Still life in PE energy: Cambridge Assoc

Is private equity investment in the energy sector dead? No – but the game has changed and to be successful, investors should adopt a new commitment strategy. While the industry faces secular challenges, managers can innovate to exploit disruption and generate attractive absolute returns.

Private equity energy has quickly gone from a growth driver to investment pariah. Throughout the 2000s and into the 2010s, persistently high commodity prices, an abundance of fragmented assets, and a strong appetite for drilling inventory helped managers achieve attractive return multiples and internal rates of return — both with low correlation to commodity prices — and proved to be a popular addition to private equity portfolios.

The prevalent strategy was the equity line of credit (ELOC). A PE energy general partner using an ELOC strategy provides third-party management teams with a committed line of equity and a multi-year time horizon to acquire and consolidate assets. Managers commit to 30–40 teams and pay the teams’ expenses while they go hunting.

ELOCs raised successive funds quickly, since thresholds for raising the next fund were based on committed rather than invested capital, and sponsors satisfied strong limited partner (LP) demand by raising larger funds. Larger funds, however, generated more fees and necessitated bigger commitments, causing cracks in alignment as sponsors became focused on fees rather than carry. This misalignment took its toll on returns, with Cambridge Associate’s PE energy benchmark returning only 11.9 per cent by the end of 2013, versus 15.8 per cent for broad PE funds, on a trailing five-year basis.

The bottom fell out in 2014 as oil prices crashed. The industry radically altered its focus away from asset accumulation and toward free cash flow. This shift effectively ended the “land grab” phase of the sector’s renaissance.

PE energy was hit hard. With competition substantially increasing, it had already become harder to find directly sourced assets, making it difficult for ELOCs to invest funds in a timely manner. Increasingly efficient pricing of land, plus the increased deployment time (and associated “J-curve” impact, as overhead expenses accumulated), have challenged ELOC managers to hit return targets and have left LPs with huge unfunded exposure as ELOCs struggle to enter into and exit deals. Further, the capital markets access needed to make larger deals happen (such as those concerning debt and initial public offerings) has made PE energy more correlated with commodity prices.
The combined result is that the ELOC strategy is outdated. So, does that mean PE energy is dead? No, but success will require a new playbook.

The new playbook borrows from the techniques of traditional buyout managers in other PE sectors. Buyout energy funds are smaller and more concentrated than ELOCs, and energy buyout managers lead all facets of the investment process in-house.

This provides a crucial competitive advantage across sourcing, diligence, and execution. Buyout managers have a leg up because they are directly connected to the entire process. They are also better suited to complex deals than ELOC managers, who must go through several layers of decision making, which can hamper investment execution. Value-focused managers need to accept some complexity, which is also crucial to capital deployment in such a disrupted market. Faster deployment and the lack of overhead expenses are both accretive to net returns. Finally, and most crucially, buyout managers’ smaller deal sizes are easier to eventually exit, since exploration and production firms can fund small purchases from free cash flow.

What’s the rub? These strategies are not as scalable as ELOCs, which limits fund size, so access can be a challenge if you are not willing to commit to newer managers.

Another winning PE energy approach today is funding oilfield equipment and services (OFS) that are building a “better mousetrap” — mechanical or digital solutions that help drillers save money. Unlike classic OFS strategies that require a rising industry tide, these funds seek to steal market share from incumbents to grow, which is non-cyclical. During the downturn, managers taking this approach have typically shown strong growth and generated lucrative exits. While not for the faint of heart, OFS strategies may offer another way to achieve absolute returns at entry valuations starkly lower than the rest of the portfolio.

Rumors swirling about the death of PE energy are grossly exaggerated. With disruption comes opportunity, and managers that evolve to meet the industry’s changes should be well-positioned to succeed in the industry’s next chapter.

Michael Brand is managing director, real assets investment group at Cambridge Associates.