In the toolbox of financial instruments, there are sometimes advantages to being “counter-cyclical.” Sure, the spotlight is on others when equity markets are described as “red hot,” or when spreads in the public high-yield market are reaching record low levels. But when these instruments fall from favor, the advantage of being counter-cyclical comes to the fore.

Mezzanine finance can perform in such a counter-cyclical fashion. Business may be steady for much of the time, and then—when, say, traditional financing sources have been disrupted and are no longer easily accessible—an upturn in demand may come from clients struggling to proceed with projects for lack of suitable funding. As public capital markets falter, mezzanine may offer a solution.

“Mezzanine always tends to be a little counter-cyclical,” observed Paul Beck, joint division head of metals and energy capital with Macquarie Bank in Houston. Noting a sharp decline in capital markets activity recently, with equity and high-yield offerings being deferred or cancelled, “those kinds of situations do represent opportunities for us,” he said.

Mark Green, president of Wells Fargo Energy Capital in Houston, struck a similar chord of mezzanine not marching to the same drum as the broader capital markets. “When the markets are frothy, we’re not as active in the mezzanine space,” he said. But when times are slack, “we’ll continue to evaluate mezzanine deals as long as the economics make sense.”

And whereas public equity markets can tend to be dependent “to a large extent on momentum and sentiment,” mezzanine deals are often “very customized solutions” that can move forward based on their individual merits, according to David Albert and Rahul Culas, managing directors and co-heads of the Carlyle Energy Mezzanine Opportunities Fund.

With capital markets for energy in disarray following the more than $35 per barrel (bbl) plunge in West Texas Intermediate (WTI) prices since mid-June of last year, what perspective can mezzanine providers offer to those E&Ps checking that they have sufficient liquidity to move a certain project or play forward?

Generally, mezzanine players indicate it is still “early days” in guessing the level at which WTI will stabilize. But opportunities for investments are not scarce.

The Carlyle Group established its mezzanine fund to provide alternative capital to energy companies in 2010. The fund typically provides debt capital to companies that cannot access such capital from traditional reserve-based lending facilities or from the broader capital markets. The cost of this type of capital varies by opportunity but is consistent with that charged by corporate mezzanine: low double-digit coupons with some equity kickers to enhance returns.

Far left: Paul Beck, joint division head of metals and energy capital with Macquarie Bank in Houston, said of the recent sharp decline in capital markets activity, "those kinds of situations do represent opportunities for us." Near left, Mark Green, president of Wells Fargo Energy Capital in Houston, says when times are slack, the bank will evaluate the mezzanine deals "as long as the economics make sense."

Culas acknowledged that accessing the debt market on a stand-alone basis—if feasible—should be cheaper. “But to get a deal done right now, you have to go out and build a book of interest over a broad base. Alternative capital can go in, really study the asset, and if it’s a good management team and a good asset, move quickly and make that decision without having to build consensus across a broad investor group.”

In addition, Culas said, unlike private equity, mezzanine doesn’t typically seek control or the majority of a project’s economic upside. This is of particular importance in a down oil price environment, when companies are hesitant to sell assets at lower established valuation levels.

Mezzanine deals are often very customized solutions that can move forward based on their individual merits, according to David Albert (above left), co-head of the Carlyle Energy Mezzanine Opportunities Fund. "Energy mezzanine isn't fighting the valuation fight," Rahul Culas (right), managing director and co-head of the Carlyle Energy Mezzanine Opportunities Fund, said.

“Energy mezzanine isn’t fighting the valuation fight,” Culas said. “If you go to a private-equity shop today, they’re going to say, ‘If you want to use our capital, you’ll have to provide us with the bulk of the upside based on today’s lower price environment.’ For mezzanine, irrespective of where oil prices are, the cost of capital is going to be a fixed coupon for the most part. So you aren’t handing over your company, or materially diluting yourself, at the exact time when most owners prefer to retain maximum upside exposure.”

