[Editor's note: A version of this story appears in the August 2018 edition of Oil and Gas Investor. Subscribe to the magazine here.]

What a difference a year makes. Throughout the past several quarters, there has been a significant slowdown in E&P deal activity compared to the near-record levels that were experienced in late 2016 through early 2017.

The slowdown is a function of shifting expectations among institutional investors of public E&P operators (publicos). That’s led to a derivative effect among private-equity-backed companies and their sponsors, as the ability to affect traditional exits through a sale to a publico or an IPO has largely evaporated.

In 2016, the mantra for publicos was “growth at any price,” and there was an increasing investor sentiment toward single-basin focus. Given the commodity price environment and the development economics of the various U.S. producing basins that year, a significant flight of publicos left their traditional basins and migrated toward the Permian Basin (and to a lesser extent the Midcontinent’s Scoop/Stack), which had become the Wall Street favorites.

Private-equity-backed companies were the beneficiaries of this model as they were able to nimbly amass large acreage positions and flip them to the publicos, which needed to fortify their drilling inventory metrics. Similar to the past, publicos were universally spending 120% to 150% of their operating cash flow on capex. The industry also saw a spike in acreage costs within the Permian and other popular basins, as the publicos scrambled to participate in the land grab.

The world changed in second-quarter 2017 when investors became focused on capital efficiency and return metrics rather than pure growth. Investors’ expectations changed, and the publicos were forced to live within cash flow. As a result, the E&P industry essentially lost its access to the public equity markets until it was able to prove it could grow without dilution and deliver full-cycle returns on the high-priced acreage acquired. For the four quarters ending first-quarter 2018, less than $6 billion of public equity was issued, compared with almost $30 billion for the same period ending first-quarter 2017.

Effect On Private-Equity Sponsors

The private-equity energy business model provides access to capital for nimble, experienced operators who seek to accumulate a group of assets (acreage), de-risk the asset by drilling delineating wells and sell the proved asset with significant upside to a larger industry participant.

Alternatively, the portfolio company may self-develop its assets—with the support and funding of its private-equity sponsor—and grow through offering an IPO. The choice to sell or IPO is generally a function of management’s depth, competencies and desires, the nature and growth potential of the underlying asset base, the capital needs to develop the asset and general market conditions.

The incentives of sponsors, via agreements with their LPs, and portfolio companies, via agreements with their sponsors, are driven by internal rate of return (IRR) and return on equity (ROE) metrics. The timing and magnitude of capital draws and returns are paramount in attaining the minimum required return hurdles.

The newfound capital discipline of the publicos, and the resulting decreased deal demand for bolt-on acquisitions, have caused an inventory back-up in the private-equity companies that had put together acreage blocks in hopes of flipping them to public operators.

While selected assets that are strategically positioned for the purchaser have continued to trade, there has been a significant slowdown in deal activity. The decline is highlighted in the accompanying chart. Note that if the Concho Resources-RSP stock merger is excluded from first-quarter 2018, then the average quarterly dollar volume for the last three quarters is about half of the level from the preceding four quarters.

The slowdown in deal flow is largely a result of the public markets eschewing the E&P sector. As a result, the IPO exit window has not been available to the more mature, developed portfolio companies, and there has not been an E&P IPO in the past six months. As such, the two primary exits for private-equity-backed companies have been unavailable.

With limited exits available, private-equity-backed companies have been forced to spend more time developing their assets. Imagine the position of a private-equity sponsor with 10 portfolio companies in various stages of maturity.

At year-end 2017, each portfolio company would have delivered a budget to sponsors to continue developing its acreage with a goal to make sure all of its acreage is held. (Leases typically have three-year terms and often contain drilling requirements.)

The annual exploitation budget, net to the sponsor, with each of its 10 portfolio companies having an annual one-rig program, averaging one well per month per rig, with an average AFE of $12 million per well, would be $1.4 billion.

The private-equity sponsors, as well as their portfolio companies, earn their extra returns based on the timing of their capital draws and returns. More fulsome development of the asset base by calling significant, late in life, capital will raise concerns about generating full-cycle investment returns in excess of the stipulated return hurdle rates.

