Energy investors and capital providers were dealt an especially challenging hand during the past two years. For some capital sources, events froze investment flow for several quarters during 2009 and 2010. In the private-equity space, however, many industry veterans continued to amass funds, make strategic investments in the U.S. and abroad and help existing portfolio companies adjust development strategies.

As debt and equity issuances began to pick up in the second half of 2010, many private-equity providers were mum. However, the perception that the group was "on the sidelines" is not quite true, says Peter Kagan, managing director, Warburg Pincus LLC.

"A lot of private-equity activities that get press coverage are the large buyout transactions. Coming out of the financial crisis, there was a lack of available leverage that hindered bigger, high-profile deals," he says. "We tend to focus on growth investing, and if you look at our activity since the economic meltdown, we have invested more than $2 billion in energy. In 2010 we invested $400 million in five new companies and several follow-on investments."

"In 2010 we were very active, as we invested $400 million in five new companies and several follow-on investments," notes Warburg Pincus LLC managing director Peter Kagan.

The firm often invests in early start-ups, growth phases and select buyouts. In many of its deals, the firm backs teams for multiyear and multitranche investing, and it often takes years to build a company of scale.

"Many of our investments have started at a few million dollars, but over time they have grown to hundreds of millions of dollars to help companies hire personnel, acquire acreage and fund drilling programs," says In Seon Hwang, also a managing director at Warburg Pincus. "Our investments often begin with backing experienced management teams who decide to launch a new venture.

"Because of the uncertainty and dislocation in the markets, there was a slowdown in M&A activity that would have freed up teams, and it was not a good time for executives to leave their jobs. Now that we have less capital-markets and commodity-price volatility, we expect to see more entrepreneurial activity."

Private-equity provider Lime Rock Partners also remained active during 2009 and 2010, committing $500 million and $325 million of capital, respectively, out of its two most recent funds, including its $1.4-billion Fund V.

In Seon Hwang, managing director at Warburg Pincus, says, "Our investments often begin with backing talented, experienced management teams who decide to launch a new entrepreneurial venture."

"A lot of the private equity that's gone into E&P during the last 12 to 18 months has been committed to teams drilling in unconventional areas, which is very capital-intensive," says Jonathan Farber, managing director. "In some cases those commitments were made several years ago, so they don't attract a lot of attention today. But, this doesn't mean there isn't a lot of capital being invested in those plays."

Townes Pressler, also a managing director at Lime Rock, adds, "Our firm definitely wasn't on the sidelines, and we saw deals being done by our competitors that were not quite right for us, but were very attractive deals. Of the $825 million we committed, $250 million was for North American E&P. Going forward, we're looking to make E&P and service-side commitments from Fund V that range from $30- to $150 million, and we expect the fund will be invested 50-50 between the two subsectors."

Private-equity firms that have been in energy for years aren't strangers to the sector's volatile dynamics. During the past 22 years, the length of time Natural Gas Partners (NGP) has been in business, the market has come full circle many times, says Tony Weber, managing director.

"NGP is always looking to invest its funds. As long as we partner with the right management teams, there are always creative ways to make smart investments. We always analyze and adjust to changes in market dynamics."

"A lot of the private equity that's gone into E&P during the past 12 to 18 months has been committed to teams drilling in unconventional areas, which is very capital intensive," says Jonathan Farber, managing director, Lime Rock Partners.

Historically, NGP's focus has been predominantly in the U.S. and Canada, but it is open to exploring opportunities in other countries. The majority of its capital targets upstream acquisitions with complementary development opportunities, including some of the emerging shale plays. Midstream has also been a very important strategy for the firm. NGP's equity-investment range has been from $25- to $600 million, with $75- to $150 million being the sweet spot.

"Today, E&P companies are selling assets in much the same way they always have, but for different reasons," Weber says. "In response to this, our portfolio companies are constantly reaching out to them in efforts to acquire assets that fit their business strategy, and had tremendous success doing so during 2010.

"As larger, publicly traded E&P companies look to sell assets to fund drilling, we anticipate there will be many attractive properties on the market. Hopefully, that will create some investment opportunities for our funds."

