A growing number of E&P companies want fast access to public-equity capital-but when is it a smart move to hitch onto alternative financing vehicles?



Despite the drawbacks of regulatory demands and increased investor scrutiny, more private oil and gas companies are making the move to public markets, and the momentum is expected into 2007. But filing costs, upfront paperwork and the lengthy route to traditional initial public offerings are helping 144A private placements and reverse mergers emerge as faster, slightly less-expensive platforms to public trading.

A number of energy companies opted for a traditional IPO this year. Lafayette, Louisiana-based Superior Offshore International Inc. filed to raise $200 million; Plano, Texas-based producer Ascent Energy Inc. filed for $200 million; and Dallas-based E&P company Exco Resources Inc. priced one for proceeds of almost $650 million.

"Companies no longer go public simply because they've outgrown the private-equity markets," says Wil VanLoh, managing partner of Houston-based private-equity firm Quantum Energy Partners. Instead, many see the potential for a higher share valuation, and for future liquidation or exit.

Yet some companies are simply not well positioned for a successful traditional IPO. The straight IPO is expensive because of the registration and marketing process, says Keith Behrens, managing director of Dallas- and Houston-based Energy Capital Solutions. And, there must be confidence that market conditions aren't going to deteriorate, he says.

"All of the vehicles leave you at the mercy of the market, but the reverse merger and the 144A take some of the risk out of a deal not closing because they can be done so quickly. Still, all three will leave you with a security subject to market volatility."

VanLoh says, "When a company decides to do a traditional IPO, it's not so much about faith in the commodity markets, because prices in oil and gas stay volatile. And the attention span of investors depends on market temperature.

"As a chief executive considering a traditional IPO, the question I'd ask is 'Do I want to risk starting the IPO process today and see that six months from now, once I've cleared the SEC and am ready to price my deal, the capital markets have softened considerably?'"



The silent IPO

Houston-based E&P company Rosetta Resources Inc. was formed in June 2005 and began operating soon after acquiring substantially all of Calpine Corp.'s U.S. oil and gas assets. The acquisition was funded from a 144A private placement and $325 million in credit-facility debt. Rosetta's shares began trading on the Nasdaq in February.

"The decision to use the 144A vehicle was made by Calpine," says Mike Rosinski, Rosetta chief financial officer. "This approach allowed it to optimize the value of its oil and gas assets by taking advantage of strong market valuations at the time and getting to the market quicker than an IPO approach...

"Calpine's objective was to consummate the transaction quickly to minimize transaction costs and potential drawbacks associated with a traditional process, such as an IPO or asset sale."

The ability to close the transaction in a narrow time period is a clear benefit of the 144A route, Rosinski says. "But when you do the offering, you still have to go through the rigors of preparing an offering memorandum, and you have to include audited financial statements in it. This can be a very intense exercise if you do not have existing, stand-alone audited financials readily available. So how quickly you get to market is really influenced by your ability to prepare for it on an accelerated time schedule."

The assets that Rosetta acquired from Calpine were included in the parent's financials, but since they weren't prepared and audited on a stand-alone basis, Rosetta had to get that done as part of its 144A.

"That doesn't happen in a week. There's a significant amount of preparatory work that needs to be done, but it does not require as much time as going to the SEC and you do not have to complete that dialog before you can go to market.

"Your biggest advantage in the 144A is that, to a large extent, you control your own destiny-you don't have to complete the SEC filing process up-front, so the timing by which you get to the market is [largely] in your own hands."

The notion that the 144A is less work than the traditional IPO is false, he adds: the issuing company still has to file with the SEC, have its registration statement declared effective and begin trading on a public exchange within a certain time frame. Once Calpine gave the green light to the spin-out, the process had to be done in 60 days. Fortunately, some preparatory work had already been under way.

"You do not deal with the SEC up-front, but once you go to market and close the 144A, that monkey goes on your back and you have to hustle to make your time frame target for becoming effective."

When Rosetta went to the marketplace, its view was that asset pricing was more favorable for the spin-out versus an outright asset sale, Rosinski says.

"I do not believe there is a material difference in 144A valuation versus the traditional IPO. There's a school of thought that, because the stock issued is not traded on a national exchange for six months, there is the element of illiquidity in the 144A alternative that causes it to be priced lower than the IPO, where you are liquid on Day One.

"There's a serious doubt in my mind about how material that discount is; in the portal market, a limited group of investors can buy and sell shares before they are available on the public exchange." The buyers of Rosetta shares in the 144A offering were thinking of the investment long-term. "They were willing to make the investment in Rosetta, knowing they would have to hold onto it for a period of time."

VanLoh adds, "The 144A route works especially well with fairly new companies that have levered up to make an acquisition and need certainty in de-levering their balance sheets."

For one of the companies Quantum sponsored this year, more time was needed to get it compliant with Sarbanes-Oxley. Doing the 144A gave Quantum a nine-month window to get everything in place, while simultaneously moving the company toward public trading.

If the 144A has such a speedy advantage, why doesn't every oil and gas company go that route? "You do take a bit of a discount-anywhere from 5% to 15%-but the trade-off is in how quickly you can access the equity," VanLoh says.

"If commodity prices do shift down materially while you are going through the IPO process, the 144A pricing discount you gave up is nothing compared with your IPO valuation sinking 30%. You have to ask whether this is a valuation you can live with today. Companies thinking about going public in today's markets that could do a $20-per-share IPO could probably walk away with $18 per share in a 144A offering."

