Are you making deal resolutions for the New Year? In this episode of Deal Us In, we welcome back McGuireWoods partners Jodie Herrmann Lawson and Susan Rodriguez to share their deal resolutions for 2023 with host Kelsey Hitchcock.
Kelsey, Jodie and Susan explore what people should be thinking through as they approach deals this year. This includes more upfront scrutiny of I9s, when to consider indemnification provisions, and what you should do if your seller has an ongoing audit.
Before you walk into a deal this year, it’s important to understand what you should be prepared for, including how to navigate due diligence and any issues that may arise from it.
Both Jodie and Susan agree that there's no substitute for good counsel that you trust. Having a trusted advisor in your corner who can look at potential roadblocks in advance may help you avoid a phone call to the litigator.
Name: Jodie Herrmann Lawson
What she does: Jodie is a high-stakes litigator who represents clients in federal and state court and arbitrations. She defends Fortune 100 companies and other businesses in cases involving torts, contract disputes, property disputes, class actions, and fiduciary, energy, and financial services litigation.
Where to find Jodie: LinkedIn
Name: Susan Rodriguez
What she does: Susan, co-leader of the firm’s financial institutions industry team, primarily focuses on government investigations and complex civil litigation. She has defended clients in numerous government enforcement actions by the Department of Homeland Security, Department of Justice, Consumer Financial Protection Bureau (CFPB), and the Federal Trade Commission (FTC), among others
Where to find Susan: LinkedIn
Top takeaways from this episode
Make I9s part of standard due diligence. Instead of adding a review of I9s to the back of a deal, it is now common to make auditing the paperwork part of upfront diligence.
Don’t let I9 issues kill a deal. In the event that you discover a serious non-compliance issue with I9s, such as government penalties, you can consider indemnification provisions to protect the deal.
Approach with caution if an audit is underway. It’s not uncommon to encounter a company still undergoing an audit, especially as the pandemic caused some audits to drag across several years.
✔️ Thank you for joining us at the table for this episode of Deal Us In. We invite you to join the conversation by using our #Dealusinpodcast on Twitter or LinkedIn.
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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.
You are listening to Deal By Deal, a McGuireWoods independent sponsor podcast. Deal By Deal invites you to conversations with experienced independent sponsors and other private equity professionals. Join McGuireWoods Partners, Greg Hawver and Jeff Brooker as they explore middle market private equity M&A to provide you with timely insights and relevant takeaways.Greg Hawver (:
Hi, and welcome to Deal By Deal, a podcast for independent sponsors and others in the private equity ecosystem. My name's Greg Hawver, I'm your host for this episode. Excited for this latest installment of Deal By Deal. What we're going to be doing on this episode is diving into two very timely and interesting topics. The first is going to be the recent developments around non-competes and restrictive covenants based on recent proposed rules from the FTC. And for that we have my partner, my antitrust partner, Holden Brooks. And then about halfway through this podcast, we're going to switch over and talk about private equity investment in the energy space. And we have for that, we're going to be joined by my partners, Tom DeSplinter, Eddy Daniels, and Brian Kelly. But first, let's dive into the recent developments around non-competes. And as I mentioned, I've got my partner, Holden Brooks. She is an antitrust partner in the Chicago and Washington DC office of McGuireWoods. Holden, welcome to the podcast. You want to tell us a little bit about your practice, and this topic generally.Holden Brooks (:
Greg, it's amazing to be here because this really is a huge development. I have spent the last 15 or so years of my career counseling private equity clients on HSR, and other antitrust issues in the M&A context. And certainly, this is going to change how we do business and how we give advice, at least for the foreseeable future. But I want to start out by making two baseline statements. And one is that it takes a village to address this issue of what the new FTC proposed rule on non-competes really means. And by that I mean that you always need to make sure that you're consulting your Labor and employment council, your deal council, et cetera. Because these provisions can be very important to a business, they can have very strong justifications, et cetera. And no one is suggesting that they are going to go away entirely or that there is no appropriate role for them.(:
The L&E council and others will know the realities of the law in particular, jurisdictions and in the context of your business in particular. And so, I just wanted to say that now that I am really just delivering the perspective of the antitrust lawyer on a broader team. The other thing I wanted to say is that a lot of what I'm going to be talking about today is the perspective of the regulators, the FTC in particular, that has proposed this rule. And that doesn't mean that or the firm believe that these perspectives are the right perspectives, or that they are correct. But we do think it's important for people to be aware of how the FTC, state Attorneys General, and other regulators are approaching the issue of non-competes, et cetera.(:
So for instance, yesterday I was reading through the 6,000 comments that have been posted to the FTC on this proposed rule. And there's a real diversity of opinion. But one of the things that's emerging is that there are a lot of folks who can speak to the value of non-competes. And that is a valuable perspective as well. So even though we're going to be talking about how the government perceives these non-compete restrictions, we certainly acknowledge that there are very strong justifications for these clauses in the business context as well.Greg Hawver (:
That's really helpful, Holden. Appreciate that. And a nice disclaimer. As lawyers, we like disclaimers. But it's important here. I mean, as Holden and I were talking before releasing this podcast, we want to get out to the private equity community, kind of our thoughts as this develops. But we also want to be careful, because as Holden mentioned, there's a lot of competing views here. So hopefully, our audience finds us helpful, and we're available to chat in more detail about any of these topics. So let's dive into the discussion here on the substance of the proposed rule. Before we do that, I want to just zoom out a bit for, this is a podcast for private equity deal makers. And so, in the context of a private equity deal, what are we talking about here with respect to non-competes?(:
There are really two main non-competes that we think about in the context of M&A deal. And a third, which I'll touch on at the end, but the first non-compete we think about is a sale of business non-compete. So that's where the seller of a company agrees for a period, call it five years, after the sale of the business, not to compete with the business they just sold to the buyer. Which makes a lot of sense. And the classic example of a hundred percent owner of a widget company agrees that he or she won't start a rival widget company two weeks after selling that business. The second type of non-compete that we think about in the M&A space is a non-compete tied to an employment arrangement. We think about those employment agreement non-competes outside of M&A as well. And that's a lot of what's been in the headlines is employment arrangements and others, not really the M&A transactions, but the employment agreement based non-compete, typically lasts during the time period that a person is employed by a company and then for a tail period thereafter, call it one or two years.(:
And the basis of that non-compete, one of the theories is that as a key employee or an employee, that person has access to confidential and proprietary information, and the company has a right to prevent that employee from competing for some period of time. The third flavor of non-compete that we see in the M&A space is tied to equity ownership in a company. So you'll close an M&A transaction and you'll have the buyer, you'll have maybe the rollover seller, maybe you'll have some key employees who own equity in that platform going forward. In the LLC agreement or other operating agreement, you can see a non-compete provision in there that says, "While that person holds equity in the company and perhaps for a tail period thereafter, that person will not compete with the company." So those are the types of tools in the toolbox that we're talking about as we launch into this discussion. And with that, Holden, if you want to dive in and tell us more about these recent developments.Holden Brooks (:
So Greg, I really want to start out with a sort of 30,000 foot view perspective here, just to, very quickly, give people some context for where this came from. Because for folks who do not follow antitrust enforcement developments on a minute to minute basis, this could really seem to be something that fell out of the sky. But the reality is, when I composed my antitrust training deck for my clients that I've been giving for all of 2022 over the past year, I had non-competes pegged as one of the top three areas that people needed to be paying attention to. And the reason is because we had been given signals from the Biden administration, from the leadership at the FTC, and leadership at the Department of Justice antitrust division, that they were going to make non-competes a real focus. And whether that was through enforcement actions, advocacy, or this rulemaking that we see the FTC engaging in now.(:
We knew that this was going to be a priority. And the reason is because the enforcers, whether they're right or wrong, really thought that economic literature pointed to non-competes, as they exist in the marketplace, and as they're implemented in M&A deals, et cetera, as being overly restrictive. That on balance, these restrictions, and covenants, et cetera, were too broad or were being implemented in a way that harmed competition and harmed society, deprived society of the benefits of competition more than they were helping competition by, as you say, providing buyers with a tool to control the risk of a seller immediately cannibalizing a business that they had just acquired, et cetera, et cetera. So they came to what they considered to be a principled conclusion, that non-competes on balance were worse for society, and that harm outweighed the positive effects. So we see that on the face of this proposed rule.(:
