FW moderates a discussion on private equity in the energy sector between Stefanie Fleischmann, general counsel at Beowulf Energy LLC, Andy Brogan, Global Oil & Gas Transactions Leader at EY, and Douglas Nordlinger, a partner at Skadden, Arps, Slate, Meagher & Flom LLP.
FW: How would you describe the current environment for energy-related private equity? To what extent are you seeing increased PE in the oil and gas sector, especially outside of the US?
Brogan: PE has played an important role in the sector since the economic downturn, providing a key source of investment for the mid-cap community. Compared to other sectors, PE firms find it relatively easy to access financing when investing in the oil and gas sector. There are several funds dedicated solely to investing in oil and gas, which have been formed and are gaining popularity. The field of active players is expanding, with new entrants joining specialist and generalist funds that have been active in the space for decades. The capital requirements of the oil and gas sector are high, which leaves room for PE players to invest. We recently conducted a survey of PE executives, which showed that respondents expected PE interest in the oil and gas sector to increase in all regions apart from Europe. The US, China, Russia and Brazil were the four countries that they singled out as being their focus for investment.
Fleischmann: Demand for high quality energy assets remains very high in the PE sector, with equity discount rates being bid into the high single digits. In our view, many of these assets are ‘priced for perfection’ with little cushion for operational or market results that fall below plan. We feel the best way to generate real returns in this market is through development, which does involve some upfront risk but if done correctly provides outsized risk adjusted returns on the back end as compared to currently operating assets. With respect to oil and gas outside the US, we have projects in both the Caribbean and Eastern Europe, which are considered emerging markets. Returns on invested capital must be significantly higher than an equivalent project in the US or Western Europe to compensate for added risk. For us, this creates opportunity if the financing challenges can be overcome.
Nordlinger: There has been a notable increase in private equity investment in the oil and gas industry. In the first four months of this year, oil and gas accounted for about 65 percent of all private equity investment in energy. The oil and gas industry requires, and will continue to require, a large amount of capital, and private equity has been moving in to capitalise on this. Furthermore, due to its disaggregated nature, oil and gas offers private equity a good choice of businesses along the entire value chain with a range of risk profiles to suit just about any investment mandate. There is an obvious role for private equity in the oil and gas sector in emerging markets, given thin public markets and weak banking systems, and we are seeing increasing activity in Africa, Asia Pacific and Latin America as emerging markets continue to develop, and as markets that were previously closed to foreign investment, such as Myanmar, begin to open up. In the electrical sector, there is substantial continued interest by private equity in conventional power generation in pretty much all geographic regions. On the other hand, private equity investment in renewable energy sharply declined by almost half in 2013, its third consecutive annual decline, with much of the decline being seen in late-stage venture capital, where investment decreased 70 percent from $1.7bn in 2012 to $500m. It’s unclear whether this decline, which has been caused by a variety of political and economic factors, including subsidy fatigue in some countries, will continue throughout 2014. There are notable hedge funds and private equity firms who remain committed to the sector.
FW: How would you describe the balance between buyers and sellers at present? Has there been a shift from a relatively seller-friendly market to a one where buyers have more strength?
Fleischmann: Higher quality assets enjoy ‘seller’s market’ status whereas lower quality assets – such as assets with commodity or sovereign risk – are considered ‘buyer’s market’ opportunities and are cheaply priced on a relative basis.
Nordlinger: Leverage as between a buyer and a seller is very situational. If we are asked to generalise, however, it seems to us that the market remains fairly seller friendly. This means that there are fewer deals and deal values are higher than in prior years. According to public sources, US deals have been valued at about 9.2 times on average in 2014, up from 8.8 times last year, and approaching the 2007 peak of 9.7 times. There could be a number of causes for this competition by buyers for fewer deal opportunities. One is that, particularly in the oil and gas industry, private equity investors are competing for resources with national oil companies – for example, in China – which might have lower cost of capital and lower investment return expectations. Another reason could be the availability of a buoyant stock market. Sellers who have assets might be more attracted to a share flotation on the public market than to private strategic sales. However, it is important to reiterate that each deal is different from all others, and just because a seller in one deal may appear to have bargaining leverage, does not mean that another seller in another deal will enjoy the same advantage.