With credit markets having tightened, causing a backup in yields, is the coupon component of a mezzanine transaction likely to rise?

“If rates widen or tighten 150 basis points, that doesn’t change the mezzanine business model,” Albert said. “Pricing changes more with the risk profile of the deal than it does with anything in the markets; pricing is correlated with the underlying business risk.”

Against the background of the crude price slump, how is the pipeline of potential business?

“The inflow is always greater for all alternative capital when the markets seize up,” Culas said, noting that in addition to the traditional, smaller companies that seek mezzanine capital, now larger companies that can no longer access the high-yield and equity markets are in search of alternative sources of funding. If crude prices stabilize, he continued, the public markets would likely return to more normal conditions. “But if prices keep falling, in a bizarre way it helps those with alternative capital.”

Drawing a distinction between how mezzanine providers evaluate financing opportunities versus their public market counterparts is the Macquarie Bank mezzanine team in Houston, which includes Paul Beck and managing director Jerry Thompson.

“We have a different view of the market and risk than a traditional bond investor and maybe even an equity investor,” Beck said. “It’s less market-driven and more asset-based. If the asset can support the debt that we are looking at providing, then we’re good to go. We really don’t care at what level oil is trading.”

Relative to high-yield debt, which has longer maturities, “mezzanine also tends to be more flexible” in terms of refinancing, Beck observed. For example, if used to convert proved undeveloped reserves into proved developed producing reserves, mezzanine debt can usually be prepaid on project completion with minimal charges. By contrast, if an E&P locks into a longer maturity high-yield issue paying a coupon of 8% or 10%, “it can use that money for the same purpose, but it’s going to sit on your balance sheet for a lot longer.”

Macquarie’s preferred deal size is $50- to $100 million. It targets a total return in mezzanine in the “low to mid-teens,” using essentially the same approach as previously, but now with a lower price deck. Historically, for the greater portion of its return it has relied on a “yield enhancement,” typically a net profits interest (NPI), overriding royalty interest (ORRI) or warrant on the back end of the debt (after payout). The coupon has intentionally made up a smaller component, lightening the interest burden to give a project a better chance of success.

However, in the current low price regime, “if anything, we may lower our return aspirations from time to time to allow deals to work and to remain competitive,” Beck said. For example, if previously the total return target was 14%, with 8% coming from the yield enhancement component, the latter portion of the return might be lowered to 5% to reflect potential commodity price upside following the pullback in crude prices.

“If you have an equity kicker that’s going to be dependent on future prices to some extent, it’s not a hard rationalization to assume that oil prices will rebound and you’ll get the benefit of that in the future. Our price deck may not show that today, but the reality is that it’s more than likely to happen. That 5% has price upside in it that the 8% didn’t at $100/bbl oil,” Beck said.

This type of adjustment in expected returns is not unusual in a lower price environment, according to Beck. “If you approach it in a predatory fashion, and try to charge people a lot of money because there’s a lack of capital, you’re going to find that you can’t get most deals to work.”

While recognizing the oil and gas sector is still in a transitional phase, not knowing how long oil prices will remain low and how quickly oilfield service costs and availability may adjust, some fallout is possible from aggressive mezzanine deals done at much higher prices.

“Depending on how long prices remain low, we may see a little reshuffling of the mezzanine market with respect to those who did more aggressive deals at higher prices and who might now be somewhat occupied with potential workouts,” Thompson said.

“Anyone who did an aggressive deal at $100/bbl probably has a bit of work to do,” Beck echoed.

Like Macquarie, Wells Fargo is a longstanding mezzanine provider, whose entry into the sector dates back to 1996. In addition, Wells Fargo is very active in the second-lien and private-equity markets, and it is seeing increasing E&P interest in preferred equity issuance.

With the weaker commodity outlook for 2015, “many of the well-managed firms have been thinking ahead as to their liquidity needs,” the bank’s Mark Green said. Cash flows are expected to be down, but many projects are still economic to drill at $70/bbl, and “in these instances we’re seeing a lot of activity in the second-lien market and in redeemable preferred deals,” he added.

