After being “decimated” during the world financial crisis, project finance and mezzanine providers have returned to the market in a significant way and are “a great source of capital for E&Ps that can’t access the high-yield or second-lien market,” according to Paul Beck, executive director at Macquarie Metals and Energy Capital, Houston.
Speaking at Hart Energy’s Energy Capital Conference in June on the topic of nonconforming debt, Beck noted the potential for a capital comeback from farm-outs, which could make a “U-turn” upward in the next couple of years as a funding mechanism for exploration and production companies (E&Ps). But this time the capital won’t be coming from foreign oil companies and investors, as it did a few years ago. Those sources have mostly dried up. It will largely come from financial institutions looking for alternative ways to deploy project finance funding.
E&Ps are in need of capital, particularly given the increased focus on execution timelines for developing the shales. Development spending should increase in the near term on an absolute dollar basis, he said. Last year the E&P sector raised $153 billion, and Beck said projections are for that figure to top more than $200 billion annually over the next four to five years, with up to a $1 trillion spent in North America alone over the period.
There is a slight capex slowdown underway in 2014, however. In 2013, 75% of E&Ps said they would increase budgets; this year the number has dropped to 55%, according to Carnite Research. And some of that investment will be shifted into the downstream and midstream sectors to “handle the increased production volumes,” Beck said.
To assess capital needs among E&Ps, Macquarie studied the top 31 publicly traded independents (excluding the major integrateds). Together they represent a little more than half of the $153 billion spent last year. They are exceeding cash flow significantly, he said. Over the past four years the deficit has averaged $20 billion to $30 billion annually--“that’s $1 billion per company on average, a huge gap,” Beck said.
A vast private-equity market is adapting to the current E&P cycle by increasing its focus on projects and lessening its backing of startups. Rather, private equity is active in project-level investments and with repeat management teams. After peaks in fundraising were achieved in 2006 and 2009, these players again topped $22 billion last year and are expected to have $24.6 billion in the coffers in 2014. “Despite the cores [in resource plays] being identified and the land grab that’s occurred, there is still good-quality acreage available, and private-equity shops are placing money with project-specific efforts and tried-and-true teams,” he said.
A new and growing area for private equity and nonconforming capital providers is joint ventures and strategic partnerships, such as those forged recently between KKR and Comstock; KKR and Hilcorp; Apollo and Caelus Energy; and Apollo and Double Eagle Energy LLC of Fort Worth.
For smaller, private independents, capital sources may be more scarce and scrutinizing, he said. But nonconforming debt is helping to fill the gap between capex and cash flow.
Front and center is high-yield debt, which has seen “explosive growth” and is five times bigger today than it was in 2005. Some $39 billion was accessed in 2012, more than $26 billion in 2013, and “we’re off to a good start this year,” he said.
Generally, high-yield issuers are spending $2.11 for every $1 they are generating internally, according to Barclays Plc (NYSE: BCS). This funding source is typically available to larger companies only, however, at transaction levels of more than $150 million to $200 million. Typical buyers include mutual funds and private bond funds, which need liquidity to meet redemptions. These investors want larger deals, diversification and liquidity, but for E&Ps that qualify, it’s a “great way to capitalize your company,” Beck said. Last year the average yield for E&P high yield was 5.4%. Some $13.9 billion in high yield had been issued in 2014 as of mid-June. “One of things we’re seeing is degradation of PDP [proved development producing] coverage in these offerings,” Beck said. “That’s what you would expect, because companies have de-risked plays, and they are leveraging up as quickly as possible.”
Second-lien debt is also filling the capital gap. These financings are evolving into “bond-like structures,” he said. Last year nearly $7 billion was done in second-lien loan transactions; as of this June, the amount was $2 billion. There are two kinds of markets for second-lien debt, Beck said. The first involves large transactions of $200 million to $400 million, arranged by advisers that handle high-yield bonds. These might be covenant-light, with quick closings, Beck said. The yields are higher than for high-yield secured debt, with Libor plus 700 and 50 to 100 basis points upfront, and Libor at 100 basis points minimum. Upfront fees are from 50 to 100 basis points. Loan funds and hedge funds are large participants in these transactions, which are “ideal for large and established public and private issuers,” Beck said.
The second--what Beck calls the “club” market--involves smaller transactions. These are arranged by banks and nonconforming lenders, with one to five lenders per transaction. These are ideal for private-equity portfolio companies, he said. Yields vary, there is more stringent due diligence and the covenants have a project-finance look. A third nonconforming debt source is financial and industry farm-ins. When resource plays kicked off, foreign investors and industry partners were a significant capital source. “That’s dried up, but I think it may do a U-turn,” Beck said.
In 2010, U.S. industry and foreign investor farm-ins tallied $8.6 billion. In 2011, farm-ins rose to $12.5 billion but crashed to just $3.1 billion last year.
In the meantime, capital is flowing from financial service companies, which have income-oriented investors, Beck said. They are development-focused, seeking to avoid exploration risk, with returns targeted in the high-teens to low-twenties. “The big difference between the traditional industry farm-out is that financial companies are not as interested in being promoted on the acreage position. They are happy to be promoted, but they are capital preservationists and want to be promoted on the back-in. So expect significant step-downs after return thresholds have been met,” he said. Hedging and leverage may be part of the structure.
Examples of financial farm-ins are Macquarie’s transaction with Baytex; and KKR’s deals with both Comstock and Exco.
Traditional project finance, such as mezzanine, is making a comeback as nontraditional energy lenders resurface, Beck said. “In 2006, before the crisis, I thought it couldn’t get frothier--there were a dozen really active players at that time. Then the market was decimated and a lot of guys went away.”
Now many of the former players, as well as new entrants, are actively putting out money, he said. They can underwrite bigger checks today. “They are as competitive as they’ve ever been and are ready to accept somewhat lower returns to keep doing deals.”
Beck noted the advantages of project debt vs. standard industry “third-for-a quarter” arrangements. For project debt, he assumes a 90% capex advance, an 8% interest rate, 100% cash-flow sweep and a 25% NPI after payout. In a recent comparison of financial terms, a typical Wolfberry well in the Midland Basin costing $1.9 million generated about a 26% return on revenue (ROR) and 2x return on investment (ROI) with traditional terms. Using a project financier, however, the return goes to 39% and a return of 9x invested capital. “You can gear these deals significantly with mezzanine debt,” he said.
In another structure using mezzanine, a bigger company can sell a package to its subsidiary, let the mezzanine source fund drilling, and once it is drilled up, convey it back to the parent. It is “completely nonrecourse, no strings to the parent,” he said. One negative is that if the parent company is public that debt will consolidate back on its balance sheet. However, it is not indicative of corporate debt, Beck said.
Project debt allows operators to reduce capital outlays, benefit from nonrecourse leverage, and fund lower-priority projects when capital constrained.
Macquarie Energy Capital has deployed more than $4.5 billion to energy and resources firms. Its preferred debt deal size is about $20 million to $150 million, and its equity hold is from $5 million to $25 million.
Source: Paul Beck
"Financial" And Industry Farm-ins: Industry partners and foreign investors might be a declining source of capital. Financial players see the opportunity.
Source: Paul Beck
Project debt vs. industry arrangements: Project debt has several key advantages over standard industry "third for a quarter" arrangements. [Above: The Wolfberry transaction is one of a series of transactions including the Bakken and Utica.]
Source: Paul Beck
Macquarie Energy Capital: Overview--risk and return