Investing in Energy the Private Equity Way
As the price of oil continues to bounce around down near $40 a barrel, energy stocks have been getting battered in the public markets. But that same destabilized market environment for energy has created certain inefficiencies that private capital should be able to exploit over the long term. In fact, private equity strategies are in a unique position to take advantage of the recent volatility and distress by acquiring high-quality assets at attractive valuations.
While over-levered oil and gas companies are now struggling to remain solvent, properly-positioned private equity investors can potentially profit from their instability. Today, capital markets that were once eager to finance O&G companies are now largely closed to new or follow-on issuances, forcing those companies in need of capital to compete for a limited supply of public funding. As a consequence, private equity funds with dry powder have increased bargaining power, which may take the form of attractive acquisition economics and better deal terms.
Another benefit private equity investors will likely be able to capture is industry talent. As an investor, it is essential to partner with the right operator, a professional who is familiar with the geology and production techniques of a specific basin. As many public companies lack capital to acquire new assets or develop existing properties, these firms have lost many key employees, resulting in a vast number of high-quality technical professionals—engineers and geologists—from which private equity firms may form management teams.
Patient private equity capital is also in a unique position to capitalize on three investment themes that are difficult, if not impossible, to access through the public markets:
- Non-core asset divestments. Private capital investors now have access to discounted properties from motivated sellers. For instance, throughout the energy boom, smaller companies that historically operated in a single basin expanded into new geographies, while larger more diversified companies grew land positions beyond their development capabilities. Now these companies are trying to maintain shareholder dividends or pay down excessive debt levels by disposing non-core assets. Private equity groups, through their proprietary networks, can acquire these assets for a discount from forced sellers in off-market transactions. While the seller views the asset as non-core, the private equity buyer may have regional expertise, allowing it to operate the asset efficiently and economically given the attractive entry price.
- Distressed debt. 1Another way for private equity investors to capitalize on the current energy market dislocation is distressed debt. In contrast to credit strategies that purchase distressed bonds and await a market rally, private equity operators may buy debt with the intent of owning the underlying asset after a default and converting these positions into equity. At that point, they can deploy experienced management teams to reduce operating costs and optimize production in an attempt to stabilize the asset for future sale.
- Small, regional deals. In contrast to investors in public equities, smaller private equity funds focus on opaque markets with less institutional competition often at a discount. In fact, from 2006 to 2015, deals valued below $100M transacted at a 28% discount to those valued above $500M, as measured by dollars invested per proved barrel of oil equivalent1. Moreover, a focus on smaller deals also allows these managers to take a regional approach to investing. It may be difficult to piece together a large, contiguous acreage package in the core of a popular basin (even in the current environment). However, opportunities exist to build scalable acreage positions by compiling small tracts with on-the-ground teams who have regional expertise and local networks.
A destabilized market for energy has created inefficiencies that private capital should be able to exploit.
Of course, private equity has its own drawbacks compared to public equity. It is less liquid, often comes with higher fees, and has an element of blind-pool risk, to name a few. However, we believe that a selectively constructed portfolio of small, targeted private energy funds is best suited to not only exploit the near-term market dislocations, but also provide attractive risk-adjusted returns over the full market cycle.
1J.S. Herolds; Property Listing Services; as of December 31, 2015.
There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors.