[Editor's note: A version of this story appears in the January 2019 edition of Oil and Gas Investor. Subscribe to the magazine here.]

When capital markets are challenging and none of the traditional instruments in the financial toolbox look attractive, investors tend to rediscover mezzanine finance. And, after the turmoil throughout world markets in October, the flexibility of mezzanine may make it particularly appealing to investors.

For users, mezzanine capital is not designed to be a permanent source of capital; rather, it is an intermediate financing tool, typically for a specific project. Terms usually consist of an interest-bearing component, coupled with an element of upside for the capital provider. Historically, the latter “equity kicker” has taken the form of warrants, net-profits interest, overriding royalty interest and other instruments.

Funding growth projects can be tough in today’s energy sector, in which E&Ps are at risk of criticism for raising debt above certain levels or for issuing equity to fund capex projects in excess of cash flow. Mezzanine financing’s focus on a particular project means leverage is generally for a limited period, while equity dilution, if incurred, tends to be temporary rather than permanent.

A leader in the sector, like The Carlyle Group LP, has recently financed projects from $75 million to $1 billion or more. Other providers focus on a narrower range of projects. Prudential Capital Energy Partners LP makes investments ranging from $10 million to $50 million in its new mezzanine fund. Macquarie Bank Ltd.’s investments typically range from $25 million to $100 million.

“There’s a particularly attractive dynamic in the market right now,” said David Albert, co-head of Carlyle Energy Mezzanine Opportunities Fund II LP. “The demand for capital is significant because of what’s happening in the equity capital markets. Equity shareholders generally want companies in the energy sector to live within their cash flow.

“That being the case, if a company needs to grow and they don’t want to do it by raising debt or having it be dilutive by issuing equity, then asset-level mezzanine or another type of structured solution is really the only way to go to increase your growth without running afoul of some of the other sensitivities out there in the marketplace.”

Promising Deals

Carlyle has joined with two large-cap E&Ps to help accelerate production growth and, in turn, pull forward net asset value that otherwise may not have been fully realized.

In September, it and Diamondback Energy Inc. (NASDAQ: FANG) entered an agreement to fund development of Diamondback’s assets in the San Pedro area of Pecos County, Texas, in the southern Delaware Basin. Of the estimated $620 million cost, Carlyle is funding up to 85% of the development in a five-year period.

In 2017, Carlyle and EOG Resources Inc. (NYSE: EOG) struck a joint-venture (JV) drilling agreement covering EOG’s assets in the Marmaton play of Ellis County, Okla. In this, Carlyle is providing $400 million in a four-year program. In both cases, after certain performance hurdles are achieved, Carlyle’s working interests will largely revert to the two E&Ps.

“Diamondback and EOG were both in the position of having more attractive acreage and inventory than they can actually pursue at the moment,” Albert said. “You could decide not to develop it and just hold onto it for later. But the further you push that out into the future, the less you’re getting any credit for it in your stock price.

“They’re going to choose their own best projects first. Some of their wells generate IRRs [internal rates of return] of 50% to 60%, for example, and others, 30%. For Diamondback and EOG, a 30% IRR well may not make the cut. But, for us to be able to partner with a blue-chip operator in acreage that is attractive, that’s a win-win for everyone.”

Factors common to the transactions are “they’re both deals where we’re funding the drillbit; they’re both deals where we’re not paying for acreage; and they’re both deals where there are reversionary working interests. So our equity participation steps down after we get a minimum threshold return.

“But they both have tails, so we keep some of the upside.”

Comparing the two transactions, the EOG deal was “a little bit later-stage” so that, “to a large degree, we had a pretty well-delineated play from the early days,” Albert said. Conversely, the Diamondback assets were “in a slightly earlier stage of development,” so “we had more protections for ourselves.

“We needed to make sure the wells were going to perform as expected before accelerating the rate of development.”

But the attraction for Carlyle’s partners is that “the bulk of the upside goes back to them after we hit a certain threshold, no matter what the return is,” he noted.

Development, Not Wildcatting

Does the structure bear some resemblance to a DrillCo JV? “It is like a DrillCo, but the main difference is the amount of reversionary interest,” Albert said.

“Most investors in a DrillCo are excited about the equity upside and are less concerned about having downside protection with some equity-kicker. It’s a subtle difference, but it drives how you structure the deal. The key question is ‘Does the asset and the structure have enough stability to give us comfort on the downside?’”

Here, the risk profile of the play—for example, a manufacturing-style play vs. wildcatting—is a major factor.

