Energy is the largest sector in the $1.3-trillion high-yield bond market, accounting for 13% of the high-yield index. Further, the energy sector has been the largest new issuer of high-yield bonds since 2009, making up 12% to 13% of total new issuance.

E&Ps specifically have taken a hefty slice of the energy high-yield market, at just over 50%. The domestic E&P high-yield bond market is approximately $54 billion, comprised of 58 companies, including 47 public companies, with equity-market capitalization ranging from $6 million (Dune Energy Inc., at press time) to $20 billion (Chesapeake Energy Corp.). From a bond investor’s perspective, a public company’s equity-market capitalization provides an attractive cushion and protection against value erosion, while the implied enterprise value offers a market valuation for the company’s resource base.

Private energy companies are also taking advantage of this financing option, however. Eleven private E&P companies currently account for $5.2 billion, or 10% of the outstanding E&P high-yield bonds. And this activity is on the rise. Some $4.3 billion, or over 80% of the outstanding private E&P bonds, has been issued since November 2009. In 2010 and year-to-date 2011, private companies accounted for 12% of total E&P high-yield issuance.

Only two of these private companies had issued high-yield bonds prior to 2009—Hilcorp Energy Co. and Chaparral Energy Inc., in 2003 and 2005, respectively. Both companies are considered “seasoned” issuers and aren’t subject to the same scrutiny as is a first-time issuer, especially given their recent value-defining transactions. In April 2010, Chaparral’s valuation was confirmed by private-equity group CCMP Capital Advisors’ $345-million equity investment, for a 37% stake in the company. And, in June 2011, Hilcorp announced the sale of its interest in its Eagle Ford joint venture with KKR to Marathon Oil Corp. for more than $2 billion, with closing expected in November.

Here are details of recent bond deals by first time private issuers.

As a private company becomes more seasoned, subsequent high-yield issuance becomes easier and cheaper. For example, Antero Resources placed high-yield bonds with a 7.25% coupon in July 2011, compared to 9 3/8% in November 2009. The Denver-based company focuses on the Piceance Basin and Marcellus and Arkoma Woodford shales.

In this article, we focus on the nine private companies issuing high-yield bonds for the first time since November 2009. In particular, we look at why the high-yield bond market has been open to private E&Ps over the past two years; why these bonds are an attractive source of capital for private companies; and the characteristics bond investors look for in private companies. Finally, we take a look at the typical terms of high-yield bonds, as illustrated by Woodbine Acquisition Corp.’s $250-million bond deal, done in May 2011, via Global Hunter Securities.

Market overview

The high-yield market has experienced strong new issuance across all sectors in recent years, reaching a record $180 billion in 2009, jumping to another record $300 billion in 2010, with a strong year-to-date 2011 issuance of $200 billion. The market’s performance has been equally impressive, with a total return of more than 55% in 2009, 15% in 2010 and approximately 3% year-to-date, exceeding returns in the stock market (S&P 500) in each period.

Given current low yields on Treasuries and investment-grade bonds, the high-yield market provides relatively higher yields. Further, default rates, a key driver of market yields, have been exceptionally low, at about 1% since 2010.

This overall strength of the high-yield market, coupled with strong crude oil pricing and U.S. merger-and-acquisition activity at attractive valuations by majors and international oil companies, is likely responsible for the recent surge in bond issuance by private (as well as public) E&Ps.

Why high-yield?

High-yield bonds represent an attractive alternative to equity and mezzanine financing. First, the traditional source of capital for E&P companies is the commercial bank, which primarily lends against the PV-10 value of proved developed producing (PDP) reserves. But E&Ps often find that growth is difficult using only bank debt.

For example, RAAM Global Energy Co. repaid low-cost bank debt (6% interest) with higher-cost bonds (12 1/2%), to capitalize on growth opportunities. Also behind the move was the management’s belief that, at the time, bank financing was unreliable, given banks’ ability to drastically reduce borrowing bases in a downturn and bank failures during the credit crisis.

Ten months after its original offering, RAAM completed a $50-million add-on offering of bonds at a lower cost than the original deal. These financings have allowed the company to build attractive positions of 104,000 net acres in the Mississippian oil play and 22,000 net acres in the Monterey shale.

High yield is also attractive compared to the mezzanine market based on several factors: timing, cost and covenants. A high-yield bond offering typically requires four to eight weeks, compared with 10 to 16 weeks for mezzanine financing, due to the latter’s cumbersome diligence and documentation process. Further, the cost of capital for even a first-time high-yield issuer (9% to 14%) is attractive relative to mezzanine hurdle rates from the high teens to the low 20s, which also may include overriding royalty interests.