So what we were presented with by the Federal Trade Commission was a proposed rule. So this is sort of the first shot across the bow from the current Federal Trade Commission, which maybe not surprisingly, is run by three democratically appointed commissioners and one Republican appointed commissioner. And obviously, this was essentially a three to one vote to approve this. And it really does embody a progressive point of view on non-competes. So of this 250-page document or whatever that contains the proposed rule, there's also a good 200 pages of rationale, and explanation, and what the FTC is calling evidence behind why it has taken this position that non-competes need to be, basically, unilaterally banned in almost all circumstances. This is just a proposed rule and once the rule is published in the federal register, which should be imminently, we start the clock on a notice and comment period by the time this gets out, that it may be in full force. Because there already have been many, many comments that have been submitted mostly by individuals who have been negatively affected by these non-competes.(:
Although we expect that there's going to be a large number of comments from various industry organizations, et cetera, that talk about how non-competes are really essential to businesses and companies who are engaged in M&A, or who need these clauses to protect their trade secrets, and protect investment in employee training, and things like that. So for the next 60 days or so, we're going to see a lot of comments on both sides of this issue. And after those comments have been received and the period closes, then we'll take those into account and determine what their final proposed rule should look like. And then that final proposed rule will go back to the commissioners for a vote, and it will or won't be adopted. But again, because we have a a three to one split on the FTC right now, I think the expectation is that the final rule would be adopted. But there may be some room for changes.(:
So when I'm talking about the primary highlights that I think are most important in the rule, these are just proposals and they could be revised by the time we see a final rule. Now the other thing I just want to mention about process here, is that even if the final rule is adopted or appears to be heading towards being adopted by the Federal Trade Commission, there are going to be plenty of challenges to this rule.(:
The first kind of challenge that I think we're going to see is whether the FTC has the power to make this kind of rule. Is this rule within the scope of the seeds rulemaking authority? And then I think the other challenge is going to be whether the nature of the rule and the content of the rule is appropriate just from a substantive perspective. Is this the kind of thing that Congress should be weighing in on? Is this the kind of thing that states should have control over? Is this the kind of thing where, whether this is constitutional in some way, et cetera. So those kinds of challenges that we would see filter up through the federal courts could also have a real impact on whether this becomes reality or not.Greg Hawver (:
So, Holden, would the challenges in the court, would those come before this takes effect as a preliminary injunction? Or would you see the rule actually take effect and then it goes to the courts? How does that play out?Holden Brooks (:
To be honest with you, I think there's any number of scenarios like that. But I think you're correct, that there could very well be a challenge where there's a preliminary injunction in the mix. Where the rule would be held in abeyance until the court determines whether it can really go into effect. Because this is going to have a huge impact on every sector of the market. And the FTC is aware of that. They are publishing graphics and press releases that talk about the volume of competition that's actually going to be affected by this. One of the main features of the rule is that it affects non-compete provisions that are in place between any employer and any worker. And the worker could be an unpaid intern or could be a CEO that is paid in the millions of dollars every year. This is something that's going to affect a lot of different relationships in every industry.Greg Hawver (:
Kind of summarize the process points of this. At a high level, is it about 180 days before we would have or 200 and some odd before we'd have a binding rule, assuming it doesn't go to the courts?Holden Brooks (:
Well, I think that is not a period that we can guess what the length of it is going to be. I think the period of time that you are talking about, Greg is the hundred and 80 days that, again, in the draft rule would be allowed in the event of the adoption of a rule, before it becomes effective. So the timeline to think about here is from now for 60 days, we're going to have comment. And then it's really unclear how much time the FTC would take to consider those comments and rewrite the rule. I don't believe that there's any real concrete limit on the amount of time that the FTC could take to consider those comments, pursue additional information, and rewrite the rule. So that's an unknown period of time. Once they do implement the final rule, the draft contemplates that parties, companies, employers, et cetera, would have 180 days until they needed to be in compliance with the rule.Greg Hawver (:
So no one needs to run into their employees the next business day after listening to this podcast and start tearing up these non-competes just quite yet. We need to wait, and see, and for a probably considerable period of time to see how this all plays out.Holden Brooks (:
