COVER STORY: INS AND OUTS OF PRIVATE EQUITY

Sponsors in the oil and gas private equity world are looking forward to 2017 with an upbeat mood after surviving the tur¬moil of two years of downturn. Fund sponsors had to closely monitor their E&P portfolio cli¬ents and help them through the crisis. They had to bail out a few of those in trouble; some were quietly consolidated or disbanded after failing to deliver on business plans to acquire assets during the halting A&D market.

Private equity sponsors were cautious too in how they deployed capital, and to whom and in which plays. And, it was no doubt challenging to field phone calls from anxious limited part¬ners who were watching oil prices fall below $30 per barrel (bbl) at one point—when their investments had been made at $50, $60 or even higher a few years earlier.

“Some private equity names you’ve known for a while are going to go out of business,” cautioned one source. The state of the pri¬vate equity industry is “a little bit of a mess,” according to another. “Going into 2014, a lot of aggressive, highly levered deals were done, so a lot of private equity firms have had some seri¬ous damage. There were just too many players who were new to the space, or not disciplined enough about the cycles. A vast majority of our PE brethren have been losing money.”

Despite the downturn that began in autumn 2014, several of the biggest sponsors success¬fully raised and deployed new capital. These include NGP Energy Capital’s $5.3 billion Fund XI that closed in January 2015. An EnCap Investments LP’s $6.5 billion fund and a Quantum Energy Partners’ $4.5 billion fund also closed in 2015. In October 2016, Kayne Anderson Capital Advisors closed the Kayne Energy Fund VII at a hard cap of $2 billion; it has already partnered with 15 portfolio compa¬nies to invest more than 40% of the fund.

Several principals left large private equity sponsors to start their own shops during the downturn. Edge Natural Resources LLC in Dallas closed on its first fund, for $446 million, in 2015. It’s owned by former NGP executives and led by partner Ray Aneed. Also based in Dallas, Pearl Energy Investments closed its first fund for $500 million in October 2015, under former NGP principal Billy Quinn.

Private equity remains committed to the oil and gas industry and has plenty of dry pow¬der to fund new companies. Research firm Preqin Ltd., wrapping up global 2016 activity, reported 46 energy-focused funds closed last year. They raised an aggregate $51 billion worldwide, with energy representing 88% of the total capital raised by the private equity industry. Of the top 10 largest natural resources funds closed in 2016, all 10 are focused on energy and nine are devoted to energy projects in the U.S.

A flurry of divestments has closed among private equity-funded E&Ps, many of which were formed three or four years ago before the downturn began, so the 2015-2016-2017 period is about the right time for the exits. Several had filed S-1’s to go public back in 2014, but the timing turned out to be impossible when the IPO window slammed shut as oil prices plunged. No matter: most of those companies have since achieved large paydays by selling to large public or strategic buyers.

Private equity-backed E&Ps dominated buying and selling activity in 2016, repre¬senting about 50% of transaction values, according to Wells Fargo Securities’ A&D team head, Art Krasny. A&D markets made a strong comeback in 2016 with a 70% increase in total transaction value and a 33% increase in deal flow, he said. In fourth-quarter 2016 alone, 31 deals were announced totaling $16.5 billion, with Permian Basin and Scoop/Stack packages dominating. Krasny’s team advised Yates Petroleum Corp. on its $2.4 billion sale to EOG Resources Inc. last year, among other deals.

Private equity firms dominated buying and selling with more than 50% of transaction value in 2016, according to Wells Fargo’s analysis.

Cautious optimism

What is the situation today, now that oil and gas prices and the rig count have begun to recover, an OPEC production agreement is in place, and so many billion-dollar deals have successfully crossed the finish line?
“There’s a general caution in the private equity investor market now and I think that’s probably warranted,” said Jordan Marye, managing partner with Denham Capital Man¬agement. “Both LPs and PE sponsors are approaching this rebound with optimism, but also a natural amount of weariness given what we’ve all just lived through.”

But Marye also points out what private equity players have achieved over the past 12 months. Some spectacular exits, either through an IPO or outright corporate sale, have generated substantial returns, which after all is the ultimate goal of private equity investors. Moreover, management teams and sponsors have grown ever more sophisticated, and focused on holding assets longer—choos¬ing to develop them rather than simply buy and flip.

