Private-equity matchmaker and corporate finance consultant Bill Weidner reminisces a tale in which a gas marketer for an operator in the northeastern Marcellus shale lamented losing $2 million per well due to uneconomic natural gas prices. So why continue to drill the wells, Weidner prodded?

“We can’t afford to lay down rigs--we paid $5,000 per acre, so we have to keep drilling,” he said.

Further, a working interest partner of the same company issued an equity raise to pay for its capex program and to be able to continue to pay distributions.

“A cynic might look at this and say, ‘Here is a company that has decided to dilute its shareholders to drill noncommercial wells on acreage it overpaid for.’ If I’m the private-equity firm that backed the management team that generated the feedstock acreage, that’s a beautiful thing,” he quipped.

Weidner spoke recently at a gathering of the Houston Energy Finance Group in Houston.

However, such economic imbalances might be a warning signal to private-equity investors. While sustained low interest rates are driving down yields of investment capital and resulting in a flood of capital into the private-equity sector, be careful out there, Weidner warns fund managers: Reality bites.

The private-to-public arbitrage that exists for exiting oil and gas private-equity investments can evaporate, as Canadian investors learned when royalty trusts were wiped out overnight. “Investors have a tendency to latch on to a particular reality, and when that reality changes, it bites.”

Investor behavior today is being driven by fiscal, monetary and currency imbalances in the marketplace that penalizes savers, the source capital for private equity. Enter private equity to the rescue, said Weidner, which typically provides higher returns in today’s environment.

“Unsustainable factors are suppressing yields, forcing investors to decide to allocate more capital to private equity.”

Private capital sources such as corporate and public pension plans and university endowments are loading up on alternative investments such as private equity. For example, in 1990, university endowments held 2% of investments in private equity. Today, it is 28%, some 230% more than these funds have invested in liquid common stocks.

“It’s good times on one hand” for private equity placements, but there could be trouble brewing on the other hand, Weidner forecasts.

Currency imbalances are creating a borrow-to-spend mentality in which the money has to go somewhere, Weidner noted, leading to unclear price signals and potential volatile outcomes. The search for yields is creating exit strategies which presently validate a circle of cash flow.

“Price distortion creates capital-market arbitrages that enrich private equity,” he said. And although private-equity-backed firms are able to put up good returns, he questioned, “is today’s killer exit strategy tomorrow’s monster write down?”

Weidner takes a historical perspective. Private-equity returns for energy placement fell from a 3-to-1 return on investment during the 1998 to 2002 “vintage” years, to just 1.2-to-1 in the 2006 to 2008 vintage time frame. That drop coincided with a 500% increase in energy private equity available between 2002 and 2008.

Weidner attributes the plummet in returns to large increases in capital, high competition for deals, a focus on unconventional plays, and emboldened management teams.

“When there was a big increase in private-equity capital for oil and gas, returns went down rather markedly. The long-term trend has been down. It’s not complicated: the more money there is, the lower the returns.”

Additionally, while private-equity sponsors have always placed an emphasis on experienced management teams, a growing reliance on a higher amount of capex from increased well costs and infrastructure build-out increases risk.

“Higher capex activities heighten management risk and increase the degree to which management has to exercise good discipline.”

Private-equity sponsors can mitigate risk by breaking traditional rules, he said.

• Focus on out of favor areas, like natural gas, conventional reserves, even coal;

• Take a minority ownership interest;

• Buy in to existing asset bases at a fair value if management warrants;

• Consider certain public equities as an alternative to private equity;

• Stay under the radar by focusing on smaller initial commitments while waiting for down rounds and up rounds to dollar-cost average.

“There is a growing scrutiny among investors looking more closely at volatility within portfolio returns,” said Weidner. “They are afraid of getting stuck with a fat tail on the next fund.”