Given the tremendous run in private equity fundraising, it’s not unusual to hear of a private equity sponsor awarding an equity commitment of $100 million or $200 million—or even more—from its latest $2 billion fund. Once an experienced management team is on board, goes the logic, it makes sense to leverage its talent with a larger sum which, when put to work, likely involves a similar amount of project due diligence as would a smaller amount.

But what if E&P or midstream companies need growth capital in more modest amounts—say, $25 million up to $50- or $75 million?

In these tough times brought on by depressed commodity prices, it’s typically the smaller companies—often overlooked by institutional capital providers even in the best of times—that find themselves more exposed to increased volatility in funding during industry downturns. But there are some private equity sponsors that do focus on funding more bite-sized projects, involving smaller sums, and of course still needing to meet the requisite risk-reward parameters set by fund sponsors.

Not surprisingly, many of these smaller sponsors are not focused on unconventional projects.

Pearl Energy Investments, based in Dallas, focuses on investments requiring between $25 million and $75 million of equity capital. It announced the final closing of Pearl Energy Investment LP with total commitments of $500 million on September 30 of last year. The Pearl Energy team is led by managing partner Billy Quinn, previously co-managing partner with Natural Gas Partners, and partner Chris Aulds, formerly co-CEO of Teak Midstream LLC.

Investment opportunities are expected to span the upstream, midstream and, potentially, the oilfield service sectors, but the lion’s share, accounting for around 70%-80%, is expected to be deployed in the upstream sector, according to Quinn, with midstream accounting for 20% to 30%. The fund has yet to establish a “dedicated effort” in oilfield serves, given the difficulty in discerning the timing of a sustained recovery in that sector, but it may at some point comprise up to 10% of the fund, Quinn added.

“Both my partner and I have done energy service deals in the past. We’ve done very well on them, but they’ve tended to be relationship-based, where we’ve known people who have acquired a company and needed growth capital,” he said. “In four or five years from now, you’ll see some people who have made some fantastic oilfield service deals, but between now and then it’s going to be a difficult business. Most businesses are in the best case breaking even and, in some cases, bleeding cash.”

Ideally, Pearl Energy’s $500 million fund will comprise about a dozen portfolio companies. Of these, seven or eight would have investments of around $50 million, or higher, with the remaining companies each having a sub-$50 million allocation, according to Quinn. As of press time, Peal Energy had made equity commitments to two management teams, one in Canada and another in the Permian Basin. Funding for one of the two teams was made in conjunction with Natural Gas Partners.

“The first thing we’re looking for is great management teams with the right mix of geology, technical, engineering, land and business skills, as well as knowledge and a competitive advantage in a particular area,” he said. “They do not have to come with a deal in hand; we will back teams on G&A (general and administrative expenses).

“Currently, with commitments to two teams, we don’t have any assets. We’re completely comfortable with that strategy.”

Pearl Energy’s strategy is “focused first and foremost on acquisition and exploitation,” said Quinn. “Our acquisition/exploitation business plan will comprise 80%-plus of the E&P portion of the portfolio. The other 10%-20% could be some lease and drill; but very little lease and drill makes sense in the current environment, so it will be more acquisition-oriented.”

When assessing unconventional properties, project economics will guide decisions, rather than any underlying bias in favor or against unconventional projects, he said. For example, drilling three infill wells at $7 million apiece on a $100 million property generating $15- to $20 million in cash flow may make economic sense. But as for putting $20- to $40 million into leasehold and then having to drill 10 wells at $6- to $8 million apiece, “that’s not the business strategy we’re going to be pursuing. There’s very little in that portion of the market that makes economic sense today,” he said.

“Most of what still makes sense in the unconventional sector is held by the big producers, and they aren’t letting core assets go,” he added. “Most are letting go non-core, typically unconventional assets.”

As for preferring either oil or natural gas, Pearl Energy is agnostic. “We let the opportunities drive the investments. We want to see good investments and goods rates of return. The only caveat is that, as we construct the portfolio over time, we don’t want a portfolio that gets too lopsided one way or the other. We don’t want it to be 80% oil or 80% gas. We don’t want to see one commodity dominate the portfolio.”

Pearl Energy announced the selection of its first portfolio company, Calgary-based Wild Wind Petroleum Inc., in October of last year. Working with Natural Gas Partners, the two private equity sponsors made a combined equity commitment of $120 million. Wild Wind is focused on acquiring oil and gas assets in western Canada for the purpose of development and exploitation.

In some ways, this exemplifies the flexibility Pearl Energy enjoys in the range of deals it can consider, both in the E&P and midstream sectors.

“Pearl Energy is set up so we can back teams focused on smaller deals—hence our equity check size in the $25- to $75 million range—because that’s typically where you can earn the best rates of return. But as you build a portfolio based on smaller deals, you sometimes find larger opportunities—and in some cases larger opportunities with phenomenal rates of return,” said Quinn.

