California Buyside

From the Pacific Coast to the Sierra Nevadas, and from the Mojave Desert to the redwood forests, California is home to wind-swept mountains and sun-drenched valleys, the entertainment industry, cutting-edge technology—and money.

In fact, the state has a long history of backing the courageous and the creative. From the gold miners of the 19th century to today’s Hollywood elite, California continues to be the land of opportunity. Every day, fortunes are made in the world-renowned vineyards of Napa Valley, the technological enclaves of Silicon Valley and the boardrooms of the state’s financial centers. In 2007, the gross state product was the largest in the U.S., weighing in at $1.8 trillion.

California is also the most populous state, and thus one of the largest users of energy. Surprisingly, it also has the smallest per-capita energy use of any state. But that doesn’t stop investors such as David Anderson, portfolio manager for Palo Alto Investors LLC, from making energy a significant part of his portfolio.

Long-term Palo Alto

“We are looking for companies that can double and double again. That’s where high-value, long-term returns are created,” says David Anderson, portfolio manager, Palo Alto Investors LLC.

Energy stocks command about a quarter of Palo Alto’s $1.2-billion hedge-fund portfolio. Of that, E&Ps make up about 50%, down from prior years when upstream comprised some 60%. Today, service providers make up about 10% of the portfolio’s energy component, down from 30% in past years. The remainder is in alternatives and other energy investments.

“We are bottoms-up stock pickers,” says Anderson. “The energy component of our funds is less than it was a few years ago in part due to performance of the sector. That doesn’t mean we don’t think energy is a good place to be. It’s simply that the relative value and opportunity may be greater in other sectors right now.”

Palo Alto rarely shorts stocks, holding about 95% of its companies long-term. Says Anderson, “We don’t look for stocks that are expected to rise 10% better than an index. We are looking for companies that can double and double again. That’s where high-value, long-term returns are created.”

The analyst has been somewhat biased to oily stocks in 2008 and 2009. “A year ago, we got out of most of the gas-oriented names when the price was extremely high during summer,” he says. “We were not predicting the economy’s fall, but we were predicting that gas would come down to $8 per Mcf from its high of $14. And it did; then it kept falling.”

Anderson had seen gas companies continuing to sell equity or tap the debt markets. While such names are creating value with their underlying reserves and asset portfolios, that value doesn’t always accrue to the investor, due to the constant need for more capital, he notes.

The hedge fund does include one challenged gas company—Gastar Exploration Ltd. But Anderson is convinced it will recover in the wake of its recent asset sale. This past July the Houston-based company sold its New South Wales, Australia, assets to an unnamed buyer and its shares of Gastar Power Pty Ltd. to an affiliate of Santos Ltd. It also voluntarily de-listed its shares from the Toronto Stock Exchange (TSX), effective July 6, and in August completed a 1-for-5 reverse-split share consolidation.

“We are large owners of Gastar, which sold its assets to get out of debt trouble,” says the buysider. “Now we think the company is in fairly good shape, although it has to hunker down to get through this low-gas-price cycle.”

Anderson cautions that gas players might be forced to hedge their gas at fairly low prices, and miss the comeback’s upside. “The best hedge is a low cost structure,” he advises.

He is also biased to microcap and small-cap companies. “Am I going to be better than the other 68 guys looking at Chesapeake Energy? Probably not,” he laughs. “There are a lot of smart people evaluating the large-caps. We deep dive into the smaller companies, taking three to six months before we invest.”

The analysts often visit a company’s operations, partners, vendors and competitors before placing funds.

The firm was an early investor in Fisker Automotive, which developed a plug-in hybrid sports car that it intends to begin selling in June 2010.

“That investment is a way for us to understand what’s coming on energy’s demand side,” he says. “When we are imbedded in a private company like this, we get more information on the technology that is coming and the factors that are changing the competitive landscape. It’s a research advantage for us.”

Palo Alto plans to increase its holdings in non-U.S. E&Ps. “We believe Europe is the next place,” he says, explaining that there is a “tremendous opportunity” in exporting shale- and methane-gas technologies to Western Europe, Poland, Turkey and elsewhere. Poland, he notes, is a very stable gas market, supporting prices at an average $10 per Mcf.

“There are mature gas and oil basins onshore Europe. They are analogous to the U.S. and much of the geology is well known. We have investments that are playing on the theme that Europe needs more gas so it can get off the Russian OAO GazProm pipeline.”

Anderson bets that small-cap E&Ps, as opposed to service companies, will create the best value during the transfer of technology to Europe. “A smart team of people, funded by $50 million, can create $1 billion of value. It’s harder to do on the service side because of scale. That’s a more capital-intensive business.”

Contrarian Kayne

“Some MLPs’ unit prices experienced distress, but we saw it more as forced selling from hedge funds that were having liquidity issues,” says J. C. Frey, partner and portfolio manager, Kayne Anderson Capital Advisors LP.

Celebrating its 25th anniversary this year, Los Angeles-based Kayne Anderson Capital Advisors LP manages some $7 billion in investments. It has some $2.7 billion invested in private upstream energy companies and another $3 billion in public securities, including midstream master limited partnerships (MLPs), shipping companies and royalty trusts.

In June, the firm closed its fifth energy private-equity fund with total commitments of $820 million. As with prior funds, the new fund targets early- to midstage North American oil and gas companies, with typical investments ranging from $20- to $150 million.

Kayne’s major concentration, as measured by funds invested, is midstream MLPs. Its activities include a variety of midstream hedge funds and publicly traded closed-end funds. The firm’s managers are particularly enthusiastic about their Kayne MLP Fund LP, and with good reason. Carved out of a larger, diversified fund in January 2003, the hedge fund is one of the largest of its kind, says J.C. Frey, partner and portfolio manager.

Frey began managing midstream investments for Kayne in 1998 and has been portfolio manager of Kayne’s public and private MLP funds since their inceptions.

The analyst’s strategy is to focus on niches and adapt to changing business cycles, finding value when timely opportunities arise. Given the unpredicted shift last year in financial markets, Frey says the fund’s ability to react quickly is a valuable asset.

“Everything has changed since last year,” says Bob Sinnott, president and chief investment officer. “Investment firms not only had to assess the strength of companies in which they invested, but they also had to judge the strength of their own investor base and those of their fellow participants in the market.”

Such problems were compounded when commercial and investment banks limited or closed access to leverage as they evaluated and stabilized their own balance sheets. This credit contraction forced many MLP funds to reduce their portfolio size.

“Times got silly and strange things began to happen,” says Frey. “When Lehman Bros. failed, it not only liquidated a large MLP fund of its own and stopped extending credit to its clients, but it also led banking competitors to stop providing investment leverage to theirs.”

Says David Labonte, senior MLP research analyst, “With the continuing collapse of energy prices compounding the liquidity problem during fourth-quarter 2008, competing firms, some of which had both financial leverage and significant exposure to commodity prices, began blowing out various positions. Kayne took the opportunity to buy some of those incredibly depressed names.”

West Coast buysiders are invested in a variety of oil and gas and renewable energy companies.

As contrarians, the managers were confident their holdings would continue to deliver promised distributions into 2009 and 2010, and in some cases increase those distributions. To that end, the team began to build sizeable positions in Energy Transfer Equity LP, MarkWest Energy Partners LP and Enterprise Products Partners LP, among others.

“Some MLPs’ unit prices experienced distress, but we saw it more as forced selling from hedge funds that were having liquidity issues,” says Frey.

Kayne also made a major shift to the general partners of MLPs. The general partners’ unit prices had been affected by investor concern that tight capital markets would lead MLPs to cut their distributions. Yet, when the capital markets improved, that concern dissipated and they recovered.

The team was confident it could identify the long-term strategic winners and manage through the market turbulence, says Sinnott.

“We avoided certain MLPs that suffered from the 2007 private investment in public equity (PIPE) overhang, where too many units were issued into the market over a short period, thus reducing liquidity and value, until we could be the final takeout,” he says. “It wasn’t uncommon to see PIPE participants unload securities at a very healthy discount to the prior market.”

The firm also reallocated its portfolio companies to de-emphasize commodity-price risk for the asset-rich investment class. The managers particularly prefer MLPs that generate fee-based cash flow, because distribution requirements tend to stress MLPs that are highly sensitive to commodity prices.

