With a robust energy M&A market expected for 2007, the ranks of seasoned upstream and oil-service management teams looking to replicate their past success will surely swell. Fortunately for them, the amount of private capital available to the energy sector is reaching flood-stage proportions.

According to one energy-capital source in Connecticut, some $30 billion of dedicated private-equity is now available for investment in the global oil and gas sector versus just $2 billion in 1998.

True, a lot of this money is flowing from momentum investors, such as hedge funds, attracted to the 25% to 30% annual returns-and much higher-now being generated by sponsored start-ups in the energy space.

But much of this private capital is also coming from seasoned energy-fund managers like First Reserve, Warburg Pincus, Yorktown Partners, Natural Gas Partners, Lime Rock Partners and Avista Capital Partners, most of which have continued to raise larger and larger pools of capital for E&P and service-sector investment during the past several years.

In addition, the upstream is drawing increased attention from large, well-established financial firms, such as CIT Energy, which seeks to provide advisory services and structured-financing solutions-including mezzanine debt, project finance and private-equity investments-mainly to entrepreneurial E&P and oil-service companies.

So there's no shortage of private-capital choices. This doesn't mean, however, energy start-ups should adopt a Monopoly-game mentality, thinking they can just automatically "pass go and collect $200." On the contrary, the top private-capital providers are looking for niche-type investments where managements have a particular competitive advantage that allows for fast-track growth-and high returns to investors.



Structured financing

This month, the ranks of Houston's energy-finance community swelled further as CIT Energy opened the doors of its new office there. The financial giant's goal: develop and expand energy corporate-finance relationships with small- to midcap companies, entrepreneurs and project developers in the upstream and oil-service space, as well as the midstream and downstream sectors.

The firm has the opportunity to play across the entire capital structure-from senior secured reserve-based lending through corporate lending on a senior or subordinated basis, including mezzanine and project financing, to investing in the common equity of companies-as well as advising on M&A transactions.

"In short, we're looking to be energy merchant bankers whose business is providing value-added advisory and structured financing solutions to targeted clients across the broad energy spectrum," says Brooks J. Klimley, president of CIT Energy in New York, the firm's global headquarters.

In 2006, CIT Energy (its parent is CIT Group Inc. with more than $70 billion in managed assets) arranged hundreds of millions of dollars in equipment financing for oil-service companies, including platforms, boats and compressors. Currently, the firm is also involved with developers in coal, power and the alternative-fuels sector-particularly those focused on consolidating ethanol and biodiesel markets.

While the new CIT Energy office in Houston initially expects to capitalize on its historical asset-based lending relationships with the oil-service sector, Klimley makes no bones about the rationale for the company's new presence in the Big H. "The biggest part of that office's energy business will ultimately be the upstream."

How big might that business be? In 2007, the firm is looking for $3- to $4 billion of gross originations in new energy financings that it will underwrite across all of CIT Energy, says John Sullivan, managing director for CIT Capital Markets in New York. "Of those billions worth of originations, which will be syndicated down, about half will be E&P and oil-service specific, with 80% of that half being upstream-oriented."

Sullivan, a former managing director and head of energy, commodity-export and project-finance syndications for BNP Paribas, notes the firm has the ability to underwrite and syndicate out large-ticket transactions, from $25 million up to $1 billion.

Since it can bring to bear a broad array of financing solutions to E&P clients, CIT Energy is particularly eager to look at complicated situations requiring thoughtful solutions, says Klimley, former head of natural resources corporate financing for Bear Stearns, UBS Securities and Kidder, Peabody.

"As a merchant banker, our mindset is not to be the next lender to the upstream-anyone can do reserve-base lending," Klimley says. "Our approach is to look for fast-growing companies-the entrepreneurs-that have significant opportunities but also may face significant structural challenges, in terms of executing and financing those opportunities.

"Frankly, the less plain vanilla the financing problem is, the more likely we'll be able to come up with a novel, more powerful capital structure for an E&P client than some of the larger commercial banks."

For coming up with creative capital solutions-be they structured debt and/or private-equity investments alongside the likes of First Reserve, Riverstone Holdings and ArcLight-CIT Energy seeks returns in the high teens.

"Because we're able to identify risk, then dimension it and price it, we see ourselves as investors and a complement to private-equity players such as these," explains Klimley. "Also, because of this strategy, we're relatively agnostic to commodity price. We focus instead on management teams, understanding play types, their cash flows, and the appropriate financing structure to employ to achieve the optimal return for our clients."

Echoing this view, Sullivan says the prospect of $45 or $50 oil doesn't really scare him. "There are still a lot of new drilling opportunities and industry consolidation left to play out, and we want to be a part of that process-providing intellectual as well as physical capital-regardless of whether those opportunities and consolidation take place at $45 or $75 oil."

CIT Energy, which taps into a broad base of institutional investors in its varied debt and equity financings, also has to constantly keep abreast of the range of sentiment toward the energy sector within that community.

"The investor universe has become much broader today in its appetite for debt instruments such as second-lien financings," notes Sullivan. "In fact, as we approach any transaction, we now have 400 different investors we need to keep tabs on, in terms of identifying who's specifically interested in the upstream at the moment, which ones demand certain types of hedging, and what their return expectations are."



Returns-focused

Based in Westport, Connecticut, Lime Rock Partners has raised $2.1 billion of private capital through five separate funds since 1998, making private-equity investments in 41 energy companies-half E&P; half, oil-service and service-technology providers.

The firm's most recent fund, Lime Rock Partners IV, closed this past September, raising $750 million. Since then, that fund has made two energy investments.

