Private Equity

Since the beginning of the recession, some publically held oil and gas producers have seen their stock prices plummet, dragged down by collapsing commodity prices and the soaring cost of debt. Many suffered a double whammy when their revolving loans were slashed by up to one-third by lenders who were pressured by risk-averse bank examiners.

Banks are still struggling after surviving a rocky first quarter. Meanwhile, astute entrepreneurs, with one eye cocked on distressed-sale assets and falling oilfield service prices, saw the opportunity to fund new, privately held companies or buy out existing companies. Who needs commercial debt or public equity when private-equity providers are looking to place millions with experienced manage

Recently, two major-league private-equity funds entered the market and hit the ground running, cherry-picking worthy investment opportunities in both domestic and global plays with known money-making management teams.

In March, New York-based Pine Brook Road Partners LLC, closed its first private-equity fund with total capital commitments in excess of $1.43 billion.

The fund’s first hard close was in December 2007, when it invested in four energy companies and two financial-services companies. Since then, it has added four more portfolio companies to the mix. The timing of fund-raising and portfolio-investment worked well for the stakeholders. As Michael McMahon, head of energy for Pine Brook, says, “It’s sometimes better to be lucky than good.”

But it was much more than luck. With president and chief executive Howard Newman’s track record and the experience of McMahon and his colleague, firm principle Craig Jarchow, the entire package seemed to resonate with investors. Historically, the principals had demonstrated their ability to invest in energy irrespective of cyclical commodity prices.

“In a normalized environment, at the field operating level, you can make a 15% to 20% return. A well-run and properly structured company can generate a higher return, about 30%, at the corporate level upon sale. If you get lucky and sell during a high-price cycle, the returns can be further enhanced,” McMahon says.

Start-up fund

McMahon calls the firm’s strategy “business-building investing.” First, the firm talks to management teams known to generate superior performance. Second, Pine Brook works to understand the team’s focus. “Focus generates relative competitive advantage, which generates higher returns,” he says.

A management approach of, “Trust me, I’ve been doing this for a long time and I am going to find oil and gas somewhere,” does not fly with these guys. In every case, an E&P team must have either a geological focus area, such as Haynesville resources, or a technological focus, such as experience with under-balanced horizontal drilling, or both, to tap the Pine Brook fund.

Also, management teams are required to bet on themselves, in every instance, by putting skin in the game. “In general, we ask management to invest a significant amount of their liquid net worth on the same terms in which we invest,” he says.

In all cases, Pine Brook uses equity capital to initially fund the companies. As an E&P matures into cash-flow generation, some appropriate level of senior debt is considered at the company level, but not at the fund-investment level.

The Pine Brook players are quite comfortable starting new businesses, investing at least $100 million for their own account, and participating with like-minded partners to initially capitalize a start-up with as much as $500 million. Large institutions, such as state and private pension funds, make up the lion’s share of the fund, with a few high-net-worth individuals getting a piece of the pie.

Investors gravitate toward Pine Brook due to its two focus areas—energy and financial services—its track record with previous companies, and its company-building investment strategy. At press time, Pine Brook had six energy and four specialty insurance companies in its portfolio, with about an equal amount of the fund’s current allocations going to each sector.

Allocations are a function of “each according to its needs.”

“We figure out the right amount of capital to get the company to critical mass and self-sustaining cash flow, and then invest this money over time. This allows management to focus on running their business rather than looking over their shoulder for the next capital raise,” says McMahon.

In April, Greenwich (Connecticut), Houston and London-based private-equity firm First Reserve Corp. closed its most recent global buyout fund, First Reserve Fund XII LP, with about $9 billion in commitments. The firm, which exclusively invests in energy and natural resources, raised the funds in less than a year— a notably short time, given that part of the fund-raising took place in the current shaky financial environment. The fund is more than $1 billion larger than First Reserve Fund XI LP.

For Common Resources LLC, the agreed-upon amount was $500 million, with an investment of $15 million during the first six months, whereas the amount agreed for Stonegate Production Co. LLC was $225 million, with Pine Brook investing $10 million during the first six months.

“Risk, primarily management’s ability to execute on its business plan, is highest when we start a company. We manage risk by monitoring management’s performance and increasing the amount of capital invested as they demonstrate their ability to perform against plan,” says McMahon

Pine Brook looks for multiples of capital employed, seeking three- to five-times initial investment, instead of an internal-rate-of-return metric. The firm tends to hold its companies longer than other private-equity players, says McMahon. “We will hold a company, in some cases, for nine years. Once you find a great management team, you create ‘tonnage’ by letting the teams continue to reinvest the capital effectively.”

Pine Brook’s exit strategy is to find a strategic buyer for the private enterprise, although a few of the businesses might be taken public.

