Private equity capital it’s more than just money

Sidney L. Tassin, Energy Spectrum Capital LP, Dallas

Numerous articles in recent months have highlighted the robust state of energy markets and observed that the industry is “awash with capital.” Capital comes in many shapes and sizes - bank debt, public debt and equity, mezzanine, industry sources, and private equity capital, to name some. Each category has its own virtues. The proper sources of capital for a company depend on the unique assets, operations, and objectives of the business.

The purpose of this article is to highlight issues from the perspectives of both providers and recipients of private equity capital. Providers of private equity typically invest in the energy industry through one of three types of transactions:

• A traditional third-party transaction where the private equity firm acquires assets from (or sells to) another industry participant;

• A joint venture or partnership arrangement where the private equity firm provides capital for the acquisition or construction of assets and shares ownership with another industry participant; and

• Sponsorship of management teams that form new companies to buy or build energy assets.

To an operating company seeking to buy, sell, or joint venture, or a management team seeking capital and sponsorship, private equity is often the most flexible and desirable capital source.

The role of private equity

Private equity is one of the few resources consistently available throughout the business cycle for entrepreneurs seeking to start or build energy companies, or for buying “non-core” assets or divisions from public sellers. Even in today’s environment of eager and competing capital sources, there are distinct situations for which private equity is the most attractive, flexible, and appropriate choice of capital. Some of the attributes of private equity are listed below and explained further in the following paragraphs:

• Private equity sources can be true business partners, helping the entrepreneur fund and grow the business through several stages.

• Experienced private equity sponsors bring a wealth of tangible business assistance to the entrepreneurial management team (e.g., deal flow, expanded network of relationships, capital markets experience, financing assistance, etc.).

• Private equity can be flexible on structure, terms, and time horizons to match the objectives of management and the requirements of the business plan.

• Private equity can be just-in-time equity, funding only as needed.

• Private equity can move quickly and confidentially and is not burdened by regulatory disclosure obligations that often impair the flexibility of public capital sources.

• Sponsorship from a respected private equity firm adds credibility to a management team as it pursues transactions with industry operators.

Items 1 and 2 above go together - we seek to be true business partners with our portfolio company management teams and to bring tangible value to their business plans. Most middle market businesses are built around two or three key managers who worked together at one of the major or independent oil and gas or midstream companies and who now seek an opportunity to build value for their own account. They typically have focused operating expertise (e.g., engineering, geology, or marketing) in a particular geographic area.

The good ones recognize that we bring a broad range of different skills and relationships to the table and welcome the diverse perspectives. We seek to provide complementary deal flow, new industry relationships, capital markets access, and disciplined business judgment to each portfolio company.

Private equity can be one of the most flexible capital sources available. While some firms seek a cookie-cutter structure for terms and governance, Energy Spectrum seeks creative structures to match the needs of the business and the management team.

The overarching requirement, though, is that the structure must align our interests with those of management in both good times and bad. We have employed a broad array of entity structures, stock classes, incentive plans, back-in arrangements, and governance provisions to accomplish these objectives.

The just-in-time capability of private equity is often overlooked. We have often sponsored companies with modest original equity infusions, enough to buy or build the current project, with commitments to provide additional equity as the business grows. This sponsorship allows the company to pursue projects with confidence in its financial capability and minimizes dilution to the management’s equity position and incentives.

Public market windows for debt and equity can close quite quickly for reasons unrelated to the issuer seeking to access the market.

This often leads to a “get it when you can” approach, rather than a “get it when you need it” approach. The appetites of banks, mezzanine, and other lenders tend to correlate positively with market enthusiasm - being most available when times are good and harder to find when times are tough.

Attracting private equity sponsorship

The primary ingredients we look for when evaluating private equity investments are:

• An experienced management team with a demonstrable track record;

• An ability to align interests with management, economically and philosophically;

• A viable business plan to buy and/or build an asset base to create value; and

• One or more actionable alternatives to realize value from the investment

We put great emphasis on the management team and the ability to align our interests with them. Common questions addressed are:

• What are the team’s specific experiences and capabilities?