“To the degree the play has been fairly well-delineated and you have protections in place, like caps on drilling costs, then you actually can get comfortable that your downside is in a manageable position,” he said. “You’re not taking full equity risk, because you have two forms of an embedded cushion.

“One, you haven’t paid for acreage. Two, you can be selective as to participating in specific fields based on, for example, results from analog wells in the area.”

Overall, Carlyle targets returns in the mid-teens, although specific risk factors, such as a play’s stage of development, etc., can move the threshold up to the higher teens, according to Albert.

Having the scale to do larger deals has helped Carlyle, as “there’s less competition for bigger deals of $500 million and up, and there’s less competition for deals with hair on them,” he said. “You have to decide which areas you want to focus on. We want to deploy capital in areas that have more attractive risk-adjusted returns, which means you have to be more creative.”

Branching away somewhat from its traditional business, the Carlyle Energy Mezzanine Opportunities Fund II LP struck its first common-equity deal in October, participating with CSL Capital Management LP in purchasing the laboratory and geological-analysis business of Weatherford International Plc (NYSE: WFT). The latter generated positive cash flow throughout the downturn and holds a leading position in laboratory services behind Core Laboratories NV (NYSE: CLB).

Meanwhile, even with cheaper funding costs, E&Ps are reluctant to rely too heavily on the banks, Albert said.

“People don’t want to draw down large bank facilities if they can avoid it,” he said. “Nobody wants to come close to the edge and load up on bank debt, given how fickle the banks have been and the risk of getting squeezed in a downturn in pricing. That’s why our capital has such appeal—because they know that, even if commodity prices go south, they still have runway.”

Similar To Unitranche

Prudential closed fund-raising on its Prudential Capital Energy Partners Fund I LP at $343 million in September. The PCEP fund continues a history of mezzanine financing previously conducted by Prudential Capital Group, the $81 billion private-capital arm of PGIM, the investment management affiliate of Prudential Financial Inc.

“Our fund is targeting the middle market,” said Randall Kob, managing principal, Prudential Capital Energy Partners. “We look to deploy $10 million to $50 million in individual transactions. We’re typically the sole capital provider in a company’s balance sheet. From time to time, we’ll provide both senior debt and junior capital from the fund, similar to a unitranche financing.”

The fund expects to deploy roughly equal portions of capital in both the oil and gas sector and the power sector. Upstream, Kob cited three opportunity sets: One, acquisitions; two, growth capital; and three, recapitalizations.

As of June 30, the fund had invested in four companies. Two were acquisitions made with the goal of using the junior capital to accelerate production and to subsequently refinance the mezzanine by increasing the operators’ reserve-based borrowing base.

One, Prairie Provident Resources Inc., is based in Calgary, where the retrenchment by middle-market banks has created particular opportunities. “We suspect there may be a size bias on the part of capital providers,” Kob said.

“We’ve seen some very solid underwriting opportunities in certain markets that are less efficient, such as those serving smaller enterprises with 1,000 to 2,000 bbl/d of production.”

In certain cases, an enterprise can be formed specifically to buy a package of properties using mezzanine capital. In this instance, Kob said, the incoming management team is not only in control, but typically contributes a meaningful amount of equity or assets to support the leverage. This is in contrast to an investment by a private-equity-backed team, where management has less control and a lower ownership interest.

Not Formulaic

“What’s different about our approach is that it’s not formulaic,” Kob said. “Deal terms are a function of the profile of the assets and the capability of the team. And we have the ability to design structures for the circumstances as they present themselves.

“Our typical investment is $25 million, but, with co-investments, we can go above $50 million for the right transaction.”

The PCEP fund is targeting IRRs of between 16% and 18%. Where the risk profile is viewed as being fairly modest, a contractual return is used, combining an interest rate, a payment-in-kind feature and certain fees. If more meaningful drilling risk is involved, a coupon of between 9% and 10% may be coupled with a net-profits interest—and potentially a warrant—to offer appropriate upside participation.

The fund may also offer an “advancing mezzanine facility,” based on a proved, producing asset that funds further development drilling, with cash flows sent to a depositary account pending well results and establishment of funding for a next tranche of wells.

“That’s probably the highest-risk form of financing we do, and our return would include a net-profits interest, warrant or common equity,” Kob said.

“We’re providing a higher level of outstanding debt than what’s available in the conforming-bank-loan market. Typically, it’s more than what can be achieved in a unitranche or a first- and second-lien format.

“And the advancing mezzanine facility is funding drilling based on a very detailed analysis of the drilling inventory and also the existing asset base.”

