Working with a private capital source can feel difficult to an independent producer. At the Independent Petroleum Association of America's private equity conference this spring, several used the metaphor of wrestling an 800-pound gorilla to describe the experience. But they also emphasized that all the heavy exercise can be very worthwhile. Producers may feel themselves pushed and pulled several unusual directions during the match. They also can come out not simply a winner, but one that is exceptionally fit financially. The climate may not be right for most independents to consider public debt and equity offerings at the moment, but the door remains open to meet with private capital sources that are ready for the right kind of deal. "It's not so much that private financing is coming back as that it never really went away," says Cameron Smith, managing director of Cosco Capital Management LLC, New York. "There are several sources dedicated to oil and gas, as well as more general shops that are ready to make deals when the public markets aren't as hospitable." Private and public financing operate as mirror images, with one sector stepping up to increase its participation as the other pulls back. Private capital providers remain more interested in rates of return than reserve growth, and they prefer returns that are competitive with or better than other businesses. "If you don't expect returns of 20% or higher, you probably should give the money back," says Charles S. (Chad) Weiss, managing director and head of energy and power at Banc of America Securities LLC in New York. "That's the level investors expect. It's return on investment, not finding costs, that matter." "We're interested in energy because exceptional management teams and focused business models can generate attractive returns, even when the industry is highly competitive," says Howard Newman, managing director of Warburg Pincus & Co. Inc. The New York-based capital provider is attracted to companies instead of prospects and looks for investment structures with interests that parallel its own. It also likes producers with a regional or basin focus, a "technology-enabled" competitive advantage, low costs that allow them to move quickly and managements that are both technically skilled-and lucky. "You have to be an excellent finder of oil and gas to attract our capital," says Bob Sinnott, senior investment officer at Kayne Anderson Energy Fund LP in Los Angeles. Private equity capital is more beneficial for producers with high operating margins (low finding and development costs and low operating costs), companies with a large inventory of opportunities that can be accelerated, and firms trading at low valuation multiples with a potential to have multiple expansion, he says. Kayne Anderson thinks that now is a good time to invest because E&P stock prices are relatively low, forward multiples are down, banks are fairly conservative and public investors currently don't like the oil and gas industry. "Right now, they don't much like any business with tangible assets. But they likely will return as companies' profitability exceeds their cost of capital," Sinnott says. The oil and gas industry currently benefits from strong supply and demand fundamentals, points out Robert L. Zorich, managing director of EnCap Investments LC in Houston. But it also must contend with a breakdown in the historical relationship between equity and commodity prices and a difficult U.S. exploration environment. Public market interest also is limited to larger independents, Zorich says. "The investment community is not very interested in techniques like 3-D seismic that increased multiples during the last capital boom." Nevertheless, Zorich sees public markets returning to upstream oil and gas stocks as investors depart high-technology issues. That rotation could be sped up if OPEC members show a commitment to stabilized, higher crude oil prices and the natural gas market tightens. "Public investment isn't going to come back to oil and gas en masse until there's a paradigm shift," he emphasizes. "It could happen as a result of someone developing a new black box that makes it much less expensive to find oil and gas. We think it's more likely when favorable conditions supplant short-term bad memories." A strong management team can influence 90% of Natural Gas Partners' decision to invest in an independent producer. David Albin, a Santa Fe-based managing director of the capital provider, says NGP also looks for producers whose interests are aligned with its own. The firm, which has backed 36 companies since 1988, also looks for managements that provide business plans (not just project descriptions) with attractive reinvestment opportunities, and who have a strong track record. It also prefers that management have a majority of its net worth invested in the business. Of NGP's commitments, 70% are to producers that acquire and exploit assets. Similarly, 70% of the firm's outlays go to start-ups, which usually don't involve themselves in exploration. "We have an open mind regarding people's experience in the business," says Albin. "We want a partner willing to take equity capital into the company. We don't want someone who's doing deals on the side." It's good news that active capital markets have expanded their services beyond simple debt and equity, observes Rick Adams, director of structured transactions at Aquila Energy Capital in Houston. But capital sources have grown more selective, he adds. "The energy capital business has been pretty wild, particularly in the last six months, where a lot of proposals have not resulted in many deals getting done. Now that prices seem to be settling down, more deals can be completed." Capital providers try to get to know a producer's projects well. They also help the client develop a coherent business and operating strategy, and they do continuous due diligence. In one case, Aquila Energy Capital rescinded a deal with a producer when discovering that the producer did not have clear title to 70% of the properties involved. Favorable comparisons of returns to general markets could help independent producers. That will be easier to achieve with the current improved oil