• Have they built and operated similar assets?

• How have they responded in prior down cycles?

• Do we need to fill out or add to the team?

• What are their personal and financial objectives?

• Are they willing to invest a meaningful portion of their capital into the venture?

• How do they resolve conflicts?

• Are our views on incentives, compensation, and governance similar?

We frequently tell management teams that we are evaluating (and that are evaluating us), “If you are just looking for financing, we are probably not the right group for you. But if you are looking for true business partners to help grow your business and create value, we believe we do that pretty well.”

Viable business plan needed

The next component, a viable business plan to build an asset base, is self-explanatory but often highly subjective. Certainly, all the business plans we see have projections of rising cash flows, profits, and values, but we know that not all wishes (or projections) come true. Working with the management team, we assess the market factors, competition, pricing, etc., to identify upside opportunities and downside risks to the business plan.

Due to the middle market size of most of Energy Spectrum’s portfolio companies, the management team and business plan are often focused in a specific geographic area - for example, consolidating gathering and processing assets in a specific region of North Texas.

The defined scope of the plan allows us to identify and thoroughly evaluate the market dynamics of the area - what advantages or vulnerabilities would we have versus competitors; who are the active producers and drillers in the region; what system upgrades would best serve the needs of our customers; what market outlets exist or can be created; etc. These questions and answers flesh out management’s grasp of the market opportunity and ability to execute the business plan.

The final ingredient is identifying one or more actionable plans to realize the value created. The strategy does not need to be set in stone or predetermined, but we must believe that exit avenues are available (even if market conditions are not as favorable as they are today).

Typically, energy assets can be sold to other industry participants because of the cash flow nature of the business. The size of the business, its operating area, types of contracts, and competitive position all bear on its ultimate marketability. Again, being philosophically aligned with management on timing and objectives is critical.

It’s more than money

All private equity firms seek these attributes, with varying degrees of emphasis. As a seller of energy assets, or a management team seeking equity sponsorship, how do you differentiate one firm from another?

First, you can judge a trapper by his pelts. Ask these questions:

• What kind of transactions has the private equity firm previously sponsored?

• What do previous management teams say about the firm’s support after the deal has closed?

• Have the firm and its principals been “all time” energy investors or “good time” energy investors?

• Can the private equity firm bring you tangible business assistance and opportunities?

Your due diligence of us is as important as our due diligence of you. It takes two committed partners to optimize the relationship.

Energy Spectrum has been managing private equity funds since 1996, and most of our principals have worked their entire careers in the energy industry. We did not show up last year when energy got hot. We’ve been through the major up-cycle of the late 1970s - early 1980s, and the ups and downs of the last 25 years. We are cycle tested. We will not lose our judgment when times are good, and we will not panic when times are tough.

You have a right to expect us to bring several strengths to the table. The first is capital, both for today and as the business grows. With committed capital, our reputation and market presence, we should add credibility and opportunities to your business plan.

We should bring new relationships, deal flow, and resources to assist you as you analyze, execute, and close transactions. And since no business plan plays out exactly as projected, we must be flexible, supportive, and timely in responding to the opportunities and challenges that will be encountered.

All of this boils down to judging the experience, reliability, and relationships of the equity firm. You want to transact with a firm that truly understands the business, that can be counted on to deliver what it promises, and that brings an expanded network of contacts and opportunities to the table. Experience counts and will count even more when industry conditions are less robust than they are today.

We expect a lot of our portfolio management teams, and they rightfully expect a lot of us. We believe that our long histories and varied experiences, in good markets and bad, enable us to support our portfolio companies throughout their life cycle. By doing so, we create value for our management teams, for our investors, and for Energy Spectrum. OGFJ

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