Private Equity Craftsmen

They say patience is a virtue, and this comes as no surprise to private equity sponsors, who are long accustomed to planning using a multiyear time horizon. In addition, private equity investments are often far from cookie-cutter in character, re­quiring intensive due diligence and backing from investors in for the long haul. Are there private equity sources ready to take on that particular financing?

Post Oak Energy Capital and Vortus Invest­ments are both Texas-based private equity sponsors focused on the upstream sector. Typ­ical investment size is on the order of $40- to $120 million for Post Oak, while for Vortus it falls into a range of $30- to $75 million. Both have an investor base made up largely of so­phisticated institutional investors: endowments, foundations, pension funds and, for Vortus, also some substantial family offices.

“It’s good to have partners who have a very long history of investing in natural resources,” said Post Oak managing director Frost Cochran. “There’s nothing about our strategy we have to explain to them.”

First fund

Based in Fort Worth, Vortus is focused on lower to middle market investments, with funding dependent on a prospective portfo­lio company having an identified asset in place at the outset. With a final closing in December of last year, Vortus raised nearly $300 million in equity commitments for its first fund. To date, over 50% is currently com­mitted, according to co-founder and manag­ing partner Jeff Miller.

“Vortus will continue to exercise patience and be very selective in its investment pro­cess,” said Miller.

“Since we always have an asset in place when we close, we do a tremendous amount of due diligence with the management team. It’s a very strict screening process,” he noted.

“We can be patient. It’s all about quality of asset, quality of management team. Is this an asset and a management team that, with our capital and with our human capital contribu­tion, we can make a much larger company? We want to achieve great things in our inau­gural fund.”

What are some characteristics Vortus typi­cally wants to see?

“First, it is important to have some histori­cal de-risking of the property itself or de-risk­ing of analog acreage,” said Miller. “Then a type curve is applied with which Vortus is comfortable, again based on existing develop­ment or analog acreage. Returns are then cal­culated using current strip pricing.”

Additional factors are considered, but Vortus is agnostic as to commodity, according to Miller.

“It’s a function of the quality of the asset and the degree to which you have to re­invest to hold the acreage,” he said. “We’re very mindful of where the asset is in its life cycle. We have to be mindful of the acquisition component, as well as the land component, and what the drilling requirements are, or if it’s held by production [HBP],” he said.

“Other factors are the prospectivity of the inventory and how you can add value,” noted Miller. “Can you add value by drilling more wells and de-risking other zones? Can you add value by lowering lease operating ex­penses, improving netbacks, restructuring contracts and so on?”

Vortus’ portfolio companies are set up as specific partnerships. This reflects each party’s separate contribution to the venture: the invest­ee’s initial asset that is contributed at the out­set of the deal; and the capital contributed by Vortus. Ownership varies, but Vortus typically holds a 60% to 90% stake in the partnership, with management owning 10% to 40%.

“Our approach is to really work as partners with the owner-operators,” commented Miller. “We love it when our owner-operators own a material part of the business. We like the alignment of interests.”

To date, Vortus has completed three trans­actions, with a fourth due to close in less than a month, and anticipates another three or four to fill out the balance of its current fund, said Miller. An investment horizon of three to five years is typical.

One early investment by Vortus, which has been rolled into the current fund, was an eq­uity commitment to Dallas-based Foreland Resources LLC. Funds were used to develop acreage held by Foreland in southwestern Irion County, Texas, that is prospective for Wolfcamp A, B and C horizons. Some 27 wells have been drilled to date on the current 18,000-contiguous-acre position, Miller noted.

“It’s a pretty robust southern Midland po­sition, surrounded by the likes of EP Energy Corp., Apache Corp., EOG Resources Inc. and another private equity-backed operator,” he said. “We’re excited about this investment.”

At the time of its initial investment, how­ever, Foreland had drilled only eight wells that were targeting the Wolfcamp B. “We used our investment to provide the drilling capital to de-risk the other benches of the Wolfcamp, and that’s how we earned our eq­uity,” Miller recalled.