Brogan: With the majors continuing to divest non-core assets and independents looking to farm-out stakes, there is a diverse range of assets on the market. While PE firms wanting to invest in the sector may face competition from corporates with strong cash positions, they are in a better position than last year. Our PE survey last year pointed to a valuation gap between buyers and sellers, but our Capital Confidence Barometer released in May 2014 pointed a closing of this gap. We think the closure is more due to sellers dropping their prices than buyers raising theirs.
FW: Are PE firms focusing on particular sectors or regions when seeking energy deals? Have there been any major deals of note in this space over the last few months?
Nordlinger: There has been considerable focus by private equity investors on the upstream sector as the race to develop shale gas and oil resources expands across North America. However, it seems that there has been a shift in this sector away from dry gas to oil and wet gas and to proven producing properties rather than unproved undrilled areas, potentially because of relatively modest prices for natural gas in the US. Buyout firms are also focusing on global oilfield equipment and services, as they can offer investment opportunities in established businesses. Furthermore, hydraulic fracking has opened up a new set of opportunities in the area to address the need for increased drilling activities, whether it be companies that are focussed on technological innovation or that provide water, chemicals or pressure pumping. Private equity deal action has traditionally been driven by asset disposals by strategic companies as a result of a decision to restructure or to shed non-core businesses. Numerous major independent oil companies are disposing of their downstream assets and some mid-stream assets such as refineries. Private equity might be involved in such acquisitions.
Brogan: I see PE firms currently being most active in North America, Europe and, to a lesser degree, the Middle East. Historically, investment has largely been focused on the oilfield services industry, downstream sector and the midstream sector in North America. However, the last few years have seen a major push by PE into the upstream sector. This was initially heavily oriented toward the onshore/unconventional plays in North America. The liquid market, short investment timeframe, availability of exit options and rapid returns are likely to continue to attract PE players to the large US shale plays. However, recently we have seen broader interest in both other mature basins, such as the North Sea, and exploration opportunities in emerging basins, such as West and East Africa. The potential returns available in this higher risk/reward activity have proved attractive to the funds that have the technological capacity to find the right projects.
Fleischmann: PE firms have their specialties, either asset wise or regionally, and we expect this trend of specialisation to continue. In the US, the biggest change we see has been the growth of fracking and cheap natural gas. This has had a profound impact on the electricity industry by reducing prices and accelerating the shift from coal. It has also spawned investment in many businesses that can either take advantage of cheap natural gas – such as LNG export or products that use natural gas as a feedstock such as plastic – or provide support to the fracking industry. There have been a number of deals in this sector, including the recent $3bn acquisition of Eagle Ford shale assets by Encana, and this trend will continue.
FW: Have there been any key regulatory developments within the sector that have impacted PE activity
Brogan: Generally, operational and Health Safety and Environment (HSE)-related regulation has been tightened and expanded. This has affected all market participants, including PE. More specifically, the MLP structure in the US has been a huge enabler for PE investment in the industry. Similarly, the changes in the UK decommissioning rules have allowed easier access to finance, and support the level of investment into that basin. We have seen governments in some regions increasing regulatory oversight and changing the rules for PE investments. Examples of these can be found in China, India and Japan, where rules on distressed investments have been changed. PE investors need to have a clear understanding of statutory and regulatory compliance obligations in each of the countries that they operate in to make their investments successful. Particularly sensitive now is the increasingly restrictive regulatory framework around transparency.
Fleischmann: Major regulatory issues include the uncertainty over carbon legislation, as that will create winners and losers that are hard to predict absent a clear directive, along with state and federal targets for renewable generation capacity, which may prove difficult to meet.
