PRIVATE CAPITAL: COMMON THREADS

In 2014, the oil and gas industry started coming undone. After years of heightened activity and unprecedented rewards, the energy space started bursting at the seams. It wasn’t the first time, and it won’t be the last, that it started to fray. But the industry’s finally becoming whole again, with private capital providers gathering the loose threads and weaving them back together.

It’s not a simple process. It takes observation to identify just how things started to split. And it takes dexterity and patience—nimble fingers for nimble capital deployment.

At IPAA’s Private Capital Conference held in Houston this January, providers shared their perspectives on the implications of the recent downcycle and how to be nimble moving forward.

While the industry is on the mend, things aren’t fully sewn up just yet. Even though “we’ve bottomed out, we are of the belief that we will be range-bound for the next couple of years,” as the industry works through these issues, said Sam Oh, founder of Mountain Capital, based in Houston. The firm focuses on the smaller end of the spectrum, with an average investment size of around $50 million to $150 million. Its current area of interest is the Lower 48.

Oh urged the industry to be mindful of the behavior that brought it to dire straits in the first place. The “classic case of the prisoner’s dilemma” in regard to production is a leading factor. “Keep producing; we see that at the OPEC level, there’s no real incentive for OPEC and non-OPEC countries to comply,” Oh noted. With that in mind, “five, 10 years from now, would I be surprised if we found ourselves in a similar situation? Probably not.”

Recognizing the limitations of a spot price-driven analysis could help the industry avoid repeating past mistakes. “Spot prices tend to drive a lot of sentiment, but spot prices in and of themselves don’t really drive fundamental value,” he said.

Mountain Capital examined the high-low for 2016 and saw that spot prices were up by more than 95%. However, looking at the 10-year forward strip revealed that they’re only up roughly 26% on a net present value basis, Oh said. People “can get really riled up” looking at spot prices, but looking further out is the ticket to a more reasonable assessment.

Brian Thomas, managing director of Prudential Capital Group’s oil and gas segment of the Energy Finance Group, based in Dallas, also pointed to the minuses inherent in the industry’s mentality. Prudential Capital’s Energy Finance Group had a $6.6 billion oil and gas investment portfolio as of September 2016.

“We’re an industry run by human beings,” Thomas said. “And human beings behave the same way every single cycle.” While that has its definite cons for the industry, it also comes with pros for providers: that very predictability offers up the opportunity for “students of human nature” to read their clients and “figure out 75% of the investing equation.”

Driven by human error, a significant threat to the industry’s success in the past few years was leverage. Looking at leverage over the past decade and a half—if you ignored 2015 and 2016—average debt-to-EBITDA for the industry as a whole has been around 1.5x, Oh said. “It feels like the right number for a business in a sector that’s relatively volatile.” But by 2016, the industry’s leverage had grown to a staggering and unsustainable 3.7x.

Glenn Jacobson, partner of Trilantic North America in the New York office, also warned against the dangers of rampant debt. Trilantic North America has four vehicles and is just shy of $6 billion of committed capital. “We’ve been involved in leveraged situations in the past; we certainly seek to avoid them,” he said. The firm views a prudent capital structure for energy businesses in the 1x to 2x debt-to-EBITDA range, “well in line with the long-term average of the industry, and certainly below where the industry sits today.”

Bringing the extreme levels of leverage down “is what we’re undertaking,” Oh said, “and I think that’s what you’re going to continue to see this year and into 2018.”

More focused portfolios

Another trend on the horizon is firm concentration, Oh pointed out. Mountain Capital runs a more concentrated portfolio, which is projected to have only six to eight investments. In the past, capital providers were too spread out in placing too many investments across the oil and gas sector. “We’re hearing that a lot of funds are becoming more concentrated,” he said. “I think that could go a long way to helping the industry.”

For its part, Trilantic North America is “very picky,” choosing two or three companies each year then going “fullbore” with the compa­nies as partners for two years, three years or whether it’s eight or 10 years, depending on the circumstances, Jacobson said.

As private capital providers scale down and maintain a lower number of portfolio compa­nies in individual funds—a far cry from 20 or 30 in a single fund, as Oh noted—they will have a greater opportunity to focus and become more diligent and prudent. This also frees capi­tal providers up to focus in on their parameters for teams they’d like to work with.

Jacobson shed some light on how Trilantic North America targets opportunities, high­lighting alignment and risk management in particular. With respect to the investment level by management teams, “there’s no set amount of equity,” Jacobson said. “To us it’s what we deem to be meaningful.” At the out­set, Trilantic North America believes that if it can draft an economic deal in a partnership agreement in which there is an opportunity for disproportionate upside to the manage­ment team, but the risk of losing money exists for both Trilantic North America and the management team, that goes a long way to limiting the risk that the management team is willing to take.

“There’s a nice balance of greed and fear where everyone sees the option plans and the incentive plans and what teams can make if it goes well.” As the provider, it’s Trilantic North America’s responsibility “to see the other side,” he said.

Still, it may have a greater appetite for risk within a broader portfolio on a case-by-case basis, depending on the area where drilling is. If one of their teams pursues multiple projects in a play Trilantic North America deems “less risky, or more proven,” and wants to test on the fringes, it will assist the team.

Hedging programs are near and dear to Tril­antic North America. As it brings wells online, it rolls a running hedging program for two-to-three years out on its PDP curve. The private capital provider prefers not to purchase PDP-heavy assets. The “bulk of our value resides in undrilled inventory,” protecting downside while not limiting upside. Hedging provides certainty of cash flow in the future, whereas if Trilantic “happens to have debt, [hedging] provides a base line for interest coverage and debt repayment.”

An evolving landscape

Mountain Capital has been “spending virtu­ally all of our time in recaps, special situations or prepacks,” Oh said. He drove the point home that while Mountain Capital is not purchasing debt securities, there are many overlevered companies out there in need of recapitaliza­tion—“situations where they’re literally levered eight to 12 times,” he said.

Looking on the horizon to the end of 2017, Oh anticipates Mountain Capital’s portfolio will have three or four companies; it closed one in late January, which will be its second funded investment. “We’re hoping to have maybe three or four funded investments by the end of this year that would essentially be recaps,” Oh said. So far, Mountain Capital has also backed one team.

In this “evolving landscape,” Prudential Cap­ital, a stable buy-and-hold investor not bound by a fund life, essentially invests across the entire private capital structure. Thomas broke down some of the major challenges.

The greatest impact has been on the senior debt market, Thomas said. Commodity price contraction of lending capacity will self-correct with rising prices in the short-term, but there are also lasting effects to watch out for. Cur­rently, tightened reins on lending activity, cou­pled with “Chernobyl-like portfolios” distract private capital providers.

The second-lien market also has its share of bumps and bruises, due to “limitations that are being placed on the sub class of secured debt as part of the capital structure,” according to federal OCC rules. Previously, the majority of second-lien deals that Prudential saw and participated in were 30% of total debt. Under the new OCC rules, Thomas expects that num­ber to dwindle to a mere 10% or 15% of total borrowing capacity, heading into the realm of stretched senior debt.

“Although there is OCC-driven dislocation, borrowers still need capital, and we are work­ing hard to meet everyone’s needs,” he said.