A later, two-step strategy involved Vortus in­vesting with an experienced operator in East Texas and North Louisiana, an area that com­bines both conventional and unconventional re­sources. An additional equity commitment was made by Vortus to SND Energy Co., which had a core holding of 45,000 net acres at the time and was viewed as “a small company with ex­tensive experience,” according to Miller.

The first part of the transaction was in­tended “to put SND in a position to be more acquisitive and to be more aggressive with the drillbit,” he said. Five months later, in partnership with Vortus, SND acquired additional natural gas assets and vol­umetric production payments (VPP) from Chesapeake Energy Corp. and Morgan Stan­ley for $129 million.

As a result of the acquisition, SND’s acre­age in East Texas and North Louisiana in­creased to roughly 225,000 net acres, and its production totaled roughly 40 million cubic feet equivalent per day (MMcfe/d). Importantly, the HBP nature of the assets was expected to provide time to put to­gether a meaningful development plan for both conventional gas development and un­conventional gas resources (Cotton Valley, Haynesville and Bossier horizons).

“We saw an opportunity with a management team that had a tremendous amount of experi­ence in the area,” observed Miller. “Their skill set matched up with the size of the opportunity. As we’ve untangled the VPPs and folded them into the organization, we’ve grown the com­pany pretty substantially. We’ve significantly increased the scale of SND.”

Late last year, Vortus joined forces with a management team with whom it had worked previously, forming North Plains Resources LLC. The management team—whose previ­ous company, North Plains Resources LLC, was acquired by Kodiak Oil and Gas in 2012 for gross proceeds of $700 million—has “a very impressive skill set of being able to op­erate in the Bakken very successfully, both in its day-to-day operations and its ability to ex­ecute on a drilling plan,” said Miller.

The newly formed venture acquired as­sets located in Billings, Golden Valley and McKenzie counties in North Dakota from Whiting Petroleum Corp. While no transac­tion value was disclosed, the acquisition in­cluded 72,250 net acres that are HBP, as well as 17,339 undeveloped net acres. The acreage position has over 170 high-quality, undevel­oped drilling locations, according to Miller.

What are some characteristics Vortus typically wants to see?

“First, it is important to have some historical de-risking of the property itself or de-risking of analog acreage,” said Miller. “Then a type curve is applied with which Vortus is comfortable, again based on existing development or analog acreage. Returns are then calculated using current strip pricing.”

Additional factors are considered, but Vortus is agnostic as to commodity, according to Miller.

“It’s a function of the quality of the asset and the degree to which you have to reinvest to hold the acreage,” he said. “We’re very mindful of where the asset is in its life-cycle. We have to be mindful of the acquisition component, as well as the land component, and what the drilling requirements are, or if it’s held by production (HBP),” he said.

“Other factors are the prospectivity of the inventory and how you can add value,” noted Miller. “Can you add value by drilling more wells and de-risking other zones? Can you add value by lowering lease operating expenses, improving netbacks, restructuring contracts and so on?”

Vortus’ portfolio companies are set up as specific partnerships. This reflects each party’s separate contribution to the venture: the investee’s initial asset that is contributed at the outset of the deal; and the capital contributed by Vortus. Ownership varies, but Vortus typically holds a 60-90% stake in the partnership, with management owning 10-40%.

“Our approach is to really work as partners with the owner-operators,” commented Miller. “We love it when our owner-operators own a material part of the business. We like the alignment of interests.”

To date, Vortus has completed three transactions, with a fourth due to close in less than a month, and anticipates another three or four to fill out the balance of its current fund, said Miller. An investment horizon of three to five years is typical.

One early investment by Vortus, which has been rolled into the current fund, was an equity commitment to Dallas-based Foreland Resources LLC. Funds were used to develop acreage held by Foreland in southwestern Irion County, Texas, that is prospective for Wolfcamp A, B and C horizons. Some 27 wells have been drilled to date on the current 18,000 contiguous acre position, Miller noted.

“It’s a pretty robust southern Midland position, surrounded by the likes of EP Energy, Apache Corp., EOG Resources and another private-equity backed operator,” he said. “We’re excited about this investment.”

