Within the past few years, the market has witnessed the meltdown of the tech bubble, the emergence of the energy sector as a powerhouse on Wall Street, a change in the tax code that reduces taxes on dividends, and an extended period of low interest rates. All these events have converged to create strong market demand for energy income-producing investments. "Many cautious retail investors, seeking returns better than their CDs-but worried that they may already have missed the big moves in oil and gas stocks-have displayed a strong appetite for yield-oriented investments within the energy space," says a Midwest market-maker. "This is increasingly the case, given the continued positive outlook for that sector." George Hutchinson, Houston-based managing director for investment-banking firm, Friedman Billings Ramsey & Co., expands on this view. "With the bloom off the rose in the tech sector and energy prices rising so dramatically over the past few years, investors-both retail and institutional-are seeking defensive investments that still have upside potential," he says. "The energy sector has therefore become attractive, in particular structured investments that have predictable, steady cash flows-such yield-generating investment vehicles as BDCs (business development corporations) and MLP (master limited partnership) funds." Last year, six such IPOs raised an aggregate $1.9 billion. BDCs, set up under the Investment Company Act of 1940, are closed-end, non-diversified investment management companies that enjoy favorable tax treatment, as long as they distribute at least 90% of their taxable income. Last year, two energy-oriented BDCs came to market, raising an aggregate $366 million: NGP Capital Resources Co. (Nasdaq: NGPC) and Prospect Energy Corp. (Nasdaq: PSEC). Both focus on making mezzanine investments in upstream and midstream energy companies. Both target total rates of return (distributions plus share-price appreciation) of at least 12% to 15%. Why their focus on energy mezzanine investments? Following Enron's collapse and the subsequent exit of the capital-providing arms of several merchant energy companies, a pretty big void was created in the energy-finance market beyond senior bank debt-in terms of the availability of subordinated debt all the way down through mezzanine/stretch debt, observes Jeff Mobley, vice president of energy equity research for Raymond James & Associates in Houston. Commercial lenders, meanwhile, haven't been all that willing to go further down the balance sheet of smaller producers to take on less secured debt facilities, he notes. "And although there's a wealth of private-equity capital available, it can be fairly expensive for many E&P companies-plus they face giving up some level of control when they access that market. NGP Capital Resources, whose $261-million IPO we underwrote last November and which draws upon the experience and industry contacts of Natural Gas Partners-long established in the private-equity arena-aims to fill this finance vacuum between senior bank debt and private equity." Much the same investment strategy applies to Prospect Energy, says Michael D. Bodino, New Orleans-based senior research analyst for Sterne Agee & Leach Inc. The firm was a co-manager in the $105-million Prospect Energy IPO last July. "In the mezzanine world, the goal of a company like Prospect Energy is to manage risk and portfolio returns such that it can take a 6% cost of capital and generate an 18% rate of return on that money," he explains. "That's a very attractive 12% spread, with very little principal risk-and it's that spread that goes to shareholders." Unlike other, non-industry-specific BDCs that have gotten a bad wrap recently because they've cast too wide a net, the energy-related ones have hard assets backing up their mezzanine loans, he adds. Hutchinson concurs that mezzanine lenders, including BDCs like NGP Capital Resources and Prospect Energy, have the opportunity to receive above-market rates of return on debt instruments that are just a bit more aggressive than a senior loan. Meanwhile, investors in these BDCs get exposure to the upstream or midstream oil and gas business without taking pure equity risk, he explains. "Compared to buying a straight bond or straight equity, investors are getting something similar to a convertible, that is, the shares represent an investment that's senior in the capital structure, they provide a decent coupon in the form of cash distributions and there's the opportunity for equity upside through share-price appreciation." MLP funds Hutchinson notes that the new, closed-end MLP funds, which not only invest in the publicly traded units of midstream MLPs, but also make direct equity investments in those entities, are similarly focused on the yield-oriented retail and institutional investor. In 2004, four such funds came to market, raising an