Mezzanine Moves

Imagine you have a great project. Deep down, you know it’s a winner, with a clear path to accelerating production. It’s still too early to take to a bank to finance, and partnering with a private-equity or industry player would likely involve serious dilution and operating control issues.

What alternative financing could you turn to? The answer is what some call mezzanine capital, and others call structured capital or project finance, meaning the financing is specific to a certain asset or project to be developed.

Mezzanine monies are an intermediate financing tool rather than a source of permanent capital. Typically, mezzanine providers share in a portion of the project’s upside while allowing project owners to retain a significantly greater share of the value created than would typically be the case with permanent capital providers.

Paul Beck, executive director in Macquarie Bank’s Houston office, acknowledges there are differing views as to what comprises mezzanine finance.

Paul Beck, executive director in Macquarie Bank’s Houston office, says of mezzanine finance, “There’s no cookie cutter way of doing it, which makes it a fascinating business.” Right, mezzanine capital may be an intermediate funding source to grow projects viewed by owners as at too early a stage to bring in private-equity or industry partners.

“Mezzanine takes on a lot of forms and structures,” says Beck, who has worked in the sector for a couple of decades. “There’s no cookie cutter way of doing it, which makes it a fascinating business. It can get complicated, in many ways much more so than equity.”

Tim Murray, managing director at GSO Capital Partners (an affiliate of the Blackstone Group) in Houston, suggests mezzanine fits more comfortably under the broader banner of alternative capital. “Our alternative capital is that which fills the void between commercial bank debt and private equity,” he says. “Sometimes that space is wide, and sometimes it’s narrow.”

Traditionally, explains Murray, the space occupied by mezzanine has tended to expand or contract depending on how aggressive capital providers have been on the risk spectrum.

“If commercial banks are willing to do second-lien and stretch-loan deals, and private-equity sponsors are willing to go down market and do smaller deals, then it’s tougher for guys like us,” he says. “But if banks are restrictive in their lending, and private-equity guys are sitting on the sidelines or refusing to write anything but large checks, we can have more capital demand than we can possibly meet.”

Amidst some signs of rising demand for mezzanine—driven in part by the upsurge in resource-play development—the opportunity set for mezzanine may be expanding, even as commercial banks are far from dialing back commitments to traditional reserve-based lending. And capital sources look to meet the demand.

“The advent of the shale plays has been kind of a game-changer for the mezzanine business,” says Mark Green, president of Wells Fargo Energy Capital, in Houston. “It has provided us with a lot of opportunity while at the same time lowering the risk we are taking. And given the industry’s focus on finding new shale plays, we think our business is going to be robust for quite some time, not just on the mezzanine side, but on the second-lien side as well.”

“There’s always a good level of demand for alternative-type lending,” Murray says. “But resource plays have raised demand overall, because even if you have a bunch of acreage, it’s not proven until you get wells drilled and on production. And until you get enough wells proven to increase your bank line to the point that your drilling program doesn’t outrun your borrowing base, you need people like us.”

One company markedly expanding its footprint in what is a relative tight group of mezzanine players is the Carlyle Group. In November of last year it announced it had raised $1.38 billion in its Carlyle Energy Mezzanine Opportunities Fund. The fund makes investments from $20 million up to $150 million, but says its fairway is typically $50- to $75 million. It is co-headed by Carlyle managing directors David Albert and Rahul Culas.

“In a nutshell, the reason we exist is that in a lot of cases oil and gas project owners don’t want to sell their assets prematurely,” Albert says. “Yet at the same time, senior bank lenders don’t have the ability to offer as much capital to this space as is needed. So anyone who wants to grow their business, but can’t access sufficient capital from the banks, and who doesn’t want to sell their company to private equity before reaching a certain size, comes to us.”

The Carlyle fund mandate covers energy broadly, but its focus is primarily on the upstream sector and power generation, with each accounting for about 40% of fund investments, and the remaining 20% split between oilfield service, coal, and metals and mining. International investments could comprise up to 30% of the fund.

One noteworthy investment it’s made is in the Philadelphia Energy Solutions joint venture involving the former Sunoco refinery.

“With domestic refining going through a mini-renaissance, the Philadelphia refinery was in the right place at the right time,” says Culas. Investment plans include a catalytic cracker upgrade and new rail unloading facilities designed to help provide a crude slate increasingly geared to domestic blends, particularly high-quality, low-sulfur grades from the Bakken shale in North Dakota.

Tim Murray, managing director at GSO Capital Partners in Houston, suggests mezzanine fits more comfortably under the broader banner of alternative capital with a sharper focus.

