Keith Behrens
Stephens Inc.
Following a wave of consolidation in E&P companies in the late 2000s and the shedding of assets to delever, seasoned management teams jumped ship, spawning a generation of upstream start-ups. With a keen understanding of niche plays, entrepreneurial E&P companies sought aggressive funding for deals (seeking cash for new drilling projects or acquisitions).
A sector that requires substantial capital, E&P companies have faced an uphill battle in the past year. Although access to credit is improving following the 2008-2009 recession, the post-crisis financial landscape is highly conservative. Fewer commercial banks are willing to provide senior credit facilities to new oil & gas company borrowers and are focused on providing debt capital mainly to existing borrowers. Those remaining active in the E&P space have lowered their borrowing bases based on a more conservative set of assumptions (tougher coverage ratios, lower forecast reserves, lower price decks). In this environment, E&P companies are handicapped to fund future plans, and often encounter reduced borrowing bases sometimes greater than the amount of debt outstanding.
Mezzanine capital financing fills the gap. The few less-restrictive traditional lenders stick to lending mainly against developed producing reserves, and are unwilling to offer enough capital to accelerate unproven drilling projects and rapid production growth. Backed by solid funding, mezzanine providers have the capital available and risk/reward palate to invest in earlier stage E&P companies. Mezzanine capital can also placate the banks, by providing debt to pay down banks’ principal albeit at an overall higher cost of debt.
Pros/cons of mezzanine capital
For projects that carry a higher degree of risk than those financed with senior debt, this type of financing can be a perfect solution. Companies with undeveloped reserves, but fundamentally-strong development plans, are ideal recipients of mezzanine funding. So, too, are companies with successful exploration programs but that are too early for bank financing given the ramp-up in production. Still other E&P companies, on the hunt for complementary acquisitions, might be prime beneficiaries. And lastly, those companies that need to stretch their equity dollars and pay back bank loans might ponder this alternative. Another advantage of mezzanine capital: funding appears as debt and can be financed from pre-tax revenue.
Geared toward E&P companies that have $10 to $300M in assets, private mezzanine funding traditionally was considered an expensive, non-pliable financing option. It is true that mezzanine capital typically carries a higher price tag (with the cost of capital typically near 15-20%) than traditional debt options, and requires a higher investment return, in the form of an “equity kicker”, than most secured and/or senior lenders. Because the investors have an “upside” component in the form of well working interests and/or equity, they will assume this additional risk since it could result in a substantial future payoff.
However, all mezzanine providers are not created equal; finding the right source can make a huge difference for E&P companies.
Mezzanine providers
Of the 20+ pure upstream mezzanine players that entered the market in the past, only seven to 10 providers remain active today. The global market meltdown contributed to the demise of “mezzanine capital” banking divisions; the survivors are exacting high costs of capital in the 20-25% range, as deal competition dissipated. Mezzanine debt with warrants and kickers are becoming commonplace. In such environment, E&P companies have to do their homework when shopping for capital.
E&P companies should seek out providers offering a lower cost of capital, friendly structure for banks and no equity kickers if possible. Such mezzanine sources do exist, as a number of providers have publicly indicated their willingness to invest in companies whose assets support $25 to $100M of mezzanine debt. Mezzanine funding is being specifically allocated to 1) bank clients that are overextended, 2) acquisition financing or 3) development drilling programs.
E&P companies in the market for mezzanine capital
And there are plenty of E&P/midstream oil/gas companies in the market for a capital infusion. We believe the acquisition market will be strong and could pick up for conventional gas properties. Given the large producing component related to many of these acquisitions, mezzanine financing should continue to be a good funding source. We believe we will also see mezzanine capital used to fund development drilling. Consider the following:
April 2010: A private, Texas-based E&P company borrowed roughly $60 million of subordinated debt, which allowed a pay down on its senior credit facility to bring the principal amount down to roughly $80 million. The subordinated debt was unsecured and included no equity kickers. Stephens Investment Banking acted as advisor in this transaction.
December 2008: Dewbre Product Development LP put in place a $50 million secured note mezzanine financing provided by Guggenheim Partners, used to support Dewbre’s multi-well infill gas development program in the McAllen Ranch Field in Hidalgo County, Tex. Dewbre is a new E&P partnership formed by Dewbre Petroleum Corp. and Harbor Hill Interests LP.
September 2008: Admiral Bay Resources Inc. secured $3.75M in mezzanine debt from provider GasRock Capital LLC. The program allows for the continuation of its Mound Valley, Shiloh and Devon/Ft. Scott Projects. The company is expanding its gathering system in Mound Valley allowing for the hook up of 12 newly drilled wells and an additional 10 well infill drilling program at the Mound Valley Project. The plan also allows for the ordering of a third electric compressor for the Shiloh Project as well as additional saltwater disposal capacity.
While several well-known mezzanine funds sit on the sidelines, others have remained open for business; there has even been a very recent surge of new entrants to the market. The cost of mezzanine capital could trend down with the addition of the newer sources; E&P companies should be on the lookout for the most advantageous funding sources as the mezzanine market continues to evolve. About the author
Keith Behrens is a managing director at Stephens Investment Banking, a division of Stephens Inc., where he covers power, energy and resource technology investment banking. Stephens is a full-service investment banking firm headquartered in Little Rock, Arkansas, with offices across the country. For further information, contact Behrens in the firm’s Dallas office at 214-258-2762.
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