More deals are being negotiated between private equity sponsors as well, with constant conversations about who’s going to be the best owner of an asset, and who’s ready to buy or sell. Some of the sponsors have rolled a few of their management teams together into one, but these were consolidations of convenience rather than big-money moves, where one team can more efficiently manage the assets of two or three others.

“2016 was one of the better deal-making environments in a long time,” Marye said. “We’ve put north of $1.1 billion to work at Denham in the last few months. There was a general paralysis through 2015 but 2016 was very active for us and many of our peers.”

One of its best exits occurred in the midst of the downturn, however, when in Novem¬ber 2015 it sold the remaining assets of Permian-focused Tall City Exploration I for $803 million. (See deal details in Oil and Gas Investor, February 2016). This followed a November 2014 sale to American Ener¬gy-Permian Basin LLC for about $440 million by Tall City, which had received $300 million from Denham a few years earlier. Tall City II later re-upped, getting another $300 million commitment from Denham in May 2016.

Denham’s deal pipeline keeps flowing too: in December 2015 it committed $250 million to Marcellus-focused LOLA Energy and in September 2016, it staked S&A Resources, focused on the Eagle Ford Shale.

Upheavals

Despite successes like these, more than one anonymous source told us privately that there’s been “enormous upheaval” within the private equity community, with some funds reporting big losses and downsizing of employees.

The record is indeed mixed as of late, but private equity sponsors take their lumps, move on and continue to invest. For example, KKR’s earlier big win was its sale of Marcel¬lus player East Resources in the summer of 2014 to Shell for $4.7 billion—after owning it for about a year. On the other hand, its high-profile $7.2 billion investment in Samson Resources Co. ended up in a bankruptcy in 2015, a total loss.

Nevertheless, KKR has continued to invest where appropriate, raising $3 billion for its second infrastructure fund that same year. The company still has energy investments every¬where from the Montney Shale to the Barnett Shale to Mexico.

In September 2016, as hints of the end of the downturn appeared, it announced a new partnership with Austin-based Venado Oil & Gas LLC to consolidate proved assets in the Eagle Ford Shale, principally funded by KKR’s Energy Income and Growth Fund I. This quar¬ter, they will close on their $800 million pur¬chase of nonoperated Eagle Ford assets from SM Energy Co.

SM, meanwhile, has agreed to acquire QStar LLC for $1.6 billion. The latter was formed by EnCap Investments in 2013 in the Midland Basin.

Caution, flexibility and patience were the bywords during the past year. Across its port¬folio of 45 companies, EnCap was running 35 rigs when oil was $100/bbl; during the down¬turn that count fell to less than a handful of rigs, but it’s since recovered to 15 or so again.

“Adapting to changing market conditions is very important; it’s the key to success!” said managing partner Murphy Markham. EnCap’s Fund X, which closed in 2015 at $6.5 billion, is still being deployed.

“When prices are low you acquire assets, and when they’re high, you focus on drilling to create value, so during this recent downturn in commodity prices, we got very focused on acquisition opportunities,” Markham said.

EnCap has clearly capitalized on market dynamics, having monetized or announced more than $8 billion worth of asset sales since the downturn was in full swing throughout 2015, with $5 billion of those upstream and midstream deals in the hot Scoop/Stack area in Oklahoma. Its portfolio companies made over $3 billion of acquisitions during the downturn.

Tremendous exits

Timing is everything in the business, with exits being no exception. There has been a flurry of spectacular private equity monetizations in the past year, primarily in the Permian Basin and Scoop/Stack, proving again that if you have the right timing, the right acreage and the right management team at the helm, great things will happen.

Before Kayne Anderson Capital Advisors sold Silver Hill Energy Partners (backed by capital from Kayne’s Fund VI) to RSP Permian Inc. in October for $2.4 billion, many factors were weighed. It flows back to what capital access and market conditions were at the time, the Kayne Anderson principals said. A soaring seller’s market for Permian assets didn’t hurt. In a matter of months, the Delaware Basin in particular went from being the industry’s neglected child to a rock star, with strategic buyers circling eagerly, driving up acreage prices to previously undreamt values.

“We contemplated all this and asked ourselves: Is it better to sell Silver Hill at $40 oil now and have the prettiest asset on the market at the time (using a long-term outlook of $60 or $70), or, wait until oil was actually hitting $60 and everything in the world was for sale? We decided to go ahead and run our process and we’re very pleased,” said managing director Chuck Yates. “We started Fund VI (and Silver Hill started buying acreage) at $100 oil and then it went down to $26, so to be able to monetize it like this … was a good deal.