Nordlinger: There appears to be reduced private equity interest in renewable energy. It is possible that private equity’s confidence has been damaged by sudden government cuts in certain countries in renewable energy incentives. For example, in 2012, Spain, the world’s largest PV market in 2007 and 2008, suspended all incentives for new projects, and Italy, the largest solar market in 2011, set an overall €6.7bn cap on subsidies for solar technology. In a number of instances – Spain, Czech Republic, Greece and Bulgaria, to cite four – the cuts were retroactive and reduced the revenues of renewable power projects that were already operating. In the wake of Deepwater Horizon, heightened political sensitivity to environmental and safety issues has raised concerns about the potential long-term costs of private equity investment in the oil and gas industry.
FW: The energy sector is somewhat unique in terms of the pressure on companies to increase output while curbing environmental impact. What activity are you seeing with regards to renewable and sustainable energy sources? Are more PE firms gravitating towards ‘unconventional’ investment opportunities?
Fleischmann: While there continues to be significant investment in the renewable space, investments have not performed that well and if anything the investment trend is moving away from renewables due to reductions in the cost of technology, cheap gas as well as policy uncertainty. Peak investment in this space was 2-3 years ago and we expect this downward trend to continue.
Nordlinger: It may be that private equity owners of businesses could pursue opportunities to achieve energy savings through investments in distributed electric power assets. For example, a number of securitised distributed electric generation financings have occurred and are under consideration in the US. The transactions involve financings on the basis of a pooling of a large number of rooftop solar panel installations, for example. This type of transaction might be attractive to private equity owners of large-scale real property portfolios. Those private equity funds might also be interested in participating in other types of energy efficiency investments, perhaps relying on new, innovative technologies. In this regard, the US Department of Energy issued a draft solicitation on 16 April 2014 for the issuance of up to $4bn in US federal loan guarantees to back innovative renewable energy and energy efficiency projects and technologies.
Brogan: PE firms have been active investors in the alternative and renewable energy space for a number of years now, providing an important source of finance for the technology-led developers. The real growth story over the last few years has been PE activity in the unconventional oil and gas sector in North America. PE has been an important source of funding for startup ventures targeting shale opportunities in the US. Shale gas and oil was identified by our survey respondents as one of the biggest game changers in oil and gas PE over the next five years. The success in the US has sparked PE interest in emerging unconventional opportunities in other parts of the world, such as shale gas in the UK and tight oil in Argentina.
FW: What unique challenges and risks are PE firms likely to face when operating in the energy sector? What advice can you offer on managing and mitigating these risks?
Nordlinger: A number of sectors in the energy industry are highly regulated. They are susceptible to environmental, safety and political risks, as well as volatile commodity pricing. Some of these risks arise because the sectors involve substantial upfront capital investment, relying for returns on long-term streams of cashflow either through spot sales or long-term contracts. Managing these risks requires a number of strategies, including: conducting extensive due diligence into the target and local co-investors and joint venture partners; structuring the investment carefully to take advantage of investment protection treaties, double taxation treaties and tax efficiencies afforded by vehicles like the master limited partnership; thinking through potential exit routes; engaging in careful contracting to mitigate against commodity pricing and exchange rate fluctuations; negotiating product sharing and concession agreements that protect against expropriation and secure the ability to remit profits and obtain fiscal benefits; utilising talented management with experience, contacts and resources in the target region; instilling a culture of health, safety, environmental, and anti-bribery and corruption regulatory compliance; and potentially obtaining political risk insurance.
