I-Banking On The Mend

Last year, after a long run of robust energy prices and plentiful investment, it became increasingly clear that the financial industry was ailing. By September, the credit-crash virus that had begun in the mortgage sector had spread throughout the entire banking industry, leaving anxiety and uncertainty in its wake.

Enter Dr. Obama, who injected the financial sector with a bailout package (the $700-billion Troubled Asset Relief Program) and a stimulus plan. Although not a perfect cure, the emergency care slowed panic fever and gave banks a fighting chance. Other countries’ governments quickly followed suit.

But not all endorsed the plan. Says one banking executive, “If the host governments had not bailed out the remaining over-levered institutions, there would have been more transactions.” Translation: Big banks wanted a clear shot at snapping up little banks.

Yet in May, when 19 of the largest banks underwent an FDIC-mandated stress test, most of them were given a clean bill of health.

The banking world saw 10 years’ worth of consolidation the week of September 15, 2008, says Greg Pipkin, managing director, Barclays Capital.

In fact, JP Morgan Chase & Co. repaid $25 billion of preferred-stock investment it had accepted through TARP and paid the U.S. Treasury $795 million in dividends on the preferred, including dividends that had accrued through the redemption date. In July, the bank reported a 36% jump in second-quarter profits.

Defending the government’s decision to inject cash into struggling financial institutions rather than purchase toxic assets, former Treasury Secretary Henry Paulson said his actions, “were not perfect,” but “saved this nation from great peril.”

Says Christopher Shebby, managing director and co-head of energy and natural resources for Stifel Nicolaus & Co., “The energy investment-banking sector is increasingly showing signs of life. After being absolutely flat on its back in the fourth-quarter of 2008, and for most of the first-quarter of 2009, the second quarter saw encouraging levels of activity.”

He notes that the factors driving recent activity in the energy sector are very different from those in 2008. Recent follow-on equity offerings have been defensive, largely meant to reduce debt and improve liquidity as opposed to funding acquisitions or growth.

“The primary aim of recent transactions has been to position the balance sheet to withstand a protracted downcycle and future commodity-price weakness in an environment where less credit is expected to be available, particularly after borrowing base redeterminations are completed this fall,” Shebby says.

As a group, investment bankers say they are closing both equity and debt deals that, for the most part, have been well received by the market. The oftentimes ludicrously high interest rates have come down. Oil and gas asset valuations can once again be quantified with some sense of certitude.

?Greg Pipkin, managing director, Barclays Capital in Houston, has worked in energy finance for 25 years. “The investment banking world went through an epic change the week of September 15, 2008,” he says. “We had 10 years’ worth of consolidation that week.”

When the smoke cleared, the world consisted of haves and have-nots, according to Pipkin. “The haves are the institutions that have specialty groups with seasoned bankers and balance sheets, which together facilitate the delivery of the full range of financial services. The have-nots are the boutiques playing in the not-so-competitive fringe. In the past year, the number of energy boutiques doubled and their fee pie shrank.”

A bought-deal cure

“While elimination of market risk is clearly the greatest benefit, the largest drawback (of the bought deal) is the inability to tell the story of the company,” says Jason T. Meek, managing director, RBC Capital Markets in Houston.

Meanwhile, M&A advisory fees are “way down,” says Pipkin, but Barclays has not been sitting on its laurels. So far this year the investment bank has acted as book-runner on several major upstream equity deals, including those by Anadarko Petroleum Corp., Plains Exploration & Production Co., Petrohawk Energy Corp. and Stone Energy Corp.

Shebby echoes the slowdown lament. “M&A activity remains very weak and IPO activity is nonexistent. Capital-raising assignments remain heavily focused on delevering and improving liquidity.”

To overcome shaky faith in the equity market, investment banks have developed a cure—the bought deal. Jason T. Meek, managing director for RBC Capital Markets in Houston, explains that true bought deals, where the underwriter takes title to the stock prior to announcement, are “an excellent way for companies to avoid market risk when seeking equity capital.”

This year, RBC acted as joint book-running manager for a $66.5-million bought deal for Penn Virginia Corp. It purchased shares at an 8% discount to the last trade and had them placed with investors prior to the market’s opening the next day.

Jim Warren, managing director of energy investment banking for SunTrust Robinson Humphrey, says, “We’ve seen 20 follow-on equity raises this year, with about five or six bought-deal transactions used to avoid market volatility and the erosion that can occur. As a rule, most of these raises were defensive in nature, meant to replenish balance-sheet liquidity and enhance borrowing-base availability, as opposed to supporting acquisitions.”

But not every overnight deal is a bought deal, Meek says. In fact, not all companies are eligible for a bought deal. General criteria for determining whether a bought deal is suitable include the company’s overall historical performance, its size, the size of issue as compared to float, the quality of institutional holders, trading liquidity and use of proceeds.

“While elimination of market risk is clearly the greatest benefit, the largest drawback is the inability to tell the story of the company. Some companies will benefit greatly by taking their pitch directly to the institutions,” says Meek.

