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

As public energy equities have become more demanding—some say “persnickety”—it has fallen to the private sector to provide both growing capital needs and a wider range of options for private capital to gain liquidity. Gone are the days when private equity (PE) could rely on a quick cash sale to a public E&P looking for growth, or a partial sale to public investors via an IPO.

Issuance of equity for acquisitions has dropped off dramatically as many public E&Ps adhere to the new-found discipline of spending within cash flow. Exceptions may be made in instances where “bolt-on” acquisitions achieve economies of scale and are clearly accretive. If not, public equity markets have a habit of increasingly penalizing public E&Ps that come to capital markets for funding.

As a result, the once “taboo” move of one PE sponsor selling to a portfolio company backed by another PE firm has become increasingly common. Accepting public equity as currency along with cash in the event of a deal with a public E&P is often a necessity. And some portfolio companies are tapping debt markets so PE sponsors can send home early cash returns to investors awaiting a more receptive equity market environment.

PE Filling The Void

In large part, these moves have been born out of necessity, as PE has steadily filled a void left by a public E&P sector chastened by investors for its lack of capital discipline in recent years. From 2010 to 2014, PE’s share of the A&D market grew from roughly 10% to 50%, noted Wil VanLoh, CEO of Quantum Energy Partners. As of mid-May, its year-to-date share stood at close to 70%.

“Private-equity companies are stepping into the gap because, without them, there would be almost no buyers today,” said VanLoh. “The only places where public E&Ps can raise money today are the Midland and Delaware basins. I’m not sure they can do it in the Stack anymore. Even though the Marcellus is great rock, it’s gas; and gas is as out of favor as it’s ever been in the 28 years I’ve been in the industry.”

VanLoh attributed capital market weakness—in spite of higher crude prices of late—to the public E&P sector’s record of consistently generating a return on capital employed (ROCE) that, on average, has fallen short of its weighted average cost of capital (WACC). The sector has historically “generated horrible ROCE numbers. It’s been 6% to 7% and, in some years, as low as 3% to 4%,” he said.

While public E&Ps are “starting to perform much better, we’re probably a couple of years out before these companies can more easily access the market,” he continued. “It’s going to take time for E&Ps to generate a ROCE greater than their WACC so that the average investor says, ‘Energy’s a good place to invest.’ And until that happens, it’s going to be tough for these companies to issue much equity.”

Change In Buyer Universe

How are PE sponsors adjusting to changing capital market conditions?

According to Murphy Markham, a managing partner with EnCap Investments, the universe of buyers for oil and gas assets has undergone a significant change.

“We’ve seen a big change in that, historically, we were building assets and selling them to public companies that were primarily looking for a growth vehicle,” he said. “With the public [equity] markets being down, five of our last seven sales have been to other private-equity sponsors. In two of those sales, the buyers actually took over the management teams.”

Markham noted that EnCap has sold some $13 billion of assets over the last two and a half years, although “the current pace is significantly less.” The two transactions he cited—in which the larger PE sponsors purchased not only the asset, but also the team operating it—were each about $2 billion or more in size, with plans to expand further and potentially go public, he said.

“As a result of the public markets being out, we’ve sold to private equity, we’ve bought from other private equity,” commented Markham.

Historically, about 95% of EnCap’s portfolio companies have realized exits through sales into a cash market, with the IPO route chosen only occasionally “for the right team and the right assets,” recalled Markham. However, the IPO market “has been significantly down over the last couple of years. The result is that we’re happy to hold portfolio companies a little bit longer, develop them a little bit longer.

“It used to be that we could go out and get a lease play, drill a few wells and be able to sell it to the public market. Now that market is not there as much, we’re having to develop assets a little bit further. I think the market is looking for more proved producing reserves, and we just adapt to that. As a result, we’ve got management teams that are drilling more wells.”

VanLoh sees similar challenges—and necessary adjustments—in generating returns to Quantum’s investors in the face of an often unreceptive equity market.

“Broadly speaking, private equity is having a harder time of getting exits,” he said. “Not only is the IPO market much less open, but public E&Ps are also not nearly as acquisitive. The fact that IPOs are harder to do is also the reason why public companies can’t raise the kind of equity they used to raise in order to fund budget deficits or make acquisitions. Private equity may have to hold longer before they exit.”

Debt Dividend Recap

One strategy employed by Quantum to return money to investors pending a final exit is called a “debt dividend recap.” This involves having a bond rating agency assess a portfolio company, and then hiring an investment bank to arrange a roadshow with fixed income portfolio managers who can potentially buy the bonds. Some or all of the proceeds are then sent to Quantum’s limited partner (LP) investors.

VanLoh cited two such issues by midstream portfolio companies: an $800-million bond offering by Oryx Midstream Services II LLC, based in Midland, Texas; and a $365-million bond offering by Tulsa, Okla.-based Intensity Midstream LLC. In addition, on the E&P side, Sentinel Peak Resources, which acquired onshore California assets from Freeport-McMoRan Inc., completed a $250-million bond issue.

