Oil and Gas Investor: The Great SPAC Comeback

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[Editor's note: A version of this story appears in the March 2021 issue of Oil and Gas Investor magazine. Subscribe to the magazine here.]

The special purpose acquisition companies, or SPACs, have always felt a little slippery and dangerous, like mercury bubbling out of a broken thermometer. Yet all of the market saw their undeniable power in 2020. A mudslide of money—more than $80 billion—was bankrolled for noninvestments. At their heart, SPACs are sleight of hand financial vehicles that, at the end of the trick, allow a private company to emerge from nowhere and take a bow through a backdoor IPO.

Investors filled up the coffers of shell companies at a record pace last year. After a public offering, SPAC shell companies go off in search of something to buy. The oil and gas sector saw that fad beginning, in earnest, in 2016. Billions powered SPACs to make what were, in retrospect, several foolhardy or overconfident investments in shale hinterlands.

The question now is whether SPACs, which have become vehicles for respected CEOs and celebrities alike, might return to the oil and gas arena, where an acute need for capital could help further consolidate shale resources.

Even in a down commodity market, energy-based SPACs have a lot of potential, according to Keith Behrens, managing director and group head with Stephens Inc.’s Energy Investment Banking Group. Behrens said Stephens is working with a group that will potentially launch an oil and gas SPAC this year.

SPACs, he said, are low-risk for investors by nature, with the capital raise placed into a trust with the option for investors to reclaim their money if an acquisition doesn’t get approved.

“I think hedge funds like this vehicle because it’s almost like a free option for them to invest capital,” Behrens said. “If you don’t like an acquisition … you can get your money back and make a return on your money by selling the warrant received as part of the investment.”

As with any similar investments, there are potential performance risks such as drops in commodity prices and unforeseen events. Management teams and sponsors bear the most exposure. They typically put up 2.5% to 3.5% of the amount raised in the SPAC IPO as sponsor capital into the SPAC. If the SPAC doesn’t work out, that capital can be lost entirely. The upside for the team and sponsors is a roughly 20% stake in the post-merger company.

A couple of recent upstream SPAC offerings, including Breeze Holdings Acquisition Corp. and East Resources Acquisition, suggest there is interest beginning to develop in the vehicles in the oil and gas world, Behrens said. Contrarians also see the current industry struggles as a good time to invest in distressed oil and gas.

“There is probably an appetite for more capital to come to the traditional oil and gas space. We’re involved in one,” he said, adding that he couldn’t share any details at this time.

Stephen M. Trauber, vice chairman and global head of energy with Citi, worked on many of the largest upstream SPAC transactions of the past decade, including ones that have persevered through choppy downcycles and others that were ultimately broken by market forces. Citi will chaperone between 60 and 80 new SPACs in the first quarter of 2021, though an oil and gas investment is likely to wait.

“You can see this has become mainstream,” Trauber said. “Everybody’s doing it. This is just another way for companies to go public.” What separates SPACs from traditional IPOs is who takes a front seat in writing the narrative of the company.

“What makes it unique as opposed to just going public is that it allows companies to be able to use their own projections,” he said. SPACs give companies the ability to “use their own projections and not rely on analysts on the Street.”

The current crop of SPACs is spread across all sectors, including clean energy, mobility, decarbonization, retail, technology and healthcare. The oil and gas sector remains a fragile area for investors seeking money for SPACs or conventional IPOs.

“Whether it be an IPO or a SPAC, which again is just another form of going public, do you have to have an investment community willing to invest in companies that are going public and within energy today? It’s very challenged,” he said.

SIDE BAR:

BANK BENEFITS

SPACs are hugely popular among investors, particularly among banks that have earned a bundle as underwriters.

In 2020 banks made billions of dollars from SPAC offerings, even amid an ongoing pandemic. As underwriters, banks receive a spread between the dollar amount they pay companies for their securities and the amount the underwriters receive from selling at the time of the public offering. In third-quarter 2020, for instance, Citigroup reported that its equity underwriting revenues, which includes IPOs and SPACs, grew by $484 million compared to the previous year—a 96% increase.

In a SPAC, “we get some of the spread upfront,” said Stephen M. Trauber, vice chairman and global head of energy with Citi. “We don’t get the full spread. We get part of the spread after the acquisition and it gets de-SPACed.”

