Capital markets are widening the avenues for oil and gas acquisition financing. Structures in recent deals involve not only common equity but also convertible debt or convertible preferred stock. Another funding for assets comprised a base of common equity supplemented with a tranche of high-yield debt.

The prospect of further broadening of capital markets may pave the way for private E&Ps to access the initial public offering (IPO) market once more. Dormant for more than two years, energy IPOs could return to the capital markets calendar by year-end, according to Tim Perry, Credit Suisse Group’s co-head of oil and gas investment banking in the Americas.

As for the expanded financial tools available in capital markets, E&Ps have been able to undertake relatively larger acquisitions and, in some cases, tap into sources at what industry observers say are surprisingly attractive terms.

In a financing by SM Energy Co. in August, terms of a convertible note offering were ini¬tially expected to include a 1.75% to 2.25% coupon with a conversion premium of 30% to 35%. The five-year convertible senior notes, due 2021, were ultimately issued on terms that included a 1.5% coupon and a conversion pre¬mium of 35% over the pricing of a concurrent equity issue. Moreover, SM Energy was able to buy up the conversion premium to 100% using a “call spread overlay,” mitigating dilution from the convertible up to $60 per share (ver¬sus the underlying common at $30 per share).

The transaction fit into a pattern of acquisi¬tion-related financings this year, often in favored areas such as the Permian Basin and Scoop/Stack plays. Several factors made the company’s deal noteworthy, not least its strategic purchase of 24,783 net acres in Howard County to more than double its footprint in the Midland Basin to 46,750 net acres. The subsequent equity offer¬ing was, remarkably, SM Energy’s first common stock offering since the 1990s.

Designed to help finance the $980 mil¬lion purchase of Permian assets from Rock Oil Holdings LLC, the offering was warmly received. An initial offering of 15 million shares was upsized to 16 million and priced at $30 per share. With exercise of the full overal¬lotment option, which raised the offering a fur¬ther 15% to 18.4 million shares, net proceeds came to approximately $531 million.

The Street’s appetite for convertible paper was at least as good, if not better. The convertible senior note offering, initially sized at $100 mil¬lion, was expanded to $150 million and, with exercise of the full overallotment option, further increased to $172.5 million for net proceeds of $166.9 million. The notes are convertible into common stock at $40.50 per share, representing a healthy premium of 35% over the $30 com¬mon stock pricing. (The conversion ratio was set at 24.6914, resulting in a conversion price of $40.50, i.e., a $1,000 note face value divided by 24.6914 equals $40.50 per share.)

As co-financing tools, the common stock and convertible note issues were highly effective. The SM Energy stock not only held its ground, but moved up ahead of pricing of the offering. Frequently, an issuer’s stock will move lower in order to attract new buyers into a public offer¬ing. However, SM Energy’s stock advanced to close at $31.06 on the day of pricing, up about 6% from the prior trading day close of $29.30.

“Since the beginning of 2015, the SM Energy offering has been the only transac¬tion in the E&P space that’s been priced at a premium from launch to close,” commented Mark DeVito, managing director with Bank of America Merrill Lynch, one of the joint book-running managers of the issue. Inves¬tors’ receptivity—as evidenced by a 20% jump in the stock price over the subsequent two weeks—provided “instant validation for the transaction.”

As for the convertible note issue, market conditions proved timely.

“It was a supply-demand equation that they were able to capitalize on,” said DeVito, not¬ing that the terms of the transaction compared favorably with supply in the secondary market and what was likely to materialize from the convertible new issue calendar. “In this envi¬ronment, given the lack of supply, the issuers are the ones that can drive terms.”

But while SM Energy had been highly “dis¬ciplined” in using its equity, resulting in a measure of “scarcity” for both common and convertible instruments, the company’s funda¬mentals were key to success of the financing, according to DeVito. “It started with having an extremely attractive acquisition in a very favor¬able basin led by an outstanding management team and company,” he said.

Top-tier strategy

SM Energy CEO Jay Ottoson outlined a pos¬itive path for the firm in the days following the Permian asset purchase.

