, all liabilities in connection with the project, subject to limited exceptions for liabilities the buyer will expressly assume. In addition, there will be negotiations over the standard by which relevant assets or liabilities will be transferred or retained.

2. Asset purchase. Skyline Renewables in late October purchased Starwood Energy Group’s 51% interest in the Horse Creek and Electra wind farms in Texas. Each farm has generation capacity of 230 MW, utilizing 100 GE 2.3-116 wind turbines, one of which is shown here prior to its installation and commercial operation. Starwood earlier had sold the other 49% of its interest in the farms to MEAG, a Germany-based asset management company. Courtesy: Starwood Energy Group

For example, the buyer might agree to acquire assets “related to the business,” “necessary to operate the business,” “exclusively related to the business,” or “to the extent related to the business.” These formulations mean very different things: some suggest the buyer is getting everything related to the business; some suggest the buyer is getting some subset of things related to the business (such that, anything that is broader than the business is being retained by the seller); and some suggest a partial assignment (for example, the buyer might take an assignment of a master contract to the extent it relates to an acquired project, but the seller might retain its interest in the master contract to the extent it relates to the seller’s retained assets). The standards agreed to in the assets/liabilities section will impact the need for a sufficiency of assets representation and warranty. From the buyer’s perspective, the buyer wants to make sure it will acquire all the assets it needs to operate the projects, and that the liabilities to be assumed are appropriately defined and capable of diligence. For example, it is easier to review “all contracts listed on Schedule X” than it is to review “all contracts related to a project,” which is an indefinite universe of contracts that the buyer cannot know without assurances from the seller.

Consideration. The consideration in a power M&A transaction will typically be comprised of a base purchase price subject to purchase price adjustment mechanisms set forth in the acquisition agreement. As is the case in private target stock purchase transactions more generally, a working capital adjustment is the most common type of purchase price adjustment.

Negotiating Points

There are many negotiating points specific to power industry M&A transactions. Some of the common items are included below.

Fuel, Spare Parts, and Inventory. Some formulation of this account often shows up in the acquired companies’ closing balance sheet as a current asset, and it can have significant value. As a key value item, the buyer might seek for the specific items of spare parts and inventory to be listed on a schedule (to make sure they are dedicated to the projects to be acquired, rather than to retained projects in the seller’s portfolio) and some assurances that items of spare parts and inventory are of good quality. Furthermore, a buyer may seek to add additional representations and warranties to that effect (conceptually, a different but related point to the working capital calculation).

Intercompany Accounts. As mentioned in this article, there are often significant affiliate transactions in the acquired company structure. These accounts are often backed out of the new working capital calculation, and there should be covenants and conditions for the seller to fully discharge these liabilities prior to closing.

Representations and Warranties. Acquisition agreements for power M&A transactions contain many of the same representations and warranties that would be expected in a typical private target acquisition agreement, including organizational authority, no violations, ownership, material contracts, legal proceedings, permits, employee matters, taxes, compliance with laws, and similar matters. Power M&A transactions also typically include a number of additional representations and warranties that more uniquely apply to the project(s) being acquired.

Sell-Side

Some specific issues for the seller/acquired company representations and warranties in a power M&A transaction are included below.

Environmental Matters. An operating project is likely to have at least some environmental issues, such as historical instances of exceeding emission limits and receipts of notices of violations from regulatory authorities, or needed storage and disposal of spent nuclear fuel (Figure 3). While most buyers can accept that aspect of transacting business in the power space, buyers should ensure that the disclosures on the schedules are narrowly tailored to specific violations (rather than just attaching environmental reports and assessments in their entirety) and that the buyer’s environmental specialists fully understand the disclosures and are comfortable that the underlying causes of any violations have been appropriately remediated. Key negotiating points include the usage of MAE, knowledge qualifiers, and look-back periods. A common risk allocation arrangement is to include a look-back period that ties to applicable statutes of limitations, and for sellers to give “flat” reps during the period of their ownership and knowledge-qualified reps for periods prior to their ownership.

3. Environmental and regulatory issues. New Jersey-based Holtec International has been acquiring power plants to facilitate the plants’ decommissioning and environmental cleanup, including the Palisades Nuclear Power Plant in Michigan. Holtec is known for its management of spent nuclear fuel. Courtesy: Exelon Nuclear

Regulatory Status. Buyers will seek representations and warranties from sellers to understand the extent to which the acquired companies are regulated as public utilities or public services companies. Acquisition agreements also often contain representations and warranties concerning the seller’s compliance with reporting requirements with the Federal Energy Regulatory Commission (FERC), the North American Electric Reliability Corp. (NERC), the applicable ISO, and other regulatory bodies.