and gas price outlook. But it also helps to be resourceful. Robert R. Anderson, president of Sapient Energy Corp., recently compared his company's returns on capital employed with that of the technology-driven Nasdaq index. "That was at the end of last year," Albin says. "We'd be very interested in seeing Sapient's returns compared to the Nasdaq now [given the market's recent volatility]." "Success drives success," observes Weiss. "There's not a lot of contrarian thinking in the public markets. Your stock price went down not because you didn't do a good job relative to your peers, but because you did not do well relative to other businesses. Investors take their money where the action is." He estimates that in the last five years, E&P companies have received $6- to $10 billion annually from outside investors. However, most of the money has gone to independents with market capitalizations of $1 billion or more; these companies provide the bigger funds with the returns they want. Weiss recommends that smaller producers send their investor relations representatives to smaller capital sources. Houston-based Newfield Exploration Co. faced that situation when formed in the late 1980s. It attracted its initial significant investment from Warburg Pincus because Joe B. Foster, its first chairman, brought in a team from Tenneco Inc. that had a lot of experience. Management demonstrated its belief in the company by committing more than half of its total net worth-virtually all of its Tenneco severance bonuses-to the start-up. The University of Texas Permanent Investment Fund and a group led by former U.S. energy secretary Charles Duncan supplied the rest of the seed capital to get the independent going. Although Newfield has been publicly traded since November 1993 and has raised $400 million in the public markets, it started with three private placements totaling $66 million. Warburg Pincus was lead investor in the second private placement and Newfield's largest investor until November 1998, when it was required to make distributions to its own investors. "I know a lot of situations where private equity-dominated boards haven't worked. It succeeded at Newfield because we shared a vision of building an enduring company that would benefit all of our owners," says David A. Trice, the company's president and chief executive officer. "Our capital partners also showed confidence in Joe Foster's ability to run the company and encouraged us to use new financial tools, such as risk management. Our interests were closely aligned, with no overriding interests for anyone. If we got rich, our investors did too." Once an independent finds the right capital provider, it should be ready to have its new partner participate in significant decisions. Private funding sources usually come on board for a limited period, with specific goals in mind once it's time to exit. They customarily become directors of companies in which they put their cash. The good ones not only have sufficient money to invest and relatively long-term investment cycles, but also the ability to provide informed outside views, according to Randy Foutch, president of Lariat Petroleum Inc. He considers it critical to start with a specific plan. The privately held Tulsa independent sought fast, disciplined growth. "That may seem like an oxymoron, but we believed that it was necessary," says Foutch. "We tried to take advantage of each opportunity to add value for the shareholders." The result is a company with total reserves that are 73% gas. It has a 10-year reserve life and substantial behind-pipe reserve potential. Its revenues rose from $4 million in 1988 to a projected $65 million for 2000. Foutch expects lariat to be able to refinance about $65 million of debt and prepare to seek additional private equity-or possibly prepare an initial public offering-in another few months. Los Angeles-based Breitburn Energy Co. LLC also knew exactly what it wanted to do before it entered the capital markets. Its basic concept was that large, mature oil fields have significant upside potential when a producer applies state-of-the-art reservoir engineering technology. It focused on the Los Angeles Basin, where it now operates 10 fields. Its reserves totaled 53 million barrels of oil equivalent year-end 1999. Its senior bank debt is a $150-million line of credit backed by Wells Fargo Bank, Bank One, First Union National Bank and U.S. Bank. It also lined up a $30-million investment from EnCap last year. "When we started, many people asked us why we wanted to get into the private equity markets when we had such good relationships with four commercial banks," says Hal Washburn, Breitburn president and chief operating officer. "We wanted to recapitalize our balance sheet to take advantage of acquisition opportunities, accelerate development of our proved undeveloped reserves and reduce our capital structure's risk profile. "Everyone tells you to raise equity when you don't need it. We believe this can help us ride out commodity price cycles." Washburn sees oil and gas capital formation as a process in which a producer establishes a track record to increase its size. The process usually begins with private individuals, often the company's founders who become its managers and directors. They become the professional team that positions the company to attract investors. Initial operations can help it secure commercial debt, which can provide the strength for the company's next level of growth. That, in turn, lays the foundation for private equity providers, who can work with investment banks to find the most attractive terms. The final step? Public debt and equity offerings, ranging from common equity (which provides the most flexibility, but can be dilutive) and convertible and redeemable preferred stock to mezzanine financing (which is the easiest to get, but the hardest to pay back). Breitburn's next financing probably will involve another round of private equity, although it also could go with high-yield debt or an initial public offering, Washburn says. Texoil Inc. also expects private capital to remain available to independents. But the Houston producer anticipates that providers don't want to see their money used