Also attractive is that high-yield bonds typically have only debt-incurrence covenants, which are much more flexible compared to the maintenance covenants in both bank and mezzanine financing. Further, these bonds typically have no amortization requirements. Houston-based Black Elk Energy LLC repaid high-cost mezz-type (20% coupon) debt owed to its private-equity sponsor using high-yield bonds. Six months after the bond offering, Black Elk completed a transformative offshore acquisition in June, doubling its size. This is the eighth acquisition it has made since 2008.

And finally, equity offerings, either public or private, involve giving up ownership and possibly, management control. Typically this is not the case in high-yield deals, except in special circumstances. Moreover, high-yield debt can be a bridge to an initial public offering.

The energy sector has been the largest new issuer of high-yield bonds since 2009, making up 12% to 13% of total new issuance. A number of private E&Ps have joined in.

Factors in successful offerings

Following are characteristics that high-yield bond investors find attractive:

Private-equity sponsor. In the absence of a public valuation, bond investors prefer private companies sponsored by brand-name private-equity groups, especially those with a deep industry focus. Thus, the Antero Resources and Laredo Petroleum offerings backed by a marquee energy-focused private-equity sponsor (Warburg Pincus) were both well received. Obviously, the greater the cash equity invested, the more confident the bondholders feel.

Management background. A management team with a proven history of value creation is a huge plus. Again, a good example is Tulsa-based Laredo Petroleum, founded in 2007 by Randy Foutch, a highly successful oil-industry entrepreneur who previously founded two Warburg portfolio companies: Lariat Petroleum in 1997 (sold to Newfield in 2001), and Latigo Petroleum in 2002 (sold to Pogo Producing in 2006).

Management ownership and equity. Bond investors like a highly incentivized management team with “real skin in the game,” i.e., a significant portion of their net worth invested in the company. For example, RAAM Global’s cofounders, Howard Settle and Jonathan Rudney, owned over 50% of the company.

Exit strategy. This is very important for a private company, where there is no public valuation for its assets. A well-defined exit strategy—either a sale (e.g., Woodbine) or an initial public offering (e.g., Laredo) allows bond investors to look for enhanced returns via an equity clawback (at a large premium to par) or sale, with a possible tender of the bonds at a premium to par.

Use of proceeds. Bond investors prefer debt repayment and attractive acquisitions as uses of bond proceeds. Dividends and/or debt repayment to private-equity sponsors are looked upon unfavorably.

History. Bond investors prefer companies with a long track record, such as RAAM (formed in 1986) and AltaMesa Holdings (formed in 1987). Alternatively, while Black Elk did not have a long track record, its acquisition history at attractive multiples was a positive factor. Reserve engineer. In the absence of a public-market value, bond investors will pay significant attention to the reserve report, evaluating asset coverage based on SEC proved PV-10 and proved developed producing (PDP) PV-10. Investors recognize the relative reputations of various reserve engineers, with Netherland Sewell & Associates and Ryder Scott & Co. considered to be the gold standards.

Size. While bigger is always better, the high-yield market has recently been open to companies with proved reserves as low as 54 billion cubic feet equivalent (Vitruvian Exploration) and production as low as 11 million cubic feet equivalent per day (Woodbine).

Asset quality. This is ultimately the key to any deal, with investors focusing on the mix of conventional vs. shale; PDP vs. proved undeveloped (PUD) reserves; oil vs. gas; offshore vs. onshore; and the full-cycle cost structure (operating and finding and development costs).

Credit statistics. Bond investors favor low debt metrics based on proved reserves, production and EBITDA. A deleveraging credit with free-cash-flow generation (capital expenditures limited to operating cash flow) is ideal.

Case study: Woodbine Acquisition Corp.

In late 2010, New Gulf Energy, Petromax and CH4 Energy placed their Woodbine operations for sale via Lantana Partners, an A&D advisory group. Richland Resources Inc., Fort Worth, signed a purchase and sale agreement in March 2011, with the $5-million earnest-money deposit funded by Richland and the placement agents, and formed WAC to do the acquisition. In 2010, Richland had hired a team of five highly experienced operations people to evaluate acquisitions, from Encore Acquisition Corp., which had been acquired by Denbury Resources in May 2010.

Based on the quality of the assets, with oil representing 93% of proved reserves, a Nether-land Sewell & Associates (NSAI) reserve report, 100% horizontal drilling success and the most recent well posting an initial potential of 1,300 barrels of oil equivalent per day, Rich-land was able to attract a well-regarded CEO and CFO, both with substantial experience at public as well as private-equity-backed compa- nies. Further, the acquisition was funded 100% with debt. Here were the main features of the WAC deal:

Section 4 (2) offering. A typical high-yield offering is done as a private placement under Rule 144A of the Securities Act of 1933. However, such an offering requires three years of audited financial statements. Since the first Woodbine horizontal well was drilled in the first quarter of 2009, only two years of audited financials were available. Thus the 144A option was not available.

