Private Placements: Filling the Capital Gaps

Looking back on the recent recession, we’re prone to the exaggerations common to any reflection on bleak times. The news from those days seems apocryphal, the mood gloomier and the weather harsher than it may actually have been.

But at least one day, October 27, 2008, during those trying times dawned sunny and crisp in Vancouver, where Lexaria Corp.’s prospects looked good. The Canadian oil and gas company had interests in Oklahoma and Alberta, but its most significant prospects were its acreage in Mississippi. Holding only minority positions in its plays, the company was seeking to expand its production and stakes in the state’s oil-rich Belmont Lake Field.

Lexaria’s problem was there was no capital to be had. Banks were attempting to gauge their own exposure to risk during the worst economic downturn since the Great Depression, and a small company on the pink sheets in Vancouver wasn’t a priority. In the end, its president and a shareholder purchased a note from the company for C$900,000, with an

18% coupon. These were certainly not the terms a producer would hope for, but its capital needs had been met. For a company with a market cap hovering around US$2.7 million at the time, it was not an insignificant amount.

As it turned out, Lexaria’s was the only public debt offering by an E&P company in the fourth quarter of 2008. An 18% coupon note for a small, over-the-counter issuer might be viewed as an outlier when surveying the landscape of available capital, but actually, just the opposite is true. The company’s difficulty in accessing capital stemmed from an acute and ever-present problem for most, if not all, small independents: high costs of capital threaten their ability to operate.

All but the largest E&Ps can fund their capital expenditures directly from operating cash flows.

Mind the gap

A number of factors have contributed to the current state of capital availability for operators: rising drilling and completion costs; the perception that banks do not want to risk portions of their loan portfolios on E&Ps and uncertainty about how potential regulatory changes could affect profitability. In truth, none of these matter. The witch’s brew that has created the current funding climate for operators does not alter the fact that production can occur profitably, and drilling success rates have never been higher. Operators continue to need external financing.

A basic metric to determine a company’s capital need is to compare its cash flow from operations to its capital expenditures. With the exception of domestic public companies identified as “mega” E&P operators, the remainder of the selected peer group was operating at a deficit as of year-end 2011—including companies with market capitalizations up to $15 billion, a staggering fact given the current oil price.

Deriving the capital need for private companies is somewhat less obvious. In a survey of independent producers, 80% of them private, conducted by the IPAA as of year-end 2009, only 21% cited bank debt a s a capital source, while 41% obtained capital from internal sources. This highlights operators’ need for external funding, and their use of sources other than debt to meet capital requirements.

Should a lender be willing to lend to an operator, the high cost of capital offers a glimpse into the plight of smaller companies. Using weighted average costs of capital (WACC), a blended cost incorporating equity and debt components of a company’s capital structure, shows the great disparity for smaller companies. WACC itself is an imperfect metric for determining the true cost of capital, as it doesn’t account for market value of assets, deferred debt service and a host of other variables that comprise the formula. However, it is useful as a basis of comparison between large companies (which are usually public) and smaller ones (which may not be public).

The cost of capital for smaller, public E&Ps can reach untenable levels.

A study of the domestic landscape of public E&Ps suggests smaller companies have to pay more to access capital than do larger companies. However, producers with $5-billion market caps aren’t necessarily small. They ostensibly have sufficient reserves to collateralize capital demands and are buoyed by a high underlying commodity price. Should they be paying costs of capital in excess of 10%? All but capital providers would likely say “no,” but probably all parties concerned have some justification to say “yes.”

So, let’s include even smaller companies’ WACCs and see where they sit on a spectrum of recent debt announcements (see public debt offerings graphic). By grouping companies based on enterprise value, it’s plain that costs of capital significantly increase as companies decrease in size. Private equity’s cost of capital bookends the chart, but that’s misleading. Private-equity firms vary greatly within their peer group in nearly every conceivable characteristic. Also, the cost of capital applied to their holdings is a proxy for the returns their investments generate. So the most plausible way a private-equity firm might have an impact in providing capital would be selecting opportunities that exceeded its projected return threshold.

Small independents (those with enterprise values between $200 million and $500 million) suffer the most in this analysis, paying a cost of capital as a group of 15%. The presumption is that lending to or investing in these companies is inherently riskier than supplying larger companies with capital. Is that necessarily true? Shouldn’t a $50-million market-cap producer be able to acquire capital proportionate to its reserve base without an exorbitant increase in its debt-service obligations?

Not all Frankensteins are monsters

Companies are turning to internal sourcing, industry partnerships and private equity specifically to avoid the steep costs of capital established in the marketplace. There is an alternative for creative companies seeking funding at a better cost of capital than currently on offer, or at worst at a cost that fills the gap between the rates small independents receive and private equity provides.

