Keeping a scorecard on private equity these days is becoming a little like watching today’s professional sports. There’s more competition from more teams, the players are getting a lot bigger, and the sums involved are magnified relative to earlier years for those making it to the finish.

The good news is that there continues to be a strong appetite for energy investments. As one private-equity insider summed up: Interest in energy is “better than almost any other private-equity sector right now. Energy is on the agenda for folks. But there is no shortage of options for investors.”

Kenneth Hersh
According to chief executive officer Kenneth Hersh, above , 11 investments were already in place at closing of NGP’s latest fund, NGP Natural Resources X LP, activated in January 2012.

“Energy is a good place to be,” agrees another private-equity sponsor, noting “there is a lot of energy private-equity capital being raised right now, and so the process may take a little longer because it is a little more competitive for private-equity dollars.”

Numbers that could in aggregate approach, or even top, $30 billion are possible if financial sponsors succeed in raising all their targeted amounts. This reflects the continued influx of generalist “mega-funds” that are expanding aggressively into what had been the purview of smaller private-equity energy funds. The funds themselves are also targeting larger amounts. First Reserve Corp. and Riverstone LLC, for example, are reportedly aiming to raise some $6 billion.

Meanwhile, a final close, at $3.586 billion, has already been announced at mid-year by NGP Energy Capital Management (NGP) for its latest fund, NGP Natural Resources X LP. It came after a one-year fundraising effort. According to chief executive officer Kenneth Hersh, 11 investments were already in place at closing. The fund was activated in January 2012 and is the 10th to be managed by NGP, bringing cumulative capital managed by NGP and affiliates since inception to $13 billion.

Why this broad strength in fundraising against an uncertain and volatile economic backdrop? Partly, it can be attributed to the “broader fundraising power” of recent entrants whose appeal is not limited to just the energy sector, says Bill Weidner, head of private capital consultancy Weidner Advisors, pointing to Apollo Management LLC, Blackstone Group LP and KKR. But the bigger drivers are the continuing low interest-rate environment and, with such low bond yields, the growing use of alternative investments by retirement funds in an effort to keep overall returns sufficiently high to meet actuarial requirements.

These factors “have combined to create this hunger for more private-equity investments,” comments Weidner. “In an odd way, the extremely low interest-rate environment continues to trigger more capital to go to private equity. That has not stopped this year, and there is nothing presently that would suggest that that is stopping—for the time being. Eventually, it will, and that will have a noticeable impact. But not for now.”

Midstream returns

Weidner sees low interest rates playing a role in greater funds being allocated to midstream assets, in particular. Strong underlying demand for midstream assets already exists, of course, as the buildout of infrastructure for emerging resource plays unfolds. In addition, however, Weidner cites the role played by master limited partnerships (MLPs), with their higher yields, acting as “a bond substitute, creating real value-added exit strategy opportunities for private equity allocated to midstream assets.“

Table: Private Equity Fundraising Targets, Oil and Gas

Fundraising in private equity could approach, or even top, $30 billion.

Returns in the sector have been strong, he notes, “not least because the overall investment community’s hunger for yield drives it to MLPs, which can award higher market capitalizations to midstream assets that might have been developed for significantly less by private-equity sources.”

If midstream investments capture a growing percentage of private equity, traditional E&P still represents the largest segment in absolute dollars. For Kayne Anderson Capital Advisors LP, over 80% of its capital will be directed to E&P, where most of the management teams it backs pursue one of two paths: one is a “lease-and-drill” strategy, in which the focus is on leasing undeveloped acreage that can be de-risked by drilling and later sold for its inventory of low-risk drilling locations; or an “acquire-and-exploit” strategy, in which value is added through new drilling, workovers, lowering operating costs, etc.

The Kayne Anderson Energy Fund VI has closed on over $1.1 billion in commitments and has a hard cap of $1.6 billion to be raised by year-end. KAEF VI is expected to have about 16 to 20 portfolio companies, with a split of roughly 10 to 12 pursuing lease and drill and six to eight pursuing acquire and exploit. Commitments range from $50- to $150 million, but will tend to be larger on the acquire-and-exploit side, resulting in roughly a 50:50 balance between the two sides on a dollar-invested basis.

Bill Weidner

Bill Weidner, head of Weidner Advisors, says the biggest drivers currently in private-equity investment are the continuing low interest-rate environment and the growing use of alternative investments by retirement funds.