Investment Activity

Commodity prices and buyer-seller expectations have had conflicting effects on private-equity investment activity. On the oil side, the price deck is high enough where sellers are more interested in selling. On the gas side, prices have not improved significantly, and that's drawing some capitulation, says Alec Neville, a principal at Dallas-based PetroCap Inc. Though Falcon E&P Opportunities Fund LP is its first fund, the firm has pursued the same investment strategy for nearly 20 years.

"A total transaction size of $40 million and below is where we play, and we think that market is underserved. We like conventional deals in mature producing regions like the Permian, D-J, California and Appalachian basins, and we typically own a working interest when we make an investment.

"A total transaction size of $40 million and below is where we play, and we think that market is underserved," says Alec Neville, principal, Petro-Cap Inc.

"Because of the opportunities in the market today, we're looking for projects that have some proved-developed-producing assets at the beginning, but we also want low-risk, proved-undeveloped (PUD) assets that can be drilled."

In December, Falcon closed an investment deal in the Permian Basin. It partnered with an operations group and bought a project that encompasses 13,000 acres, most of which was held by production. The assets represent 650 barrels of oil equivalent per day of current production and more than 200 PUD locations. The firm is also looking at a Cherokee Basin coalbed-methane transaction.

"The Cherokee Basin project has a significant chunk of acreage, plenty of PUD locations and a large number of producing wells. At current pricing the PUDs are not economic, so you go into it knowing that you're not going to drill the PUDs today, but the option is there going forward. Since there's no lease expiration it's like warehousing gas reserves into the future."

Neville says some unconventional-focused E&Ps have found they have the wrong capital structure for the current gas-price environment, and are having a hard time surviving.

"If you look at 2005 through 2008, a lot of private-equity investments were backing management teams in unconventional shale-gas transactions. While the dance has not stopped, the music has certainly changed. So part of the drop in investments is because the interest in backing gas transactions is lower.

"Also, the shales have migrated to the very large-cap end of the spectrum. They make sense, but mainly for the joint ventures between national oil companies and independents, because it's a long-term bet. We think it's a great time to own natural gas, but you can't have lease expiration staring you in the face. So, if you can own long-term gas reserves at today's prices, it's a wonderful investment."

While lower gas prices and the uncertain outlook for future prices have created a general bias towards oil and liquids-rich properties, NGP's investment thesis has always started and ended with management, Weber says.

"We believe in partnering with 'owner-manager' teams that have not only developed a track record of generating excellent operational results, but more importantly, consist of people that think and act like owners. As a result, we let them lead us to good investments. Our funds have been very active investing dollars over the past year and many of the assets we have purchased are heavily gas weighted."

In 2009, NGP elected to back a top-quality Calgary-based management team with a view on how the heavy oil play in the Lloyd­minster area of Saskatchewan was emerging with the advent of new technology and its application, as well as narrowing price differentials. NGP initially backed the team with a $125-million commitment.

In early 2010, the team approached NGP with an opportunity that had not yet been made public. A Canadian major was going to divest its conventional cold-flow heavy-oil assets in order to focus capital on its emerging shale play in British Columbia.

"The industry hadn't learned about the divestiture and NGP's portfolio company was able to gain a four-week head start," Weber says. "We did a top-to-bottom analysis and valuation of the assets based on the team's industry knowledge and public data. The team had several members who had operated similar heavy-oil assets and, as a result, was able to accurately assess the nature and value of the assets. The head start also enabled us to put third-party debt financing in place for the bid."

The early work the team was able to do enabled NGP and its portfolio company to understand the upside potential far better than any other bidders. The portfolio company won the bid and, together with NGP, was able to sell down a piece of the equity needed—$300 million—within a matter of two weeks.

"Going forward, we're looking to make E&P and service-side commitments from fund V that range from $30-$150 million...," says Townes Pressler, managing director, LIMe Rock Partners.

The team at Lime Rock has been concerned about gas fundamentals for the past three years. Farber says he hasn't seen signs that the industry is constraining drilling activity in a way that would result in meaningful recovery for North American gas pricing. While the firm would like to be able to jump back into the gas game in a big way, right now it's selectively pursuing gas projects that make sense in a lower-price environment, he adds.

