DALLAS—An independent E&P operator can be so blinded to its needs that it happily grabs the cash it needs without thinking through the pitfalls.
Borrowers often forget the strings (and sometimes ropes) that come with the money, said Scott Cockerham, vice president of business development for U.S. Energy Development Corp.
A former investment banker, Cockerham observed operators often were less keen to hear about the authority they would be facing, he said at Hart Energy’s recent A&D Opportunities and Strategies Conference in Dallas.
The questions don’t occur until later. In the case of private equity, for instance:
- Who can pull the plug?
- What happens should the drilling program go bad?
- Who controls the checkbook?
Answers: Private equity can control nearly all of it. Firms might even change the operator’s focus; its controls for compensation; check signing, auditing and reserve reporting; and add staff to the mix.
Trying to explain those controls—even throwing in a first-born child for hyperbole had little effect. Cockerham said, was often met with: “They can have that … Just give me the money.”
Today, Cockerham works for a company that is general partner with nearly 40 private-placement direct-investment drilling programs. The company conducts energy-related acquisitions as well.
In the past decade, the company has deployed nearly $750 million to operators. Investors are still projected, but individual plans are kept more intact.
Using cost of capital as a baseline comparison, Cockerham focused mainly on fundraising through private equity, mezzanine financing and accredited investor partnerships or “retail” in Dallas.
Dealing with different lenders can mean higher costs of capital. Private equity might run 30% but he said firms prefer 45% to 50%, he said.
“Really, it just means the money that’s coming back to the people who made the right choice, picking the right team and helping them execute a great program,” he said.
Mezzanine financing also imparts some of the same controls as private equity, but has greater flexibly for borrowers.
“It has to fund the drill bit, but if you have other opportunities, they’re somewhat flexible,” he said.
Even so, he said, “they have an IRR [internal rate of return] they have to target, and the way they target that, more often than not, is by adding a few more bells and whistles,” including prepayment penalties.
Retail fundraising, Cockerham said, focuses on a growing group of wealthy, accredited investors. Such investors have a small portion of their portfolio to devote to energy, sometimes less than $100,000.
They’re generally extremely tax sensitive and served by financial advisers who bear the responsibility of educating their clients on value propositions, Cockerham said.
To maximize returns for investors, operators surrender initial intangible drilling costs to the investor to them.
“On a return basis, when they’re able to write down 80% to 85% of their investment, it makes a lot of sense,” Cockerham said.
The possible downside: operators, in order to maximize intangible drilling costs (IDCs), need to drill as fast as possible.
Cockerham’s company, U.S. Energy Development Corp., tries to spud all such capital within a year of closing a fund, which means it has to execute a partnership every year.
As with other forms of fundraising, it’s expensive. The representative cost of capital is 10% to 17%, he said.
“Half of that goes to people who are wholesaling for you, and then the other half goes to the folks who are going ahead and selling,” he said.
The idea is to get the attention of financial advisers who will persuade their investors to invest in the product.
As for institutional investing—via endowments, foundations and family offices—Cockerham believes they’re much more patient, might have the same back-office requirements and might not have an exit strategy. But, “they are in it for the long haul,” he said.
While the costs of capital are low, the first time to raise a fund makes you a rookie, no matter how long you’ve been in the business.
Afterward, however, fees start to abate, raising money gets easier, and an operator can then move to larger and larger drilling program sizes.