“Our vision is for SM Energy to be a pre¬mier operator with top tier assets,” he said at the August EnerCom conference in Denver. “We believe the combination of our proven ability to deliver better wells at lower costs in the Midland Basin and achieve additional scale in tier-one acreage holdings there, will allow us to high-grade our capital program, achieve higher operating margins and create differential value for investors.”

SM Energy has identified about 1,200 gross unrisked locations in four benches (Lower Spraberry, Wolfcamp A and B and Middle Spraberry) across its recently acquired acreage, noted Ottoson.

“If you look at what this acquisition does for us as a company, we have now achieved a scale in the top-tier portions of the Midland Basin that rivals the pure-play companies that have very high valuations,” he said. “As a result of this transaction, we will be high-grading our portfolio. It’s really easy to see a path, through this transaction, to SM being a much more highly valued company.”

A research report by KeyBanc Capital Markets on Aug. 10 noted that, pro forma for the acquisition, SM Energy had one of the lowest valuations in its coverage universe. At $30.35, the stock was trading at a 7.3x mul¬tiple of enterprise value-to-2017 EBITDA as compared to an average coverage multiple of about 12x and a premium multiple in the mid-teens or higher for certain Permian players.

“We would argue for a higher multiple as we see SM Energy having an improved return profile and the ability to achieve double-digit growth in oil production while spending within cash flow at $55/bbl,” the report said. KeyBanc upgraded the stock to Overweight with a $40 target.

SM Energy Co. funded its acquisition of nearly 25,000 acres in Howard County, Texas, with equity and convertible notes offerings, asset sales and its credit facility.

Added firepower

Other recent acquisition-related offerings include those by two Austin, Texas-based E&Ps: Jones Energy Inc. and Parsley Energy Inc. Jones completed a dual-tranche offering of common stock and a perpetual convertible preferred issue. Parsley priced a follow-on offering of common stock, as well as issuing a further tranche of high-yield debt from a shelf filing.

While the upstream industry has tended to use convertible instruments somewhat spar¬ingly, it has at times combined common and convertible issues to have the added firepower to make acquisitions that are of significant size relative to the issuer, observed Nathan Craig, managing director in energy investment banking at J.P. Morgan.

“Historically, the convert market hasn’t been substantially tapped by upstream companies,” said Craig. “Usually, as well as in this case, it’s been tapped in conjunction with a signif¬icant acquisition. There’s a strong correlation between large acquisi¬tion financings and convert issues. When you have these large acquisi¬tions—meaning large on a relative basis—issuers may often want to tap both the common and convert markets to maximize proceeds and access two distinct investor bases.”

J.P. Morgan was a common thread connecting all three of the above issues—those of SM Energy, Jones and Parsley. In each case it served as either lead left or active bookrunner. As for SM Energy’s dual-tranche offering, “the exe¬cution was phenomenal,” Craig said, with the 1.5% coupon being “tighter” than the 1.75% to 2.25% marketing range and the conver¬sion premium being at the high end of the price talk of 30% to 35%.

“The convert market has been eager for new paper,” he com¬mented. “There are lots of convert investors, hedge funds and long-only investors that want to play the energy space. I think a lot of convert investors understand the growth story that comes with an acquisition and are ready to put money to work. We’ll see more opportunity for that as larger acqui¬sitions come to fruition.”

With a market capitalization of about $175 million prior to its move to tap capital mar¬kets, Jones’ dual-tranche offering—raising combined gross proceeds of $150 million—exemplified a small-cap E&P’s ability to finance a relatively large acquisition. Jones’ combined gross proceeds from the two issues represented almost 90% of its pre-offering market capitalization, according to J.P. Mor¬gan. By comparison, while SM Energy raised significantly larger absolute proceeds, they constituted a more manageable 35% of its pre-offering market capitalization.

The assets’ location in the favored Scoop/Stack play aided Jones’ ability to put together a financing package. The purchase price was $136.5 million for approximately 18,000 net acres primarily in southern Canadian and northern Grady counties in Oklahoma. About 70% of the acreage is operated, with an aver¬age working interest of roughly 50%.