Sufficiency of Assets. Buyers will seek representations and warranties from sellers to ensure that the assets to be acquired in the transaction (directly or indirectly by stock purchase) will be sufficient to operate the projects in the manner in which they were operated by the seller (or sometimes, also in the manner proposed to be conducted by the buyer). An asset deal can make the necessity of this representation more acute—if the acquired assets are just a listing of specific assets to be acquired/retained without any sort of standard (that is, “all assets necessary to operate the business”), how can the buyer be sure that it is getting all the assets it needs without some contractual representation? Sellers often resist this representation on the basis that it offers too much of a guarantee to the buyer that the project will operate as intended, often with some sort of response to the effect that the assets “are what they are.”

The parties can often agree to inclusion of the representation and warranty on the basis of negotiating acceptable limits of indemnification obligations (that is, de minimis thresholds, deductibles, baskets, caps, and the like) for any breach. Sellers may agree to include the representation but seek to add exceptions for assets owned or services provided by affiliates, post-closing transition services to be provided by the seller, and other exceptions listed on a disclosure schedule. Buyers should ensure they can diligence and have suitable arrangements in place for any such exceptions.

Real Property. At a general level, the buyer wants to ensure that it will be acquiring all of the real property interests it needs to maintain and operate the project or the site. The mix of real property interests could consist of owned real property, leased real property, easements, and other contract rights. The buyer will want to ensure that there are no violations of contracts that are listed as title exceptions and that the title exceptions do not interfere with the operations of the project.

Credit Supports. A project company or its owners will often have posted credit support, such as bonds or letters of credit, for the benefit of third parties. It will be the seller’s expectation that in connection with the closing, the buyer will post replacement credit support, and the seller’s credit support will be terminated. In order for the buyer to know exactly what credit support will need to be replaced, the buyer should seek a representation and warranty from the seller regarding an accurate listing of all relevant credit supports.

The acquisition agreement will also likely contain covenants related to the replacement of the seller’s credit supports. While the seller may seek for its credit supports to be released and terminated as of the closing, there may be practical limitations on the buyer’s ability to post the substitute credit support prior to the closing, including whether the consent of the applicable beneficiary is required and can be obtained. Thus, the buyer may negotiate for the ability to “back-to-back” the seller’s credit support for some transition period following the closing until the buyer is able to post its own credit support.

Affiliate Transactions. It is common for buyers to encounter situations in which the seller or an affiliate is the owner of an asset that is used by the project company or provides one or more services to the project company (such as operations or administrative services). Thus, it is essential for the buyer to understand what contracts, permits, systems, or other assets the buyer would not be getting by virtue of acquiring the acquired companies, and what services the buyer might require (either by way of transition services from the seller or by sourcing from a third party) in order to operate the acquired companies in the same manner as they were operated prior to the closing. The buyer should seek a representation and warranty from the seller concerning all of these affiliate arrangements, and then ensure that either these arrangements are assigned to the relevant acquired company as a condition to closing or the buyer is able to obtain a replacement from a third party upon the closing.

Buy-Side

Some specific issues for the buyer representations and warranties in a power M&A transaction follow.

Regulation as Utility and Generation Capacity. Sellers may seek representations and warranties as to whether or not the buyer is a regulated utility and as to the existing generation capacity of the buyer and its affiliates. These representations and warranties serve as part of the seller’s due diligence process to ascertain the regulatory risk of the transaction, so that the seller can evaluate the likelihood that a transaction could be denied by a regulator and thus select the buyer that provides the most deal certainty. Sellers may also seek broad assurances from the buyer that there are “no legal impediments” for the buyer to close the transaction. Buyers may resist these representation and warranties depending on negotiating leverage, as they shift risk allocation for a failed transaction due to regulatory concerns.

Qualified Owner. Sellers may seek representations and warranties as to whether or not the buyer meets the exceptions to when a change of control requires lender consent under the existing financing that is to remain in place following the closing. These exceptions may contain objective and subjective components. The buyer might accept this representation and warranty where the financing is intended to remain in place, but might limit the scope to the objective/verifiable components.

