During the final months of 2010, industry watchers were paying special attention to E&P announcements, reading between the lines for insight about development strategies and revised sentiments about natural gas. A year previous, just as energy reporters were starting to think about the holidays, the surprise was the flurry of M&A deals that suddenly came across the wires. Near the end of 2010, however, the markets saw a different surprise when two well-known, gas-weighted E&Ps, Quicksilver Resources Inc. and Exco Resources Inc., announced plans to take the companies private.

"While each potential transaction must be considered on its own specifics, they represent a maturing of the downcycle and a natural consequence of plen­tiful financing," Stephen Richard­son, analyst, Mor­gan Stanley & Co. Inc., wrote in an early Novem­ber research note.

"For E&Ps, avail­able funding levers have proven key to financing development and growth in a low commodity price environment. Buyouts represent another alternative to weather the downcycle. This highlights a disconnect between required return and view of commodity upside in the public vs. private markets.

"While likely related to the perceived duration of the downcycle, we view the transactions as expressions of a common view; natural gas fundamentals have bottomed, and its cyclical nature will reassert itself for those willing to take a multiyear view," he said.

Quicksilver's announcement was made in mid-October, when the board received a letter from Quicksilver Energy LP indicating that it, along with members of the Darden family, wanted to explore strategic alternatives for Quicksilver Resources Inc. (Thomas F. Darden is currently chairman, and his brother, Glenn Darden, is president and chief executive.) The board quickly formed a committee of independent directors to consider proposed transactions, and Credit Suisse Securities (USA) LLC and Tudor, Pickering, Holt & Co. Securities Inc. were named as independent financial advisors. At the news, the shares rose from $12.61 to $14.65. At press time, they'd closed at $14.88.

On the heels of the Quicksilver announcement, in November, Exco Resources Inc.'s chairman and chief executive, Douglas H. Miller, offered to purchase all of the outstanding shares of stock of the company for $20.50 per share, a 38% premium over the October 29 closing price. At the news, shares climbed from $14.80 to $19.26. At press time, the shares were at $18.50.

The proposed Exco acquisition would merge the company with a newly formed acquisition vehicle. In his letter to the board, Miller wrote that he'd "discussed this proposal with Oaktree Capital Management LP, Ares Management LLC, and (major shareholder) Boone Pickens, and each has expressed an interest in pursuing the acquisition with me."

Miller also wrote that he expects to reinvest a significant portion of his equity ownership as part of the transaction, with the remaining financing coming from senior management, outside investment partners and, as needed, third-party debt financing. Barclays Capital Inc. and Evercore Partners are advising Exco's special committee; J.P. Morgan Securities LLC and Goldman, Sachs & Co. are Miller's financial advisors.

Betting on the Assets

"…This isn't a bet on gas," Miller said during a conference call in November. "I'm betting on the assets and the people. I'm also a believer that gas is going to be cheap for at least the next 12 to 18 months and I think it's an opportunity to get private and be ready to go, make some acquisitions."

No stranger to the take-private process, Miller took Exco private in 2003 and, in the mid-1990s, Dallas-based Coda Energy Inc.

It's not entirely surprising that select gassy companies are making this move now, says Kim Pacanovsky, a managing director at New York-based McNicoll, Lewis & Vlak LLC, a boutique investment bank and institutional broker-dealer. From a political standpoint, while there were many good pieces of pro-gas legislation written that could have improved gas demand, they were never passed and gas-weighted companies are pressing onward.

"Many management teams have taken a company public, then regretted it, because of all of the pulls of the public market," Pacanovsky says. "But at some point, if you're running a company and you have a large insider ownership position, if you see your work and the value you've created are not being represented in the stock price, selling the company or taking it private can be a reasonable solution.

"The one disadvantage is not being able to tap the public markets for capital, but with the amount of private equity available now, this isn't the big issue it used to be."

The appeal of going private has also grown during the past two years as the public finance markets have changed. Jack Aydin, analyst, KeyBanc Capital Markets, says, "During that time period, the way many E&P assets were being valued was a very haphazard process. Companies saw a lot of volatility in their stock prices and, ironically, there was a disconnect between stock prices and company asset values in the ground."

And the investment landscape has evolved. Exchange-traded funds, the increase in the number of foreign buyers interested in U.S. assets, zero interest rates—all of these things have changed asset valuations and the way the investment culture works. The turmoil in the financial markets also played a role, Aydin says, and the new environment, along with the rules, regulations and compliance inherent in the public markets, probably became too cumbersome for some companies.

"On a long-term basis, all E&Ps want to create net asset value, but private companies have the luxury of time and flexibility to unlock the resource upside value. Public companies are constantly pushed to meet or exceed production goals, and if a company misses them, it gets crucified regardless of whether the circumstances were beyond the company's control.

"Private companies still have investors to answer to, but the time horizon to see returns is different and as long as management is executing on its business model, near-term hiccups are viewed as bumps in the road."

Valuation Driven

If a public company can't get the valuations it seeks in the public markets, this is part of the incentive to consider going private.

"While we were not surprised by Exco's buyout announcement, we were surprised by the valuation," says Sunny Sekhon, financial analyst and vice president, Dahlman Rose & Co. "At roughly 10 times our 2010 EBITDA (earnings before interest, taxes, depreciation, and amortization), the multiple seems higher than normal for Exco, though this could be explained by large future potential and currently (and temporarily) weak natural gas prices.