aggregate $1.6 billion. They are: Tortoise Energy Infrastructure Corp. (NYSE: TYG) in a $315-million February IPO; the Energy Income and Growth Fund (Amex: FEN) in a $128-million June offering; the Kayne Anderson MLP Investment Co. (NYSE: KYN) in an $830-million September IPO (See "On The Money," March 2005, Oil and Gas Investor); and the Fiduciary/Claymore MLP Opportunity Fund (NYSE: FMO) in a $330-million December offering. "The beauty of these funds is that their returns are generated from portfolio holdings and direct-equity investments in diversified gas transportation and processing MLPs, many of which have structured themselves away from taking commodity-price risk by simply providing their services for a fee," says Hutchinson. Adds Bodino, "What an investor is buying in these publicly traded funds are baskets of MLPs, which diversifies and reduces an investor's risk; also, these funds are run by very savvy management groups that are focused on yield to shareholders." St. Louis-based A.G. Edwards & Sons was the lead underwriter of the two Fiduciary MLP-fund IPOs last year. According to the firm's MLP analyst Ronald F. Londe, the total return in 2004 for MLPs under his coverage was 24.4%; year-over-year distribution growth, meanwhile, averaged 7.9%. During the past five years, his MLP coverage universe's total return averaged 34.3% per year as distributions grew an average 6.1% annually. The outlook for midstream MLPs remains bright. "As oil and gas demand grows in the U.S. at a projected annual 2% to 2.5%, so will throughput on the pipelines that transport those commodities," says J.C. Frey, senior managing director for Kayne Anderson Capital Advisors in Los Angeles. "Also, a significant amount of assets have not entered the MLP space but likely will [to handle liquefied natural gas and Canadian crude oil]. So for 2005 and beyond, we're looking for new MLPs to be formed while existing ones get bigger." The strategy of energy-related BDCs and MLP funds is the same: to grow distribution yields and total returns. Mezzanine-level returns In addition to the fact that NGP Capital Resources doesn't pay taxes on its earnings, its BDC structure exposes investors to emerging E&P and midstream investment opportunities they otherwise couldn't make on their own, says John Homier, NGP Capital's president and chief executive officer in Houston. The new energy-focused BDC is targeting mezzanine investments that have the potential to generate double-digit returns, consistent with what lenders normally receive for making loans with equity kickers. For providing mezzanine-level returns, which typically average in the mid-teens, NGP Capital receives a 1.8% management fee plus an incentive fee equal to 20% of net investment income in excess of an 8% annual hurdle rate of return. "With an estimated $2 billion of primarily mezzanine capital exiting the energy space during the past three years, our sponsor, Natural Gas Partners, saw this investment vehicle as an opportunity to expand beyond its core private-equity business," explains Homier. "Indeed, the energy mezzanine-finance arena is as thinly populated as I've seen in the past 20 years." In its selection of upstream investment candidates, NGP Capital seeks operators that not only have a base of proved developed producing (PDP) reserves, but also a good development story that needs capital. "The predicate for the mezzanine deal could be an acquisition with lots of recompletion or infill-drilling opportunities; an asset base of PDP reserves with a series of relatively low-risk, step-out drilling opportunities; or it may be the need for a bridge loan," says Homier. "In any of these cases, we're able to evaluate, commit and close quickly-usually in a matter of weeks." Through year-end 2004, NGP Capital completed two mezzanine-debt investments in a pair of private E&P companies in an aggregate amount of $67 million. Says Raymond James' Jeff Mobley, "The risk profile and safety of cash flow of this BDC is better than many common-equity investments. From its IPO through the next two years, we look for an annualized total return potential of around 25%, which implies cash distributions of at least 10% and anticipated share-price appreciation of 15%." The analyst adds that because of its BDC structure, NGP Capital Resources-which he rates Outperform-is more permanently capitalized and therefore able to focus exclusively on making investments, versus alternative investment structures that may need to constantly both invest and raise capital. 