Covenants. Acquisition agreements for power M&A transactions contain many of the same covenants that would be expected in a typical private target acquisition agreement, including interim period operating covenants, efforts to obtain consents and approvals, access, offers to employees, notices of certain events, and similar matters.

Some specific issues for the covenants in a power M&A transaction include the following.

Regulatory Approvals. As noted in the first part of this series in the November issue of POWER, power industry M&A transactions typically require the approval of one or more regulators. Obtaining approvals under the Hart–Scott–Rodino Act, the Federal Power Act, and/or from the applicable state or local regulatory authorities may be the gating items to closing. Thus, the acquisition agreement will contain detailed covenants on the parties concerning their obligations to obtain those approvals. Typically, the agreement will set forth some timeframe after signing by which the initial filings must be made (such as five to 10 days after signing). The agreement will impose some efforts standard on the parties to obtain those approvals and general cooperation covenants to keep each other in the loop concerning communications and developments with the regulator. While sellers often seek a “hell or high water” provision in their auction forms requiring the buyer to close no matter what conditions the regulator may impose, buyers will often seek to limit their obligations such that the buyer will not be required to dispose of any assets or agree to any other conditions that could adversely affect the buyer.

Interim Period Operating Covenants. As is the case in typical private target acquisition agreements, a power M&A acquisition agreement will contain affirmative covenants for the acquired companies to operate in the ordinary course of business during the interim period and negative covenants for the acquired companies to abstain from taking certain actions during the interim period without the buyer’s consent. In addition to generally applicable restrictions such as amending organizational documents, selling assets, issuing equity, entering into, amending, or terminating material contracts, hiring new employees, and the like, a power M&A acquisition agreement will likely contain some restrictions unique to the industry. For example, the agreement may contain obligations, restrictions, and parameters around, among other matters:

In addition, some buyers may negotiate for which of these restricted actions may be rejected in the buyer’s sole discretion, and for which the buyer’s consent may not be unreasonably withheld.

Casualty and Condemnation. Casualty and condemnation provisions are typically heavily negotiated in a power M&A acquisition agreement, because the real value is tied to physical assets that must be functioning to derive revenue. These provisions allocate risk of loss between buyer and seller to the extent of casualty and condemnation events that might occur during the interim period between signing and closing.

A common framework is a multi-tiered structure that allocates risk between the buyer and seller. For example, the agreement might provide for three different thresholds:

Other key negotiating points include how the amount of damages is calculated (such as restoration costs or lost profits) and by whom (such as an agreed engineering firm or appraisal firm), and the entitlement to insurance proceeds.

Intercompany Accounts. As mentioned above, a typical project holding company structure might involve a significant degree of affiliate arrangements. In addition, the working capital adjustment might not account for changes in intercompany balances. Thus, the buyer should ensure that intercompany liabilities are fully satisfied as a condition to closing. When the dust settles, the buyer wants to take the acquired companies with all intercompany liabilities fully paid off, and all intercompany contracts (except contracts in which specific arrangements have been made to continue the relationships) terminated.

Post-Closing Payments. Buyers should be aware that for some projects, at any given time, payments are flowing between the acquired companies and the ISO. At the moment of closing, there could be amounts owed to or payable by the acquired companies relating to the pre-closing period. Thus, many buyers attempt to capture that value by including a covenant or specific indemnity relating to these net overpayments or underpayments. If such a provision is included, sellers will often seek a reciprocal provision in their favor.

New Title Policies. It is critical for buyers to verify title to the projects, both for their own ownership and because lenders will require it as a condition to obtaining financing. A well-prepared seller will have commissioned recent surveys and title commitments in preparation for the sale process. Sometimes, the data room will contain outdated title materials that may not even reflect recent facility expansions. Because title is a critical value item, the buyer will often seek covenants concerning the seller’s cooperation to obtain new surveys and title policies, and a condition to closing concerning the issuance of the new surveys and title policies. Sellers may be cooperative on these aspects of the transaction, but may resist agreeing to closing conditions outside of the seller’s control that could reduce deal certainty. For example, the seller might provide that its only obligations are to provide the affidavits required by the title company in order for it to issue the new policies.

When new title policies are required, the buyer’s preference is often for the parties to attach “pro forma” title policies to the acquisition agreement, essentially policies with agreed upon exceptions that are in a position to be issued in that form at the closing. Otherwise, the onus will be on the buyer to negotiate the policies and exceptions with the title company between signing and closing of the acquisition agreement.