More and more companies are also turning to a private investment in public equity (PIPE) for additional financing.

The private placement of securities adds validation both to existing shareholders and those who invested in the PIPE and can bring in others, including big name investors such as Fidelity Investments.

“It’s basically them saying, ‘I liked the acquisition, and I liked the price at which you’re buying it,’” Trauber said. “It helps generate enthusiasm for that. So the PIPE is profitable.”

The de-SPAC, which undoes the SPAC shell company, also generates fees through an M&A transaction. A new, public company emerges after the shell company combines with the private company.

The banks also help build a new client to lend money and help make acquisitions.

“If you’re an early stage, you’re in a much better position long term with that client to be able to generate fees like you would with any client,” Trauber said.

Trauber has explored the idea with some potential upstream oil and gas teams. Overall, Citi has been slow to act.

“As you can imagine, if this is just another form of going public, we don’t really have an ideal market out there right now,” he said.

However, Trauber said he expects to see a couple of companies enter the public space this year, “whether it be through a SPAC or through an IPO this year ... knock on wood.”

He continued, “We have that opportunity because we haven’t seen an IPO in the sector in a while except for one or two in the mineral space about a year ago. But until we have an IPO market and an investment community willing to invest in energy, it’s going to be tough to do SPACs in the energy sector.”

Up, up, upstream

Upstream E&P SPACs began their ascent in 2016 as well-known CEOs signed on to shepherd the selection of acquisition targets by blank check companies. Oil and gas industry leaders including Mark Papa, Jim Hackett and Steve Chazen headed companies.

“The investment community already had a great affinity for” those leaders, Trauber said. “They had made money for the investment community before, and they really wanted to back those individuals.”

Some fared better than others. Papa’s Centennial Resources Development Inc. has managed to sustain itself in the Delaware while Hackett’s Alta Mesa Resources ended, ignobly, in bankruptcy and liquidation.

“So the early ones, namely Centennial for instance, which was Riverstone’s first [SPAC] deal, were very successful,” Trauber said.

The first several upstream SPACs found success at a time in the energy sector in which the market was gently gliding higher and investors were still enticed by the sector, Trauber said. Growth was still being rewarded and the Permian Basin’s deals, particularly in the Delaware Basin, were on fire.

“If you wind back the clock a few years, there were all these positive factors,” Trauber said.

But as time marched on, the investment community and the energy sector hit rough patches, from small and large independents to the major oil companies. SPACs were just another casualty. “You look at all the energy companies that have fallen on hard times because of commodity prices and high costs, low returns,” he said.

One of the lasting imprints made by upstream SPACs has been the messy journey of Alta Mesa Resources, which attempted to unite an upstream E&P, a midstream company and a SPAC vehicle led by Hackett called Silver Run Acquisition Corp. II. The deal to unite the Stack play E&P and midstream companies cost more than $1 billion. By the end of its run, the company was a penny stock on the Nasdaq. Alta Mesa suffered from a precipitous fall in commodity prices and from choosing assets in what had been a premium market in the core Anadarko Basin.

“Right before that deal got done, it was a hot basin,” Trauber said. “Everybody was looking to try to make acquisitions in that basin.”

Hampered by rock quality, assumptions about well spacing and operational issues, the company sought protection in Chapter 11 bankruptcy after commodities tanked.

“It had very little to do with the SPAC structure and everything to do with the fact that energy was coming apart at the seams at the time,” Trauber said. “It was just bad timing at the end of the day.”

Energy IPOs faltered as investors came to see little need for more public Permian Basin and Bakken Shale companies. The industry’s shortcomings became clearer as well.

“The market was starting to come to the realization that a lot of these companies weren’t generating cash flow [and] weren’t generating returns,” he said. “So the IPOs became more and more challenging over time.”

Let there be SPACs

A potential SPAC comeback in 2021 in the oil and gas industry remains feasible. Analysts and bankers see them as natural acquirers for distressed assets. And beyond is still murky, although some see the investment vehicles as natural acquirers in the oil and gas industry.

E&P companies have struggled to find capital for acquisitions, and SPACs could again return to the sector as the need for additional consolidation shapes the oil patch.