Sponsor Response

Private-equity sponsors have reacted in multiple ways, ranging from defunding portfolio companies to rolling together companies in the same basin, to sales of companies to other sponsors.

In the past several months, there have been several private-equity sponsor to private-equity sponsor sales of portfolio companies. At first blush, this may seem irrational, but it makes sense in situations in which there is still considerable development drilling to be done and the selling fund is smaller than the buying fund, and/or the selling fund is close to the end of its fund life and the buying fund is just getting started.

From the selling fund’s perspective, it is able to calculate a terminal value and close out its investment. Assuming the portfolio company has been successful, management can lock in a nice multiple and stop the IRR clock from ticking while continuing to have access to capital to further exploit its asset base.

The buying fund is able to put fresh capital to work quickly and can get a multiple pop when the markets open up for IPOs or divestitures later on. There are also cases where companies move from larger sponsors to smaller sponsors when the project is working, but it is just not large enough to be exciting, or move the needle, for the larger selling fund.

Deal activity has experienced a significant slowdown largely due to the public markets avoiding the E&P sector. For the four quarters ending first-quarter 2018, less than $6 billion of public equity was issued.

There have also been several instances—especially when a sponsor has multiple teams in the same basin—in which two or more companies are combined to minimize the general and administrative burn while the sponsor is waiting for the market to turn. Further consolidation is possible. For example, as of May 2018, just six private-equity sponsors had made nearly $9 billion in commitment in the Permian Basin, to 47 companies, according to various reports.

In other cases, a sponsor can pull the plug on a portfolio company if it is not getting traction or is being outperformed by other peer portfolio companies.

As the private-equity sponsors seek to rationalize their capital, there has also been an increasing relevance of joint ventures and Drillcos. (See the March 2018 issue of Oil and Gas Investor on Drillcos.) These structures, which come in all shapes and sizes, allow an outside party to provide development capital, for a pre-agreed return, to be paid out of proceeds from the development.

This is appealing to a sponsor because outside capital is developing the assets in a structure that has a fresh IRR clock and hurdle rates that are less than its private-equity capital. Companies seeking Drillco arrangements, due to capital rationing by their sponsors, seemed to predominate at the February 2018 NAPE.

Outlook For Private Equity

Notwithstanding current market conditions, which have stymied investment exits, private equity should be the ultimate beneficiary of the current market situation. As stated earlier, there are still public companies that have not completely pivoted toward the single-basin focus that is being required by the public markets. As these publicly owned operators make these strategic moves, they will shed no-longer-core asset packages, which will be well-suited for private-equity-backed teams.

There will also be some fallout from all of the restructuring that has occurred since 2015. The restructuring recipe during the downturn was prepack, file, bankruptcy, equitize and emerge—with the same assets, same management and a dysfunctional shareholder base. This shareholder base, which largely consists of hedge funds, has its own IRR hurdles to deal with, and time is not a friend. These new owners are not long-term holders; they care little about the success of the company and are looking for an exit.

Since the equity markets will not currently accommodate secondary offerings, owners are seeking wholesale asset sales to generate liquidity or mergers of sufficient size to have enough float to accommodate their escape. These sales should generate some private-equity acquisition opportunities as assets move their way up and down the property food chain.

While estimates vary, it is generally accepted that there is more than $100 billion-plus of energy private-equity dry powder in the market. The market remains competitive. However, nimble and smart private-equity-backed management teams will continue to deliver excessive equity returns by exploiting market inefficiencies and applying technology and operational expertise to assets that have been starved for capital because of financial constraints and lack of attention.

Brian Williams is a partner and Brock Hudson is a managing director at Carl Marks Advisors, an investment banking and financial restructuring firm. Williams has more than 20 years of oil and gas investment banking, strategic advisory and operating experience focused on oilfield services mergers and acquisitions, public and private capital raises, restructurings, principal investing and executive management. Hudson has more than 30 years of oil and gas asset management and financial transaction experience including 17 years in oil and gas asset investment management and 12 years as a reserve-based energy lender. He specializes in structuring and leading complex and innovative acquisitions, divestitures and financial transactions and capital raising.

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