A private placement allows an E&P company to offer securities of any type and any combination to investors. The passage of the Jumpstart Our Business Startups Act (JOBS Act) in April 2012 allows broader marketing and investment in private placements, enabling issuers to reach a larger investor universe for substantially more capital. Given this greater freedom to finance projects for smaller operators, let’s look at a potential structure for a hypothetical E&P.

First, we have to match the incentives of the parties involved in the issue. The issuer (in this case the operator) wants control of operations, little upfront capital contribution, and a deferral of any debt service until it can afford to pay it. Essentially, the operator wants it all, but without the acreage it provides and its expertise to develop the play, there is no opportunity. Investors, on the other hand, want equity participation in the project and the ability to prove the contributed acreage’s potential before committing all of the necessary capital.

A gap exists between available funding options in the marketplace for operating companies.

There’s a way to provide both parties with what they want. Under this scenario, we’ll say that the issuer needs $100 million to finance its project. The issuer has spent $15 million acquiring acreage that it contributes to the project for equity on a heads-up basis (see sample E&P project capitalization). The investor group contributes $10 million for equity in the project. This gives the issuer majority control (60% of the project’s equity).

Additionally, the investors provide another $20 million in debt to the issuer to cover the remainder of operating costs. The yield of the debt (and of any investor equity that was preferred) is paid in kind (PIK) until the project has sufficient income to pay it in cash. The debt can be structured with a flexible yield (say 15% for PIK yield but 10% for cash) with the issuer holding the option of how debt service is met. Bank debt can also be used to replace investor debt or meet investor debt service once the project has accumulated sufficient reserves to collateralize lower cost of capital credit.

As the project advances, investors provide more debt to fund operations. In this case the interest continues to be PIK. Should the contributed acreage prove to not have the potential advertised in the issue, investors would have the option to discontinue funding the project.

By Year 2, the project has generated reserves sufficient to allow the E&P to acquire bank debt. The issuer pays down its debt obligation to the investors with the lower cost of capital debt (bank debt). Depending on how the private placement was structured, the issuer can sell down the assets, exit the project outright or continue operating.

Here’s an actual example of how these deals are structured. Starting in late 2007, the Direct Capital Unit of the D. E. Shaw group provided Patriot Resources Partners LLC with $85 million of capital in the form of an equity investment and first lien credit facility. The founding partners of Patriot had aggregated an attractive acreage position in the Wolfberry play of the Permian Basin in West Texas and hired Park-man Whaling LLC to raise capital for drilling and additional leasing. The initial capital from the D. E. Shaw group was in the form of equity that de-risked the project and was followed with debt capital once reserves and production were established.

In January 2012, the Direct Capital Unit spun out of the D. E. Shaw group to form Stellus Capital Management LLC, where an energy team led by Todd Overbergen will continue to provide flexible equity and equity-linked debt capital with a focus on the upstream sector.

According to Overbergen, “The Patriot investment we made while with the D. E. Shaw group is an example of how we partner with management teams to provide flexible equity and equity-linked debt capital to bridge the funding gap that many small independents face, without excess dilution.”

If the investors in this hypothetical financing insisted on majority control of the project, it’s simply a matter of changing the proportions of equity issued in the private placement. Another consideration for the investors in increasing their equity stake is to lower their tax liability (PIK interest constitutes phantom income with tax consequences). Other levers could be used to incentivize the issuer, including ceding equity for subsequent favorable project performance or paying a waterfall on exit.

The hypothetical capital structure outlined gives an operator control and flexibility while providing investors direct access to a potentially lucrative opportunity.

The structure is not perfect. Compatibility between issuer and investor is as crucial in this scenario as in any partnership. Some operators will be extremely wary of a structure where investors could pull the plug on funding a project. Some investors will be unhappy with the moderated returns provided by debt compared with the outsized returns available with equity exposure alone. The beauty of private placements, however, is that risk, incentives and operational needs can be mitigated with creativity.

Conclusion

E&P companies have always faced risk in finding funding for operations. All but the largest of operators have to juggle production, asset sales and reserve management in order to stay alive, regardless of the price of oil. The current paucity of capital from lenders to operators comes when drilling success rates are at their highest, but drilling and completion costs are most expensive. The use of flexible processes like private placements allows issuers to create project structures that finance growth until they are able to secure lower cost of capital funding.

Scott Cockerham is a partner at Parkman Whaling LLC, an energy investment and merchant bank in Houston. Prior to joining Parkman Whaling he worked in investment management at Deutsche Bank and Goldman Sachs.