"E&P companies and private-equity firms are willing to do deals in the current environment. The energy private-equity space is relatively well funded. The shale plays are enormous, and the capital demand for their development is in the billions. However, when you look at public companies, the stock price they trade at now discounts a long-term price expectation in the market of $5.25 to $5.50 per thousand cubic feet (Mcf).

"The reason capital flow has been slower is because there's a mismatch on price expectations. Three years ago, gas prices peaked at $14 per Mcf and the industry consensus on future pricing was $8 to $10 per Mcf. It steadily marched down. We're seeing a lot of business plans that are predicated on $5 pricing, but many private-equity firms are unwilling to assume that type of price deck."

Pressler says, "During the past three years, there has been a lot of money made trading leases in the shales. We feel like most of the money has already been made on the lease side and we are returning to our core competency of backing teams that can execute on the projects in those basins. If you believe, as we do, that gas will be soft for the next 18 to 24 months, it is difficult to get excited about opportunities that have two- to three-year lease expirations. We have a five to seven year exit horizon and can be patient with the right teams and assets. We don't want to be pushed into making uneconomic decisions to hold leases."

One of the firm's large shale investments has been with PDC Mountaineer, a joint venture formed in 2009 between Denver-based PDC Energy and Lime Rock. One of the things that attracted Lime Rock was the JV's held-by-production acreage.

Pressler adds, "When gas prices dropped, it caused us to look at new oil investments; it also impacted the way our existing companies operate. Where possible, we are working with our portfolio companies to shift drilling from gas to oil and liquids."

As a global firm, Lime Rock looks for opportunities to invest in conventional and unconventional E&P and service deals worldwide and adjusts for risk as needed. While the majority of the firm's investments are in North America, it has made investments in places like Turkey, Iraq, Romania, Ukraine and the UAE. Recent fundings include Calgary-based Black Shire Energy, which focuses on acquiring and exploiting mature conventional assets in western Canada. Lime Rock is also looking at a conventional deal in Texas that involves using technology developed and refined in the shales.

Meanwhile, Kagan agrees that low gas prices are creating opportunities, and the team at Warburg Pincus is looking at select gas deals now.

"When we look at our portfolio, we definitely have companies that have benefited from improved oil prices and lower gas prices. However, we have found that good management teams are able to build companies, growing reserves and production, throughout the cycles."

Hwang adds, "Back when gas prices were closer to $2, E&P companies were still able to earn money, so commodity prices are really only part of the equation. This is why the current pricing environment isn't that daunting to us. If you have a company of scale and other parameters line up, prices can be an opportunity to get lucky instead of a reason not to do a deal."

During the past 22 years, the length of time Natural Gas Partners has been in business, it has seen the market come full circle a few times over, says Tony Weber, managing director.

The energy team's bread and butter is domestic E&P, but it has also been active in North America in power development, midstream and other segments of the energy complex. It has ramped up its international energy investments as well, and executed transactions in China (an early-stage CBM company), India (an import, storage and terminal business for petroleum products), Brazil (power development) and Israel (a battery storage technology company) in 2010. Recent investments include ones in Gulf Coast Energy Resources, which focuses on conventional oil and gas plays across the Gulf Coast of Texas and Louisiana; China CBM Investment Holdings Ltd. (CCBM); and Calgary-based E&P Canbriam Energy Inc., which develops unconventional onshore resources in Canada and the U. S.

The Road Ahead

This year, the firms agree unconventional resource developments will likely draw a healthy chunk of private-equity dollars because of their massive size, repeatability and the headline successes companies have had. Private equity will also play a role in future joint-venture opportunities in the shales. Conventional investments will increase as well, though on a smaller scale.

"The shale plays continue to dominate the news and we've seen many private-equity firms direct their focus here," Weber says. "I imagine we'll see much of the same in the coming year or two, and possibly much longer."

The management team at PetroCap is excited about the outlook for the small, conventional onshore market and Neville expects energy-income funds with low-risk, income-driven models will remain attractive to investors.

Farber adds, "There's still some degree of uncertainty in play in energy, but the drive in many parts of the world to improve the standard of living has to be driven by increased energy consumption. Therefore, to global asset allocators and investors, the energy sector is viewed as less risky compared with many others. The valuation of the sector, in a relative sense, should continue to do quite well."

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