In looking at the Bakken and similar “hot” shale investments, Culas takes a cautious approach.

“Everyone wants to be in the Bakken right now,” making for a “more challenging” set of investment opportunities, he says. In addition, with long lateral wells costing $7- to $10 million apiece, diversification in the Bakken is not as easy to achieve, even with a $50- to $75-million investment. To date, the Carlyle fund has steered investments to other shale plays, the Cline and Mississippian, via funding for TexOak Energy, based in San Antonio, Texas.

Albert describes how a typical mezzanine deal might be structured: a loan carrying a 10% cash coupon; an additional 2% to 3%, payable on the outstanding balance, which can be paid in cash or accrued via a payment-in-kind (PIK) feature; and a net profits interest (NPI) or overriding royalty interest that can represent either a small yield enhancement or, in some cases, a material equity position in the project or company, depending on the risk profile. The latter is clearly “the most complicated element” to negotiate, he says.

Overall portfolio returns are targeted at roughly 15% to 18%, but “we could do, and have done, deals at 12% if we really like the investment profile,” Albert says. The fund also can offer a straight equity investment, but targeted returns in that case would be a “multiple of capital” invested.

EIG Global Energy Partners, with its oil and gas team based in Houston, prides itself on being one of the longest-standing players in the structured capital sector. Founded in 1982, it previously operated as the energy and infrastructure group of Trust Company of the West, before spinning out in its current form in January 2011. EIG is notable for the scope of projects it can undertake across the energy spectrum, both domestically as well as internationally.

“The advent of the shale plays has been kind of a game-changer for the mezzanine business,” says Mark Green, president of Wells Fargo Energy Capital, in Houston.

As energy projects have tended to become more capital intensive, EIG has been able to expand the capital it puts to work in its portfolio investments. The lower end is usually $100 million, with its typical deal size falling into the $200- to $400-million range, and some being as large as $500 million.

“The ability to go bigger is, in our view, an advantage,” says senior vice president Patrick Hickey.

EIG looks for projects in the E&P sector as well as in power, infrastructure, midstream and gas gathering and processing, and mining. Investments are often project-related.

An example is EIG’s $450-million investment in Plains Exploration & Production Co.’s Gulf of Mexico subsidiary Plains Offshore Operations Inc., primarily designed to fund the latter’s share of capital investment in the Lucius deepwater development and exploratory drilling of its Phobos prospect. In return, EIG received a 20% equity interest in Plains Offshore Operations. The investment took the form of a convertible preferred stock through which EIG receives a 6% cash dividend, paid quarterly, plus a 2% annual dividend, which may be deferred and accumulated quarterly until paid.

In the shale plays, EIG was a major player in financing Chesapeake Energy Corp.’s development of the Utica shale in Ohio and Pennsylvania. The investment took the form of perpetual preferred stock with EIG entitled to receive a distribution of 7% per annum plus upside via a 3% overriding royalty interest in the first 1,500 net wells drilled on Chesapeake’s Utica leasehold. EIG purchased $500 million of the preferred shares, and other investors, including limited partners of EIG’s managed funds, purchased the remainder, resulting in a $1.25-billion transaction.

GSO Capital Partners has likewise led a transaction to finance a Chesapeake Energy play, also raising $1.25 billion, this time targeting Cleveland and Tonkawa unconventional liquids-rich sands in Roger Mills and Ellis counties, Oklahoma. (GSO and EIG have both participated in the Chesapeake transactions led by the other.) The deal involved a Chesapeake subsidiary selling a preferred stock, bearing a 6% annual distribution, paid quarterly, and a 3.75% overriding royalty interest in the first 1,000 wells to be drilled on the subsidiary’s leasehold.

While GSO Capital can do very large financings like the Chesapeake deal, Murray sees a sweet spot for alternative finance around $100

million and lower. He characterizes commercial banks as being “reasonably aggressive” still in offering stretch loans and second-lien deals, and thus “eating into opportunities for classic mezzanine lenders,” but rarely wanting to expose as much as $100 million. On the other side, some private-equity sponsors have minimum thresholds of $100- to $200 million.

Even though resource plays have attractive attributes—rapid return of cash, for example, from the wells’ initial flush production—commercial banks tend to have difficulty keeping up with financing needs, Murray says. Even if banks use quarterly redeterminations, they typically require six months of production for operations to be included in a borrowing base. High-yield debt is also typically not an option for less-established E&Ps.

As a result, resource players are turning to mezzanine financing. But what factors help make a match?