At the time of its initial investment, however, Foreland had drilled only eight wells that were targeting the Wolfcamp B. “We used our investment to provide the drilling capital to de-risk the other benches of the Wolfcamp, and that’s how we earned our equity,” he recalled.

A later, two-step strategy involved Vortus investing with an experienced operator in East Texas and North Louisiana, an area that combines both conventional and unconventional resources. An additional equity commitment was made by Vortus to SND Energy, which had a core holding of 45,000 net acres at the time and was viewed as “a small company with extensive experience,” according to Miller.

The first part of the transaction was intended “to put SND in a position to be more acquisitive and to be more aggressive with the drillbit,” he said. Five months later, in partnership with Vortus, SND acquired additional natural gas assets and volumetric production payments (VPP) from Chesapeake Energy Corp. and Morgan Stanley for $129 million.

As a result of the acquisition, SND’s acreage in East Texas and North Louisiana increased to roughly 225,000 net acres, and its production totaled roughly 40 million cubic feet equivalent per day (MMcfe/d). Importantly, the HBP nature of the assets was expected to provide time to put together a meaningful development plan for both conventional gas development and unconventional gas resources (Cotton Valley, Haynesville and Bossier horizons).

“We saw an opportunity with a management team that had a tremendous amount of experience in the area,” observed Miller. “Their skillset matched up with the size of the opportunity. As we’ve untangled the VPPs and folded them into the organization, we’ve grown the company pretty substantially. We’ve significantly increased the scale of SND.”

Late last year, Vortus joined forces with a management team with whom it had worked previously, forming NP Resources LLC. The management team—whose previous company, North Plains Resources, was acquired by Kodiak Oil and Gas in 2012 for gross proceeds of $700 million—has “a very impressive skillset of being able to operate in the Bakken very successfully, both in its day-to-day operations and its ability to execute on a drilling plan,” said Miller.

The newly-formed venture acquired assets located in Billings, Golden Valley and McKenzie counties in North Dakota from Whiting Petroleum Corp. While no transaction value was disclosed, the acquisition included 72,250 net acres that are HBP, as well as 17,339 undeveloped net acres. The acreage position has over 170 high quality, undeveloped drilling locations, according to Miller.

Investing through the bottom

Post Oak takes a dual approach to up­stream investments, funding both lines of eq­uity to E&Ps as well as investments requiring an identified asset to be in place from the outset. Its funding is split roughly evenly be­tween the two strategies, although expected returns vary widely.

Funding used to accelerate growth or ex­pand assets of an existing operating company are targeted to generate private equity-like returns of 25% to 35% or more, depending on the investment’s duration, said Cochran. However, if an investment involved a “true greenfield” opportunity, the project would have a goal of returning “no less than 2.5 times our money, and hopefully something better than that,” he said.

In instances in which it extends a line of equity, Post Oak is a control investor, typi­cally holding 85% to 95% of the capital, with management retaining the balance. In deals involving assets operated by an existing com­pany, the two parties are more likely to share control, with each putting up half the capital.

The investment horizon of a transaction is typically two to seven years, with a general expectation of five years.

Post Oak is currently investing its third fund, which, like its predecessor, was closed when it reached a “hard cap” of $600 million. The firm has resisted the trend to raise succes­sively larger funds.

“We view our fund size as a constant, and it is the rate of deployment that changes. The faster that we deploy a $600 mil­lion fund, the faster we’ll raise the next one,” said Cochran. “Our goal is to not tie up our fund investors’ capital in unfunded commitments, because when they make a com­mitment to us, they can’t use that capital somewhere else. And with a typical investment size of $40- to $120 million, $600 million has been the right fund size for us over time.”

In terms of its E&P investments, a “very long and successful partner­ship” has existed between Post Oak and Crown Oil Partners, according to Cochran. Currently, Post Oak has two tranches of investments with the Midland-based operator: an earlier $100 million commitment, focused on the Delaware Basin, and an in­vestment this year for $105 million, focused on the Midland Basin.