Says Sinnott, “During the past two years, we’ve seen newly formed MLPs suffer through dramatic changes in their economics due to commodity-price changes. We focused on firms that could take advantage of that volatility in their gathering and processing activities.”

When evaluating when to fund and how much capital to place with a pipeline operator, Kayne considers its hedging strategies, internally generated expansion plans and cost-of-capital issues.

Looking into 2010 and beyond, MLPs are “still very attractive and undervalued across almost any metric,” says Frey, pointing out that renewed access to capital has reduced the MLPs’ capital costs, making growth projects not only attainable but now very profitable.

He predicts that increased shale-gas production and imports of Canadian crude will require new pipelines and equipment to meet market demand. As these projects are completed, they will become competitive and hard to replicate. As a result, he has no doubt that new capital will continue to flow into the MLP space to finance acquisitions and expansions.

“Even with a modest revaluation, coupled with high current yields and growth rates, it is not unreasonable to expect 20% to 30% returns through 2010,” says Frey, while admitting that in today’s financial markets and political environment, nothing is guaranteed. Today, the average yield of MLPs hovers around 9%. At the peak of their market prices, yields were driven as low as 5.25%, “which implies that there is additional room for revaluation,” he says.

Frey is certain, however, that as capital “gets back to work, one can assume that more investors are going to be looking for yield first, particularly in light of this low-interest-rate environment.”

Labonte adds that in addition to satisfying income-oriented investors, the MLP asset class is attractive to investors seeking an inflation hedge.

Says Ric Kayne, chief executive and founder of the company, “Investors should take advantage of market declines and not run from them. Periods of great stress are traditionally periods of great opportunity.”

CalPERS capital

“We focused on firms that could take advantage of that volatility inherent in their gathering and processing activities,” says Bob Sinnott, president and chief investment officer, Kayne Anderson Capital Advisors LP.

California is also home to the nation’s largest public pension fund, the California Public Employees’ Retirement System (CalPERS). The Sacramento-based agency of the California executive branch manages pension and health benefits for more than 1.6 million California public employees, retirees and their families.

Even this giant has felt the past year’s financial distress. At press time, CalPERS’ total fund market value was $202.1 billion, a decrease from its assets’ peak value of $260.6 billion in October 2007. Nonetheless, the agency estimates it will pay a whopping $5.7 billion in health benefits this year alone.

In fact, included in its top 20 largest holdings are ExxonMobil Corp. (with a fund share of $2.1 billion as of year-end 2008), Royal Dutch Shell ($1.1 billion), BP Plc ($1 billion) and ChevronTexaco Corp. ($868.3 million).

lthough we don’t invest directly in stocks, we have energy investments across the board,” says Clark McKinley, public information officer for investments. “We don’t have a consolidation for energy, but we hold about 9,000 companies’ stocks and a lot of those are energy investments. We have all the big ones that are in the index funds.

“We also have a private-equity fund, named Alternative Investment Management. Energy makes up about $2 billion of the total $21 billion invested,” says McKinley. “There is a like amount committed, but not yet invested. Those are invested with fund-management partners.”

In addition to income-oriented investors, the MLP asset class is attractive to investors looking for an inflation hedge, says David Labonte, senior MLP research analyst, Kayne Anderson Capital Advisors LP.

Such partners include ArcLight Energy Partners, Blackstone Capital Partners, Kohlberg Kravis Roberts & Co. and Lime Rock Partners, among others.

“We are not a research outfit so we don’t aggregate the types of industries into sectors. We do know that we will continue to be invested in the energy stocks going forward. There is no plan to change that,” McKinley says. “We are long-term investors. We plan to follow the indexes and keep our seat at the table.”

Recently, CalPERS added a new dimension to its fund portfolio—commodities investment. Oil futures have made up as much as 30% of that portfolio. The pension fund’s fully collateralized swaps with investment banks generally follow the weightings of Standard & Poor’s Goldman Sachs Commodity Index, with some opportune tweaking by CalPERS officers.

“Investment officers have discretion to invest from 0.5% to 3% of the total CalPERS market value (today, up to $171 million) in commodities by the end of calendar year 2010, but there’s not an absolute requirement that they do so,” says McKinley. “We continue to move prudently in this relatively new sub-asset class.”