OIL & GAS FINANCIAL JOURNAL: I understand that Intervale invests exclusively in oilfield manufacturing and service companies. Has this always been your focus? What is your thinking behind investing in this particular market segment?
CHARLES CHERINGTON: Yes, it has been our sole focus. If you look at the private equity space in energy, there are a lot of funds that start small and invest with a multi-strategy approach in oilfield services, E&P, power, midstream, etc. With E&P, horizontal wells are very expensive. Investing in services is a better fit for us because it allows for greater scale. If the size of a fund gets too big, you will be competing for a small number of deals with a large number of buyers, which lends to an unfavorable risk/reward ratio. So our pledge to our investors is that we will focus only on services and will stay reasonably small. If you can do that, like we have, you're able to compete for quite a large number of deals, usually on a sole-source basis. About 90% of what we do is sole source and negotiated directly with the seller. Our focus is very deliberate, and it's intended to allow us to target that segment of the market.
OGFJ: You mentioned horizontal drilling. How has the "Shale Revolution" affected your business and the service companies you invest in?
CHERINGTON: It's almost impossible to overstate the impact of the Shale Revolution. We started Intervale in 2006, but I've been investing in energy for more than a decade. When I first started, it was widely thought that North America was a nearly dead market. The major service companies were all looking outside the US to expand their business. If you looked at the Permian Basin in 2004-2005, Midland was almost a ghost town. Today there are traffic jams everywhere, and you can't find a hotel room because of the huge increase in drilling activity and production. This is true in other shale plays as well. The Permian went from drilling shallow, vertical wells – really low-cost wells – with relatively small reserves to what you see now, which is basically a large-scale manufacturing operation with incredibly dense drilling. You know you're going to get hydrocarbons in every well, and the well is going to follow a certain profile, so there's a drive for scale and efficiency.
If you're investing in the service business, companies need to provide lower costs or provide a technology that enables drilling to happen in a place it might not otherwise occur. If you can do either of these things, you can capture market share very rapidly. Today, it's much more about manufacturing efficiency than it ever has been in the past. For Intervale, we are much more focused on North America than we have ever been. The opportunities here are plentiful and attractive. Whether it's a product or a service, our focus is on companies that can help operators drill their wells more effectively either through cost or technology.
OGFJ: Is it fair to say that shale drilling is largely a manufacturing operation today?
CHERINGTON: Absolutely. It is a manufacturing process. You are mass producing wells. The guys who got to a basin first and bought the acreage at a great price are going to do extraordinarily well. They're going to become billionaires. But we're past that now. All the major shale plays have been delineated. The only way you're going to make really good sustainable profits is to have a very efficient drilling operation. E&Ps today are totally focused on driving efficiency and managing their service costs. If a drill bit manufacturer can provide a greater rate of penetration or you can drill longer with a single bit before having to strip it out, you are saving valuable rig time, which increases returns. The cost of the bit is trivial compared to the savings it can generate if it's the best bit for the application. On the product side, we look for proven engineers or manufacturers who have some competitive advantage.
On the service side, it's really about having the best people. The people who survived the industry downturn of the early 1980s are really the best of the best. Most of them are now in their 50s and 60s and are prized commodities. They have 30 years' experience, are experts at what they do and have developed long-term relationships with potential customers. As investors, we seek out the best members of that small tribe to train the younger guys just coming into the industry. A lot of what we do on the service side is compete for that talent. We like to think of ourselves as an employer of choice. A lot of the people we hire are coming from the big service companies. They want a shot at having a meaningful equity stake in the business.
OGFJ: Dramatically increased production has created a need for expansion of midstream infrastructure to get product to market. I know that Intervale's focus is on oilfield manufacturing and services, but would you consider getting into midstream if the right deal came along?
CHERINGTON: We would certainly look at midstream deals if it involved providing equipment to midstream companies or getting into gathering systems, distribution systems, etc. The challenge is that the MLP market has really driven up the price for assets in that space. We've seen good opportunities and attractive companies, but the prices sellers are seeking because of the MLP market are too high for us. Midstream has a lot of growth potential over the next 10 years, but the prices are going to be real challenges for a lot of prospective investors.
OGFJ: Intervale has raised $1.2 billion over the past eight years and is currently investing from its third fund. Can you describe the types of investments you are seeking?
CHERINGTON: The most important driver is an outstanding management team. Not just experience, but people who are best in their class. If you find someone like that – not just a CEO, but a CEO who is going to bring a team with him, they're going to bring in customers. They're going to be able to attract the talent needed to grow and scale the business up. Production is attractive to PE firms because it's less cyclical. Subsea is attractive because there is steady, long-term growth there. For us, it's a combination of being able to find the right management teams and finding the right industry sector. We will either buy companies that we upgrade from a management perspective, if it's in a sector we believe in, or we will hire an exceptional management team and have them start from scratch. If you look at Fund II, there are several deals where we hired great management teams and provided them with growth capital. So the common denominator, whether it's a buyout or growth capital, is that we need great managers to run the business. This is more crucial in the oil business than in any other industry.