“Our philosophy is that we don’t want management teams setting up, on day one, to focus on larger deals. We see the right investment opportunity as being focused on the smaller end,” he observed. “But with strong relationships with our co-invest partners, we can easily step up and do larger deals. If we find something large—while not looking for it—with a great rate of return, the capital is there.”

On the midstream side, led by Chris Aulds, the former co-CEO of Teak Midstream, Pearl Energy sees many more acquisition opportunities than just 18 months ago, according to Quinn. Not only are E&Ps divesting midstream assets to raise cash, but midstream players themselves are expected to shed non-core assets over the next couple of years, he said. In addition, Pearl Energy would look at “greenfield projects that are backed by good contracts.”

Pearl Energy’s goal is to generate three times its original investment over a period of four or five years, “and we think we can do that with smaller checks,” said Quinn. With the invested capital enjoying a compounding effect over several years, this is the metric preferred by Pearl Energy’s investors and its management. The same risk-adjusted returns are targeted for both E&P and midstream, because “it’s all competitive,” he added.

Bayou City

Bayou City Energy has focused on serving E&Ps seeking smaller equity commitments as well, in this case, investments ranging from as little as $5 million up to $50 million. The firm is led by founding partner William McMullen, formerly with private equity sponsors White Deer Energy and, earlier, Denham Capital; and partner Mark Stoner, who previously was vice president of finance with Alta Mesa Holdings LP.

Bayou City’s strategy is designed to fill a “funding vacuum” among small E&Ps who have historically been underserved by the institutional capital market. “Operators work hard to boot-strap a concept into production and reserves,” Stoner said, “but often are disproportionately vulnerable to cash flow disruptions during volatile market cycles like the one we are currently experiencing.”

Bayou City’s equity commitments, which are 100%-focused on the upstream, will fall into one of two categories, according to founder McMullen. One is to provide small operators with traditional private equity growth capital. The other is to provide dedicated drilling capital for companies looking to accelerate development of world class assets.

When investing with a small operator, Bayou City’s terms will normally include control of the board. In the firm’s two recent equity commitments, both have been “control investments,” with a minimum 51% ownership. “We want to be additive in shaping and forming strategy at the corporate level,” McMullen said. “We don’t want to just provide dedicated working interest capital, where we can’t influence capital decisions and drilling programs.”

Activity by Bayou City portfolio companies typically targets conventional plays or, in some instances, shallow unconventional plays. The two portfolio investments to date have both been in conventional, shallow oil fields, where wells cost less than $1 million apiece.

Unconventional assets are largely off the radar for Bayou City, said McMullen. “It would be hard for us to play in the core of the core in the big unconventional plays given our fund’s size and targeted strategy. We look for assets that are production heavy and offer paths to growth beyond just putting new holes in the ground.”

The backbone of Bayou City’s business is aimed at “prosecuting the plays with the lowest F&D costs (finding and development costs) in North America, both in terms of new drill F&D and operational F&D,” observed McMullen. “We want to invest in resilient assets, meaning assets that have the ability to generate significant cash, even in the current environment.

“When evaluating opportunities, we look really hard at the lease operating expense (LOE) statement, because that gives us a good financial picture of the operational capability of an asset from a cash generation standpoint. And, of course, we look at the reserves and management, etc.”

Last November, Bayou City partnered with a north Texas private operator, TXON-SCZ LLC, as part of a plan to acquire and consolidate three proximate sets of assets under a single local operator. Bayou City first facilitated the merger of two entities to form TXON-SCZ, which then acquired additional oil and gas properties from a third party. The consolidation involved properties just outside Wichita Falls, Texas, across 22,000 acres that are held by production.

“The consolidation allowed us to achieve great economies of scale right out of the gate,” said McMullen. “This is long-lived production; it’s almost all oil. Production has been essentially flat for decades. There are a good number of near-term opportunities to improve existing operational margins of the fields by enhancing existing production or lowering LOE through increased scale. The consolidation and subsequent acquisition was important to the strategy.”

These types of fields have breakeven levels, in terms of LOEs, that are in the “low to mid-teens,” said McMullen, “so even at $35-$40/bbl, you’re still improving the balance sheet month over month from those barrels.” And while the current focus is on basic blocking and tackling to enhance output from existing wells, he pointed to “hundreds of PUDs (proved undeveloped locations) in this field that we think we’ll eventually develop in a drilling program as an avenue for growth.”

An earlier investment by Bayou City similarly involved long lived, low decline conventional oil fields in the San Joaquin Basin in California.

“Everything we step into is geologically de-risked,” noted McMullen. “We want to enhance and optimize existing production. Again, margin matters to us. We’re going to make money and create value by expanding that margin. That’s where our bread and butter is, that’s where we’re value creators. And if we build cash, there may be opportunities to use that cash to prosecute an accelerated development campaign or possibly do bolt-on acquisitions.”