simply to reduce debt. So the company probably will take an equity route. "I like one d-word, dilution, better than another, debt. Too much of the second can lead to a third d-word, dead," says president and CEO Frank Lodzinski. Originally founded as Clifford Oil & Gas in 1996 with $10 million of financing that ran out three years later, the company took over Texoil in 1997 in a reverse merger. Officers and directors hold a 37% interest, with the balance divided among other investors that include EnCap, First Union and Lincoln National Life Insurance. Meanwhile, Spinnaker Exploration Co., another Houston-based independent and one of only two to complete an initial public offering since 1998, started its financing in the private market by negotiating with its first two capital partners, Warburg Pincus and Petroleum Geo-Services AS. They set the tone for a continuing relationship, recalls Roger Jarvis, Spinnaker president and CEO. "We did not find it necessary to negotiate every point. It was tough, but effective, because the three participants entered the process determined to see an agreement emerge." Producers need to remember that it takes a lot of effort for an investor to accept a high degree of risk, Jarvis adds. "That's inherent in exploration. But we never compromised what we felt was necessary to be successful." Spinnaker takes a less traveled road of growing through exploration instead of by acquisition. It tries to listen closely to its capital partners and pay close attention to changes that are taking place. "We've never made an acquisition, but grew through the grass roots. None of this would have been possible without our partners knowing what we intended to do, and how we planned to accomplish it." Founding employees continue to comprise much of Newfield's investors, Trice says. "We continue to own about 11% of the company, and it's a much bigger pie now. But private equity helped get us started, and we believe it will continue to help us," he said. "It also helps to have more than one 800-pound gorilla." BACKING NEW Companies that seek capital from private sources seem to do better when they already have identified a specific operating niche. So it's not surprising that at least one provider is taking a similar approach in deciding where to spend its investors' money. Dirk W. McDermott had more than 20 years' experience in oil and gas technical, management and investment positions when he founded Altira Group LLC in 1997 to provide capital and management resources for energy industry technology ventures. "Traditional venture capital firms often fear to tread into energy technologies. But you can't get around the fact that the energy industry, including oil and gas, is becoming increasingly dependent on advanced technologies to increase shareholder returns. It became apparent to me that there was a need for private capital to fund the development and commercialization of new energy technologies," he says. "We try to find companies that have unique products and proprietary technology. We generally work with them in their early stages, more as a venture capitalist than a conventional private equity investor. So entrepreneurs who have developed a technology or want to license one can come to us. Our own group of investors include some individuals and families that are very well known in the energy industry and possess the vision to see the opportunities in this area." Altira has approximately $30 million of investments under management. The Denver-based capital source has 11 companies in its portfolio, most of which are involved in software, services or electronic commerce in the energy industry. Companies in which it has invested include Canyon Offshore Inc., a Houston supplier of remotely operated vehicles that work offshore; Reservoir Characterization Research and Consulting Inc. (RC2), which provides integrated reservoir modeling consulting, training and software tools; and TransZap Inc., a secure, automated business transaction Internet service that seamlessly integrates the oil and gas back office. Altira has three partners, McDermott, Peter Edwards and Jim Newell, and a web site, altiragroup.com. "Most private equity investors in oil and gas tend to be cash flow oriented. They base their investments on a company's multiple. The companies we evaluate are often in such early stages that they're still mostly an idea or a vision in the founders' minds. We help take them to the next step," McDermott explains. Altira recently began fund-raising for its third fund, seeking a minimum of $75 million, and is looking at the entire energy industry, including electric power, for technology candidates. "We try to make investments that will grow faster than the general industry. That brings in a lot of the software and Internet technologies." Altira usually leads a company's first financing round and joins other partners in later rounds. That essentially happened with Canyon Offshore when a fund managed by Schröders joined with Altira in making a second round investment. Later, SCF Partners invested in a third round. And one year after Altira made the first round investment in RC2, it co-invested in the company with a fund managed by First Reserve Corp. Another Altira investment helped Coherence Technology Co., the sole licensee of BP Amoco's patented seismic processing technology, to grow to a point that it was acquired by Core Laboratories BV in 1999. "We look at the technology itself to determine if it's patented and protectable, and whether it can have a significant impact on the industry. Because the oil and gas industry can be so volatile, we look for management teams that can duck and weave if the going gets tough. Lastly, the market for the technology has to be large enough and growing fast enough to justify our investment," says McDermott. He believes that Altira's capital source role is particularly important as major oil companies and governments continue to reduce their energy research and development commitments. "Even when a technology is fully developed, it can be difficult to get it fully utilized and commercialized." Altira wants to be able to make a difference while providing strong returns for its own investors.