OGFJ: Can you describe the investment process?
CHERINGTON: We negotiate directly with the seller. About half the time we make the first overture and half the time the seller approaches us first. We look at several hundred deals a year. We will only work hard on about 20. The prerequisites for a deal are that the sellers must be willing to reinvest a significant portion their sale proceeds, unless it's somebody who's really looking to retire and might be in their 70s or 80s. If the sellers aren't fully invested in the business, they're just going to wait out their non-compete and go back into business against you. So it has to be a deal where they're incentivized to stay with you and will profit from the deal the second time around.
Secondly, they may have had a successful business in one or two basins, but now they need us to help them go national. We have the expertise to help them accomplish that goal, and we're pretty hands-on. They need to understand this and be committed shareholders but also be flexible managers. They need to be willing to let us bring in outside talent to help them grow the business.
Finally, there is the due diligence. The most important part of the due diligence process is talking to the customers. We need to be persuaded that the company has an outstanding reputation in their field.
OGFJ: Is there a typical investment amount that you would make in a company?
CHERINGTON: We are size agnostic. In Fund II, we wrote some initial checks that were less than $5 million. That's because we thought there was an opportunity to grow the business rapidly through organic growth, but also through acquisitions. However, typical investments are more on the order of $30 million to $70 million.
OGFJ: Do you ever provide seed money, venture capital, to commercialize a new product or technology that you think could be successfully marketed in the oil and gas sector?
CHERINGTON: We had a couple of small venture deals in Fund I. While the overall returns were good, we had one great success and one failure. While the investments were quite small, those kinds of deals aren't going to scale necessarily. They take a lot of attention, and getting oilfield operators to try new technology is extraordinarily challenging. The industry isn't resistant to incremental technology, but it is to new concepts. If you think about it, that's because engineers at big oil companies are incentivized to avoid mistakes. An engineer looking at a new technology would see a disproportionate amount of risk compared to the reward for trying something new. We have found the technology adoption cycle to be very slow – slower than just about any other industry out there. So this kind of venture is less than ideal for PE investors.
OGFJ: Who invests in your funds? Are they individual investors, institutional investors? Are they inside or outside the US?
CHERINGTON: They are overwhelmingly US and largely endowments, pensions, and foundations. As I'm sure you're aware, there's an enormous amount of new fund formation. I was talking to one of our investors yesterday, and he said he had seen three new funds in the last three weeks. Getting back to your earlier question about expanding our focus from oilfield services, if we followed the money and raised a bigger fund, I think it would be almost a guarantee of mediocre returns. It's a unique segment within the energy industry for that reason.
OGFJ: Do you have a standard time period for the investment? How do you determine when is the best time to monetize?
CHERINGTON: We generally try to get our businesses up to $50 million or more of EBIDTA. Obviously if the right opportunity arises before that, we'll sell. But that's the goal. The reason is that it allows buyers with larger pools of capital to chase the deals. We're selling into the segment of the market that we're unable to compete in as a buyer. And that typically is going to take three to seven years.
OGFJ: Are most of the companies you invest in typically sold in this fashion? Do some do IPOs?
CHERINGTON: Typically we've sold to strategic buyers. We're building very focused platforms that are built around a single product or service offering. We really don't want to build large holding companies that are unfocused because those are hard to sell. We have not sold to financial buyers, but we're seeing a huge upsurge in interest from big generalist funds that are entering the space in growing numbers. So I would expect a growing number of financial buyers among the successful bidders in the next couple of years.
OGFJ: Finally, how is regulation affecting the petroleum industry, especially with respect to water? Do you see any business opportunities there?
CHERINGTON: You know, regulation is the service investor's friend, provided that it is modest in scope. If you look at areas that are going to provide investment opportunities in the coming years, I would point to closed-loop drilling and completion systems where you're not allowing methane to escape. Those are going to be mandated by law and will create a lot of investment opportunities. Flaring will be eliminated. Water will increasingly be recycled. And that's both to minimize cost and because there is growing pressure to manage that as a resource. Well integrity is another issue. What we're seeing is that regulations that came about in the offshore market in the wake of Macondo are now spreading to land. You're going to see better BOPs on land. You're going to see requirements for more cement around producing zones and around aquifers. All of these regulatory trends create the need for more services. It's been useful to us to anticipate where regulations will come and using that as an investment thesis.
OGFJ: Thanks very much for your time.