In the Delaware, where some un­certainty lingers as to where to land and complete wells for optimal re­sults, a recent increase in activity has led to results “very similar to those in the Midland Basin in terms of pro­ductivity and estimated ultimate re­coveries. In addition, drilling and completion costs for wells have come way down, like they did in the Mid­land,” said Cochran.

Another upstream relationship was made when Post Oak commit­ted a $100 million line of equity to UpCurve Energy LLC. The Hous­ton-based company has brought together a specialized team of former Cono­coPhillips employees focused on recompleting highly engineered horizontal wells in prolific shale plays. Leading UpCurve is former Cono­coPhillips reservoir engineer CEO Denis Pone, who holds four patents in enhanced oil recov­ery and production optimization.

Cochran said due diligence on the team’s ConocoPhillips work showed “very impres­sive” results.

“We were able to perform due diligence from publicly available data as to what the wells looked like both before and after they did their remedial work, that is, their re­fracks,” he recalled. “We were able to create from the public record their track record, and it was very impressive.”

Cochran predicted strong growth for Up­Curve based on “vast opportunities across nu­merous shale plays.” In acquiring assets, it has taken a “multi-pronged approach, includ­ing joint ventures, farmouts and outright acre­age acquisitions,” he said. “There’s a lot of human capital involved in terms of their ex­pertise, which is service-oriented, and they’re capturing that value by owning a position in the assets.”

In addition to upstream investments, com­prising about 75% of its fund, Post Oak may allocate as much as 25% of its investments to midstream and oilfield service. However, Cochran is quick to note the firm’s “core focus is in the upstream,” with the oilfield services sector viewed as an “opportunistic strategy that is a derivative of our upstream strategy.”

As an example, Cochran cited the energy industry’s rapidly growing use of production chemicals as it transitioned from vertical to horizontal drilling. This led to Post Oak’s in­vestment in chemical producer Refinery Spe­cialties Inc.—but with the caveat that no debt would be used.

“We don’t use debt in any of our ser­vice companies. As a result, our production chemicals company is quickly becoming one of the largest private production chemicals companies in North America, purely because it’s a survivor,” he said. “We didn’t buy it ex­pecting oil prices would go down, but we structured our investment such that it would have durability. And if that did happen, it would be the last man standing.”

According to Cochran, Post Oak’s inves­tor base is made up of large institutions that are mainly looking for exposure to the en­ergy space. “We’re not creating diversifica­tion by investing in small deals for them,” he observed. “No single investment we’re mak­ing is going to be meaningful in their overall portfolio. They’re just looking for exposure to the energy space over time.”

How does the investor base look at hedg­ing strategies employed by some portfolio companies?

“Most invest with us to be exposed not only to the entrepreneurial capability of the management teams, but also to be exposed to the commodity,” commented Cochran.

“If we hedge that away, we’re hedging away some of the exposure they’re seeking. We do some hedging whenever we use lever­age in our portfolio companies. We hedge to protect repayment of the debt, but we do not hedge to protect our equity returns. Our part­ners are investing with us with the expecta­tion that they’re getting exposure to both the good news and the bad news in energy.”

With oil having moved up substantially from a West Texas Intermediate price of $26 per barrel—and with new funds ready to in­vest following Post Oak’s latest fund closing in May—is there pressure to move quickly? Or is there a discipline to invest methodi­cally and not try to time the market?

At the time of the previous fund’s closing, when crude was trading around $100/bbl in early 2014, recalled Cochran, “we found very little opportunity in that environment to deploy capital effectively. We couldn’t find good value in that market.”

However, in the spring of 2015, Post Oak started to move more aggressively in deploy­ing capital.

“Timing is huge in our business. We went from a record low capital deployment in 2014 to a record high capital deployment over the second half of 2015 and the first half of 2016. And, barring a downturn in the global economy, we’re on track to continue that for the remainder of this year.

“Timing matters for sure,” continued Cochran, “but you can’t time the exact bottom of the market. We hope to be invest­ing as the market is bottoming, through the bottom and through the recovery.”