Both the common and the perpetual con¬vertible preferred issues were upsized, raising over a third more equity than originally antic¬ipated. An initial 14 million share offering of class A common stock was upsized to 21 million shares and priced at $2.77 per share. The perpetual convertible preferred issue was expanded from $50 million to $80 million, and then, with the overallotment option, $92 million. Terms offered an 8% coupon and a conversion price set at a 15% premium to the common offering price.

The acquisition has given Jones a scal¬able footprint in one of the most coveted resource plays in the U.S., stated CEO Jonny Jones. “This acquisition high-grades our Midcontinent position and significantly enhances the growth outlook for Jones in 2016 and beyond.”

The financing by Parsley combined a $200 million tranche of high yield with the compa¬ny’s sixth follow-on offering of common stock since its IPO in 2014. Proceeds from the offer¬ings, for which J.P. Morgan acted as sole active bookrunner, are earmarked to fund Parsley’s $400 million acquisition of Permian assets, including 9,140 net acres in Glasscock County and various mineral and royalty interests.

The common stock offering, initially filed for 7 million shares, was upsized to 7.25 million shares and further expanded to 8.34 million with exercise of the full overallotment option. Priced at $33.55 per share, it raised gross proceeds of $280 million. A 6.25% senior note offering, due 2024, was drawn from a shelf offering and priced at 102 to yield 5.835%, a tighter spread than expected over the treasury market.

As with the convertible market, the high-yield market has been “starved for paper” in energy, which makes up just 8% of the overall high-yield market now, down from a peak of around 20%, according to Craig. “The chal¬lenge is that there just hasn’t been any real issuance,” he said. “You’ve seen the complete evaporation of bond issuance in the market.”

Noting that year-to-date energy equity issu¬ance has already exceeded that of full-year 2015, Tim Perry of Credit Suisse is optimistic that equity markets will remain open to E&Ps, assuming commodity prices track consensus in a “general movement upward.” Offerings tend to be “highly oversubscribed,” and mar¬gins for E&Ps operating in certain basins are poised to look increasingly attractive as oil and gas prices move up into a range of $50 to $60/bbl and $3 to $3.25/Mcf, respectively.

Sustainable structures

However, near-term access to capital mar¬kets may be increasingly shaped by two fac¬tors: the ability to attain key acreage positions in favored basins, and E&Ps’ increasing affil¬iation for capital structures that are “highly sustainable even in a period of low commod¬ity prices,” Perry said.

Although varied capital sources may be available—through equity, convertible or high-yield markets—many E&Ps are “wanting to de-lever,” observed Perry. Whereas acquisi¬tions may have traditionally been financed by 50% equity and 50% debt, he observed, “the new rule is to do it 100% with equity.” And E&Ps that earlier may have had 25% to 50% outstanding on their revolvers, leaving 50% to 75% available, are tending to “have zero out¬standing on their revolvers and perhaps cash on their balance sheet.
“Overall, the industry wants to run on 2x debt-to-EBITDA on an unhedged basis,” Perry said. “The industry is moving toward that level, but most companies are still above it.”

How focused are investors on certain plays or specific parts of plays?

“There’s no doubt that investor interest has generally been confined to acreage located in the right places, and that’s been a relatively small number of counties in the U.S.,” said Perry. “If you have acreage in those areas, you absolutely can raise capital—and, frankly, you can do it relatively easily.”

Credit Suisse has been a predominant force in the sheer number of equity offerings it has led in the energy sector. Does it expect mar¬ket access to broaden to include a wider range of E&Ps?

“I think smaller companies definitely have access to the market,” said Perry. “What’s most important is not so much their size, but where their acreage is—is it in the core of the core? And, secondly, do they have a capital structure that, post-transaction, is via¬ble through the cycle. There are still a lot of mid- and small-cap companies that haven’t accessed the market, and there’s probably now availability to those companies who didn’t have it six to 12 months ago.”

Is the market ready for IPOs?

“We see two to three companies coming to market with an IPO before year-end, and we expect strong investor demand,” said Perry. Subject to market conditions and SEC approval, likely timing is between Labor Day and Thanksgiving, “and we expect the Perm¬ian will be well-represented.”

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