"We believe, however, that a weak pricing environment could persist longer than a few quarters and could continue to weigh on the credit. An additional equity contribution could be required in order to consummate a transaction with a reasonable pro forma capital structure."

The company's third-quarter production was 29.5 billion cubic feet equivalent, reflecting daily production of 320 million cubic feet equivalent. Exco's capex budget for 2011 is $976.2 million, of which $768.9 million is allocated to development and completion activities. It currently has 25 operated drilling rigs across its portfolio, and operations in the East Texas, North Louisiana, Appalachia and Permian areas.

Meanwhile, Quicksilver Resources reported record average daily production, producing more than 362 million cubic feet equivalent per day in the third quarter of 2010. Total production for the period was 33.3 billion cubic feet equivalent (78% gas, 21% natural gas liquids and 1% oil and condensate). The company's 2011 capex is approximately $455 million, which includes $280 million for drilling and completion activities, $85 million for gathering and processing facilities, $50 million for leasehold and approximately $40 million for other property and equipment. Geographically, $320 million is earmarked for Texas; $110 million is for Canada; and $25 million combined is for other areas in the U.S.

Quicksilver has several hedges rolling off next year and it has a "company-maker" project in its shale-gas assets in the Horn River Basin of northeast British Columbia. There, the company's third completion had an initial production rate of more than 14 million cubic feet per day, and, considering the hundreds of potential locations and consistently strong results from nearby operators, the company could achieve a meaningful production ramp-up given adequate project financing and takeout capacity. Quicksilver holds 100% working interests in 20 exploratory licenses covering approximately 130,000 gross contiguous acres in the basin. Drilling to date has already validated eight licenses totaling nearly 50,000 acres.

"Unfortunately, it isn't receiving much credit for Horn River because the development timeline is very long and the market is very negative on gas right now," Pacanovsky says. "The management team did a really good job of building gas value when that market was gaining strength. Then the recession hit, and we saw companies picking up acreage in oilier plays. It's often in a company's best interest to have some flexibility with which commodity they are putting dollars towards."

Why Go Private?

Also, in line with staying flexible, Aydin says companies considering the take-private scenario shouldn't be highly leveraged. To go private, unless a company has an investor contributing equity, the money has to be borrowed. Companies with a smaller debt load are better positioned to implement such a strategy.

"Quicksilver is asset-rich, but it has somewhere north of 60% in leverage, so the question is how much more leverage does management want to assume. They could actually get more value if they sold assets in a piecemeal fashion. In this scenario, maybe it's worth paying a greater premium and taking on the additional leverage."

Companies with assets that have a good, long-term development horizon can be good take-private candidates, but management teams and private-equity firms have to be positioned to take risk near-term, as it relates to natural gas prices, Aydin adds.

"It's actually surprising that so many private-equity shops, flush with cash, haven't moved more aggressively in the gas-focused areas of the E&P sector. While each take-private announcement is a case-by-case situation, the outcome can be a good indicator of asset valuations in a specific area. And as those valuations continue to be examined, we're going to see more foreign interest in the E&P sector going forward, especially during the next year."

For gas-weighted companies that have fairly high insider ownership, a take-private proposal in the current environment may be a logical step. But the take-private model doesn't work for every company. It's also not something most management teams would encourage if they don't own a large chunk of the stock, because they probably don't want a group of money managers running the company, Pacanovsky says.

Investor Perspective

Houston-based investment management firm Triple Double Advisors LLC is in a unique position to evaluate the Quicksilver announcement, since it has been an investor on both sides of the E&P's balance sheet, says John White, vice president. Triple Double Advisors was an investor in Quicksilver's common stock and also currently owns its 8.25%, 2015 senior notes.

"On one hand, as a former stockholder, we were pleased with the take-private announcement, as we made a small gain on the stock," White says. "On the other hand, as a bond investor, we were disappointed because the bonds declined in price due to uncertainty about the capital structure."

The firm eventually sold its stock position because of the potential deal risk, he adds.

"We were also a bit surprised by the announcement, because, in our view, gas-focused E&Ps were not trading at a price that would reflect the reality of the current strip," adds Gabriel Chavez, vice president. "At the time of the announcement, stocks of gas-weighted producers were not pricing in $4 gas long term. Even now, as a result of this small rally in natural gas, these stocks are reflecting about a $6 natural gas strip.

"At the time of the go-private announcement they were pricing in about $5.50. If you think there's upside in the deal, and with the stock reflecting approximately $5.50, that's about $1 higher than the current 2011 strip. It's a big bet on natural gas."

Chavez says most of the upside, in his opinion, was priced into Quicksilver's stock when the stock shares reached a little more than $15 soon after the go-private announcement. The bonds, however, were a different story. They had traded as high as $109 during the summer of 2010, but dropped to $102 in November.

Chavez says natural gas stocks are likely being punished in the public markets as a result of increased 2011 capex budgets, and this is perhaps a sign that Wall Street isn't happy financing gas producers' very aggressive growth plans.

"From our conversations, getting people excited to take a big bullish bet on natural gas is a very difficult sell right now," Chavez explains. "In looking at the E&P companies, even average-quality oily producers are outperforming the best gas producers.

"What's interesting is that the dislocation between what the equities are pricing in—in terms of a gas-price deck—and what the commodity market is telling us, has grown ever wider. We are still on the lookout for early signs of a natural gas rally, but all of the fundamental data we look at regularly says it's not happening anytime soon."

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