?Earlier this decade, major merchant energy companies, such as Enron Corp. and Aquila Inc., had E&P mezzanin­­e divisions, operated as profit centers, that also provided physical positions for their trading desks. After those doors closed, only two E&P “mezz shops” survived—TCW Group Inc. of Los Angeles and Houston-based Wells Fargo Energy Capital.


Today, new mezzanine capital providers are sprouting up like Texas Bluebonnets in the springtime.


“Many industry people are aware that mezzanine finance is once again readily available,” says Michael Nepveux, Denver-based senior vice president of Wells Fargo Energy Capital Inc., a non-bank subsidiary of Wells Fargo & Co. “But I continue to be surprised by how many aren’t.”


Wells Fargo has some $11 billion dedicated to the energy sector. Of that, 40% is invested in upstream. Its mezzanine subsidiary, Wells Fargo Energy Capital, currently has about $500 million committed to E&Ps.


“We are the only mezzanine capital provider with an office here in the Rockies,” says Nepveux. It’s a good place to be, wih new unconventional plays opening and additional pipeline takeaway infrastructure under way.


As high commodity prices, new technology and resource plays continue to provide fertile ground for E&P start-ups, “mezzanine is the right solution for many of these companies,” says Nepveux. He points out that some of the newer E&Ps, even those that have yet to develop production, might assume their only capital source is private equity. That’s just not true.


Mezzanine providers such as Wells Fargo Energy Capital will finance embryonic E&Ps. As an example, Wells Fargo recently worked with a local private E&P that was started by two Denver-based energy veterans.


“That start-up didn’t fit into the typical private-equity investment model due to its small size and its very conservative investment criteria. We viewed it as similar to mezzanine risk,” says Nepveux. “The company really believed in making $10- to $20-million acquisitions of long-lived, PDP-dominated assets with low-risk upside. You don’t need a lot of equity to close and develop those kinds of assets, so they were just too small for today’s private-equity funds.”


Nepveux and his team arranged an equity syndicate that has since funded the company’s two major acquisitions, while also providing a second-lien credit facility.


“That’s an example of how we are growing with E&Ps right from the beginning. We will be with them right through to an exit,” he says.


While mezzanine cost-of-capital is slightly higher than commercial debt, mezzanine providers typically provide higher advance rates than commercial banks, which is essential to accelerate funding and development. Mezzanine shops also take more reserve risk than commercial banks, he says, and therefore require companies to raise less third-party equity capital than would otherwise be the case.


Also, as opposed to private equity, mezz shops allow owners to retain more of the upside, maintain control of the board and orchestrate the exit strategy.


“If an operator has proved locations to drill, and good expected returns, there is a good chance that he really doesn’t need to accept the dilution inherent in raising equity capital,” says Nepveux. “We are finding that many projects that have been on the drawing board for a number of years are now economic, due to high commodity prices. So it’s a good time to raise drilling capital using mezzanine finance.”


Wells Fargo provides debt against proved and lower-risk probable reserves to E&Ps that, in some cases, do not have a single producing well. Then, as production begins and grows, Wells Fargo will refinance the mezzanine loan with a senior, conforming loan.


“We’ve observed that some mezzanine shops seem to operate under a ‘scorched earth’ policy. By that, I mean some mezzanine shops are strictly transactional,” he says. “At the time of exit, when the equity kickers are to be sold, often there are differences of opinion on the kicker valuation. Many times, that ends the relationship. Most of our business is repeat, or referrals from former clients, so that shows customer satisfaction with prior deals,” he says.


In 2007, Wells Fargo led and underwrote hold positions of about $350 million in 35 discrete debt transactions. About half those deals were project loans with equity returns. The other half were second-lien type deals. On the equity side, Wells Fargo completed about a dozen deals, averaging one per month.


“And that pace is continuing this year,” Nepveux says. “About half of this year’s seven equity deals are direct investments and about half are fund investments, with an average hold size of about $8 million.”


On the debt side, to date in 2008, Wells Fargo has underwritten about $160 million of final holds in 14 deals, most of which it led. About half were project loans with equity returns and the other half were second-lien deals.

Expanding junior capital
Another mezzanine provider, Siemens Financial Service Inc. (SFS), based in Iselin, New Jersey, sees no slowdown in mezzanine capital flowing to E&Ps.


“We currently have an initiative to expand our junior capital investing,” says Kirk Edelman, senior vice president and general manager of energy investing. To that end, SFS plans to open a new office in Calgary later this year to complement its existing offices in Iselin, Atlanta and Houston.


SFS also plans to expand its Houston office, headed up by Charles Johnson, vice president and business development officer, within the next three to six months.


“When I refer to junior capital, I mean all of the forms of capital below senior debt but senior to common equity,” says Edelman. “It’s broader than simply mezzanine, and includes products such as second-lien debt, holding-company debt and even preferred equity.”
Second-lien debt is big in the E&P space, he says. SFS anticipates eventually converting its junior capital initiative into a fund structure with a targeted first-close between $500 million and $1 billion. The fund will benefit from the addition of SFS’ existing portfolio of junior capital investments.


“We are really bullish on this and we’ve gotten a lot of traction in a short period of time,” he says. “Over the past two years, SFS has been building a strong, diversified portfolio of junior capital investments in the energy sector.”


Edelman explains that without a track record, a typical first-time fund usually faces challenges attracting investors. “We believe that this will be less of an issue for us for a number of reasons. First, the originators average in excess of 20 years of experience each in energy financial services. Also, we are building an investment portfolio using proprietary capital, we have a significant deal pipeline and the Siemens reputation in the energy industry offers a tremendous advantage.”