Bayou City has an advisory board made up of a number of distinguished industry professionals, including Charles Cherington, co-founder and managing partner of Intervale Capital. As a private equity sponsor of oilfield service companies, Intervale has a synergistic relationship with Bayou City in that it offers access to oilfield service providers for Bayou City’s portfolio companies where it makes sense. The relationship with Intervale effectively brings “in-house” a comprehensive suite of operational expertise either previously inaccessible or financially impractical to Bayou City’s portfolio of small operators.

Bayou City Energy has focused on serving E&Ps seeking smaller equity commitments ranging from as little as $5 million up to $50 million. The firm is led by founding partner William McMullen (left) and partner Mark Stoner.

Talara Capital Management is focused on making upstream, middle market private investments in the U.S. and Canada. Investments include structured finance, mezzanine and drilling joint ventures, but the predominant focus is private equity with board control. Equity investments range from $25 million up to $100 million, but the firm’s “sweet spot” is $50-to $75 million, according to Talara managing partner and chief investment officer, David Zusman, CFA.

Talara Capital Management's “sweet spot” is $50- to $75 million, according to managing partner and chief investment officer David Zusman.

Talara has doubled in size over the last 12 months, bringing its portfolio of investments to some $500 million, while still having “a few hundred million in dry powder,” according to Zusman. With offices in New York and Houston, Talara has raised funds from some of the top endowments in the country, as well from large pension plans and family offices. Prior to Talara, Zusman was a partner and portfolio manager with Perella Weinberg Partners.

“We think the opportunity set in the middle market is particularly strong,” said Zusman. “There truly is a dearth of players in the middle market relative to the quite large number of companies in need of capital at this stage of the commodity cycle.”

Talara’s investment strategy is described as being more “asset centric” by Zusman. “On the risk curve, we tend to play between an ‘acquire and exploit’ and a ‘fast follower’ strategy.”

This means that a potential management team looking for funding needs to come knocking with both a business plan and a proposed asset acquisition in hand.

“At this point in the commodity cycle, we’re focusing on finding properties with a balance of currently producing cash flow and developable low cost assets,” he said. “We tend to evaluate opportunities on a developed basis. On day one, we want to risk a development plan for the asset.

“We’re looking for more than a team with a business plan and substantial G&A burn upfront. Obviously, the team matters a lot, but we need both the team and the asset. We’re focused much more on risking an already identified asset development plan, where over five years you can really drive cash flow. The vast majority of our exits are via the sale of proved developed properties.”

With E&Ps now competing in a “race for efficiency,” as opposed to the prior “race for land” in the now long-gone land grab, Zusman places a premium on efficiency and low cost structures. For example, “we tend to look for inflection points in asset efficiency, sometimes driven by improved completion techniques, sometimes by a shift to more of a development phase from a prior delineation phase.”

In late 2014, Talara lead a $70 million line of equity investment, along with company management, funding New Century Exploration LLC. Recognizing increased drilling efficiency and improved completion techniques in that part of East Texas, the company was able to acquire acreage prospective for the Eagle Ford and drill to expand production. This was an instance of a “fast follower” strategy, playing off analog data from offset operators to the south and east.

Zusman noted that some private equity sponsors serving the middle market will fund vertical plays, rather than being solely focused on horizontal plays. This can bear significant fruit if it involves using unconven­tional technologies.

“One of our themes is applying unconventional technologies to conventional reservoirs in some of these niche plays, which offer great opportunities in terms of returns and cash flow,” said Zusman. “We’re seeing a lot of investor interest in moving down market to these smaller opportunities, which have been overlooked over the last few years.”

As an example, Talara led a $60 million line of equity investment to fund Viola Oil and Gas Holdings LLC, an operator in the Illinois Basin that has used slick water fracking techniques in vertical wells, as opposed to the simple acid jobs previously performed. This led to “significant improvements in production,” according to Zusman.

“While we didn’t have an asset that we acquired, we had done a very significant amount of geologic work in a very well-defined area,” he said as regards the Viola investment.

In terms of restructuring opportunities, “we’re in the very early phase of a significant bankruptcy and restructuring cycle,” said Zusman. “Even if we get some improvement in commodity prices in the second half of 2016, we’ll still see a significant amount of restructuring opportunities. Our pipeline has exploded in the last three or four months in terms of the opportunities we’re working on now.”

Talara’s portfolio companies are run conservatively, with “very modest levels of debt, if any,” he said. In addition, significant hedging is employed.

“We’re a big believer that there’s enough operational and geological risk in portfolio companies that wherever you can reduce commodity risk, you should. It helps you be a more efficient player. If you can run a continuous drilling program with the same rig and the same crew, for example, that’s a better model to drive cost down and be more efficient.”

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