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Three Actions for Investors
Asset buyers have traditionally been operators and private equity/funds/long-term infrastructure investors. However, over the last few years, there has been an influx of alternate investors looking for new areas of growth and return, such as real estate investors acquiring pipelines, or pension funds investing in power plants and ports.
At the same time, asset due diligence has become increasingly challenging, particularly since it is driven by quality, location, technical complexity and gaps in perceived valuations and risks. The influx of new types of buyers and the increasing complexity of due diligence should drive the need for additional rigor.
The buyer needs to ask:
The approach to due diligence has often relied on desktop studies, benchmarking, and to some degree, on site visits, where applicable, to identify opportunities and risks in the target asset. Our experience working across markets and sectors suggests that implementing the following three actions will help buyers get the most out of due diligence efforts:
These actions complement traditional approaches and promote greater understanding of the assets that are being acquired. These actions will also lead to more meaningful and practical outcomes by helping buyers uncover opportunities that could either enhance value or identify hidden risks that could threaten success long after the acquisition is complete.
Buyers need an understanding of the life value of the asset, including its end-of-life plan vs. the value of its current state. An integrated approach needs to consider the current and future production and operational characteristics, the engineering required to extend the life of the asset, and the environment costs to decommission the asset at the end of life. In this regard, an integrated approach is not merely the sum of the operations, technical and environmental views but, rather, a holistic asset view. Experience shows that the challenge of doing a simple sum of all the siloed views often results in a collective exaggeration or underestimation of risks.
On the other hand, the integrated approach is a result of several trade offs conducted during the due diligence. Examples of these trade offs are between CAPEX investment and maintenance improvements on equipment, infrastructure upgrades and production management, or minimizing risk thresholds and managing risks across the asset life cycle.
Questions buyers should ask include:
During the due diligence process, significant effort is invested in defining the long-term capital requirements to improve or extend the life of the asset. For example, in evaluations related to onshore unconventional oil and gas assets, capital is needed for equipment to sustain operations and for drilling and completions. An integrated view of an asset will enable trade offs between capital allocation options and operational improvement options. Exhibit A provides examples of these trade offs for an upstream shale asset, allowing for more targeted and informed deployment of capital and accelerating the return on investment.
Synergies during the due diligence are often found in procurement, organization and logistics, and impact operating costs. However, when the operational and engineering views of assets are integrated, new synergies may emerge from the perspective of capital projects.
Take, for example, the due diligence of a crude terminal. If we consider the simple example of merging two neighboring merchant tank operations, there are obvious synergies. The benefit to the owner is in the form of reduced operating costs related to utilities, power consumption, maintenance and operations. Workforce headcount could also be reduced for a cost savings.
However, the larger opportunity is in optimizing capital expenditure, which can only be fully appreciated when looking at the asset on an integrated scale, specifically the integration of engineering and operations.
Building off the merging of two neighboring tank operations in the example above, there could be avoided capital if one of the tank farms has a heavy duty pump already installed that is now appropriate for the combined asset. It is important to note that to make the combined tank farm work on a broader and fully functional scale, additional capital expenditure will likely be needed. This expenditure will be determined through an integrated view of both operations and engineering to determine a required configuration, interconnects and new pumps needed for operating the entire facility as one asset, and an integrated logistics solution to accommodate the facility requirements. These synergy costs could not be estimated appropriately without an integrated view of operations and engineering functions.
For the example above, bringing in the engineering and operational views resulted in net capital synergies of $40 million on a 5-year NPV, despite capital spend to interconnect the two terminals.
Consider the example of the purchase of a pipeline asset where, often, there are functional silos between engineering, operational, environmental, and compliance/HSE views of the asset. Each of these functions will have specific business requirements in and of themselves, and will work on risks and opportunities for their own sake, often to a comprehensive level of detail for the purpose of seeking budget requisitions.
The pipeline’s engineering group may desire improved quality and reporting from the field. This enhanced reporting could require instrumentation upgrades and software systems to achieve desired results. Within another silo, the operations group may seek improved production and maintenance processes and may seek new inspection software and hardware to track leaks and repairs.
Due diligence efforts often utilize external benchmarking to compare the asset to similar assets in the market and industry. As an enhancement, we suggest that a historical performance review of internal best demonstrated practices and costs may be more meaningful. Reviewing internal best practices gives buyers the ability to drill down into root causes and understand the drivers of poor performance. Poor performance and high dispersion around a variable mean for standard operating metrics, such as throughput, uptime, maintenance costs, etc., should cause concern.