Notable was its $73-million commitment this past fall to Augustus Energy Partners LLC, a new, private Billings, Montana-based E&P company focused on the Rockies and Midcontinent. The commitment was part of an overall $228-million private-equity backing, in which Lime Rock was joined by Greenhill Capital Partners of New York and Kayne Anderson Capital Advisors of Houston in providing the majority of the start-up's funding.

Denver-based Rivington Capital Advisors LLC, through its affiliate Rivington Securities LLC, served as sole financial advisor to Augustus on the transaction.

One of the reasons Lime Rock was comfortable with this commitment is that Augustus is led by Steven Durrett, a successful entrepreneur Lime Rock backed at United States Exploration Inc., a private Rockies producer that was sold last March to Noble Energy for a total consideration of $411 million, says Jonathan Farber, a Lime Rock managing director.

Earlier in 2006, in Lime Rock Partners Fund III, the firm made a $50-million commitment to Bridge Energy, an Oslo, Norway-based E&P company operating in the Norwegian sector of the North Sea, and a large commitment to Arena Exploration, a joint venture in the Gulf of Mexico between Lime Rock Partners and Houston's Arena Energy LLC.

"The amount of capital coming into the energy sector today is much higher than has been the case historically," says Farber. "As we calculate it, there is now $30 billion of dedicated private-equity capital available for investment in the global oil and gas sector compared with just $2 billion when we started Lime Rock in 1998. This makes us a bit cautious. A surplus of capital typically leads to lower returns over the long term."

To meet its targeted rates of return for each investment of 25% to 30% annually, Lime Rock during the next two to three years will be making about a dozen select, high-quality investments in its current $750-million fund, each generally in the $40- to $60-million range.

"We're not looking for cookie-cutter-type investments," Farber says. "We're looking for entrepreneurs in both the E&P and oil-service sectors who can create specific niches of competitive advantage in a play or region, either because of their knowledge, their discipline or their long-term focus."

An ideal candidate is the management team at Arena Energy, he says. "This group has been highly successful in the Gulf of Mexico and its cost structure and overall F&D (finding and development) costs have been far better than its industry peers."

Focusing again on returns, Farber notes that a few years ago Lime Rock recognized that purchasing proved developed producing (PDP) reserves in the U.S. wouldn't likely generate its targeted 25% to 30% rates of return, and that many investors, although wanting exposure to rising commodity prices, were averse to exploration risk.

To address that issue, the firm created Lime Rock Resources in July 2005, raising $450 million for that investment vehicle. Rather than backing E&P companies, this entity acquires operated and nonoperated interests in domestic oil and gas fields and has its own staff of engineers, geologists and production accountants to manage those properties.

During early 2006, Lime Rock Resources acquired three oil and gas producing properties, two in East Texas and one in New Mexico. "While the overall risk profile of this entity is designed to be much lower than that of our private-equity funds, its returns are also designed to be somewhat lower-more in the mezzanine-level range," says Farber.



Seeking niches

Since its formation in July 2005, New York- and Houston-based Avista Capital Holdings has done a lot more than just manage what was then $1.3 billion of direct equity investments in energy contained in Credit Suisse's $5.3-billion DLJ Fund III portfolio. Indeed, true to its mandate from the market-maker, which covers the entire portfolio, it has grown the energy investments in that fund to nearly $1.5 billion.

This includes upsizing an original $87-million private-equity infusion for Laramie Energy to $137 million to allow that private Denver-based operator to accelerate its drilling and acreage position for tight gas plays in Colorado's booming Piceance Basin. Similarly, it has ballooned its backing of Enduring Energy, another Rockies-based producer, from $50 million to $80 million.

But as a stand-alone entity, Avista Capital Holdings-through its wholly owned subsidiary Avista Capital Partners-has also wasted no time spreading its own wings in the private-equity space. In fact, during the past 18 months, it has used the Avista Capital Partners Fund I to make nine private-equity commitments totaling more than $600 million; five of these are energy-related and add up to about $270 million.

"With more and more capital pouring into the energy space and valuations in the sector already high, we're trying to find niche-type situations where companies have a particular competitive advantage that hasn't yet been recognized by the market," says Steven A. Webster, co-managing partner for the parent company and head of Avista Capital Partners' energy-investment activity in Houston.

Case in point: Geokinetics Inc., a small publicly traded Houston seismic company that has grown to international scale through acquisitions, the latest being its $125-million purchase of Grant Geophysical in September. Besides taking a $50-million equity position in Geokinetics, Avista also put up, alongside RBC Capital Markets, half the $100 million of senior bridge financing that allowed the acquisition to take place.

"Geokinetics is an excellent example of a company with a niche focus, in this case seismic-a largely overlooked sector that has not seen much investment, not much price appreciation for the services provided, and where we see potential benefits from consolidation longer term," says Webster.

Another niche investment, this one in the upstream, is Avista's mid-2005 private-equity commitment of $50 million to London-based Celtique Energy, which is focused on developing large-scale prospects, particularly in mature onshore European basins where resource plays could end up being a growth factor.

"While we like places like the Piceance and Uinta basins in the Rockies, we don't think gas-resource plays are limited to North America," says Webster. "In our view, there's going to be a lot more exploration money committed on a worldwide basis to finding similar resource plays in international markets that haven't been as exploited."

With a target in 2007 of ultimately having $1.5 billion in its Fund I, Avista Capital Partners is looking to complete several more E&P and oil-service commitments for its own account-its investment sweet-spot being in the $50- to $100-million range. One such deal just closed is a $90-million commitment for Manti Resources, a private Gulf Coast oil and gas producer based in Corpus Christi.

The expected returns? That's a tough call. "With so much capital in the energy space, it's becoming a much tougher investment environment," says Webster. "However, we're hopeful that Avista can replicate what we think will be a likely three-fold return on the $1.5-billion DLJ Fund III portfolio."