Private equity looking for growth and high returns in a recovering market is still finding a home in oil and gas investing. That’s the message the founders of EnCap Investments LP are getting, just days removed from closing their latest oil and gas investment fund. Hard-capped at $3.5 billion, EnCap Energy Capital Fund VIII was oversubscribed with 190 institutional investors, many of them repeat customers.

Though 2008 was a challenge, appetite for oil and gas investing has rebounded, driven by weakness of the dollar and strengthening oil prices. EnCap’s track record added spice to the menu. Four of the 10 largest oil and gas property sales in 2010 were by EnCap portfolio companies, and one of the largest initial public offerings last year was of another, Bakken-focused Oasis Petroleum Inc., which IPO’d in June.

EnCap is not waiting to put Fund VIII to work: a third has already been committed, and 20% of the total will be dispersed to portfolio companies this year.

Some aspects of the business are changing, according to managing partners Bob Zorich, Gary Petersen, Martin Phillips and David Miller, who founded the company 22 years ago. The four equal partners have seen their private-equity funds grow in billion-dollar increments in each of the last three funds, a necessity born of increased technological requirements in oil and gas.

EnCap Investments’ managing partners founded the company 22 years ago. Left to right, Bob Zorich, Martin Phillips, Gary Petersen and David Miller.

“We’ve gravitated toward more sophisticated and experienced management teams that typically have diversified, multibasin strategies that incorporate advanced technology and therefore, require larger capital commitments. As a result, individual commitments are somewhat larger, but the number of portfolio companies per fund is relatively constant,” Phillips says.

The newest fund, like its predecessors, will finance around 25 companies over a five-year period at a fairly even pace, about 20% per year. The multiyear funding strategy helps mitigate risk, allowing EnCap to jump on emerging opportunities.

“We typically advance capital over a two-, three-, or four-year period as our portfolio companies bring compelling acquisition and lower-risk drilling opportunities to the table and demonstrate progress in executing their business plan. It’s sort of like an equity line of credit,” says Miller.

Some 60% of the people with whom EnCap invests are repeat E&P teams. Their results have been so good that 95% of the repeat start-ups don’t even have assets, only a proven team and an agreed-upon strategy. Of the eight teams to which the firm has already committed with Fund VIII, six are prior winners. The balance in any given year ranges from two to five new management groups.

“Typically, the new people who join us fall out of industry consolidation. So when Conoco bought Burlington, for example, we got a couple of Burlington teams,” says Zorich. One of those became Oasis.

Then too, executives leave companies for other reasons, in order to fly on their own. The most recent deals, closed in January, both involved $150-million commitments from EnCap. The president and chief executive of Rex Energy Corp., Ben Hulburt, left that company last fall, and formed an Appalachian shale-focused company, Eclipse Resources I LP. Two executives formerly with Pioneer Natural Resources Corp. have formed Venado Oil and Gas LLC, with a South Texas focus.

Outside of the occasional comment, the partners aren’t interested in molding each new company’s strategy. Though they have plenty of experience and have seen lots of projects, they endorse rather than set specific strategies for their companies.

“We either buy into the vision, or we don’t fund it. If we are creating the vision,” says Zorich, “then it’s a bad fit. The guys we back have to have the passion to make it work.”

“Our real contribution is on the risk-management front, and the exit strategy,” notes Phillips. A shared view of risk and opportunity is essential between EnCap and its portfolio teams. While hedging is a component of managing risk, Miller says, “It’s really more about making good decisions as far as capital allocation is concerned and, in the case of drilling-oriented strategies, not exposing too much money to acreage too early. It’s their company and they manage it day to day.”

Generally, the strategy the 40 to 50 management teams pursue is a function of the current industry climate. “A key piece is asking yourself where you go to make money, and where you go to build an opportunity set that someone wants to buy,” Zorich says.

There is a lot of debate currently within the private-equity community about whether to fund shale-focused companies, but EnCap knows what it wants to do.

According to Miller, “We’ve been investing significant amounts of capital in companies pursuing the shales for well over a decade. In fact, we already have some 20 full-cycle investments in the various resource plays, and that part of our investment strategy has worked very well. But…we don’t care whether a project is characterized as conventional or unconventional. Our decisions are a function of what the economics look like, our assessment of the underlying risk, and whether or not the company is creating a base of assets that will be attractive to the buying universe.”

EnCap thinks it could take another couple of years for the natural gas picture to improve, so it’s not been willing to completely embrace the forward curve. “Fortunately, many of our portfolio companies are in plays with a strong liquids component, which enhances the drilling economics,” Miller says.

The exit strategy is another important consideration throughout the company-building process for each portfolio company. Once the latter has added value to assets by developing them effectively, it sells to a larger entity looking to grow or take a position in a play where the buyer may have no exposure.

After selling, many EnCap-backed teams start again with a new round of EnCap funding. Several of its companies are already doing so. Miller cites Laredo Energy, now building version five; Plantation Petroleum Holdings LLC, under way on version four; and Cordillera Energy Partners, on its third iteration.

Changes since 2008

Factors like acreage and development costs are constantly shifting, so adapting to circumstances is essential to investing at the right time and price. The dance between price, play maturity and data availability and risk is tricky. However, the EnCap founders believe the volatility after 2008 had the positive effect of shaking out models that did not work, and validating teams and strategies that did. Besides having a strategy, Petersen credits flexibility for some of their portfolio teams’ success.

“The guys who get frustrated with the bureaucracy are good candidates for private equity, because we have no bureaucracy. Our guys are 100% focused, daily, on creating value. The competition has to worry about the assets they already own, which is often distracting. That’s the edge our guys have.”

Investors have changed as well, remarks Phillips. “The institutional due-diligence process in general is much more extensive. A lot more of our investors are spending more time here in Houston, looking at every file, talking to every professional.”

Petersen says the big challenge in the future for private-equity providers is the continuing goal: to find the right opportunities to get into at the right time.

“For us there is always tension around point of entry,” Phillips explains. “If the play is too immature and there is very little data, it is typically relatively inexpensive to get in but the risk profile is higher. The other end of the spectrum is a mature area where you have a lot of data and it has been largely de-risked, but the entry price there is higher. Managing that tension and that risk is what we do.”

Adds Petersen: “The opportunity set in 2011 is not the same as in 2008.”

One growing opportunity? The midstream. EnCap joined forces with Flatrock Energy Advisors in 2008 to create a midstream fund.

“It’s benefited our upstream partners, bringing the possibility of a midstream solution to them,” says Phillips. “The fund has activities in virtually every one of these major unconventional plays, from the Eagle Ford to the Marcellus to the Bakken and Haynesville.” With half the roughly $800-million midstream fund committed, the group has been pleased with results thus far.

The group thinks that investor sentiment will continue to be strong on oil and gas. “Most people view energy, and oil and gas in particular, as a very positive place to put money. There is no question about it. People view oil as a safer place to invest. When you look at the economy in general, energy is a good bet,” says Zorich.