“Being the PE guys that we are, every day we wake up everything is for sale—at the right price,” he said, only half joking. Kayne Anderson still has client companies with a significant presence in the Permian, as well as in the Scoop/Stack region, and any of these could potentially sell or look at a public offering, he added.

One advantage of running a portfolio of several E&Ps operating in different plays is the knowledge-sharing opportunities between them. “We’ve been able to say to a company’s management, for example, have you doubled your sand concentration here … have you tried this new frack log?” said partner Mike Heinz. “We’ll get the guys together and tell them about lessons learned because we’re seeing the latest and greatest from all across North America, and we can apply these best practices across the whole portfolio.”

Last October, Kayne and partner Casillas Petroleum Resource Partners LLC closed on a Scoop bolt-on package for $294 million.

One of the bigger examples of a successful Oklahoma exit, however, is that of Vitruvian Exploration II LLC, which just agreed to a $1.85 billion sale. The company was formed by Quantum Energy Partners in September 2012 under former Southwestern Energy Co. executive Richard Lane, with an initial commitment of $250 million.

By the end of that first year, Vitruvian II had acquired assets in the Woodford Scoop play and launched a two-year drilling program with up to four rigs. Net production grew to 183 million cubic feet equivalent per day (MMcfe/d) last year. Now, it has a PSA (purchase and sale agreement) to exit to Gulfport Energy Corp.

“PE is motivated by a couple of things—some sponsors have been able to take money off the table. That’s their purpose, that’s what they’ve promised their investors,” said Geoff Davis, managing director of Morgan Stanley.

“But for every one of those successful PE-backed companies there are 10 who might be struggling. There are something like 300 management teams out there now, so not all of them will have the right acreage or the top-quartile wells that make them attractive enough to sell to the public—or, find a private suitor. The market sees maybe 5% or 10% a year at best, of PE-sponsored companies that get to ring the bell.

“The S-1 … is only done when the story is going to be attractive to investors: it’s in an oily play, with great breakevens, with multiple lay­ers, and only for companies that have demon­strated low costs and good money management. The market’s savvy enough that it has to be in the right zip code for breakevens. That’s why the IPO and M&A markets have drifted to oily companies in the Permian.”

Morgan Stanley represented Devon Energy on the buy side and Memorial Resource Develop­ment Corp. on the sell side in their big trans­actions with Felix Energy LLC and Range Resources Corp., respectively. In monetizing Felix, EnCap took Devon stock and cash for the upstream portion for $1.9 billion.

Felix, initially funded by EnCap in 2013, had been approached off and on for about a year, Davis said; all the while its value kept increasing.

“Every new bid kept setting a higher floor. It took a substantial offer with a short fuse … there was a concurrent desire on Devon’s part to own the dedicated Tall Oak Midstream sys­tem and Felix wells dedicated to that system, which would be to their advantage on rates, capacity, timing. At the time this was done, in such a lower price environment, it appeared to be a dramatic offer.” Felix Energy I has already morphed into Felix II, he added.

There may be other private equity-backed companies that have filed … but that doesn’t mean they’ll go out, Davis said. “If you file an S-1, it tells the market that you’re looking to monetize … and if there is an alternate struc­ture or an amount that would derail an IPO at a good value, then bring it on,” he said.

Exit twists and turns

A good exit is always the goal, but getting the ball over the goal line can take a lot of plays. A private equity sponsor may have 30 or 40 teams in place, yet only a handful may be able to cross the line, where a return can be calculated. “There are a lot of examples of good businesses not ready for prime time,” said Davis.

Although an IPO is a frequently used exit strategy depending on market conditions, in the end it’s a partial exit. Dheeraj (D) Verma, recently named president of Quantum Energy Partners, explained.

“While you’ve created a pathway to liquidity with an IPO, you really only fully exit if you sell the stock later,” Verma said.
“Typically you take 15% to 30% of the company public and that capital comes in to help with funding its activities, but the major shareholders [private equity sponsors] get diluted over time.”

As we’ve seen repeatedly in the Permian Basin, the minute a company announces it’s preparing an IPO filing, it’s really signaling that it’s in play: it’s asking the marketplace to take a look and assign a value. That value can be achieved either in the IPO or an outright sale of the whole company, with the latter often being quicker and for more dollars.