Fortunately, the lead placement agent, Global Hunter, had previously completed successful bond offerings for Black Elk Energy and Vitruvian, neither of which had three years of audited financials, under Section 4 (2) of the Securities Act of 1933. The difference between a 144A and a Section 4 (2) offering was in the mechanics of the deal closing. A 144A offering was closed with a simple trade ticket with the underwriters of the deal, who were the initial purchasers of the bonds and then resold them to bond investors.

In a Section 4 (2) offering, bond investors purchased the bonds directly from the issuer and the closing involved an extra step: instead of a trade ticket, investors had to sign a purchase agreement for the securities.

Registration rights. WAC bonds came with registration rights. This is important for two reasons. Prior to bonds being registered with the SEC, they can be traded only among qualified institutional buyers (QIBs). Once bonds are registered with the SEC, they become freely tradable among all investors (including individuals), thereby increasing trading liquidity.

These private E&Ps have been high-yield issuers.

The second reason registration rights are important is availability of financial information to the market. For bonds without registration rights (also called 144A for life), financial information on the company (e.g., Hilcorp) is not readily available, making it difficult for analysts and investors to evaluate the securities.

Ratings. WAC bonds were unrated. Since warrants were required to sell the bonds, they had an implied rating of CCC, with the company saving the cost of rating by Moody’s and Standard & Poor’s. This was similar to unrated Vitruvian bonds, which also were sold with warrants.

Security. WAC bonds were secured, with a second lien on all assets. As is typical, WAC’s revolving credit facility with Texas Capital Bank had a first lien on all assets. The security makes the bonds more attractive to investors and was also featured in the RAAM Global, Vitruvian, Black Elk and Milagro Oil & Gas bonds.

Note that private first-time issuers like Antero, NFR Energy and Laredo were able to sell unsecured bond deals, likely due to the perceived name brand of the private-equity sponsors behind them, Warburg Pincus (Antero, Laredo) and First Reserve (NFR).

Maturity. WAC bonds had a maturity of five years, in line with the RAAM, Black Elk, Vitruvian and Milagro secured deals. The maturity of the unsecured bond offerings of other private companies ranged from seven years for NFR Energy to as long as 10.5 years for seasoned issuers Chaparral and Hilcorp.

Coupon/Original issue discount (OID). WAC bonds carried a 12% coupon and were issued at a discount of 99.085 to yield 12.25%. The majority of the new issues were sold with an OID, with the only exception being Laredo, sold at par. Coupons ranged from 9 3/8% (Antero) to 13 ¾% (Black Elk), with yields ranging from 9.5% (Antero, Laredo) to 14% (Black Elk).

Units/Warrants. The WAC offering was for 250,000 units, consisting of $250 million in aggregate principal amount of notes and 250,000 “penny” warrants (with a strike price of $0.01 per share) to purchase shares of common stock. Given there was no equity in the deal and bond investors put up the entire purchase price (except for the earnest money deposit), bondholders received about 70% of the equity in the form of warrants, with the remainder going to the parties who made the earnest money deposit and to management.

Covenants. WAC has some very restrictive covenants relative to other bond deals. The credit facility carve-out is a hard $40 million, compared to all other E&P deals, where this is based on a percentage of SEC PV-10 so that the revolver size can grow as the company grows. WAC’s restricted payment basket does not include 50% of cumulative net income, as is the case with every other high-yield deal. WAC also has a maximum capital expenditure covenant.

In addition, WAC bonds have an excess cash-flow sweep covenant, whereby WAC has to make an offer to repurchase bonds (at par) with 75% of excess cash flow (EBITDAXinterest-dividends-taxes-capex-working capital change-debt repayment) in excess of $5 million. By comparison, only Black Elk bonds have the maximum capex and excess cash-flow sweep covenants.

Liquidity event. Management is incentivized to sell the company or take it public. If WAC is sold for over $500 million, bondholder ownership will drop from 70% to 62%, with management and the entities that funded the earnest-money deposit getting the remaining 38%.

In conclusion, the high-yield bond market represents an attractive source of capital for private E&P companies. Given characteristics that are attractive to bond investors, and successful positioning, E&Ps can benefit from this financing strategy.

Ravi Kamath is the head of fixed income research, with a current focus on the energy sector, at investment bank Global Hunter Securities. He has 20 years of research experience, both on the sell side and buy side, covering equities, fixed income, and a broad array of cyclical industries, including energy.