Carve-Out Financial Statements: A Necessary Step in the Process

by Opportune LLP
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When commodity price volatility subsides and the appetite for mergers and acquisitions gain momentum in the upstream segment of the oil and gas industry it will be important to understand the requirements, pitfalls and guidance around the preparation of carve-out financial statements. As the market turns, we expect an increase in deal activity at both ends of an entity’s life cycle: private equity firms flush with cash targeting and poaching specific acreage, which they believe will offer the greatest returns and both private and publicly held companies with liquidity issues spinning off valuable acreage into new entities or tapping public markets to get the cash required to develop this valuable acreage.

Lessons learned from the last downturn led the “smart money” investors to devote capital specifically to low-cost oil and gas reservoirs, including the Permian, Eagle Ford and SCOOP/STACK, among others (the “Target Assets”). Purchasing, segregating and raising money to develop these Target Assets can often take the form of complex transactions that require detailed financial statement disclosures and U.S. Securities and Exchange Commission (“SEC”) filings. In order to tap the public markets, consummate a transaction or to comply with a requirement under Rule 3-05 of Regulation S-X a company oftentimes has to prepare carve-out financial statements containing historical financial information of the acreage in question. To give a flavor of the type of transactions that require carve-out financials, below are examples of what we’ve seen recently in the marketplace:

  • Company A owns valuable, underdeveloped Eagle Ford acreage prime for development, but lacks working capital required to maximize the return the acreage could provide. Further, Company A also owns aged producing acreage that is less appealing and drags down the value of the Eagle Ford acreage. In order to obtain the capital required to develop the Eagle Ford acreage at the lowest cost, Company A spins off the Eagle Ford properties into a new entity that will file a registration statement and complete an initial public offering (“IPO”). As part of the registration statement, Company A will have to prepare historical carve-out financial statements of the Eagle Ford acreage that will be audited and included in the registration statement.
  • Private Equity Firm B uses contributions raised in a new fund to purchase $300 million worth of properties in the SCOOP/STACK that are comingled in various reporting entities of the seller. After the purchase, Private Equity Firm B creates a new, privately-held company to own and develop the properties. This newly created private company determines the cheapest way to raise capital to develop these properties is to complete an IPO. The Company will have to work with the seller of the properties to obtain enough historical financial information to carve-out financial statements of the assets acquired that will be audited and included in a registration statement.
  • Publicly filed Special Purpose Acquisition Company C (“SPAC C”) uses its publicly raised funds to purchase $500 million worth of Permian Basin assets owned by various entities of a single parent company. As part of the transaction, the seller will receive a combination of cash and shares totaling a 30% non-controlling interest. To consummate the business combination, SPAC C will file a Form DEFA-14A proxy statement that will include audited historical carve-out financial statements of the assets acquired so shareholders can vote on the business combination.

While the three transaction examples listed above have their own unique elements, they all require the presentation of audited historical carve-out financial statements. These financials will not only be included in the various registration statements, but often they will act as the accounting predecessor entity on the go-forward Company’s quarterly and annual financial statements. This sometimes-overlooked requirement can cause headaches, delays and unnecessary deal risk.

To prevent these headaches, it is important to have an open dialogue with the accounting firm tasked with auditing the carve-out financial statements early on in the process to set expectations, review any assumptions used and discuss methodology. Hiring the right professional advisor to assist in this process can go a long way in alleviating some of the pressures and can provide the expertise required to be involved in completing a transaction.

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