One of the challenges for a private equity sponsor is that the market is always skeptical when a private equity-backed company says it will go public. So often it ends up being acquired instead, Verma said.

Such was the case with Vantage Energy LLC, which was fortunate to have assets in the core of the Marcellus Shale. Quantum and the Vantage management team under CEO Roger Biemans had pursued a dual path, working on an IPO in 2014 after having waited nine years, an unusually long time compared to the standard private equity hold period.

The S-1 for an IPO was filed in 2014, but the timing couldn’t have been worse given the downturn, so they withdrew the filing. “We just continued to develop the assets and we knew we had a great team with Roger. The plan was to go public later, but meanwhile, a lot of public companies were approaching us to sell. This was a Marcellus gas play but gas was only $2 to $2.50 so we were being patient—we weren’t going to rush out and just sell,” Verma said. “We’d talked to a variety of strategics too [buyers such as private equity or majors].”

The private equity backers put an additional $300 million into Vantage, but in early 2016 it got interesting. Alpha Natural Resources was in bankruptcy court and both Vantage and Rice Energy Inc. were looking at its Marcellus assets. Vantage Energy won them in May 2016. “We literally doubled down on Vantage and then sold it soon after to Rice Energy, which had been one of the other bidders.”

The Vantage IPO had been filed again, but literally a week before pricing, after the road show had been done and the market sentiment toward Vantage was being tested, Rice Energy swept in and bought Vantage for $2.7 billion, bulking up its inventory in Pennsylvania by 66%. Quantum received $1 billion of Rice stock as a Vantage selling shareholder, which made the deal even more attractive to Quantum and its private equity partners in the deal, Riverstone Holdings and Lime Rock. Each also took some cash. The deal closed in October 2016.

“It made a ton of sense when you put the two companies together, with all the synergies they had. We had built a real business over that nine years, and all along the way we had had offers, but gas prices were so volatile. It was pretty unusual,” Verma said, “because most PE firms don’t build a company from scratch like that. It’s a great example of a good exit.”

The end result was that Quantum, which had owned about 45% of Vantage, took more stock in Rice than cash, now owning about 8% of Rice, which is a recognized leader in the Marcellus with a lot of upside.

During the oil price downturn, many private equity-backed companies grabbed an opportunity to exit, especially if their assets were in the Permian Basin or Scoop/Stack plays.

Selling for value

EnCap Investments generally prefers outright sales rather than IPOs for its portfolio clients, although certainly both remain viable options. It has been busy throughout the downturn, having announced or closed more than $8 billion in strategic divestitures and $3.1 billion in acquisitions since 2015, according to Markham.

The largest was the combined sale of Felix Energy to Devon Energy for $1.9 billion and the associated Tall Oak Midstream to EnLink Midstream for $1.6 billion, in the Stack play. Recently closed was EnCap's divestiture of QStar Energy LLC, formed in 2013 but sold to SM Energy Co. for $1.6 billion. The asset base? You guessed right if you said Midland Basin.

Are any of these sales meant to offset losses elsewhere in the portfolio? “No, absolutely not,” said Markham. “We are selling where clear value has been created and we can generate strong returns for our investors. When we have the opportunity to turn a dollar into $3 or $4, then we exit.

“It’s about maximizing the value of each individual company and not playing one against the other across the portfolio. The basins that are hot [Permian, Scoop/Stack] where people are willing to pay a premium, to gain a strategic position, that’s where we have focused our exits. We look at each portfolio company individually and if we have created some real value, we’ll pull the trigger.”

Thanks to a challenging if not grueling two years of low oil prices, investors in private equity are of two minds: be contrarian and deploy capital, or wait it out. “I think it’s a risk-off environment, even if oil prices are coming back up and a lot of balance sheets have been restructured,” noted Marye, of Denham Capital. It has 12 E&Ps and two midstream firms in its portfolio and in 2017 will close on its next fund—the last closed
in 2013.

“I think the LP market is relatively fatigued by the oil and gas market overall, even though some funds have had good returns,” Marye said. “And we’ve all raised a lot of money from a relatively finite market. We at Denham have been fortunate in that we have a core group of investors and for the right set of opportunities, they are on board.”

In the end, in good times or bad, having a loyal core of investors and the right management team who can maximize the right assets, is the formula that makes all the difference.