This variability increases investment risk. Taking an internal look will also help buyers quantify the level to which operations can improve, providing far greater insight than what could be gained from an external review.
For example, in the upstream sector, segmenting owner operated vs. non-owner operated shale wells may be insightful. An analysis of these segments in historical performances and trends, and lease operating expenses anomalies over a multi-year period, may reveal the true operating performance of the asset at a granular level rather than at an asset level. In this case, insights may not be visible using only external benchmarking.
For one asset’s wells, the scrutiny of internal best practices provided stark differences between owner operated wells and non-owner operated wells. In this particular instance, there was an opportunity to scrutinize internal best practice between actual downtime, as well as production volumes and variable costs between the operators, as shown in Exhibit B below.
The large contrast within this asset indicated great potential for improvement in the future performance of the owner operated wells.
Historical performance and trends can reveal more than what is presented in a particular reporting period. For example, reported controllable downtime of assets can appear high as a percentage compared to peers, with uncontrollable downtime in top quartile performance. Looking at historical performances, the buyer would be able to see achievable future best practices and a balance between uncontrollable and controllable downtime. It is an important consideration, as reducing downtime can significantly impact overall lifting costs per well, by both increasing volume of hydrocarbons produced and reducing maintenance spend.
During the due diligence process, much effort is spent on the alignment of strategic, operational and management fit between the buyer and seller, and naturally, getting the right price. However, the costs of not aligning on risk and the subsequent liabilities have significant commercial implications.
Buyers sometimes do invest the time and effort in understanding the operational, technical, regulatory and environmental risks and often develop a registry of risks. However, these risks need to be monetized if there is a gap between the current state and the desired future state of both the buyer and the seller based on their risk culture and behaviors towards risk.
Questions the buyer should ask include:
Risks manifest in the operational, technical, and environmental performance of the asset. Additional root cause analysis will magnify the fundamental human, cultural and value-driven behaviors that drive these risks. For example, asset owners with less rigorous environment, health and social practices than a buyer’s may expose the new owner to unexpected social and reputational risks. This same operator may also have inadequately characterized environmental liabilities that result in the buyer assigning additional risk; for instance, many local communities are generally concerned with groundwater contamination, surface water and air pollutants.
Low HSE performance could tarnish existing local relationships, including activist groups in the area. Depending on the complexity of the asset, additional risks may have to be factored in for future regulatory shifts and implications for asset retirement obligations.
Personal biases and differences between the buyers and sellers on acceptable standards in safety practices and their individual tolerance often mask the true degree of risk. There may be potential future issues and related costs when considering all the environmental liabilities, as well as the associated social/brand implications, of the assets under review. The lack of alignment or risk tolerance between seller and buyer during the traditional due diligence process produces a chronic undervaluation of the cost of retirement and the extent of liabilities of legacy assets.
Understand if assets are “prepared” for saleAnother aspect that is largely underrated, and often misunderstood, is the asset owner’s behavior toward the assets they are seeking to divest, in that they are presenting the best possible condition of the asset for sale. It is a repeatedly observed trend in due diligences that total operating costs are usually under significant scrutiny post-decision of the desire to divest. If possible, the buyer should observe operating costs over an extended period of time to identify operating cost reductions or deferment of a short-term nature in the pre-sales process that may have longer term impacts on asset production, reliability or lifespan if not corrected.
Drastically reducing operating costs, including maintenance and environmental controls, invariably has medium- to long-term assurance, safety and/or environmental consequences (e.g., pipeline maintenance cost reduction eventually resulting in excessive corrosion, rupture and catastrophic spills) and can be the source of potential problems. It also requires spending above and beyond the previous operating cost to return the asset back to required standards.
Due diligence, and the acquisition process in a competitive environment, brings many risks and opportunities. With increasing complexity and a changing regulatory environment in the acquisition of assets in the energy, industrial and infrastructure sectors, taking these three actions will bring greater clarity and insight to buyers’ due diligence efforts.
Smart buyers who adopt an integrated asset approach, careful scrutiny of internal best practices, and alignment of risk tolerance, will be better equipped and informed to do the right deals at the right price. Taking these steps now will allow buyers to uncover opportunities that could enhance value and discover hidden risks that could pose a threat to long-term success after the acquisition is complete.
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