Shebby agrees, but says, “If there’s no significant strategic story to tell in support of a capital raise, there’s really no reason to use a full marketing effort that includes a road show. Recent data has shown that fully marketed deals have priced at much deeper discounts that those deals that employ some form of an accelerated marketing approach.”

The largest oil and gas bought deal to date occurred in May, when Anadarko sold some 30 million shares of common stock at $45.50 each, for a gain of $1.37 billion. Barclays and Swiss bank UBS AG were joint book-runners on the overnight transaction.

Stephen M. Trauber, Houston-based global head of the energy investment-banking group, vice chairman of the investment-banking department and managing director for UBS, calls the transaction a two-handed deal.

“UBS and Barclays bought the equity,” he says. “We took the risk that we would be able to resell it to the market. That was a successful transaction that illustrated the ability for quality E&P companies to access the equity market in a big way.”

Bought deals are just one example of accelerated marketing efforts undertaken in support of equity offerings. Others include overnights, one-day marketed transactions and wall-crossing deals.

Although investment banking has recovered substantially from last September, it is clearly not at the level of 16 months ago, and it favors debt over equity. In fact, for some E&Ps, going to the equity market is “a sign of weakness,” says Trauber.

Jim Warren, managing director of energy investment banking for SunTrust Robinson Humphrey, says, “We’ve seen 20 follow-on equity raises this year, with about five or six bought-deal transactions used to avoid market volatility and the erosion that can occur.”

“Any companies that are tapping into the equity markets now are paying for it in discounts, which can happen at any time from announcement to pricing. Discounts can be as high as 15% to 30%, depending on the nature of the company and how desperate they are for the capital,” he says.

Other bankers note that the typical discount for overnight and accelerated book-build transactions has generally ranged between 5% and 10%, whereas the discount for fully marketed transactions has averaged more than twice that.

Keith Behrens, Dallas-based managing director for Stephens Inc.’s new energy group, says the discount is lower. “We have seen a fairly consistent 5% or smaller discount in equity offerings. The more liquid larger-cap companies have been at the low end of the discount range. I believe if the equity markets slow, possibly driven by soft gas prices, you will continue to see offering discounts like we have seen recently.”

Yet, it is also encouraging that there have been a few large private-equity raises, he says, noting Kohlberg Kravis Roberts’ recent $350-million placement in East Resources Inc. and EnCap Investments LP’s outlay in Talon Oil & Gas to fund its acquisition of Denbury Resources’ Barnett shale assets.

Meanwhile, pipeline master limited partnerships (MLPs) are top dogs in the current market as the U.S. continues to build out infrastructure.

“We’ve led the market this year, having completed about 18 equity offerings in the midstream sector,” Trauber says. “To fund their organic growth, as well as their acquisitions, midstream companies need to tap into the equity market frequently. Retail investors, who tend to be more defensive in this market, like these securities because they pay.”

SunTrust’s Warren says although the overall market has been markedly off this year, due to lower asset and equity valuations, “We’ve seen the investment-grade MLP universe actively access the bond market, which is very open to them.”

This year, SunTrust has been joint book-runner on several midstream debt issuances, including those for Magellan Midstream Partners ($300 million), Atmos Energy Corp. ($450 million), Oneok Partners LP ($500 million) and Enterprise Products Partners LP ($500 million).

But not all deals have been defensive. Warren notes there are acquisition opportunities for E&Ps having the wherewithal to buy assets from other independents, which are becoming more willing to divest, even if their noncore assets are worth less than in 2008.

Fort Worth-based Encore Energy Partners LP’s follow-on offering of 9,430,000 common units on June 29 provides an example. It priced the units at $14.30 each, raising $129.1 million to fund its acquisition of Rockies and Permian Basin properties from Encore Acquisition Co., and its acquisition of properties in the Midcontinent and East Texas from Exco Resources Inc., Dallas, for $375 million in cash. In addition to UBS and Barclays, joint book-running managers included Merrill Lynch & Co. and Wachovia Securities.

Warren observes that small-caps are experiencing more erosion in their equity as they trade well off their 52-week highs.

“Market caps are down, on average, as much as 70%, compared to 30% for large-caps. The small-caps have fewer levers to pull when accessing the markets, and they rely more heavily on bank borrowings that are under pressure from borrowing-base redeterminations,” he says.

Severe dislocation

Also opening up is the bond market, which is accepting high-yield bond issuances from a wide range of single-B to BB-rated issuers. “We have seen E&P independents complete 17 high-yield bond issuances this year,” says Warren.

“The high-yield market followed the recent equity offers,” says Stephen M. Trauber, Houston-based global head of the energy investment-banking group, vice chairman of the investment-banking department and managing director for UBS.

“The high-yield market followed the recent equity offers,” says UBS’s Trauber. “We’ve seen E&P companies issue long-term yields at relatively attractive levels, compared with those exhibited six to 18 months ago. Those deals were also a defensive measure as opposed to relying on bank debt.”