Not surprisingly, fewer opportunities are currently seen in natural gas, given low commodity prices. At the same time, Kayne Anderson says it is “fairly agnostic” as to whether returns are earned in oil or in gas, or via one or the other of the two E&P strategies described above. With horizontal drilling opening up emerging resource plays—as well as allowing bypassed zones in older fields to be exploited via lease and drill—“this is a great time to invest in the oil and gas space,” comments Kayne Anderson managing partner Danny Weingeist.

In addition, “these resource plays require a tremendous amount of capital to fully develop. This will lead to opportunities for our acquire-and-exploit companies, as public companies divest legacy conventional assets to raise capital to fund resource play development.”

Lime Rock Partners’ strategy of roughly equal weightings in E&P and oilfield service over time reflects the backgrounds of its founders. Both former Goldman Sachs equity research analysts, Jonathan Farber and John Reynolds covered the E&P and oilfield service sectors, respectively. While varying from year to year, the two sectors tend to each account for 45% of investments made by Lime Rock, with oil service technology making up the other 10%. The firm does not focus on midstream, which in terms of expertise was “a little out of our strike zone” when Lime Rock was founded, according to managing director Townes Pressler.

Kayne Anderson

“This is a great time to invest in the oil and gas space,” says Kayne Anderson Capital Advisors managing partner Danny Weingeist.

Upcoming investments may reflect a growing appetite for E&P relative to the somewhat below-average weighting of 40% expected for its recent Lime Rock Partners V Fund, which closed in April 2008. “While we’ve been active investors in E&P over the past few years, we also saw somewhat better competitive dynamics elsewhere, with significant competition keeping reserve and acreage prices high and our deep caution on gas prices making us highly selective on gas plays. That being said, I would see us moving a lot stronger on E&P right now.”

Pressler offers a bullish view on the long-term fundamentals for gas, and expects a catalyst in the next 12 months to provide opportunities to add to the firm’s unconventional gas portfolio. What catalyst? A tightening of financing sources, as the banks “pull in their horns,” for example, or as competing joint-venture financing is more fully invested.

A typical commitment by Lime Rock is in the $80- to $120-million range, although that level may be reached initially through a $25- to $30-million tranche for acreage acquisition, with subsequent investments layered in as the concept is proved up and developed. “Teams we back are teams we want to see go through a full cycle—owning an asset, developing an asset, and selling an asset,” says Pressler. “Some people like to acquire and prove the concept and flip it. We are more full cycle.”

Proving a concept

Geographically, just less than 50% of the firm’s Lime Rock Partners V Fund was invested outside North America. The latter fund raised $1.4 billion, and a similar amount is targeted to be raised this year, with $800 million in commitments secured to date. The firm clearly enjoys the flexibility of investing across more than a single sector and single continent. “A lot of people don’t know that in addition to offices in Houston and Westport, Connecticut, we have offices in London, Aberdeen and Dubai,” says Pressler. “If we are not seeing opportunities in the U.S., we are looking at investments in the North Sea.”

In general, the firm targets a three times return on investment, although funding an acquire-and-exploit strategy versus a drilling concept has “very different return thresholds for us,” notes Pressler.

If midstream investments capture a growing percentage of private equity, traditional E&P still represents the largest segment in absolute dollars.

Lime Rock earlier this year funded Capstone Natural Resources, whose management (ex-Arena Resources) is focused on acquiring producing properties in the Central Basin Platform of West Texas and exploiting them through in- fill drilling and production optimization. “We see this as lower risk,” he says. It has also funded CrownRock, a joint venture with CrownQuest Operating that was an early entrant into the Wolfberry play and was aggressively leasing before the play was well-defined. It now has 10 rigs running, having proved up what was just a concept a few years ago.”

Townes Pressler

Lime Rock Partners’ managing director Townes Pressler expects opportunities to add to the firm’s unconventional gas portfolio.

Mike McMahon, a founding partner with New York-based private-equity firm Pine Brook Road Partners LLC, suggests that fewer opportunities lie ahead for getting an early acreage position in a hot emerging play and then being able to flip it for multiples of one’s investment.

“People are realizing that the layups have all been taken, and now you are forced either to take more risk in the rock properties or come in later in the life cycle of the projects.”