'Mud on our boots' Fundamentally a mezzanine investor in the upstream, midstream and downstream segments of the energy sector, Prospect Energy Corp. approaches its yield-oriented investments from a credit perspective. As such, it looks first for collateral values-engineered reserves in the case of the E&P sector-and a first or second-lien position, says John Barry, the firm's chairman and chief executive officer in New York. "We then look for good cash-flow coverage by the borrower and finally, since mezzanine is deeper in the balance sheet than senior debt, some kind of equity kicker-warrants, options, a net-profits interest or royalty interest-that compensates us for our increased risk exposure." Depending on the risk taken, Prospect Energy, which has been making mezzanine investments across many industries since 1988, seeks total returns for its shareholders in the mid-teens or higher. "When we've invested all our proceeds within this energy-only BDC, we expect to provide investors a yield (cash distribution) of 6% to 10%-hopefully at the lower end of that range because a lower yield would imply a higher trading price for our shares," says Barry. "In making energy investments, we don't mind getting mud on our boots or having oil splatter on us-walking muddy roads helps us better understand operators and move more quickly than our competitors," says the hands-on Barry. One of the major benefits of the BDC structure, he points out, is that it creates a permanent source of funding. "Unlike the private-equity market, where one has to raise a new fund every five years or so, this structure allows us to focus solely on investing and not spend so much time raising money as we did in the past." Weighing the merits of mezzanine financing versus private equity, Grier Eliasek, Prospect Energy's president and chief operating officer, notes that in addition to being a cheaper and more available form of capital, mezzanine funding allows an energy company to retain equity ownership and control of its business. To date, this new BDC has completed three energy investments: a combination $5.3-million equity infusion and $18.4-million mezzanine financing for Gas Solutions LP, a private Longview, Texas-based pipeline and processing company; a $4.8-million senior loan with warrants for Natural Gas Systems, a publicly traded Houston E&P company; and a $3.9-million debt and equity investment in coal producer Unity Virginia Holdings. Says managing director Dave Belzer, "We currently have some 50 transactions in our pipeline and we're looking to close one per month in the range of $3- to $10 million." Expanding universe In the vanguard of the new closed-end MLP funds that marched to market last year, Tortoise Energy Infrastructure Corp. raised $315 million. Notably, the offering was oversubscribed. What's more, Tortoise's stock has since appreciated 20% in value, reflecting the increasingly positive retail and institutional investor sentiment toward yield-oriented energy products. Tortoise Energy's investments target the midstream growth leaders within the current universe of 32 energy-related MLPs. Five years ago, that universe was made up of only 18 companies. Since then, the group has expanded at the rate of three new entries per year. "This group, which is largely engaged in fee-based transportation activities, produces steady cash flow with less exposure to commodity prices than other energy investments," says Dave Schulte, Kansas City-based managing director of Tortoise Capital Advisors and president and chief executive officer of Tortoise Energy Infrastructure Corp. Schulte, however, points out that Tortoise Energy-which also makes direct equity investments in MLPs-is looking beyond steady cash flow, to midstream partnerships that are demonstrating visible growth. Indeed, the company went on record earlier this year as stating that it expects its distribution yield, recently 6%, to grow at an annual 4% rate based on current market conditions. Driving this expectation is the anticipated growth in the economy and population which should spur higher demand for oil and gas products. "Greater consumption means that greater volumes of oil and gas will have to be transported, and the infrastructure assets we invest in are paid for on a volume basis," Schulte says. Faced with increasing product demand, the industry will also need to build new midstream assets such as LNG (liquefied natural gas) terminals and processing facilities to feed the existing pipeline infrastructure, observes the Tortoise Energy head. At the same time, MLPs will continue to grow through further asset acquisitions. "We've identified a core market opportunity where we're matching the demand for funding in the midstream infrastructure market with the demand for yield-oriented investments among retail investors who are also looking for some measure of yield growth," Schulte says. Although the bulk of investors in Tortoise Energy are retail, he points out that some 20% are institutional-pension funds, 401(k) accounts and foundations. "Because our fund is structured as a taxpaying corporation, these tax-exempt investors are able to avoid paying unrelated business taxable income (UBTI) and hence, can participate."