Shebby agrees, saying, “Bond yields have improved dramatically since fourth-quarter 2008, when the credit markets were significantly depressed and typical single-B-rated E&P credit was trading to yields in the high teens and low 20s.”

By the end of second-quarter 2009, those yields had contracted several hundred basis points (bps) and were trading generally at yields in the low double-digit range. In fourth-quarter 2008 and first-quarter 2009, single-B-rated credits were shut out of the high-yield market.

“As we progressed through the second quarter of 2009, the markets slowly opened up to these issuers, due in large part to strengthening commodity prices and greatly improved sentiment in the broader equity market,” Shebby says, citing Atlas Energy Resources’ $200-million high-yield issuance at 12.5% in July as an example.

Meanwhile, BB-rated E&P issuances traded to low- to mid-range double-digit yields at the height of the credit crisis at the end of last year. By early third-quarter 2009, yields for these credits had also contracted significantly and were trading in the high single-digit range.

“The improvement in sub-investment-grade bond yields is a sign that the credit markets have stabilized and that the worst appears to be over,” says Shebby. “While debt capital is certainly not as attractively priced as it was prior to the onset of the global financial crisis, the markets are once again open to sub-investment-grade issues with reasonably strong balance sheets.”

At press time, non-investment-grade, single-B company debt was trading from 9% to 11%, somewhat lower than last September’s range of 13% to 15%.

Says SunTrust’s Warren, “In September 2008, issuing commercial paper into money-market funds through the year-end was not an option for many investment-grade companies, so they were drawing down their revolvers. We had severe dislocation in the debt markets, even for investment-grade issuers.”

Consequently, commercial banks experienced heavy drawdowns on facilities that were typically envisioned as backstops, which tightened their liquidity. This, coupled with possible bank defaults, caused the London Interbank Offered Rate (Libor) to sharply increase against the Federal funds rate as banks tightened credit from other banks. By September, the three-month Libor had risen to 281 bps. But—good news—in July 2009 it fell back to a more typical 50.3 bps.

“We’ve seen bad markets stabilize this year, evidenced by a reduction in the TED (T-bills versus euro-dollars) spread,” says Warren.

Historically TED spreads range from 30 to 50 bps. Yet, in October of 2008, the TED spread gaped to 436 bps, “a significant anomaly,” says Warren. “That was a lock-up of credit among banks. At one point Libor soared to 474 bps. Today, the three-month Libor is down to 51 bps, the three-month T-bill is 17, so the spread is back to the mid-30s. That signals a market recovery with flowing liquidity.”

M&A malady

Despite the return of debt and equity deals, the M&A market remains somewhat stagnant, say investment bankers. The availability of capital is still low and it costs more than in previous years. More importantly, many E&Ps are trading at substantial discounts from 18 months ago, making it difficult for decision-makers to consider a sale.

Says RBC’s Meek, “For the first six months of 2009, E&P companies raised approximately $35 billion in debt and equity. During this same time period, the industry has traded only about $3 billion of assets. M&A and A&D were clearly not the drivers for the recent capital-market activity.” Meek expects busy fall and winter seasons for both M&A and A&D.

“The more liquid larger-cap companies have been at the low end of the discount range,” says Keith Behrens, managing director for Stephens Inc.

For such deals, stock-trade transactions are favored when both sides of the deal are valued in depressed shares. Conversely, a cash sale is less favorable due to its absolute-value nature. Also, there is not a lot of conviction that the market will steadily improve.

“Both buyers and sellers don’t want to look foolish by undertaking a transaction now when the market might get stronger, which is beneficial for the seller, or weaker, which is beneficial for the buyer. I am seeing a period of relative stagnation in the market,” says Trauber.

Not surprisingly, when capital and commodity markets stabilize, shale plays are expected to draw the lion’s share of new investment.

“Shale plays are a growth story, and they require a lot of capital. Investors are drawn to them. But there is still opportunity in the conventional oil and gas plays,” says Trauber.

The same is not true for service companies, he says. “There will be a bifurcation between companies driven by international opportunities and those focused on the domestic market,” he says. Large-cap service companies with oil-dominant customers outside the U.S. will draw more capital than domestic gas-concentrated firms, until prices pick up.

Meanwhile, some E&Ps have deliberately positioned themselves to weather the crisis, says Meek. The vast majority of capital-market activity for the first half of 2009 involved seasoned issuers who wisely bolstered their balance sheets and delevered by terming out debt or raising equity in preparation for what could prove to be a challenging natural gas environment for the rest of 2009.

For those that undertook such strategies, it was “a no-lose situation,” he says. “If natural gas remains weak, they will be able to weather the storm. If natural gas improves, they will be well capitalized to take quick advantage of low service costs by accelerating their drilling activity or by acquiring assets when their lesser-capitalized competitors are out of the market.”