“While it’s tough to issue equity in public markets today, there’s a lot of debt capital available,” observed VanLoh. “When we went on the road with Oryx and Intensity, we went to the bond rating agencies, got rated, and went on a two- to four-day roadshow. The investment bankers built a book, we priced and issued the bonds, and three days later received proceeds and sent the money to our LPs.”

100% Of Upside Retained

Even as all or part of proceeds are returned to investors, equity upside is undiminished, noted VanLoh.

“We were able to send a lot of money home to our investors, and yet, we still maintain 100% control of the asset and 100% of the upside,” he said. “For Oryx, we returned multiples of our invested capital to our LPs. For Intensity, we returned almost 100% of our invested capital. And for our E&P portfolio company, Sentinel Peak, we took our entire equity of about $250 million out.”

At the same time, Quantum has been careful not to burden portfolio companies with too much debt.

“Oryx, Intensity and Sentinel Peak were all underlevered companies,” according to VanLoh. “They’d grown so much and had so much excess cash flow that we could borrow some money against future cash flows and send it home to our investors. We levered both midstream companies at less than three times debt-to-EBITDA. For Sentinel Peak, leverage was approximately two times debt-to-EBITDA.”

Given that PE firms now make up a bigger portion of the A&D market, transactions are more common involving one PE-backed company being sold to another portfolio company backed by a different PE sponsor—so-called “sponsor to sponsor deals,” said VanLoh. As an example, he pointed to the sale of Stack assets developed by Quantum-backed Vitruvian Exploration III to a Riverstone-backed portfolio company.

In addition, with the IPO window barely open of late, asset sales are increasingly likely to receive bids comprised of both cash and equity when selling to a public E&P. This was the case with the $2.7 billion sale of Vantage Energy LLC, backed by sponsors Quantum, Riverstone and Lime Rock Partners, to Rice Energy Inc. Consideration was split as $1.35 billion in cash and $1.35 billion in stock.

“If you want to sell to a public company, you have to be willing to take some stock back,” observed VanLoh.

Manufacturing A Strategic Buyer

Similar sentiments were echoed by Chuck Yates, managing partner of Kayne Anderson Capital Partners, who emphasized the importance of identifying a strategic buyer and being willing to accept stock as consideration in the current capital market environment.

“Today, the deals that get done involve what I’ll call the most likely buyer, the strategic buyer,” he said. This may be an E&P with adjoining acreage, for example, or one poised to share in an improving cost structure due to synergies and lower general and administrative expenses. And, in the event of a sale to a public E&P, the relationship may be one where Kayne Anderson is “willing to take stock,” which would avoid pressure from future financing needs on the acquirer’s stock price.

“It’s almost more important today to know what’s going on with the buyer than it is necessarily with our own assets—had we delineated it all and the like,” observed Yates. “That means we’re engaging with the strategic buyers when they want to talk. We spend a lot of time talking about ‘manufacturing a buyer,’ figuring out what the concerns are for the buyer and what we can do to get a deal done. It’s almost like a jigsaw puzzle these days in terms of making it happen.”

Likewise, as equity commitments are made to each portfolio company, Quantum tries to embrace the well-known Stephen Covey habit: “to begin with the end in mind,” according to VanLoh.

“The market may change, and the prospective buyer may no longer be a buyer in three or four years, but we spend a lot of time trying to build a business that a public E&P is going to want to buy one day,” he said. “And today that looks like the acreage has been largely de-risked, that the asset generates a lot of cash flow—because public E&Ps now need to be able to develop the assets with internally generated cash flow—and it’s located in a basin that is ‘hot’ today or is expected to be a ‘top quartile’ basin in the future.”

Early Returns To Investors

How important can a “debt dividend recap” be to a final portfolio company exit?

“Basically, there are only three ways to exit a portfolio company: sell it to a public company; sell it to a private company; or take it public,” said VanLoh. “If the market’s not great for selling assets, you’re buying yourself time, you’re getting money back to your investors, and you’re de-risking the investment by taking money off the table. Commodity prices have been going up, but they could go back down.

“The objective is to get an asset to the point where once somebody buys it, all they have to do is finance the acquisition—in other words, so there’s enough cash flow from proved producing assets to fund the drilling program without needing to issue more debt or equity,” he continued. “If an asset is not ready to sell today, maybe we use a combination of the cash flow and some of the debt from the bond issue to just keep developing it. It might be ready in a year or two from now.”

For the LP investors, the early return of funds is key in calculating their internal rates of return (IRRs).

“It gets money back to the investor sooner, which is always important in the IRR calculation and helps increase the IRRs on our funds,” said VanLoh. “If you’re trying to achieve 25%-plus rates of return, sending money home a year or two earlier goes a long way to doing that.”

Chris Sheehan can be reached a csheehan@hartenergy.com.

Comments