In mezzanine, where activity over the past couple of years has been “fairly stable,” Green said Wells Fargo’s “hold level in a deal can go to up to $50 million, although we have syndicated transactions of up to $150 million.” In second lien, transaction size can be up to $75 million, and it has syndicated deals of up to $200 million. Direct equity deals (traditional private equity or preferred equity) are typically $20 to $40 million.

Targeted returns in mezzanine are 15% to 25%, depending on the perceived risk of the project, with the lower end applying to more mature, development-type projects, and the upper end to less mature projects. A coupon is typically set at 5% to 8%, a level designed to avoid high interest costs burdening a project, with the result that most of the projected total return is expected from an equity kicker, usually in the form of a NPI, after payout, of 20% to 50%.

The NPI may be subject to a “stepdown” provision, which is “all part of the negotiating process,” Green said. For example, if the NPI were 20% to 30% in a project, Wells Fargo could “step down” the NPI once it attained a predetermined IRR and return on original investment, lowering it to, say, 5%. “Then we’d still have a portion of the upside, but it wouldn’t be unlimited,” Green said.

With banks due to redetermine E&P borrowing bases in March and April, Tim Murray, a 20-year veteran of mezzanine finance, expected "there'll be some stress in the bank lending market if oil prices don't correct."

While Wells Fargo had found it more difficult to find mezzanine deals meeting its risk/return criteria in the earlier, more robust capital market conditions, this could change, Green said.

“We haven’t seen a lot of new deals since the price shock occurred, but to the extent it washes out competitors, we should be able to see a better risk/return, provided the drilling economics make sense.”

Tim Murray, who has been active in mezzanine for 20 years, sees opportunities for new money arising from the stretched balance sheets of unconventional players who have yet to HBP key play acreage—yet also have lower borrowing base redeterminations looming.

With banks due to redetermine E&P borrowing bases in March and April, Murray expected “there’ll be some stress in the bank lending market if oil prices don’t correct.” This could lead to a “classic example” in which E&Ps dependent on bank debt for development of unconventional plays face large reductions in borrowing bases. Potential borrowing base deficiencies could be compounded further by instances where E&Ps have costly acreage—and meaningful upside—that is yet to be HBP.

“People have been buying hundreds of thousands of acres for a lot of money,” Murray noted. “If they don’t HBP that acreage in the primary term of the lease, they’re going to lose it. So they’re desperate to find some capital to capture that value and prove up the rest of the acreage, despite the low commodity background.”

In order to offset commodity price weakness, the mezzanine provider will likely factor in some reduction in costs of drilling and fracking additional wells on the remaining acreage, Murray said. “Although the economics aren’t that robust at $75 per barrel, once the rig costs and frack costs come down, and you get back to drilling, we’ll finance that.”

Regulatory constraints on commercial banks do not apply to mezzanine providers, who can thus act with greater flexibility, Murray pointed out. Strategies for capital-constrained E&Ps might include bringing in mezzanine capital to take the bank out, and recapitalizing the whole company, as well as providing additional capital behind the bank. But with the latter, “the problem is the bank is still driving the bus, and you’re just sitting in the last seat of the bus, which adds some risk there,” he said.

Seasoned professionals at MLV & Co. recently established a new vehicle to provide mezzanine finance with initial backing of $300 million, according to Rob Lindermanis, managing principal.

"Historically, when prices show a rapid decline, a lot of traditional senior debt lenders go in to shock mode for a little while, and are very reluctant to lend, and that creates an opportunity for BlueRock," Cathy Silva, founding partner, BlueRock Energy Capital, said.

Another opportunity Murray anticipates may stem from a possible thinning of mezzanine ranks. In particular, he expects some less-experienced players who had struck more aggressive deals in an “overheated” market in first-half 2014 may now be “sidelined” as they take care of problem deals in their portfolio. “Some of that money is being chased out of the market.”