Mezzanine criteria

GSO Capital wants to see operating personnel who have a demonstrated record of drilling horizontal wells with multistage fracs and, says Murray, a leasehold position that has plenty of running room “in the right part of the neighborhood. In the neighborhood is not enough.”

There is no required set amount of production; GSO cites as an example a Permian deal based purely on acreage. In cases where there is production, 80% of anticipated output is generally hedged.

Deal size can be from $25 million to more than $500 million, but $50- to $100 million is the preferred range for these smaller upstream financings. Typically, the loans carry a low-teens interest rate with an overriding royalty interest/NPI designed to bring portfolio targeted returns to “the mid- to high teens or higher” level.

Overall portfolio returns are targeted at roughly 15% to 18%, but “we could do, and have done, deals at 12% if we really like the investment profile,” says David Albert, Carlyle managing director.

The GSO portfolio, weighted most heavily in E&P currently, is open to raising its participation in other areas, mainly midstream—possibly via a greenfield project; power; and, on a “selective” basis, oilfield service.

Macquarie emphasizes similar criteria, plus others, for funding mezzanine candidates. In addition to acreage in the resource-play core, says Beck, it is important to have enough running room not only to put significant capital to work, but also to eventually attract a buyer. A sale to a larger company that is better financed usually occurs in eight or nine mezzanine cases out of 10, with Macquarie simultaneously selling its equity stake, according to Beck. His group has put some $4 billion to work in the sector over the past 10 years.

Beck highlights the bank’s technical expertise, including seven in-house engineers and a geologist. All engineering is done internally, on the basis there should always be in-house responsibility for an investment. And return expectations are aligned with Macquarie’s view of the risk, which may be higher or lower than perceived by a third-party engineer or the client.

“I always tell people when they come in to talk about a financing to view us more like an oil and gas company than a bank,” Beck says.

“Most of our clients are private companies. We have a few that are public; and if they are public, they are mostly small cap,” a group whose need for alternative capital tends to move inversely with equity-market sentiment. “We tend to see more business from them when the small-cap market is closed.”

“With domestic refining going through a mini-renaissance, the Philadelphia refinery was in the right place at the right time,” says Rahul Culas, co-managing director, Carlyle Group.

Business is spread throughout resource plays. Beck cites the Bakken as being “front and center, just because it’s so big.” Macquarie has recently funded Bakken activity on a nonoperated basis. Transactions have also centered on the Eagle Ford’s strong economics and the Permian Basin’s stacked pays. Deals to develop the emerging Woodbine, Buda, Georgetown and Austin Chalk trends have also made Southeast Texas a “hot play.”

In terms of deal structure, Macquarie says the bank’s balance sheet allows it to offer greater flexibility in the initial coupon it sets on transactions and also to do slightly riskier deals than commercial banks would, with slightly higher rates.

“We tend to ask for a lower coupon,” says Beck. “We want to keep the burden to the loan repayment as reasonably low as possible to give the project the best possible chance for success.”

On a project targeting a mid-teens return, for example, Macquarie may charge a lower interest rate of, say, 6% to 8%, and then take a higher NPI, overriding royalty, or even a warrant. The same return, in line with peers, is achieved, “but we’ve bifurcated the components in a way that we feel gives the client and the project a better chance of success than with the burden of all that interest.”

Deal size is normally no smaller than $25 million, with the fairway being in the $35- to $75-million range, but often larger. There is a draw fee of 1% upfront, but generally no overriding royalty during the coupon period. Beck attributes Macquarie’s ability to structure transactions with an equity kicker at the back end, after loan repayment, to confidence in its engineering and property valuation.

Macquarie is also offering a vehicle that it calls a “financial farm-in” wherein the bank earns a real property interest, akin to a working interest, by acquiring a portion of largely undeveloped acreage with dollars that are then used to drill wells on the property. At reversion, i.e., if drilling has been successful and funding has been recouped plus a set rate of return, “almost all” the working interest is returned to the operator, who maintains operating control throughout. A key attraction is that the financing is off balance sheet—there is no loan involved.

Wells Fargo, whose entry into the mezzanine sector dates back to 1996, views the emergence of shale plays as having enhanced mezzanine’s

attractiveness.

“The shales have made mezzanine even more attractive because they have significantly reduced the reservoir risk, and it’s become more an issue of execution risk,” Green says. “We’ve seen hardly any dry holes in the mature plays such as the Barnett and the Bakken. However, it takes a lot more dollars than it used to because of the high well and facilities cost, and our challenge is making sure that the drilling is economic in the current price environment.”

