With public and private upstream operators looking at alt funding to continue growth of operations, private equity-backed companies are also taking alternative approaches to their business.
After the downturn of 2016, private equity jumped into the oil patch to the tune of more than $100 billion and counting. Some of the most active quarters over the past few years have seen more than $20 billion deployed. Arbitrage was seen between the low prices of upstream assets that companies were unloading versus their inherent value; investing the time and money was a no-brainer for most funds.
The problem that private equity has always had: exit strategy. If timed correctly, they will jump into the market at, or near, a low to provide liquidity to the market and then jump back out as public companies have the capability to acquire. This was prevalent over the past few years as we saw upstream transactions reach more than 300 deals in 2018 alone, representing more than $80 billion. However, we live in a cyclical market, and if not timed correctly, private equity can be caught holding the bag.
As capital has dried up for public E&Ps due to hedge funds and investors demanding a return to profitability and banks shunning risk inherent to the sector, private equity has had a harder time cashing out. This is both due to a scale and liquidity issue. Consolidations for many larger E&Ps require what is known as “moving the needle.” This is a scale few companies reach (generally $1 billion and greater) as a standalone portfolio company.
On the other side, small and mid-cap operators don’t have the balance sheets to acquire due to the multiples being demanded for private equity to satisfy investors. Private equity is also less likely to take a stock transaction, which is easier for small- and mid-cap companies, as it is hard to show value to their investors if they become tied up in a public market with flighty retail investors.
The risk is more inherent on companies that received funding more than four years ago, as the typical fund has an initial life span of five years, with an extension of up to an additional five if investors so choose.
As the end life of a fund becomes clearer, the investment committee is less likely to allow capital to be deployed for fear of not getting a significant return prior to redemption notices. Now, some funds can roll forward and many have investors OK with an extension of the fund life. However, the writing is on the wall right now that many of these companies will not have an exit anytime soon, begging the question, “How does private equity exit?”
The short answer is they don’t. Instead, they flip the script.
Instead of buy-and-flip, they become operators themselves. The return to this strategy goes back to the days of DrillCos and joint ventures, where investors’ returns were more based on cash flow of exploiting the asset and tax deductions from drilling and completion expenses, rather than a quick flip. It is a different type of risk than buy-and-flip but is a time-proven model for good cash on cash returns.
The negative of this buy-and-operate model is that you need less portfolio companies within the fund to exploit assets under management. More private equity sponsors are starting to consolidate their portfolio companies to lower overhead expenses, but also to grow the asset base and drilling program potential for what will become their hold strategy.
By consolidating the portfolio companies, private equity sponsors are also making the assets more attractive to larger buyers that can still float bonds or equity to acquire assets. Consolidation is not limited to within the fund that the portfolio company is in. Cross-fund and cross-sponsor consolidation is also occurring to maximize the value of the assets these various sponsors hold.
Like many industries, buyout private equity has a large amount of dry powder to deploy, and with the recent shutting of capital markets to public companies, a new life has been given to private equity. Unlike a public operator, private equity can shift strategies to maximize returns based on what the prevailing market needs.
Capital deployment for upstream has started to shift focus to minerals and alternative lending strategies. By providing the liquidity the market needs to make deals happen and to allow operators without the capital availability to grow, private equity is more important than ever.
DrillCos are fundamental in allowing operators to prove up or grow an asset that is non-core compared to selling in a buyer’s market. Mineral acquisitions tied with upstream private equity-backed companies give additional value to acquisitions by providing higher net royalty interests and an alternative cash flow. These consolidated assets of minerals and producing properties are more attractive due to their long-term value in stacked plays. If an operator buys a private equity-backed company that owns the majority of minerals under its producing assets, you answer only to yourself where pooling laws exist and more revenue is retained, raising both net present value and internal rate of return.
We have seen less companies being funded in this transition to buy-and-hold as well as a rise in alternative funding. What is yet to be seen are the long-term implications on basins and offset markets, such as oilfield services, as we have more private operators developing assets.
Private equity tends to be more forward thinking, pushing the boundaries of basins, plays, and economics. They have spurred the growth and interest in basins such as the Permian, Powder River, DJ (Wyoming), Uinta, and Haynesville. Will the shift affect our growth as an industry and the movement to new undeveloped plays? Will we begin to see less exploration and exploitation onshore? Only time will tell how the public markets shunning of providing capital will affect the growth of our industry.
As we look to the future of liquidity and capitalization within our industry, we must focus on both public and private markets. Private equity, like hedge funds, provide liquidity to markets when conventional avenues are closed. They are the innovation drivers for expanding plays and improving efficiencies like venture capital is to technology companies.
While public markets are going through a fundamental change in our ever-cyclical market, private equity will fill the gap to ensure that we as an industry move forward. For public companies that are facing financial headwinds, private equity will be the one coming to their aid. It might not be this quarter or next, but as companies start to feel the pressure, or face selling an asset at a lower than needed multiple, private equity will be there.
Public companies come and go, PE will always be around. If you don’t believe it, look at how much money the largest funds have raised over the past year in anticipation of future exploits, more than $100 billion in 2019 alone that will be deployed over the next five years.
Following the money isn’t the easiest. Enverus has tracked more than 6,000 private equity events over the years to keep an eye on these trends, more than 600 of which are shown in Figure 6 depicting the fund raise and closure over the past few years.