The investments’ expected duration may vary—from a relatively short timeframe for an advancing mezzanine facility dependent on near-term well results to a more-typical mezzanine investment of up to five or seven years.

In the U.S., investments are likely to be made predominantly in private companies. In Canada, however, the fund is invested with publicly held Prairie, and Kob said further such investments may occur.

PDP vs. PUD Weighting

For Macquarie Bank, the focus of mezzanine finance continues to be mainly on private operators, often those “a little off the radar,” according to Drew Allen, senior vice president in its energy-capital group.

The sweet spot for investments is $50 million, but can range from $25 million to $100 million for “a single hold.” Macquarie can also participate with other capital providers in larger “club” deals.

Key drivers for private operators turning to mezzanine are threefold, Allen said. One, a soft A&D market for less-delineated assets; two, increased investor focus on free cash flow vs. growing inventory, as witnessed in 2016 and early 2017; and, ultimately, three, the “need to drill more wells to get to a monetization event.”

Similarly, for public companies, mezzanine continues playing a key role in financing specific projects at more attractive costs of capital than in equity markets, Allen said. “Frankly, it may not make sense to issue equity if the assets being developed are no longer considered an ‘equity’ level of risk.”

However, in recent years, he noted, mezzanine finance has experienced increased competition from new capital providers primarily offering DrillCo structures.

“We think of our form of capital as acceleration capital for a project that essentially already works and is economic at today’s prices,” he said. “But you can only get so far with a borrowing base, so we provide the additional capital to accelerate the development plan at a cheaper cost of capital than equity.

“We work with companies and their private-equity sponsors who want to continue developing their assets in preparation for a monetization event down the road at a better valuation, and we provide them the capital to get there.”

Most financings by Macquarie involve “non-equity levels of risk, where hydrocarbons are clearly in the ground, and operators have shown those hydrocarbons can be extracted economically,” Allen said.

These financings can involve projects that are more heavily weighted with PDP [proved developed producing] assets to ones that are more weighted to PUD [proved undeveloped] assets, according to Allen. The PDP vs. PUD weighting, as well as the amount of capital the company is seeking, are factors determining Macquarie’s cost of capital, along with other structural items, such as hedging and covenants.

Projected returns targeted by Macquarie, assuming no equity-kicker, can vary from 8% to 15% “all-in.” In addition to an upfront fee, variables include a floating interest rate tied to Libor depending on the perceived risk of the deal and a possible pre-payment penalty. If risk levels warrant inclusion of an equity-kicker, “we’d want to be up in the 15% to 20% range for our all-in return,” Allen said.

In terms of E&Ps that may find mezzanine attractive, he pointed to “small private companies that are a little off the radar because they either haven’t drilled that many wells or they’re under-served because they don’t have a large acreage position.

“It’s fairly rare that you see a capital provider finance a company with only 5,000 to 15,000 acres. That’s where we can carve out a niche.”

Macquarie is willing to downscale in terms of acreage size in light of its in-house technical staff—four engineers and a geologist—who can evaluate assets very closely and come up with an educated view of the project’s future cash flow, Allen said. If everything goes to plan, “these are three- to four-year deals that we expect to be refinanced in 18 to 24 months.”

Capital Competition

Allen is candid about other sources of private capital providing increased competition in the space. “The reality is that it’s become harder to find a good [mezzanine] deal right now with equity upside,” he said. “Private equity has just ballooned because the flexibility they provide makes it easier for companies to execute on their business plans.

“The other factor is the re-emergence of DrillCo joint ventures. Some companies and sponsors are less inclined to take on leverage or want to lay off some risk, and they view DrillCos as a potential way to do that and bring in more capital.

“Historically, when we’d do mezzanine deals, they were with operators that were either so-called ‘mom and pops’ or small private operators that already owned an asset. They may have had some other type of capital behind them, but it wasn’t private equity.

“We were typically the primary capital provider in those deals. Now we’re a secondary source of capital, working with private equity, as opposed to competing with them on occasion. And that’s where we want to be and plan to be in the future.”

Nonetheless, deal flow is termed “healthy” because of the apparent logjam in A&D and equity markets—not despite it.

“We’ve seen a lot of activity in the last 12 months; deal flow has been healthy,” Allen said. “I keep coming back to a saturated A&D market and a highly cautious equity market.

“The smaller E&Ps have to grow up more—to be more mature in the life cycle of a business—to attract a buyer. By necessity, you have to find capital elsewhere to continue drilling wells.”

Chris Sheehan can be reached at csheehan@hartenergy.com.

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