Overall, “it should be a good time to be a mezzanine lender,” Murray said. “When the public markets contract, the private capital guys fill in that opportunity.”

Seasoned professionals with more than 30 years of experience in the energy finance industry have established a new vehicle at MLV & Co. to provide mezzanine finance as one of several capital options for E&Ps. The new vehicle, with initial backing of $300 million, is called MLV Energy Partners LLC and is “just starting to review potential investment opportunities,” according to managing principal Rob Lindermanis.

Prior to joining MLV, Lindermanis served as a managing director in Macquarie’s Energy Capital Group. Previously, he was a managing director at Imperial Capital LLC, which acquired Petrobridge Investment Management, a firm co-founded by Lindermanis.

The MLV fund favors E&Ps specializing in a specific geological and geographical niche, with a good technical and operational understanding of the area, and that have “a reasonable amount of proved developed producing properties with good upside potential,” Lindermanis said. “We’d rather work with an E&P involved in a specific area than someone involved in projects spread over multiple states. We like someone with a focused plan.

“Our typical deal is a $20 million initial advance with a $50 million facility to grow into,” Lindermanis said, which is often a differentiating factor. “We are willing to come down in size if we see an opportunity to grow the relationship. We think there’s an opportunity to help companies who don’t have a $50 million initial need. We can assure E&P companies that the transaction will be evaluated, approved and closed in a timely manner.”

Lindermanis characterizes most of the projects in its deal pipeline as “drillbit-oriented.” Roughly 70% are to accelerate development drilling or are exploitation/enhancement projects, with the remaining 30% being “acquisition-driven.”

While “every deal is different,” Lindermanis said, total returns targeted by the fund are typically in the “mid-teens.”

In addition to pricing, Lindermanis emphasizes the importance of a structured financing in terms of how much equity clients will create and how much they will retain. “I tell all my clients to take a hard look at the capital structure and make sure it works for them.”

For BlueRock Energy Capital, which serves a niche in financing “micro-independents,” history is starting to repeat itself as the pace of inquiries rises. “Historically, our business does pick up a little as oil prices go down, and we’re seeing a slight uptick in the number of calls at a time that is usually seasonally slower,” Cathy Sliva, BlueRock’s founding partner, said.

BlueRock offers funding in amounts from $1- to $10 million, with $3- to $6 million being the “bread and butter” of the business. The financing package offered by BlueRock is distinctive in that the capital is provided not through a loan but rather through BlueRock’s purchase—on a temporary basis—of an ORRI in the properties. This is reassigned to the operator once BlueRock has received its capital back plus a contractual rate of return on its investment. Total projected returns are in “the mid-teens.”

“Historically, when prices show a rapid decline, a lot of traditional senior debt lenders go into shock mode for a little while, and are very reluctant to lend, and that creates an opportunity for BlueRock,” Sliva said. “We are able to lend more aggressively than a bank and customize our product for individual projects.”

Moreover, Sliva emphasized, BlueRock is able to work with greater flexibility with clients facing a severe drop in the commodity price.

“A client looking to borrow money from BlueRock knows we are not going to pick up the phone and say, ‘Write me a check.’ If it’s a good relationship, we’ll call him in and discuss what we can do for the next six months to make it more manageable. We’ll restructure the deal, so that it’s a win-win relationship.”

Given a revenue-sharing model it uses, an initial condition for working with BlueRock is that clients have at least some production—even if it is only 20 bbl/d. Remarkably, from an initial $3- to $6 million deal, as many as 98% of BlueRock clients go on to do multiple projects with a higher cumulative transaction value, Sliva said.

“A lot of our clients are ones that aren’t quite bankable, and we help them grow to a point where they have the size and diversification that they can then go to a bank for a lower cost of capital,” she said. “We kind of get them ready, and then they graduate.”

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