As energy projects have become more capital intensive, EIG Global Partners has been able to expand the capital it puts to work in its portfolio investments, according to senior vice president Patrick Hickey.

Green says Wells Fargo is generally both basin- and product-agnostic, but focuses primarily on drilling economics. In addition to mezzanine deals in the Bakken and Eagle Ford, he cites “several deals in the Marcellus that turned out quite well.” On the midstream side, the bank has financed Fayetteville, Marcellus and West Texas assets, where recent industry buyouts have occurred at 12 to 16 multiples of EBITDA (earnings before interest, taxes, depreciation and amortization).

With second-lien, mezzanine and direct-equity investments at Wells Fargo totaling $1.4 billion (and corporatewide energy loan commitments totaling $30 billion across upstream, midstream and oilfield services), the bank’s horizon of deal sizes is broader. Mezzanine transactions begin at $10- to $25 million, but can grow to $50 million with success and, with other partners in the shales, reach $100 million. Second-lien loans are typically $10- to $75 million, while direct-equity investments are $10- to $25 million.

In mezzanine transactions, Wells Fargo prefers a “modest” coupon, typically prime plus 3% to 4%, to avoid high interest costs burdening a project and protect cash flows to fund drilling. Terms are less likely to include an overriding royalty, but generally provide for a NPI, after payout, of 2% to 50%, depending on the project. For projects reaching a prescribed return of, say, 1.25 to 1.50 times the original investment, however, there may be a “stepdown” in the equity kicker terms of up to 50%.

Overall portfolio returns are targeted at 15% to 25%, with the lower end applying to more mature, development-type projects, and the higher to less mature projects. No. 1 on Green’s list of criteria for an investment is good management. “Management is first and foremost. You can never underestimate the importance of a quality management team.”

The priority to be placed on people was something partner Cathy Sliva learned quickly after founding BlueRock Energy Capital in Houston. Early on, she recalls, risking was skewed heavily to technical analysis of the project rather than to both the technical side and the personnel behind it.

The priority to be placed on people was something partner Cathy Sliva learned quickly after founding BlueRock Energy Capital in Houston.

“We learned quickly that the people can be more than half the risk. You can have a great project with incredible potential, but if you don’t have the right people executing, you don’t have anything.”

BlueRock Energy Capital specializes in financing a niche of “micro-independents” looking for $1 million to $10 million in capital, with $1- to $3 million being the “bread and butter” of the business. Although deal size is small, multiple projects with the same E&P are not uncommon; Sliva says “quite a few” E&P clients have had $15- to $20 million invested with the company in multiple projects.

Financing is typically designed to help a producer grow production. As capital is put to work to develop a growth wedge, revenue generated under the BlueRock model goes first to meet royalty, tax and lease operating expense commitments. Remaining revenue is then typically split 90% to BlueRock and 10% to the operator, until BlueRock receives its capital back plus a contractual return on investment. At that point, revenues revert to the operator, and Blue-Rock receives just a small permanent overriding royalty interest, usually 2% to 3%.

“At the end of the day the operator owns everything except that small 2% to 3% override, and that’s what is attractive to him,” Sliva says.

The package offered by BlueRock is distinctive on several counts. Capital is provided not through a loan, but rather through BlueRock’s purchase—on a temporary basis—of an overriding royalty interest in the properties. The latter is reassigned to the operator once BlueRock has received its capital back plus the contractual return on investment. Financing is nonrecourse, and the client retains the eventual upside in the project as well as control as operator.

Targeted returns vary with a project’s perceived risk, but “the blended return is usually somewhere in the mid-teens,” Sliva says. There is some risk-sharing in that, if projected revenues come in light due to lower realized prices or production falling short of expectations, it takes longer for BlueRock to meet its return target. Conversely, if production exceeds projections, “the shorter is the time it takes to get to the point where our temporary overriding royalty gets assigned back to the operator, and we are out of the deal.”

Given its revenue-sharing model, one initial condition to work with BlueRock is to have at least some production—even if it’s only 20 barrels per day. “We get quite a few phone calls from people who have a drilling prospect, but if they don’t already own some production somewhere, we can’t get started with them.”

Assuming some production, BlueRock’s deal structure—under which an operator gives up a heavy cut of revenues upfront, but only a small overriding royalty at the back end—is favorable, Sliva says. “If a producer really believes in his projects, and you do the math, he is better off partnering up with BlueRock rather than selling down a working interest or going with an equity partner, because at the end of the day he ends up with much more.”