In January, Enverus said private equity capital is already looking to take advantage of opportunities created by the oil and gas downturn. Other potential buyers include energy-focused SPACs.

Broadly, energy SPACs are hot, cutting across renewable energy and oil and gas, Opportune said. The two most recent oil and gas SPACs are connected to both energy veterans and deep pockets.

RELATED:

SPAC Acquisition Concerns Loom Despite Growing Popularity

In August 2020, Terrence M. Pegula, billionaire NFL and NHL team owner, raised $300 million in gross proceeds to acquire distressed oil and gas assets across the industry, according to federal regulatory filings. Pegula will serve as East Resources Acquisition’s chairman, CEO and president. Before his sports investments, Pegula cashed out his East Resources E&P north of $6 billion to Royal Dutch Shell in 2010 and American Energy Partners in 2014.

Without an acquisition, East Resources said it wasn’t the right time to comment on its SPAC.

J. Douglas Ramsey, who served as the president and CFO of Saddle Operating LLC, is also targeting the oil and gas industry, through Breeze Holdings Acquisition. The company raised $100 million in November. The company didn’t respond to a request for comment.

Andrew Dittmar, Enverus M&A analyst, said the window in which SPACs flourished in 2016 and 2017 was, in hindsight, a strong time in the energy industry. Few traditional IPOs were launched, and few private companies could build a private company from an asset base to IPO launch.

“While you couldn’t do that, you could do this backward system where you give them the cash first and then went out and found an asset and then bought it,” Dittmar said. “It provided a way for common investors, people on Wall Street … to participate—what essentially is the private equity business model in the industry.”

Dittmar said the model is similar to a private equity firm such as KKR or Blackstone giving an executive team a commitment to back a potential acquisition.

“That’s how the SPACs run that commitment. They raise the cash, they still have to find an asset, [and] you have the option to update or opt out,” he said. “Then they sort of are off and running from there. It was another way to tap capital for these teams.”

Private equity companies are also continuing to look for exits that SPACs could provide.

Those exits have been challenging. Diamondback Energy Inc.’s agreement to buy Guidon Operating LLC, backed by Blackstone, was one of the first exits Dittmar has seen in a long time. Dittmar said SPACs will return, to a degree. “There’s going to be a lot of acquisition opportunities in the industry over the next couple of years,” he said, noting that public companies will look to shed assets and private equity-backed teams are still looking for an exit.

Dittmar expects assets to be offered at modest valuations, with companies acquiring cashflow generating assets while paying little for upside. Public companies have prioritized saving cash, and with many of them with years of running room they already need to tackle, it’s less likely they will make big bids on assets. Private equity is also under pressure due to the number of their outstanding commitments as well as potential investor pressure to unwind investments.

“Someone’s going to take advantage of those opportunities,” he said. “We’re not going to let great investment opportunities go to waste. The capital to pick up these things is going to come from somewhere. And I think of it as part of it will come from the SPAC side.”

Some assets are particularly appealing, he said.

“It's a very attractive time to invest and then [acquire] distressed companies that lack access to capital,” Behrens said. “There are private equity-backed companies that are long in the tooth, and there hasn’t been an active A&D market to get those companies sold at compelling valuations.”

There are also many oil and gas companies with significant debt, and traditional IPOs have not been an option.

“Those are just natural targets,” he said. “So, yeah, it’s a great time to have a pool of capital and a public vehicle and be looking for opportunities.”

Undeniably, past upstream SPACs had their share of problems, including Alta Mesa. Behrens said that doesn’t discount the validity or usefulness of the SPAC model. Some of those companies were pounded, like the rest of the industry, by a sinkhole in the commodities market. In other cases, a play’s geology didn’t live up to its billing.

But Behrens said SPACs in other sectors have performed extremely well. “I think it’s kind of enamored investors to invest in these vehicles,” he said.

Renewed interest in SPACs may also be a sign of disquiet in the markets.

“The other thing that may be so attractive for investors is today there is probably less confidence on where the markets are going,” Behrens said. “So if you think about it that way, the market’s going to go up and down; there’s all this noise out there, there’s COVID [and] there’s an election.”

That’s made SPACs an attractive vehicle to “park” their money and earn a return “until things kind of settle out,” Behrens said.