Buyout fund

Houston-based managing directors Tim Day and Hardy Murchison were pleased, but not particularly surprised, at investors’ enthusiasm for the fund.

“Our ability to attract investors into such a large fund is dictated by the fact that a group of core investors, mostly pension funds, historically have represented over 75% of the investment in our funds,” explains Day. “We believe that the investors like going into an energy-specific fund because we tend to use less leverage and be less affected by today’s market issues.”

Murchison says most of the investors were eager to put money into a new First Reserve buyout fund, despite a tough environment, largely because of the firm’s success through a variety of cycles over the past 25 years. Due to the size of its funds, First Reserve typically invests in existing companies as opposed to start-ups.

“After two slow quarters, deal flow is rebounding,” says Murchison. “The capital markets are not there with unlimited sources of public equity and cheap debt, so there is a real need for private equity to step in and help fund growth in very high-quality, long-term projects. Now that we have raised this fund, we are looking to put dollars out.”

First Reserve’s investments are segmented into energy services and equipment, resources, (oil, gas, coal and uranium), midstream (pipelines and field processing), downstream (refining, transportation, terminals and storage), power (generation, transmission, distribution) and alternative energy (wind, solar and methane) subsectors.

“There are areas of investment that we really like; worldwide energy infrastructure, global oil, deepwater oil and gas in particular, and the higher-margin North American gas resource plays,” says Murchison. The firm’s recent placements include CHC Helicopters, which provides service to offshore oil and gas platforms, Dof Subsea, which serves offshore energy construction, and Midstates Petroleum, which develops U.S. onshore oil. “These are targeted to the sectors that we think make sense,” says Murchison.

Through another investment, NFR Energy, which it co-owns with Nabors Industries, First Reserve has one of the largest positions in the East Texas Haynesville shale. Combining its East Texas and Rockies assets, NFR has more than 950,000 gross acres, more than 1,000 wells (80% operated) and about 50 million cubic feet per day of gas-equivalent production.

“In Fund XII specifically, we hope to establish a large position in at least one, preferably multiple, North American gas shale plays,” says Day.

The fund also partnered with Schlumberger to buy Saxon Energy Services, a driller with a large client base in the Fayetteville, Barnett and Marcellus shale plays, and a focus on large international land drilling projects managed by Schlumberger.

In fact, the firm is significantly focused on energy service and equipment-manufacturing businesses. “It’s one of our largest areas of investment, especially for the upstream sector. We invest in everything from rigs to compression and valve manufacturing. Historically, about half of any given fund has been invested in this sector, and the other half has been mostly split between reserves, midstream and power assets,” he says.

Given the size of Fund XII, the target range for equity-investment placements is between $200 million and $800 million per company. “We are targeting $1.5 billion in investments during the next 12 months,” says Day.

A major criterion for investment is significant management investment in portfolio companies. “Whether it’s a start-up or a buyout, we expect senior managers to have dollars invested alongside ours,” says Murchison. “It’s as important in our model as it is in venture-capital start-ups.”

Day says that, during the evaluation period for any potential investment, portfolio managers construct a plan for company growth and eventual exit. Companies usually are held for between three and six years, but “we are disciplined about how we do that, so if there is an opportunity to exit sooner that makes sense, we usually take advantage of that.”

As for exit strategies, there is a lot of variability, with an almost-even distribution in the past between taking companies public and selling them to strategic buyers, many of whom are themselves publically held.

“We tend to have an idea which strategy we target, at the beginning of the investment. Oftentimes we are planning for both, knowing that the ultimate exit could be a trade sale,” says Murchison.

One of First Reserve’s recent deals was its investment in Kennesaw, Georgia-based Brand Energy & Infrastructure Services, which provides scaffolding and related services to refineries, petrochemical plants, power and Canadian oil sands companies. Brand Energy counts ExxonMobil, Shell, BP, ConocoPhillips, Chevron, Marathon, Valero, Dow Chemical, Syncrude and Suncor as its clients.

“We really like that business because these are operations that are core to the maintenance of the facilities,” says Day. “Brand Services has many of its sites located within refineries so they have consistent workloads. They are also the largest in their sector. With that kind of market share, their customers are offering them even more services.”

Day sees some consolidation of such outsourced services. He also likes the fact that Brand Energy’s management team is comprised of experienced, former-General Electric managers

Also, while capital expenditures may come and go, he says, there always seems to be new environmental mandates and changes in the configuration of the facilities, which generates new business for Brand Services. “It’s a nice core and steady business for us and one that we are still happy to own.”

As a complement to its other investments, First Reserve recently joined forces with a group of senior insurance professionals to create a new energy-sector specialist insurance company, Torus Insurance Holdings Ltd. (Bermuda). Torus is supported by a $720-million equity funding from First Reserve.