The significant drop in oil and gas prices over the last two years has created many buying opportunities for private equity firms including the bigger players — particularly for investing in distressed companies in the sector.
According to Pitchbook, private equity raised close to $34 billion for oil and gas funds in 2015 — a 94% rise from three years ago — as new transactions continue to be executed.
Two of the largest oil and gas funds raised in 2015 were EnCap Energy Capital Fund X worth $6.5 billion and ArcLight Energy Partners Fund VI worth $5.6 billion.
There are many reasons why private equity might continue to look into oil and gas.
One factor is competition for deals, partially driven by the $1.3 trillion in dry powder that these firms have to invest. Additionally, corporate acquirers that have a lower cost of capital are vying for the same assets. Plus, other industries are not faring that much better than oil and gas. One source estimates that purchase price multiples are currently 9x to 10x, which are in line with those seen in the oil and gas space.
PE firms may also be drawn to distressed oil and gas companies thanks to the many avenues available for them to participate in the sector, including as alternative lenders.
Bank regulators have now imposed restrictions on bank loans and the amount of capital requirements for banks, which have inhibited these institutions from dedicating resources to distressed loans or companies that have poor credit ratings.
“This is a tighter credit market than 2015 as result of the difficulty to syndicate deals, the threat of a recession, and a tougher regulatory landscape,” says Craig Lilly, a partner at Baker & McKenzie. “Some banks have been reticent to offer leveraged financing on some of these deals, which has also curtailed dealmaking in other sectors and required funds to put more equity capital at risk to close deals.”
On the other side of the banks are private equity firms, which “are focused on obtaining high rate of returns from these alternative lending structures,” says Douglas Getten, a partner in the securities and capital markets practice group at Paul Hastings LLP.
Even larger private equity firms like Apollo Global Management, Carlyle, and Blackstone were actively raising money for oil and gas investments in 2015.
At that point, it seemed the interest from these private equity investors was strong “to invest in the downturn and to follow the old adage ‘buy low and sell high,’” Getten says. “That’s been in effect since the commodity price fall of 2014 where there has been an appetite to acquire distressed assets.”
Opportunities for PE
Indeed, private equity firms are becoming even more active in oil and gas after finding different ways to do so. Many of these firms have grabbed up property in the sale of bankruptcy assets while others have chosen to provide liquidity to distressed companies.
In addition to providing alternative lending, private equity firms “can help companies refinance bank or high yield debt,” says Paul Hastings’ Getten. “What usually happens is that a private equity fund will be making a significant investment as an out-of-court solution to distressed companies.” In this situation, the private equity fund comes in as a capital provider or as part of a long-term restructuring solution that does not involve a bankruptcy filing.
General partners are also getting more creative in structuring novel deals as a way to invest in the oil and gas sector and achieve their return expectations.
Baker & McKenzie’s Lilly says that many funds are returning to the “buy and build” strategy, using established portfolio companies as platforms to accelerate growth. Add-on acquisitions provide flexibility to allow portfolio companies to grow their core businesses or an adjacent business. “This may be well suited for bargains in the oil and gas sector. The lower middle market is attractive because it is off the radar of corporate investors,” Lilly says. “In larger deals, you may see funds partner with strategic acquirers to mitigate risks. Also, funds are seeking debt funds to finance deals since they are willing to provide more debt on deals than traditional banks.”
PE Innovates Through New Structure
The dramatic oil price drop has also presented investment opportunities for private equity firms interested in the oil and gas sector if they believe that these prices will rebound in the future.
John Sirico, an analyst at independent credit research firm Covenant Review, says that such investments may take the form of direct equity investments in oil and gas companies, and/or buying their debt — i.e., loans or bonds that are likely have attractive yields in the current market and may even be accompanied by warrants.
“These companies have historically relied on reserve-based lending facilities (RBLs) that at sit at the top of their capital structures,” Sirico says. An RBL is a revolving line of credit provided by banks and institutional lenders who are secured by first liens on the proven reserves included in a related borrowing base that is generally re-determined by the lenders on a semiannual basis. “Not surprisingly, these borrowing bases (and, thus, availabilities under RBLs) have been shrinking given declines in oil and gas prices,” Sirico says.
Oil and gas companies are seeking to fill this hole and private equity firms are looking to come into the capital structure in a relatively safe position coming immediately behind the RBL lenders. A recent example of a deal like this is from Clayton Williams Energy, where private equity firm Ares Management was able to provide a second lien term loan priced with attractive interest rates and robust hard call protection. Connected to this, Clayton also acquired warrants to acquire a substantial portion of the common stock.
“In such a situation, the private equity investor tends to win in almost any scenario,” Sirico says. “If the company performs, the investor receives attractive loan yields and, if the stock price rises, also realizes additional returns on its warrants. If, on the other hand, the company struggles and ends up in bankruptcy, the investor may be still able to acquire ownership of the company (either in a 363 sale or a plan of reorganization) unless its loans are repaid or otherwise left unimpaired.”
This type of deal is a win-win for all the participants in the transaction. While the oil and gas company benefits from much needed capital, the banks and institutional lenders may also have the advantage to reduce their exposure and lessen their related capital reserve requirements.