Even if entering after resources have been identified and validating wells have been drilled, returns can be “very attractive.” Often operators “bite off more than they can chew, so what they seek to do is either sell off non-priority projects or do a joint venture with private equity to allow them to extend their operating capabilities over multiple basins.”

Pine Brook is a $1.4-billion fund focused on helping start new businesses or recapitalizations. It is led by former Warburg Pincus vice chairman Howard Newman; energy is one of two areas of expertise, the other being the financial sector. After allowing for incentive arrangements for management, Pine Brook and its co-investors typically end up with a controlling interest in the companies they back. In energy, “management is the key to success. And since we are building companies from scratch, management is even more critical to our business model,” says McMahon. How to find good management? “The best way to find an outstanding management team to back is to back an outstanding team that previously made money for you.”

Mike McMahon

Mike McMahon, with New York-based private-equity firm Pine Brook Road Partners LLC, says that fewer opportunities lie ahead for getting an early acreage position in a hot emerging play.

Denver-based SFC Energy Partners reached mid-2012 with nearly 100% commitments in its Fund I, which raised $415 million, while three portfolio investments representing a 26% commitment have to date been made in Fund II, which raised $596 million in 2011. SFC looks to back “solid management teams with sound technical basis and business plans,” notes managing director Geoff Solich, and the firm continues with the same oil-weighted bias adopted for its first fund in its Fund II investments, which are “virtually all oil-based business plans.” Both Funds I and II made capital commitments to ExL Energy II, whose focus is on the continued development of assets in the Wolfbone play in the Permian Basin.

Lane Britain, managing director of Falcon E&P Opportunities Fund, describes his firm’s private-equity role as much by outlining what it does not require as what it does. Its investing criteria do not require operators to give up an equity stake in the operating company, nor does it seek operatorship of the properties, “and for most of the small operators that we partner with, that’s important.”

Lane Britain

Lane Britain, managing director of Falcon E&P Opportunities Fund, describes his firm’s private-equity role as much by outlining what it does not require as what it does.

The fund, which held its final close in November 2011, has committed $101 million of the $163 million it raised to six operators spread across Texas, Oklahoma, Kansas and Wyoming. Investments are made through non-operated working interest purchases in individual projects. Falcon participated in 52 wells in 2011, and that number should increase in 2012.

“We are busy trying to invest the rest of the capital and are always looking for good projects,” says Britain.

Falcon looks for projects of less than $50 million in total size and typically invests $5- to $30 million per project.

“We are focused on an underserved market segment,” comments Britain. Falcon partners with operators in two primary deal types. One is helping turn an exploration project into a fully developed project. Another is partnering on acquisitions that are larger than the operator could undertake on its own. For a project to meet Falcon’s criteria, there needs to be some proved developed properties (10% to 30% of reserves) and lots of drilling. Once Falcon has regained its capital and reached a return hurdle, the operator backs into a portion of Falcon’s interest. The back-in rises with project returns.

Falcon takes a contrarian view on several fronts. With the industry focused mainly on shale plays, the firm looks mostly at conventional projects. The Falcon team is happy to look at both oil and gas projects, but Britain is quick to say “we’re very bullish” on the long-term outlook for gas. “Prices have stayed consistently low” to the point that people “are conditioned that $5 per Mcf (thousand cubic feet) gas is not a near-term possibility. This makes transactions possible.”

Earlier this year Falcon made an initial investment in the Arkoma, partnering with Redbud E&P to acquire about 100 operated wells, as well as a West Texas oilfield with conventional and Cline shale drilling. Several months later, Falcon and Redbud were able to add substantial scale and synergies in buying a larger Arkoma package. The long-lived Hartshorne coalbed-methane properties now comprise 448 operated wells, 280 nonoperated wells and 115 miles of gathering system.

So the flow of private equity continues, both small and large: KKR’s purchase of Samson Resources, and Apollo’s acquisition of El Paso upstream assets. (For more detail, see Investor’s September issue.) What could muddy the waters? Interest rates are clearly a factor. Also, “what you don’t hear a lot of is what the end results were from the capital allocated to dry-gas shale plays at a time that was not especially propitious,” says Bill Weidner.

“That’s the elephant that’s somewhere in the room; it’s just not clear. This is a business where timing is not a small factor.”