Successfully completing the private placement provides momentum toward a public listing, Rosinski adds. "It's a nice feeling to come out and know that once you have completed your 144A, have your financial house in order, and have the filing process under way, the exchanges will welcome the opportunity to work with you."

The 144A route isn't for all energy companies, he says. "But it is giving companies that are interested in accessing public capital another alternative to consider. It's a truly viable alternative for accessing public capital."

Reverse merger

The reverse merger is a path to public equity that can close even faster than both the traditional IPO and the 144A offering. J. Russell Weinberg, managing director of Energy Capital Solutions, says it has been particularly a viable route in the past few months while there has been a delay in public markets being able to absorb scheduled, traditional IPOs.

The prominent benefits to the reverse merger (and the 144A) are not return-related, but capital-related, says ECS' Behrens. "You're least exposed to market fluctuations, and that comes at a cost. With either one, you have to go through the SEC process post-closing of the equity offering to get the underlying shares registered. It's less of a liquid market than what you'll find in an IPO, and investors want to be compensated for that."

The 144A or reverse merger is interesting when the desire to get to market quickly is strong, Behrens adds. "There may be concerns that equity market conditions are going to change. Either of these vehicles could get your deal closed faster, and you would deal with the registration process later. In a traditional IPO, you're exposed to market fluctuations throughout that process."

On average, a reverse merger takes about six months to complete, Weinberg says. Ideally, the deal involves a strong private company with an experienced management team, solid assets and good use of proceeds. The entity is merged into a "clean" public-company shell, and the private company ends up owning about 96% of the resulting business.

When the merger closes, ECS brings in capital from institutional investors, usually hedge funds. The firm has done two of these deals to date, one worth $15 million and another worth $90 million, both for ethanol producers.

"When a traditional IPO prices, it's trading the next day. With our vehicle, there's still four to six months before it's a fully distributed public company. Investors recognize that and they have more patience. If there's a day of rough sledding in the public markets, they don't hold their money-they go ahead and fund the transaction," he says.

The reverse merger does have disadvantages, such as the absence of an extensive road show and subsequent research coverage. These can be addressed by going to conferences after the deal and telling a company's story to potential investors through other venues, Behrens says.

Weinberg says, "Ten years ago the reverse merger would not have been wise to pursue-or the capital wouldn't have been available. The institutions that dominated the public markets then were big mutual funds whose minimum investment was $5- to $10 billion. The advent of the hedge-fund phenomenon is the driver that puts small-cap companies in a position to attract public capital because, with so much money under management, a $10-million investment becomes meaningful."

When Bill Transier, chief executive and president, and John Seitz, vice chairman, formed North Sea-focused Endeavour International Corp. in 2004, they wanted a listing on one of the bigger U.S.-based exchanges and quick access to stock liquidity. In late 2003 they opted to do a reverse merger with Continental Southern Resources Inc. and North Sea New Ventures Inc., the private company the pair originally formed to launch their exploration strategy.

The team did a PIPE (private investment in public equity) transaction, registered it, qualified to list on the American Stock Exchange and raised $50 million in the original deal. The transaction took four months. About $10 million was used to pay debt and restructure the company and the rest got Houston-based Endeavour up and running. The company is currently drilling two wells and plans up to six more in 2007.

"We knew we needed capital to move forward," Transier says. "When a shell company approached me about running it, we saw that we had an opportunity to trade our company into it, get some equity and get a big equity position for the management team we wanted on board.

"We had a lot of private-equity sources that wanted to put capital into the company. But private-equity guys want you to be indentured servants for years and, even if you make things work with a compounded return of 20%, they're only willing to give you 6% to 8%. That wasn't enough of an incentive to get the kind of team together that we wanted."

A traditional IPO was never a real option for Endeavour. "It would have been hard for us to have gone public that way because we were asking for people to invest in exploration. We would have been saying, 'Just trust our idea, and put a bunch of money into this company.' You could argue that's what we did through the reverse merger, but there were assets in the company that helped show downside protection if our business model didn't work."

Transier says management's decision to go this route was driven largely by business strategy. "But consider where the capital markets are. If you're in a resource play today, the IPO route may be great because everybody loves those plays and the low-risk manufacturing process that goes with them. But if you're an exploration company, you need to find some other method."

The additional due diligence required in the reverse merger is critical. "The biggest mistake a company can make is to not do enough of it on the shell company...Then they get caught up in some kind of issue that they have to spend time, energy and money fixing after the fact. I thought we did a good job of it, but we had surprises ourselves."

Transier says investors are not as interested in pure exploration companies today, and he sees a number of them struggling to raise capital in U.S. public markets.

"Today, Endeavour would get much better valuations on the Oslo or the London Alternative Investment Market (AIM). Capital is flowing to those exchanges. It's not flowing in the U.S. as much because people are scared of the regulatory environment and associated costs. We've made ourselves uncompetitive from a cost-of-public-capital point of view.

"But no matter which route you take, accessing the public markets is difficult and expensive, and if you don't have good guidance on your side, you'll be spinning your wheels for a long time."

According to Behrens, while market conditions matter, picking a path to the public-equity market often boils down to how quickly a company needs cash in the bank. "If you need the capital quickly, the 144A or reverse merger makes more sense. If timing is not as important, or if the markets shifting downward is no big deal, then the traditional IPO is an option.

"The 144A offering or the reverse merger can cut your process time in half, and the capital-raising portion of the transaction can close in six to eight weeks. But in the end, your success as a company comes down to the quality of management and the asset base-not the vehicle you use to go public."

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