What Is Private Equity Thinking?

DALLAS – In this period of consolidation on the horizon, every company in search of investors believes its assets are the most attractive.

What is private equity to do?

Post Oak Energy Capital Managing Director Frost W. Cochran offered some sage advice in just two words: patience and duration.

“You just have to have it or you are going to get market therapy,” Cochran said during the roundtable discussion, Management Teams, Waterfalls and Exits – What Private Equity is Thinking at the recently held Energy Capital Conference by Oil and Gas Investor earlier this month. “In the case of private equity it’s an investment class that’s really well suited for this mark and transition right now because we do have patience and we do structure companies for a duration.

“We have tried to structure teams the last five years for a duration as well in terms of having all of the disciplines necessary because if you don’t you are going to be on the receiving end of market therapy. Sometimes that’s helpful for an inpatient management team as they keep going out there pushing and trying to understand where their asset value is and be shunned by the market. But I think most private equity funds and investors are pretty well. … Rarely are we surprised the market views our assets at any given time and so we wait patiently for those windows to find our exits or recaps in hopes to kind of shepherd the assets in the management team’s direction.”

The three-member panel, which also included Denham Capital Managing Director Geer Blalock and Carnelian Energy Capital Managing Director Preston Powell, took on topical issues such what can be built that will sell today, what constitutes a sound infrastructure investment and investing with so much consolidation on the horizon.

Their message to potential investors and companies alike was: be smart, be bold and be willing to take chances. Here is a look at some of the questions the panelists answered during the discussion.

What is the DNA or thinking of those who have stayed?

Cochran: “In our case, we have had a very stable investor base because, in private equity, this is the case in other private equity shops that are Texas-based,  that layer of real assets is important in the portfolio of pensions and endowments and foundations which are primarily our investor base. It’s not as big of an allocation, of course, as we would like it to be, but nonetheless, they look at decades and not quarters and that exposure is important to them if you think about all of the other things they are exposed to in their portfolio.

“We do recognize the true fundamental value that’s in the space right now we are probably on the cusp of transforming from a capture mode to true cash flow and cash on cash generation. It needs to be proven, but I think there is enough capital out there that believes that is probably going to be the case. You need to allocate to the space.”

Powell: “A lot of times some of these investors come in when things are really low and they weren’t quite clear when they had the space before and then they pull back when things get a little tough. So that’s been an interesting thing. You have seen that in the public markets and to a degree you have that play out in the private markets, as well.

“A lot of these investors saw what happened in early the 2010s. Things were going pretty well for the private equity markets in energy.  Then funds got much larger and those returns were smaller and you saw some of those investors pull back.

“To Frost’s point, there [are] investors who stayed in the market and actually put more money into this because they see the opportunity so it’s been an interesting dynamic that isn’t just specific to the public equity market.”

What can management build today that will get sold?

Blalock: “It’s going to sound a little bit like a broken record but the emphasis that is being put on this industry by public markets ripples through the private side as well. To focus on developing assets with embedded margins and free cash flow that can stack up along with existing development  “As private equity buyers it’s important to build what the market needs or anticipate what the market needs in the future. Historically we build assets and we were selling them to a market window that was really focused on establishing inventory.

“So where do we go next? You are going to have to pay for that existing unit to where you try to stack up with the best economics. If not you have to deliver cash flow that can be utilized.”

Will any of you or do you suspect any other private equity firms may consolidate?

Cochran: “It’s definitely something that the industry in the act of doing. We don’t have a lot of history because we don’t run a very large portfolio. Our company tends to not overlap much so it’s hard to find great synergies among them, however, occasionally we have to consolidate companies with other private equity fund’ portfolio companies and those have been win-win strategies for the private equity sponsor to a large extent, the management teams as well. I think you can do that and become too big if you are not careful.

“There is a place where you do capture cost synergies, particularly in the long hold period.”

With the base of consolidation on the horizon, how do private equities management teams get over the asset evaluation of buying where everyone believes their assets are prettier?

Powell: “That in and of itself presents challenges. We show up with cash and we know what cash is worth. They have assets and typically there is a disparity in what those assets are viewed to be worth today versus what they will be worth. There is no magic bullet or approach there other than maybe it’s time to work through more creative structures to help bridge the evaluation capital.”

The industry seems to really be pushing back against the White House’s interest in keeping oil prices really low or does the industry like that just to keep Saudi Arabia in check? Do you think oil is too low?

Cochran: “We didn’t understand why oil was at 70-something. You can earn and fair and decent return when oil was at 50.

“We would all love oil to be 70-something but if Exxon can grow production at $50 and generate returns, we better be able to live in that world and produce in that world where if oil is 70 sell into it because it’s not going to stay there. If it’s 90 it’s really not going to stay there but if it’s 35 it’s going up.

“If you are a 5- or 10-year investor like us, that is everything. Our view on oil prices is driven by what’s the marginal basin supplying the world.”