Yes, but I do want to point out, Greg, that one of the types of advice that we are giving our clients right now is that this rule aside, even if no one had ever come up with an idea for an actual formal rule for the FTC to propose and adopt, there's still, and always has been, antitrust risk associated with non-competes. As you mentioned, these are non-compete provisions that have usually a geographic scope, like you cannot compete within this particular space. And a temporal scope as well, like you cannot compete for a certain amount of time. And the antitrust laws across the board have always required that those terms be reasonably calibrated to protect legitimate business interests. And so, those non-competes, to the extent that they are overly broad in states where non-competes are legal to begin with, have always been subject to being challenged under the antitrust laws.(:
What we're telling our clients now is that even if this rule doesn't go into effect, or even during the period of time between now and the time it does go into effect, we think that the risk environment has potentially changed a little bit, insofar as it's going to be easier for restrained employees to bring challenges to these provisions, because of what the FTC has sort of put out there. And it's just an opportunity for businesses who routinely incorporate these provisions into their contract, acquiring companies who are negotiating non-competes with targets, to consider whether these are... To just take another look at their practices with respect to how they compose and negotiate these clauses. Because I think rule or no rule, they're going to be subject to increased scrutiny going forward.Greg Hawver (:
That makes a lot of sense. And I've got a couple questions about specific scenarios, but before we jump into those questions, maybe we should cover off just a quick description of what the actual rule is. I mean, there's 180 days to rescind these non-competes, and it's relatively clear as it relates to workers. But there's a sale of business exception. Do you want to talk about that? That's definitely pertinent to our listeners.Holden Brooks (:
Yes. And I want to say that again, this is part of a draft rule, so this could change. But the perspective of the FTC, as it's reflected in the draft rule, is that you would, as a buyer, be able to impose non-compete provision on selling individuals, to the extent that each of those individuals had at least a 25% equity stake. And I was on a conference call recently with an FTC official who was asked about this 25% equity stake threshold. And whether that was going to stick and what was the reason behind choosing 25%, et cetera. She basically said, 25% may or may not be the right number. It's what we chose as a threshold number in order to make sure that where these restrictions were being applied, and were not sort of an end run around a non-compete ban in situations where, for instance, a regular run of the mill employee might have had a 1% equity stake that they had received as a bonus or something like that.(:
They really wanted to get feedback on an exception that would only apply to individuals that had significant equity stake. So far we've been counseling clients who are in negotiating non-competes in the sale of business where there are, for instance, three equal owner parties who are selling. And we've said we don't think the rule would apply here, because the equity threshold, everyone has above 25%. But in situations where you have a physician practice that has 10 equal owner physicians, there's more of a question there about whether that rule would apply to those provisions or not.Greg Hawver (:
This ban applies to individuals, and workers, and the exceptions if that individual or worker also was an owner, and sold 50% of the business ,or 75% of the business for example. I guess another way of asking the question is, does this rule apply at all to entities and private equity firms that might own a portion of a business, and then they sell that business, and agree not to compete against the businesses that are sold?Holden Brooks (:
It really is at the worker level. The rule really is at that worker level. They're concerned about the economic liberty, so to speak, of individuals to go out and innovate and compete in this space. So the rule really is targeted towards these individuals who have expertise and want to compete. And I would think about that as being fully as focused on individual people and not companies necessarily.Greg Hawver (:
Yeah, I mean to me, it's really interesting because on one end the spectrum, you have a widget company owner who owns 90% of that business, and then sells that business for a $100 million. And it seems very reasonable and makes total sense that that person should be able to agree not to compete for five years and start a new widget company the next week after they sell it to a buyer. And that's kind of on one end of the spectrum.(:
And on the other end, you've got these non-competes out there with relatively low level workers that... Those are the stories you see in the newspaper that you read them and you're like, wow, that really is harsh to restrict that person from getting a job in X, Y, Z geographies. And then you've got the tough cases in between, where a buyer of a business is buying a business that's not a widget company, but is comprised of people, like physicians for example. And maybe there's 10 physicians. And so, how does a buyer protect the business and the bill that they just bought, while at the same time this rule and these different thresholds? And so it sounds like you've been thinking about that a little bit and maybe the answer is, well, we'll just have to wait and see what the final rule says and just kind of follow those thresholds.Holden Brooks (:
I think that's right. But I can tell you that the FTC, one of the things they did in the proposed rule is they set out a bunch of alternatives. They expressly asked for feedback on some alternatives, and some of the alternatives to this rule would acknowledge that there is a difference between, for instance, a low wageworker who works at a sandwich shop, who wants to be able to move to a better paying job at a competing sandwich shop. And a physician or an executive, et cetera. So one of the things to watch, and how this rule shapes up, and in terms of the content of the comment, is there a compelling case to make to the FTC that this should not apply in the same way across the board? That there are principled reasons that are specific to particular types of workers or sectors of the economy, where this rule should apply differently.(:
And I have to say, I think that physician practices is going to be one space where we see a lot of principled debate on how it should apply. And professional organizations were, as you say, a lot of the value is tied up in those individuals. On the flip side, Greg, I just want to point out too, that in the physician practice space, there is a history going back a long time of the Federal Trade Commission and the Department of Justice recognizing that there may be a particular harm to society associated with enforcing non-compete provisions against physicians.(:
So we see very concrete examples of enforcement actions, and advocacy on the part of the FTC and the DOJ antitrust division. I think responding to physicians who feel that they are unfairly being restricted from practicing in a certain area for a certain amount of time. And the FTC or DOJ taking up their case, recognizing that where we deny a physician the opportunity to practice in a certain space, there are patient care repercussions, and patient relationship repercussions, et cetera. I think that, again, I think there's going to be some really good conversation around how this should apply in the physician practice space, because I think that the circumstances are very unique. So that's one place to watch in the comment period.Greg Hawver (:
This has been extremely helpful. So if you're a private equity professional out there, and you've got an LOI that you're working on, and you're thinking about discussing non-compete provisions in there with respect to sale business and employment agreements, what guidance would you give other than, call your lawyer and chat through it with them. Which is never bad advice, but I hate that. Maybe that's the only advice here, because it's a facts and circumstances, call in each case. But thinking about looking at future deals and deals that have yet to be structured. Any thoughts on that?Holden Brooks (:
So I think there are really three areas to think about. One of them is to get smart about alternative ways of protecting the value of your investment that are not going to hinge on non-competes. And we're trying to, as a law firm and law firms across the country, I think are trying to get smart about this. Are there ways to use trade secret protections or other tools that still help you protect value, but do not restrain the ability of former employees to go out and do what they're going to do? So being wise to the reality of this rule, and trying to be nimble in terms of being able to pivot away from your traditional a hundred-mile five year non-compete boiler plate that you've put in every agreement, would be smart. The other strategy I think is to really try and make your non-competes to the extent that you don't have any alternatives as defensible as possible. Make them narrow and appropriate from geographic and time perspective, so that you could defend it. You could defend it as being reasonably necessary to protect your investment.(:
Is this a situation where maybe it's a three-year timeframe, where you could reasonably earn back your ROI? I think being thoughtful about the scope of your non-competes is also going to be a good idea to the extent that you're continuing to use them. Because they're just going to be, again, more defensible in this environment where those kinds of provisions may be more vulnerable. I think the other thing to do to be smart is, when you're thinking about the value of a target to factor in the value of that target, if the non-competes that that entity has in place, we're suddenly going to go away. Think of a strategy for being able to come up with a range of valuations based on those non-competes staying in place versus the non-competes going away.(:
And then I think the third thing is to think about long-term, playing a long game, what are the opportunities in your business that you may have for acquiring targets or entering into a new space once there are no non-competes that are restraining people in the event that the final rule does come to pass? Because I think that's another place where people might be able to really move forward with some interesting strategies if all of a sudden there's a lot more latitude about what people can do once those non-competes are not in place.(:
I think that getting wise about alternatives to non-competes, being smart about using non-competes that are narrowly tailored, and then thinking about long-term, what's your strategy in a world where non-competes may not exist or may be more vulnerable? What kind of opportunities does that present? I think are really the things to think about. If you're a portfolio company that actually has contracts with these non-competes between you and employees, we are also saying to our clients, you don't need to immediately start taking action to dismantle those. But it's probably a good idea to think about what your steps would be in the event that you do have to contact workers to modify these clauses, or waive them, et cetera. And I think some clients are even thinking about that proactively about, maybe we're not really that concerned with these non-competes staying in place. They don't have much value to us. They're on balance going to create more legal risk than they are benefit to us. And they may proactively waive them in response to these developments to the extent that they're not linchpin provisions in their employment contracts.Greg Hawver (:
I think this is a great place to finish the conversation with those parting words of advice. And Holden, really thank you for the time. We're going to have to circle back on this in a couple weeks or months, and have your update on the current state of play whenever things develop further. So, thank you for joining me on this one.Holden Brooks (:
No problem. Great to be here.Greg Hawver (:
For today's episode, we're excited to take a deep dive into private equity investing in the energy space. And when we say energy, we're casting a very wide net. And I'm excited to be joined by my partners, Tom DeSplinter, Brian Kelly, and Eddy Daniels who all focus in different aspects of private equity and/or energy. So with that, I'm going to flip it to them to give a really quick overview of their practice, and also talk about where McGuireWoods fits in the intersection between energy and private equity. And then we're going to dive right into some exciting topics as far as what are opportunities that might be good fits for independent sponsors within the energy space in particular. Snd we'll also talk about the Inflation Reduction Act, some exciting opportunities there. So we're excited. We think this is going to be a very topical and relevant discussion for independent sponsors. So Tom, you want to take it away, then Brian and Eddy?Tom DeSplinter (:
Sure, thanks, Greg. I'm Tom DeSplinter, I'm a partner at McGuireWoods here in the private equity group. Focus on very various industries including energy, healthcare, manufacturing services, but have a significant experience in the energy sector. I started my career at BP, in the integrated supply and trading group before becoming a lawyer. And then after becoming a lawyer, kind of went in-house for a couple years with a Blackstone portfolio company in the energy sector, particularly in the transmission sector called Grid Alliance, which is now owned by NextEra. So in the independent sponsor world, we see obviously, independent sponsors focusing on the energy sector in ways that might differ from some of the larger energy players, in that they might focus on cash flowing opportunities or mature businesses that might already be kicking off EBITDA, or might be ancillary to other services within the energy sector, whether it be oil and gas, or power and gas.(:
And so independent sponsors are often coming in and looking to buy a business that's already functioning, and can then play alongside larger players in the sector, or work with developers, or majors, and things like that. So that's where we see independent sponsors play a lot. And we would like to have our industry chair, Brian Kelly here. And Eddy Daniels who's one of our partners that focuses on regulatory. And so I'll let Brian introduce that, and then we can talk about a little bit more how independent sponsors and private equity coincide with our energy expertise here at McGuireWoods.Brian Kelly (:
Thanks, Tom. Good afternoon, my name is Brian Kelly. I've been practicing in the energy and project space for over 20 years. I'm the current co-head, or actually, leader of the energy industry team at McGuireWoods. And on my side, really focus on direct investment into infrastructure, energy generation infrastructure, as well as buying, and selling, and financing that infrastructure.(:
And just as Tom was saying, from the independent sponsored perspective, what you're seeing now, given the recent legislation that we're going to talk about shortly, you're going to see tremendous opportunity for independent sponsors to come in either from a ancillary services perspective, by providing a corollary benefit to energy generation, either from a service perspective, or from a manufacturing segment perspective, or depending upon commodity facing exposure, directly investing into various size of projects, renewable solar battery as you like. Given the breadth of the energy generation credits and the incentives available, I think that you're going to see a larger proportion of independent sponsors in the next three to five years start looking at how they become developers in the space. We can give it more into that. But Eddy, why don't you maybe introduce yourself as well, give a little view on this.Eddy Daniels (:
Great. Yeah. Hi, I'm I'm Eddy Daniels. I'm a partner in the McGuireWoods, Texas offices, both Dallas and Houston office. A good part of my career in-house as a general counsel for firms that were either investing in energy, or financing energy transactions, and doing commodity trading around energy assets. At McGuireWoods, we are representing clients, as Brian and Tom mentioned, that are buying and selling energy assets, especially renewable assets, solar, wind, battery storage, renewable natural gas, just to name a few.(:
We're seeing tremendous amount of activity in buying shovel ready projects, but also more and more interest in buying portfolios of projects. I think some sponsors were finding that they were spending considerable effort trying to purchase shovel ready projects only to lose the bid. And frustrated with losing the bids, they're like, "Hey, one way I can not lose a bid is to buy a whole portfolio of assets and then I've got them. And I can develop the ones I want and I can sell the ones that I don't." So I think we've seen an uptick in that kind of transaction. So it's a little about the practice. Tom, maybe we can get into the questions.Greg Hawver (:
Great. I've got a quick question for you, Eddy. This is Greg following up on that, what are some of the opportunities that you're seeing? I think a couple are already mentioned, but maybe we just give an overview of the intersection of what you're seeing from private equity investing, and what's in the bill.Eddy Daniels (:
The Inflation Reduction Act does a couple of things. It extends an existing tax credit scheme that was expected to step down over time. And instead of stepping down, it extends that period out. It also expands the types of programs that are eligible for these tax incentives. So whereas historically it was wind and solar but not so much battery. The existing tax credit scheme allowed batteries only as a small percentage of a bigger project. The inflation reduction Act now will allow energy storage projects or battery projects to get their own tax credits. And also I think extends to existing nuclear fleet, expansion of or reinvestment in the existing nuclear fleet. Again, under the theory that this is a zero carbon energy source. And so therefore, should be included in these tax credits as a way of de-carbonization. It also changes the fundamental... One of the fundamental realities in the old scheme was that you had to have a tax equity investor who had an appetite for the tax credits. Because that was the primary currency of the scheme up until the Inflation Reduction Act.(:
So if you invested in these low carbon or zero carbon projects, you were given either investment tax credits, which was cash that could be applied to lower your development cost, or production tax credits, which were tax credits based on the production of clean energy. Well, in most cases, owners of these projects didn't have the types of taxable gains that gave them an ability to use the tax credits profitably. So what was done instead is tax equity investors would partner with the developer. Usually there'd be some form of an LLC agreement where the tax equity investor buys a series of membership interest that entitles them to the tax attributes, and some percentage of the profit of the and loss of the underlying project.(:
And then those investors were entities like Bank of America, JP Morgan, Berkshire Hathaway, entities that have tremendous balance sheets with huge operating incomes, and, therefore, an ability to profitably apply the tax credits to reduce their tax bills going forward. The Inflation Reduction Act expands the ways that projects can monetize these tax credits so that they don't have to always market them to a tax investor. There are more ways they can monetize those directly. And specifically, it also extends to some types of governmental entities who generally aren't taxpayers and wouldn't get any tax benefit from the tax credits, and ability to monetize these tax credits as well. Brian, you want to build off that?Brian Kelly (:
I think in some ways, the numbers here I think, provides some breadth in terms of the scope of what this legislation handles. I mean, to go off of what Eddy just said, it's $160 billion in tax credits are going to be available for projects. $53 billion in clean energy manufacturing tax credits. So that's to help develop domestic industry for batteries, for cable, for solar panels, for inverters, and the like. $50 billion for clean energy building tax credits to help and create energy incentives for upgrading aged infrastructure, commercial infrastructure with lighting, heating, things of that nature. $2 billion for transmission financing. Transmission's going to be the next biggest issue when you're trying to deploy all these assets that we're talking about from a project perspective. The next constraint in the system's going to be transmission. $2 billion for transmission financing.(:
And then just building off of what Eddy said there, really refilling the ability for the Department of Energy to issue loans, direct loans. And that'll be $250 billion in loans for either repowering, repurposing, aged infrastructure, generation infrastructure, and replacing infrastructure. Every one of these along the way has both an infrastructure development perspective, but then also a services perspective that Tom was touching upon before. Whether it be transmission financing, that's cable manufacturing, that's going to be iron developing, that's going to be site selection. If it's going to be manufacturing, clearly construction industries, things of that nature to develop that. If it's going to be in the transmission space, again, not only the cable manufacturing, but also the ability to go out and develop those lines over hundreds of miles of track. And then in terms of repowering the aged infrastructure, the ability to go out, and develop the turbines, things of that nature to take advantage of the funding to kickstart, not only further domestic production, but further enhance renewable generation domestically.Tom DeSplinter (:
Yeah, Greg, and what Brian touched on there in the domestic production, I think is a huge point. And the whole make it in America initiative that the Inflation Reduction Act is really pushing forward is really something that independent sponsors should focus on, I think. Because there just isn't the supply chain to build the infrastructure for a lot of the goals that the administration and the Act is driving towards, whether that be wind turbines, or battery lithium-ion, even just manufacturing vehicles. So one of the things was the more high profile is that prior to the Inflation Reduction Act, as Eddy said, there were certain incentives for solar or wind, but also for electric vehicles including a tax rebate. But as many people know, like with Tesla, they already hit their cap. I think it was 200,000 vehicle per manufacturer cap. And I think Ford had as well if you hadn't, but they extend that indefinitely.(:
And so Tesla now can qualify again, except that the components over a certain threshold, I think it still needs to be handed down through regulatory guidance. But they need to be made in America. And so a lot of that just isn't made in America at this point. And so they aren't able to qualify for those tax credits. So to the extent that independent sponsors are looking for opportunities to invest in EBITDA generating businesses that have built in demand. I mean, Inflation Reduction Act just creates massive amounts of demand for those types of businesses to be made here in America.Greg Hawver (:
Yeah, it's definitely consistent with some macro themes. And then it sounds like there are definitely opportunities and the middle market to lower middle market, which sometimes I think about as enterprise value, between 20 million to 50 million anywhere in there. It seems like there's touchpoints all along this ecosystem. So do we want to talk a little bit about, as far as general themes go, ESG. And maybe independent sponsors and other PE professionals seeking these investments, and then taking them to perhaps bigger fish looking to satisfy ESG mandates as far as clean energy goes and things of that nature?Tom DeSplinter (:
Yeah, I mean, I'll kick it to Brian and Eddy, as they are very well versed in this too. But I think particularly for... Greg, you know my practice is focused on private equity and independent sponsors. I think one of the biggest things is for Lps. They have their own ESG mandates and focusing on environmental, social, and governance requirements so that they're diversifying their portfolio with clean energy products and investments. And so for them to be able to say that they're invested in a fund or with an independent sponsor that is invested in something like solar, wind, or bio, that's a big thing. So I think that's also something independent sponsors should focus on, is to be marketing to LPs that have that kind of mandate in family offices too, that want to say that they're helping with the energy transition, and they're able to diversify their portfolios like that.(:
But I'll take it to Brian and Eddy also, because I know they're well versed in some of the larger companies, particularly the McGuire Woods deals with. I mean, we have large energy companies as well as large developers in private equity and trading houses that are dealing with this too.Brian Kelly (:
No, agreed. Agreed. One moment of transparency. The ESG piece is important and we're going to talk about that. I think perspective just helps here too is that we're trying to get to a place stepping away from where we are now. 60% of our energy right now is fossil fuel based. So to keep that in mind in terms of the opportunity here that's provided by this legislation, and recognizing that there's a number of social impact funds, there's a number of access from LPs that are focused on the S in the ESG, that this legislation really helps develop in two ways. One, the fact that it's providing the ability from either a reducing coal exposure to optimize prior sites that are used for fossil based generation. All that would be within a social impact funds purview.(:
And then secondly, there's additional enhancements from a tax equity perspective. If you're able to provide an apprenticeship program. If you're able to hit certain domestic content requirements that Tom was talking about before, that's going to further incentivize or enhance the ESG profile of a facility. Another way to think about it too, if we're stepping away from the services side, thinking more about it from an infrastructure perspective, optimizing sites that were previously used for coal, or for sites that were used as a storage, or a dump site for fly ash, which is a byproduct of coal generation, and being able to optimize those sites, will fall within the development structures of the Inflation Reduction Act for enhanced tax equity treatment.(:
So when you take these pieces of it and you look at it from a holistic perspective, the ESG mandates that are going to be accompanying many of these elements from a LP perspective fit and dovetail very well with what's being provided by this legislation. And think about the opportunities when, again, you realize that as we all are on this call right now... This podcast, excuse me, right now, 60% of our annual US electricity production is developed from a fossil or natural gas base.Greg Hawver (:
That's great.Voiceover (:
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