4. Regulatory approvals. The volume of deals in the renewable energy sector, including the solar industry, continues to increase, and those deals often need regulatory approval. As an example, Sempra Energy in September 2018 said it had an agreement to sell about 980 MW of its U.S. solar assets to Consolidated Edison. The agreement is subject to approval by the Federal Energy Regulatory Commission and the U.S. Department of Energy. Courtesy: Pexels

Conditions to Closing

Acquisition agreements for power M&A transactions contain many of the same conditions to closing that would be expected in a typical private target acquisition agreement, including the accuracy of representations and warranties, performance of covenants, delivery of closing documents, receipt of required approvals, absence of an MAE, and similar matters. While these components typically are not controversial, some heavily negotiated aspects of the representation and warranty bring-down condition include when the representations and warranties must be true (only at closing vs. both signing and closing) and how accurate they must be (all respects vs. all material respects vs. MAE standard).

Some specific issues for the conditions to closing in a power M&A transaction include the following.

New Title Policies. As noted previously, the buyer may seek the issuance of new title policies as a condition to closing.

Repairs or Restoration. Further to the points above concerning casualty loss and condemnation, buyers generally seek to avoid closing on the acquisition of a project that is not capable of operation. Thus, buyers may seek to have certain repairs or restoration activities completed as a condition to closing.

Assignments. As noted above, a buyer may uncover through its diligence review that a particular contract right associated with a project is owned by an affiliate of the seller rather than by the project companies. The buyer might seek for this contract to be assigned to the project companies as a condition to closing, so that the buyer can ensure that the project will have sufficient contract rights on a post-closing basis. In addition, a seller may seek to have all of its affiliate contracts terminated as a condition to closing.

Termination

Acquisition agreements for power M&A transactions contain many of the same termination rights that would be expected in a typical private target acquisition agreement, including termination rights for breaches of the agreement (often subject to a cure period), a governmental order restricting the closing, the occurrence of a drop-dead date, and similar matters.

Remedies for Breach and Failure to Close. Most of the negotiations are typically around the remedies for breach and the resulting failure to close. Sometimes the negotiated remedies are parallel between buyer and seller, though often times they are not. For instance, one party’s remedy might be limited to payment of a termination fee, while the other party might have the right to sue for damages, collect a fee, or obtain specific performance. Some common alternative termination remedy provisions include:

Post-Closing Recourse

Some post-closing remedies include the following provisions.

Seller Indemnity. The prototypical post-closing remedy for the buyer in respect of a breach of the seller’s obligations under a power M&A acquisition agreement is a right of indemnification, pursuant to which the seller agrees to indemnify the buyer for defined categories of losses arising out of the seller’s breach.

Most of the negotiations are likely to involve the economic terms of the indemnification provisions, such as:

Escrow. Buyers often seek to deposit a portion of the purchase price with a third-party escrow agent to be held for some period of time following the closing as security for any post-closing obligations of the seller. The escrowed funds are available for indemnification claims successfully asserted by the buyer, and are returned to the seller at the end of the agreed escrow period to the extent remaining.

In transactions that involve representation and warranty insurance (RWI), it is common for the parties to agree to deposit the seller’s share of any retainage into escrow. For example, in a transaction with a 1% deductible that is to be shared equally by the parties and a 15% policy cap, the buyer would bear the first 0.5% of losses, the second 0.5% of losses would be covered by the seller’s escrow, and the remaining 14% would be asserted against the RWI policy. In recent transactions, insurance companies have been willing to offer lower or no seller retainage.

Parent Guarantee. As noted earlier, a buyer may seek for a creditworthy parent company of the seller (either the ultimate parent company or an intermediate level company with sufficient assets) to guarantee the seller’s post-closing indemnification obligations. While guarantees are often included in transactions, they are typically hard-fought aspects of the transaction, as they often involve additional parent company board approvals. Sellers may seek to limit the guarantor’s exposure, such as by including a cap equal to a stated percentage of the purchase price or a time period limitation for claims. From the buyer’s perspective, the guarantor should cover all obligations of the seller under the acquisition agreement and should assume the same monetary and temporal limitations as the seller.

Representation and Warranty Insurance. While RWI policies have grown significantly in recent years, buyers should also be aware of some of the practical limitations of seeking RWI as a substitute for typical seller indemnification. They include:

—Jeff M. Dobbs and Robert S. Goldberg are partners with Mayer Brown LLP in the firm’s Houston office. Part 1 of this series ran in the November 2018 issue of POWER

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