SIDE BAR:

FOOLPROOF SPAC

TPG Pace Energy Holdings Corp. followed the pattern of its predecessors—chiefly by creating a SPAC that traded on the reputation of Steve Chazen, the former CEO of Occidental Petroleum Corp.

Backed by TPG, the shell company raised $650 million in May 2017 to form Magnolia Oil & Gas Corp. In a $2.6 billion partnership with EnerVest Ltd., Chazen targeted Eagle Ford and Giddings Field/Austin Chalk assets in South Texas to create the company. Chazen said he formed the company with a foundation on capital discipline, free cash flow and growth.

Andrew Dittmar, Enverus senior M&A analyst, said Magnolia also formed around what they considered a higher PDP component and shift from growth at all costs to making money. “Magnolia came around at the time that transition was starting,” Dittmar said. “So they went out and shopped for … something that could support capital returns out of the gate and kept the acreage payments moderate.”

Working through the same downturn, Magnolia hasn’t suffered as gravely as many of its peers. Magnolia ended third-quarter 2020 with about $148.5 million cash on its balance sheet and an undrawn $450 million revolving credit facility. The company has no debt maturities until 2026.

In a 2018 interview, Chazen said he wanted to create a company that was nearly “foolproof.”

“You’ve got to run these things so any fool can manage them,” Chazen said, “because eventually one will.”

Risky businesses

The profits generated through SPACs have whipped investors into a near frenzy, sparking concerns, or at least reservations, in the investment vehicle.

For private equity firms, “the economic incentives for these sponsors to do more is just huge,” Trauber said. “It’s 10 times. And so these guys are coming in and doing them.”

SPACs blasted off in 2020, with the number of shell companies created quadrupling to 248 compared to 59 in 2019, according to SPACInsider.com. SPACs generated proceeds of about $83 billion—six times the capital raised in 2019—and even a couple of energy companies managed to get into the mix.

While SPACs have existed since the 1990s, they have only begun to attract giant sums within the past decade, causing some concerns by financial experts. Opportune’s Josh Sherman and Lynn Loden wrote in January about their concerns that investors, sponsors and auditors should keep a close eye on SPACs.

“SPAC investors are simply betting on an all-star CEO or private equity sponsor for the chance to approve the company’s first acquisition and balance sheet structure in return for a share of the financial promote previously held only by the sponsor and management team,” they wrote.

Sherman and Loden said they like SPACs, which give capital an outlet to markets. But they worry that the current SPAC boom is “eerily similar to the shale boom,” which from 2010 to 2016 raised more than $100 billion in funds earmarked for the oil and gas industry.

“The result was an overinvestment in oil and gas acreage and asset development that either never materialized into a public vehicle or may have been brought to market too early through de-SPAC transactions,” they said. “Fast forward to today and it appears that an influx of new capital from SPAC IPO proceeds in 2020 may be helping to artificially escalate P/E ratios across all market sectors.”

Trauber said there’s little or no risk to SPACs. The investment vehicles have undergone a series of reforms since they were first introduced in 1993.

“There were some energy SPACs and a lot of those, because of what we’ve seen in energy, haven’t done well,” he said. “But you know this is applicable to any sector that has a large number of private companies because you’re buying private companies to go public.”

For banks, there’s little to no risk, other than to an institution’s reputation—in the event “you end up doing just a bunch of SPACs that never find acquisitions,” he said.

Banks do screen sponsors to see whether there are enough potential acquisition targets to make an acquisition. SPACs typically have about 24 months to make an acquisition, which ties up money for the banks and investors.

Trauber said a growing pool of dedicated SPAC investors are now behind the investments. SPACs, he said, feel like an equity investment with funds holding large amounts of capital they want to put to work.

“Most of these SPAC investors don’t stay in. They end up selling it [to] … ultimately long investors. But there’ve been great returns, you know? And so there’s very little downside with real good upside option value [which] is why people are playing it.”

But Trauber does see a potential for trouble without self-discipline from all stakeholders, particularly in the targets companies seek. So far, Trauber hasn’t seen SPAC valuations getting out of whack. But new entrants into the SPAC space give him pause.

“I do get a little nervous that you get euphoria in any area, in any product,” he said. “At some point, somebody pulls that last straw and things come tumbling down.”