Just as private-equity (PE) management firms range in size and sophistication, so do the endowments, pension funds and other institutional investors that put their capital to work through the PE firms. The traditional model of a limited partner (LP) writing a check to a general partner (GP) firm and the GP then handling management and direct commitments to operating companies is changing. Increasingly, LPs are stepping up to be co-investors and in a few cases, even co-leads.

Stanford University has an endowment of $23 billion, administered by Stanford Management Co. Of the total assets under management, $1.8 billion is allocated to a natural resources portfolio under managing director Thomas Lurquin.

“The nature of the investment universe today in oil and gas is among the most dynamic in history. The mandate for this portfolio is very flexible, and I consider myself very fortunate,” he said. About 80% of the portfolio is in oil and gas. “Over time that number will grow more diversified, but that is where we like it these days.”

Stanford has been putting its capital into the upstream sector for more than 20 years and has a reputation among PE managers as a knowledgeable investor. “Our strategy has evolved over that time,” said Lurquin. “We are in conventional as well as unconventional, and we are happy to look across basins, on- and offshore. We have companies in most basins because unit economics are most important for us, not geography. We are agnostic about most things except team and asset quality as well as pricing.

If those look good, we are always interested in new ideas and are actually willing to take some risks.”

Indeed, Lurquin said his group is doing more direct investment. “We primarily invest through general partners, but direct investment has had a role for many years. Of the $1.8 billion in the portfolio, $1.3 billion is through GPs and half a billion is direct. There is a lot of focus on growing the direct portfolio.”

This does not put Stanford in competition with its GPs; quite to the contrary, said Lurquin.

“Direct investment takes its place alongside the investment through funds. We work in close cooperation with our GPs to take advantage of attractive opportunities. We have also gotten behind some IPOs. Those have been a compelling story in the past few years.

“Historically our bias has been upstream. We have found the midstream to be extremely competitive. There are huge opportunities, but they are well-known.”

The portfolio also has small positions in oilfield services, midstream and in utilities.

Just as the bulk of the Stanford natural resources portfolio is in oil and gas, the bulk of the oil and gas segment is in private-equity.

“We have a small public-equity sleeve and a small credit sleeve,” said Lurquin. He explained that having those segments is less a matter of asset allocation or diversification, but more the flexibility to work with GPs to take advantage of opportunities.

“Our GPs give us broad exposure, and direct investing gives us the ability to take advantage of compelling opportunities or to overweight certain assets. We think of direct investments as just-in-time investments or thematic overlays where we can be co-investor with a GP.” To be sure, Lurquin and his team are active investors—he has even on occasion brought opportunities to his GPs—but he said that for all their benefits direct investments take a great deal more involvement.

“Some models are moving more to direct investment,” said Lurquin. “The furthest along are the Canadian plans, and also the sovereign funds. Among LPs that is a major trend in the last few years. Here at Stanford it started in our natural resource portfolios but now is into other portfolios as well."

That said, Lurquin stressed the importance of the GPs. “As an LP you are outsourcing some of your risk to people who can hold that for you. Managing assets is a very different skill set from finding investments. There are different resources required and different obligations to yourself and to the operating company. Doing some direct investment, we know firsthand what those varying skill sets are, and we appreciate the GPs we work with. It can be a real challenge to move from one to the other. Not every LP can step out to be a direct investor.”

Returning to his main theme as both an investor and a fiduciary manager of assets for a major global research university, Lurquin emphasized prudence. “We always have to wonder why we are getting any given opportunity, and how does it fit with our objectives and methods. Every play has a cycle, and we always have to have our skeptical spectacles on. We have to be careful not to try to follow too fast in any new play.”

Matching funds and funders

The key, said both LPs and GPs, is understanding and matching the investor to the opportunity.

“With over 30 years of history, we have a very well diversified group of investors,” said Alex Krueger, president of First Reserve Corp. “We have strong funding from state pensions. We are also seeing more investment from overseas, including sovereign wealth funds. We recognize the benefits of matching the investments that we make to some extent with our investor base, so today around half of our investments are overseas. We have companies operating in approximately 50 countries doing about $30 billion in revenue.”

As with other managers, Krueger has noted a rise in co-investment by LPs. “Energy investors are very interested in the midstream and the downstream, as well as equipment and services for co-investing and even direct investing,” he explained.

“People can understand those businesses. E&P is more complex and the group of co-investors is smaller; not insignificant, but smaller.”

Still, overall Krueger sees more financial sophistication and understanding of risk management on the part of LPs. Beyond co-investors, he noted a select group of investors that are capable of co-sponsoring capital commitments. “There are a few that can partner in deals alongside GPs.”

You gotta know the territory

“We believe the LPs who work with us regularly recognize that we are experts at the energy sector,” said Greg Beard, senior partner and head of natural resources at Apollo. “They understand that this is a cyclical business and that we manage for value throughout the cycle. We structure our investments to survive the cycle. Our LPs are focused on operating performance, by us and by the operators in which we invest.

“One reason we believe our LPs invest with us is that the oil and gas sector is all about access to capital today. There are many fine boutique firms with knowledge of the industry. We have that knowledge as well but importantly, we also have the ability to invest billions of dollars. To us, that represents a significant advantage.”

Having seen a lot of history and made a lot of deals, Peter Leidel, co-founder of Yorktown Partners, is enthusiastic about the options now open to PE firms and the LPs that invest with them. “There are a lot more PE firms and capital structures of different forms in the industry than ever,” he said. “For example, some of the operators we have backed have taken capital from other PE investors in the form of working interest in wells or fields.”

It is good to have those different forms of capital available at different levels, Leidel stated. “Some investors or managers are happy to be involved at the mid-teens level of returns, where they are not paying for acreage. They add capital at important points.” He added that high-yield debt is also an important tool, though one that Yorktown does not use often.

Our LPs tend to be university endowments and foundations that have a long-term outlook on energy. For them the sector produces solid returns and they want continued exposure as well as steady results. Generally they have been pleased with the results. We have repeat investors just as we work with management teams on a recurring basis.”

Yorktown does not see a lot of investment from sovereign wealth funds, but it does on occasion commit capital overseas. “Internationally there is both political risk and fiscal regime risk. You also need a team in country that knows both the geology and the markets. But opportunities can be found. We have operating companies in Brazil, Colombia and Egypt. There really has to be a compelling opportunity to support the extra scrutiny in advance as well as the continued support.”

Quite a few LPs have become more active as direct investors, added Rich Aube, managing director of Pine Brook’s energy investment team. “We have been open to that from the start. The energy industry has become materially more capital intensive, and that is very attractive both to GPs and to LPs of many sizes and in many structures. Despite the large inflows we have already seen, many LPs view the market as more attractive for opportunities than it has ever been.”