Brogan: The oil and gas sector is one with very high potential risks. Operationally, a lot of the activities can be potentially very dangerous and a relentless focus on the HSE issues is essential. The industry is also politically sensitive and requires expertise in managing government and national oil company relationships. Additional complexity comes from the industry’s common practice of conducting its operations through joint ventures with consensual decision-making. Finally, particularly for upstream, the investment pattern can differ from standard PE models as successful exploration tends to lead to massive additional investment requirements, rather than instant returns. It is essential that PE houses entering this particular sector understand this dynamic and have a fund structure that can accommodate it. A focused approach to identify and understand potential risks during due diligence is necessary for evaluation purposes. It is important that investors consider not only the risk profile they are buying into, but also how this may change over time and how they can manage this.
Fleischmann: The key challenges we see are, firstly, managing commodity risk, as a wrong bet can be catastrophic, as evidenced by the Energy Future Holdings bankruptcy, and secondly, managing operational risk, as PE firms expertise in financing does not translate into understanding the intricacies of managing a large scale energy asset.
FW: When structuring and negotiating energy deals, what steps should PE firms take to help drive returns and value further down the line?
Brogan: PE firms that are most successful often start with the exit in mind. In many cases, PE firms identify a handful of specific potential acquirers that can help drive the development of value creation throughout the ownership period. Ensuring that all parties are aligned at the outset of the deal is critical. An effective strategy can be to take a smaller stake at the outset and ensure that management has enough equity interest to remain sufficiently aligned to execute on the strategic vision and seek out additional opportunities for the entity. I think that the most important determinant for success is having the right management team in place and successful PE firms often have strong relationships with management teams well before the initial investment. However, when a change is needed, they make it quickly.
Fleischmann: Entry point is extremely important, as overpayment for an asset will make it very difficult to generate adequate returns no matter how well the asset performs. Also, as discussed earlier, we feel that PE firms will find it very difficult to provide the returns they are promising their LPs unless they take some upfront development risk or backend commodity risk. Of course, these risks need to be carefully mitigated, with entry price being a big component of this. We see many investments made where the returns are advertised as ‘contracted’ and therefore premium prices are paid, yet significant back end residual risk remains. PE investors need to make sure they acknowledge this risk and reduce their price accordingly – which can be hard to do in a competitive auction scenario when they are trying to put money to work.
FW: How are companies within the industry enhancing their focus on governance and fiscal rigour?
Fleischmann: Increasing transparency in governance is a trend PE firms are following, both with their portfolio companies as well as for their LPs.
Brogan: Regulators are broadening the scope of their focus on the industry. As a result, PE investors are demanding more transparency from the firms with which they do business. This changing environment has placed a large burden on compliance teams, who must have an intimate knowledge of regulation in each of the geographies in which they operate. A stable fiscal regime is a critical factor for companies involved in the oil and gas sector. Long-term investment decisions are made on the expectation of certain rates of taxation, and changes to those rates can undermine the economics of projects and limit future investment in affected geographies.
FW: How would you characterise PE exits in the energy sector at present? What exit routes are proving popular in today’s market, and with what levels of success?
Nordlinger: There is a large amount of capital to be exited in 2014, but the options look good. Sales to corporate acquirers have been and will remain private equity’s most common exit route. Of the 122 exits so far in 2014, 78 have been via corporate acquisition. Private equity funds will profit from the fact that companies need to satisfy their shareholders’ mandate to grow. Furthermore, companies have plenty of cash to do deals – wide open credit markets and low interest rates enable companies to leverage their acquisitions, increasing purchasing power. As of late January 2014, buoyed by strong stock market gains and favourable pricing conditions, 41 buyout backed companies had filed for exchange listings – more than half based in the US, 9 headquartered in Europe and 6 in the Asia-Pacific region. By comparison, at the same point going into 2013, just 12 buyout-backed companies globally had declared their IPO intentions. Just how many sponsor-to-sponsor exits there will be in 2014 will depend on how many exits end up being siphoned off by corporate acquirers and how well the IPO market holds up as the year advances. To date, there have been 17.
