In 1988, Joe Foster, then the chief executive officer of Tenneco’s oil and gas business, was out of a job. His parent company had sold his well-functioning division in pieces for approximately $7 billion to a diverse group of international oil and gas companies. Undaunted, Foster and 22 of his fellow executives pooled $3 million of their severance money and started Newfield Exploration Co. Aided by an incremental $3 million from friends and family and another $3 million from the University of Texas Endowment Fund, they promptly drilled two dry holes and had “issues” with a third well in the shallow waters of the Gulf of Mexico.

Entrepreneurial efforts are not for the fainthearted or for those without great perseverance. Despite the difficult start, Foster led his team forward, raising $20 million of new funds from private-equity providers and more funds from other university endowments to finance their next wave of drilling activity. With this added capital, Newfield Exploration hit its stride with a string of successful discoveries. This is a wonderful case study of successful entrepreneurship that brought together great leadership, strong execution skills, and sufficient risk capital to build a company of scale.

While thousands of oil and gas companies have been started in North America since Colonel Drake’s famous oil well in Titusville, Pennsylvania, in the mid-19th century, most have financed their early days by raising money locally to pull together a grubstake, to buy acreage and drill a few wells. Successful results meant that they had sufficient credibility and cash flow to keep going. For a small handful, added financing came from a few risk-tolerant endowment funds or wealthy family offices.

However, the upfront risk capital required to launch, grow, and nurture an exploration and production company to reach sufficient scale has grown substantially over the past 25 years. Everything has gotten much more expensive—acreage, people, data, drilling rigs, steel pipe, deeper and more complicated wells, new drilling technologies, etc.

The bar that defines “scale” has risen to a level where approximately $1 billion of value has become the threshold to allow access to much-lower-cost capital, either from a corporate acquirer or the public markets. For most E&P entrepreneurs, these capital needs no longer can be met by passing the hat around the neighborhood.

Over the past year, private equity has come under increasing attack in the popular press, due in part to the heighted profile of Mitt Romney’s presidential campaign. Lumped together with the excesses of some Wall Street financiers and hedge fund billionaires, private equity’s negative reputation has gotten painted with too broad a brush. Admittedly, there have been a few bad actors and some disappointing results. But, there is a meaningful segment of the private-equity industry, especially for the oil and gas business, that continues to provide the enabling capital, strategic guidance and financing skills to launch and grow new companies. In this realm, private equity wears a well-deserved large white hat.

E&P companies have been huge beneficiaries of an increasing wave of private equity following the model of Newfield Exploration. Throughout North America, and increasingly around the world, experienced private-equity providers are investing billions of dollars annually to launch and grow new companies. The list of highly successful private-equity-backed E&P companies includes a wide variety of strategies, geographic focus areas, corporate cultures and entrepreneurial experience: Antero Resources, Bill Barrett Corp., Cobalt International, Common Resources, Concho Resources, East Resources, Enduring Resources, Kosmos Energy, Laredo Petroleum, MEG Energy, Spinnaker Exploration, and Spring Energy in Norway, to name a quick dozen.

This list represents only a small sample of the hundreds of companies around the world that have recognized the benefit of tapping funds controlled by the growing number of large investment firms that bring both money and expertise to the most talented management teams to build companies of scale. The success stories have followed a wide variety of strategies and basins, ranging from offshore West Africa to the Canadian oil sands and the North American oil and gas shale plays.

Once the province of a specialized group of funders, private equity’s support for oil and gas companies has gone mainstream. Early pioneers in the space such as Yorktown Partners, Warburg Pincus, and First Reserve Corp. have been joined by dozens of other firms that have raised tens of billions of dollars of fresh capital to deploy behind these entrepreneurial ventures.

More recently, as financial engineering-based private investing has gone out of fashion, the well-known traditional leveraged buyout firms such as KKR, Blackstone and Apollo have built investment teams dedicated to the oil and gas space. Despite all of the obvious risks, for most it has been a very lucrative endeavor where the value creation has come primarily from fostering an increase in reserves and production, and less so from sly trading around hydrocarbon price movements.