SFS plans to continue to make significant investments in the oil, gas and power sectors. Edelman says SFS is one of the few firms that can “invest at almost any layer of the capital structure from senior debt to equity, and if necessary, we can invest in more than one layer in the same transaction.


“We are not forming the fund because we are short of capital. But we do want to bring in outside capital to help us continue to grow at the rapid rate we are now, and quite honestly, the economics of a fund structure are attractive.”


The firm is currently having discussions with potential partners who would serve as cornerstone investors in the fund and might play a role in the fund management company. “It is important for us to identify partners who share our views of the market opportunities but also complement the skill set that SFS has to offer,” says Edelman. The fund will be focused on mid-cap players for mezzanine and other types of junior capital, which is where Edelman sees expanding opportunity.


Recently, SFS worked with a Texas-based E&P looking to finance exploration activities in its Louisiana properties. SFS provided $20 million through a high-yield credit facility with a net-profits interest kicker. The deal closed during the third quarter of this year.


While SFS looks for placement of $10 million and up, it hasn’t come across a deal yet that has “stretched our upper limit,” Edelman says.


“We are not a bank. We are an industrial company. So we are not regulated by banking authorities. That means we can be more nimble and flexible than many of the regulated financial firms in the market,” he says.

Both hats on
“Mezzanine capital is back, in full force, but it is a little different from the past,” says Paul Beck, executive director in Macquarie Group’s Houston Energy Capital office. Macquarie also has energy capital offices in Calgary, London and Sydney, Australia.
“There are fewer project finance and mezzanine deals today,” says Beck, “but there is much more mezz capital from sources like hedge funds and independent finance companies.”


Despite Macquarie being a commercial bank, “we don’t really act like one,” he says. “We do provide senior debt capital, but have historically focused on mezzanine and equity. We really provide all forms of capital on the balance sheet. And the lines have become grayer than they used to be.”


To be successful as a project finance and mezzanine provider, “you have to have both hats on,” he says. It’s important that providers have experienced oil and gas bankers, but they should also be staffed from a technical perspective. Macquarie has 10 engineers and a geologist on staff to evaluate assets, in addition to its financial professionals. Altogether, they have more than 25 years of technical and financial experience in upstream oil and gas.


“We want to approach the business as an oil company would, so it’s important to act accordingly. We want to be able to understand the project at the reservoir level,” he says. “We don’t want to be wholly dependent on a third-party engineering report.”


Beck also notes that hedging capabilities play an important role. Using an outside hedging entity can create issues with inter-creditor relations and margins, especially with current commodity price volatility.


“We do all our hedging internally,” says Beck. “That removes the middleman and security issues. Effectively, we function as a wholesaler that doesn’t require margin.”


Nevertheless, Macquarie’s energy group is willing to take some price risk, particularly on deals that have large development drilling components. Beck points out that the risk is more on the reserve side than on the price side.


At press time, the bank had some $700 million in mezzanine capital committed to E&Ps. The group focuses on small and microcap E&Ps, offering $15- to $100-million mezzanine transactions, and going larger with syndicated deals.


“We have closed numerous transactions where a start-up is drilling from scratch with no existing production,” he says. “The key is that the management has a known track record and is experienced in its type of play.”


Going forward, mezzanine capital will be both more and less in demand from shale players, depending on the maturity of the shale plays, he says.


Mature shale plays are exhibiting less demand, due to a trend of consolidation. Acreage and its associated production is being consolidated into more closely held positions operated by large players such as Chesapeake Energy Corp., XTO Energy Inc., Petrohawk Energy Corp., Southwestern Energy Corp. and others. For example, the Barnett has become so fully leased and closely held that new mezzanine capital demand has diminished there, he says.


However, many of the new shale plays, such as the Marcellus and Bakken, are growing more active. Beck sees opportunities for mezzanine deals with small, lesser-capitalized indepe­ndents operating in those plays.

“As for the Haynesville, that seems to have zoomed by us as lease costs are so expensive now. But the New Albany and Bakken shales and the Montney shale in Canada could be fertile areas for mezzanine deals. In those less-mature plays, there should be plenty of mezzanine opportunity,” Beck says.

New funds, new office
In addition to the established mezzanine capital providers, there are a few new faces.


In June, Barclays Structured Principal Investing, an affiliated principal credit investment unit of New York-based Barclays Bank PLC, secured its target of $1 billion in capital commitments for its new fund, Barclays Structured Principal Investing Fund LP.


By collaborating with leading financial sponsors, the fund will provide $20- to $150-million transactions across a broad spectrum of private junior capital instruments. Its transaction portfolio ranges from unitranche, second-lien and mezzanine debt to holding company notes and structured preferred stock.


Also, in August, Barclays Capital, an investment banking division of Barclays Bank, launched its Houston-based investment banking team, formed to provide financing, advisory, risk management products and services to the energy sector.


Barclays’ Houston office managing co-directors, Joseph C. Gatto, Jr. (previously with Merrill Lynch & Co.) and Russell A. Johnson (previously with Deutsche Bank Securities) will combine energy investment banking and a commodities platform to provide sector-specific products investment and derivatives.


Barclays Capital has some $2.4 trillion under management, with offices in 29 countries and more than 16,200 employees.


Meanwhile, Calgary-based Invico Capital Corp. recently launched its CanBridge Capital Fund LP, an open-end mezzanine-type debt fund. The CanBridge Fund will hold a diversified portfolio of mezzanine-type debt investments in companies generally operating in E&P, oilfield services and related manufacturing, and real estate sectors throughout western Canada.

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