Brogan: With some attractive growth opportunities available in oil and gas, the priority at the moment seems to be on investing rather than exit. For those considering an exit, they should consider multiple divestment options. Companies preparing for sale should approach the full set of potential buyers and create a sense of competition. IPOs offer a popular exit route, particularly in the US and the UK. Oil and gas ranked fourth in terms of the total value of PE-backed IPOs in 2013. Despite the market volatility, an IPO window is largely open for profitable and well-governed companies. However, companies need to start preparing to go public a full 12-24 months in advance.
Fleischmann: Exits are company specific, and can be either M&A or public market: common stock or Master Limited Partnerships (MLPs). MLPs are proving to be very good ways to exit at high valuations, with yields around 5-7 percent, but the asset must fit the specific MLP criteria.
FW: Going forward, how do you expect PE activity in the energy sector to develop over the next 12-18 months? Do you see any major challenges on the horizon?
Brogan: I expect interest in the oil and gas industry from PE firms to increase globally over the next few years. Respondents to our survey saw Africa as the next big market for oil and gas PE investment. I think that because of some of the political issues, PE investments in Africa have tended to lag behind those in other regions. But as political tensions are alleviated, PE firms may look to re-evaluate their strategy. I think that Latin America and Asia Pacific will also see new PE investments in the next few years. Energy demand growth in Asia offers attractive growth prospects for companies involved in the oil and gas industry. Additionally, markets that were previously closed to foreign investment, such as Myanmar and Mexico, are beginning to open up.
Fleischmann: There will be continued activity in the next 12-18 months, particularly for high quality assets with current cash flow. This is the preferred investment for the infrastructure funds, which is by far the largest energy PE subsector: over $240bn infrastructure funds have been raised since 2006, and only a fraction of this has been put to work. The challenge will be for these funds to find investments that will return the 12-15 percent annually after fees they have promised their investors. This will be increasingly hard in a world where the kinds of deals they like to do – low risk, some cash return – are bid to 8-10 percent annually before fees and carry.
Nordlinger: The outlook is very favourable. Successful fundraising in 2013 has resulted in fresh capital for deals, with energy-focused funds in 2013 raking in a record $35.83bn. Credit markets are open and the global economy is recovering. The challenge will likely continue to be finding good investments at a reasonable price in an environment where there are too many buyers chasing a relatively limited number of assets. Private equity investors will need to be careful that they do not overpay. In the renewable energy sector, there seems to be subsidy fatigue in some important parts of the EU, such as Spain, which creates headwinds against additional investment in that sector. Likewise in the US, where gridlock in Washington has caused uncertainty in the sector about whether tax benefits will be forthcoming. However, the economics of renewable energy are improving every day, hopefully creating new opportunities for investment.
Stefanie Fleischmann joined Beowulf Energy LLC as general counsel in 2007. Prior to joining Beowulf, Ms Fleischmann was part of the M&A group at Paul, Weiss, Rifkind, Wharton & Garrison LLP and was associated with Freshfields. She received a JD from Heidelberg University and an LL.M. from Boston University. Ms Fleischmann is admitted to practice in New York and Germany. She can be contacted on +1 (212) 343 8353 or by email: firstname.lastname@example.org.
Andy Brogan is EY’s Global Oil & Gas Transactions Leader. Mr Brogan has been with EY for 25 years and has advised oil and gas companies on a variety of public and private transactions covering both upstream and downstream operations in more than 30 countries. His clients have ranged from large global enterprises to independent resource companies and he has also worked for various Governments in connection with transactions in the oil and gas industry. Mr Brogan can be contacted on +44 20 7951 7009 or by email: email@example.com.
Douglas Nordlinger is a partner at Skadden, Arps, Slate, Meagher & Flom LLP, and global head of the firm’s Energy and Infrastructure Projects Group. He represents clients in a broad array of corporate, commercial and finance-related transactions, with a particular emphasis on the energy industry and other infrastructure projects. He can be contacted on +44 (0)20 7519 7030 or by email: firstname.lastname@example.org.
© Financier Worldwide