The entry of these very large, high-profile firms means increased capital flows and more headlines. This trend will likely continue as long as the big global providers of private equity—pension funds, endowment funds, and sovereign wealth funds—increase their allocations to the energy sector seeking returns uncorrelated to general stock market performance.

At some point too much money will overwhelm the system and investment returns will suffer. But, so much equity capital is now required to feed the manufacturing-like operations of the expanding shale plays and deepwater exploration, that the supply and demand of equity should remain in balance for a few years.

Moreover, with access to larger private-equity funds, sometimes working as a consortium, newly-born E&P companies are able to get to scale quickly and go up against large independents and even super-majors competing in lease sales, deploying hundreds of land brokers, and working the corridors of energy ministries around the world to access significant new opportunities.

Creating value

Quality management teams have the luxury of selecting their financial partners from those anxious to deploy capital. However, savvy entrepreneurs in search of equity will learn quickly that all private-equity firms are not the same nor are all dollars of equal value.

A reputation for creating incremental value after the investment separates the top-tier private-equity investors from the enlarged pack. If the ultimate goal is creating a very large pie, then aspiring Joe Fosters will want to align themselves with those who can make each slice substantially bigger by providing the counsel and advice to help develop winning strategies—and avoid previous mistakes made by other young E&P companies.

The business model for private-equity-backed E&Ps is well-established. This has made it easier for the more entrepreneurially minded E&P executives to leave the comfy confines of Big Oil and start out on their own, knowing they can afford sufficiently high-quality resources to ease the transition from large company to small.

Access to plentiful equity capital and those investment partners that have developed the scars of prior efforts greatly reduces the risk of starting a new enterprise. Much as it has worked for the past 40 years in Silicon Valley, where the local venture capital ecosystem consistently spawns innovative new businesses, the E&P world now follows a similar track. It is able to form new, well-capitalized start-ups on a regular basis whether they are in Houston, Denver, Calgary, London, Beijing or Sao Paolo.

Perhaps most interesting is the number of serial entrepreneurs who have honed the private-equity model to build one successful company after another, usually with each larger than the last. Randy Foutch of Laredo Petroleum Holdings Inc. is on his fourth such endeavor. George Solich at Cordillera Energy has scored the hat trick.

With the large inflows of money available today, private equity is able to dial up or dial down its investments and can sculpt risk-reward profiles that meet the needs and expectations of its institutional clients. Some firms have the risk tolerance for frontier exploration and expect venture capital-like rates of return for their equity dollars. Other firms prefer to pass on exploration, and instead are satisfied to generate lower rates of return, perhaps mid-teens annual percentage rates, when the projected risk is much lower.

In a low-interest-rate environment, delivering such a level of returns still provides an attractive outcome for some investors, knowing that they do not have to be concerned with dry-hole risk. The most obvious examples of this strategy come from the specialized resource funds, such as Sheridan Production, Lime Rock Resources, and Quantum Resources, where their institutional investors desire long-lived, mature domestic U.S. production profiles, and heavily hedged hydrocarbon prices.

Institutional investors have pumped billions of dollars into these funds over the past few years, and their appetite continues to be strong.

Multibillion-dollar acquisitions of E&P assets from Samson Resources and El Paso’s E&P arm exemplify a more recent private-equity strategy where traditional funds have used their large scale to acquire significant properties while utilizing their financial engineering skills. Although the buyers will deploy some of the operating cash flow to support production and reserve growth, a meaningful portion will service significant debt used to pay for the acquisitions.

Low interest rates and commodity hedging help accommodate this strategy, but by definition the operating cash flow cannot be used both for debt service and reinvestment into fields.

When Joe Foster launched Newfield Exploration, he proved to be a pioneer in tapping private equity. He charted a course that other entrepreneurs continue to follow.

Jeffrey Harris recently founded Global Reserve Group LLC, a New York firm dedicated to advising and investing in oil and gas companies around the world. He spent the past 29 years at Warburg Pincus.