A group of intelligent, accomplished people of varying ages are sitting around a table enjoying each other’s company. They are discussing various business, social and political issues, and how these issues can affect their daily lives.
As the gathering continues on and the participants are increasingly comfortable, they begin to throw out phrases such as “much too risky for me”, “I like what I see, but it costs too much to play” and “I’ll take some of yours if you take some of mine.”
Is this a poker game between old friends? A family reunion? A baseball card convention?
It could be any of these, but this could also depict the “old way” that small and mid-sized independent energy companies financed their operations – and many still do.
Old financing options
In the “old days” the financing options for small and mid-size independent energy companies primarily consisted of friends and family, industry partners, wealthy individuals, banks, and public stock offerings.
Let’s look at the pros and cons of each.
Friends, family, partners, and wealthy individuals
Financing from friends and family, industry partners and wealthy individuals exhibit many similar characteristics. Often, this type of financing is done with parties with whom the operator is familiar. In some cases ongoing relationships are established that enable the operator to have consistent sources of capital.
The fundamental economic terms of this type of financing are fairly simple and consistent. For E&P companies the “third for a quarter” economic terms are prevalent. For midstream and downstream companies this type of financing comes with a variety of structures and terms, sometimes favorable and sometimes not.
For sizable projects this financing usually requires repeated overtures to many financing parties. It can therefore be extremely time consuming and often hampers development progress. Senior company managers and geologists tell us that presenting prospects and seeking financing often takes at least 50% of their time.
With the possibility that historically high energy prices will continue, the big money is usually made 12-36 months into the project when it can be monetized. In today’s institutional financing marketplace company owners are often able to preserve a large chunk of ownership – usually much larger than “third for a quarter” – and can therefore benefit significantly when assets are monetized.
Financing from wealthy individuals may be driven primarily by tax incentives instead of the merits of a project. However, financing from individuals can be very cumbersome since many people invest infrequently. In many cases operators must also adhere to strict state and federal securities laws depending on the size and scope of their project.
Pros
- Financing terms are fairly standard
- Longstanding positive relationships can be cultivated
- Operators with little cash can sometimes obtain financing
Cons
- Cumbersome and labor intensive for larger projects – often have to obtain financing from numerous parties
- Significant time taken away from executing the business plan
- Financial providers are sometimes unsophisticated concerning business matters
- Operators often retain a small portion of the well ownership, and therefore receive a relatively small payout when assets are monetized
Bank financing
For established companies and operators, bank financing is often a good alternative. It is generally the least expensive option, and the only “money cost” is the interest rate (which is relatively low) and any fees the bank may charge.
When a company has valuable, broad asset base and low to moderate capital requirements, banks can be the best financing option. However, bank financing usually requires personal guarantees and the company’s assets pledged as collateral.
With many companies now ramping up their expansion activities, bank financing is overly restrictive. While the banks desire to maintain existing relationships with good customers, the collateral available to support their loans is sometimes inadequate.
For example, we are working with companies who desire to take large lease positions because they want to extend an existing play or they anticipate a new play. Generally, banks are not as comfortable with collateral in the form of land leases as they are with, say, PDPs or machinery, so to move forward the companies must find alternative capital sources.
Pros
- Relatively inexpensive financing
- Good for mature companies/operators that have valuable assets and are not growing rapidly
- Many banks understand the energy industry
Cons
- Banks often do not go far “out of the box” with financing structures
- Usually require personal guarantees from owners
- High growth companies or operators can miss opportunities due to restrictive loan requirements preventing advancing of funds
- Certain types of collateral, e.g. land leases, intangible assets and seismic, may be undesirable to banks
IPOs
Many small and mid-size energy companies have tapped the public equity markets in recent years. In 2007 $16.1 billion in worldwide public equity deals were floated by energy companies in offerings of $200 million or less; there were 219 equity offerings of this nature (Source - Bloomberg). Moreover, some small and mid-size US energy companies tap equity markets in countries such as Australia and Sweden.
While issuing public equity can “jumpstart” a company, it is usually not the sole financial solution.
We see a recurring pattern of companies raising public equity, and once these funds are initially invested the growth pace is slowed due to inadequate funding. The companies find themselves in a bind – do they issue more equity which would cause considerable dilution to existing shareholders, or do they slow development significantly and rely solely on cash flow and bank financing?
Moreover, for companies trading on US public markets the reporting, administrative, and “public relations” requirements of senior management are quite demanding and expensive.
Pros
- Projects can be “jumpstarted” early on
- Potential source of “exit” funding for management and investors
- Provides exposure to public capital markets
Cons
- Stringent and expensive reporting and administrative requirements
- Often funding is not adequate to accomplish growth goals
- Much of management’s time is devoted to dealing with investors
- The market value for public companies is often far less than net asset value
Institutional financing
Institutional financing has been around for a long time, but its use in the energy industry just now seems to be hitting stride. For many years numerous industries (e.g. heavy manufacturing, restaurants, retail, healthcare) have taken advantage of institutional financing for growth, to diversify their financial sources, and to provide liquidity for owners.
The institutional financing market – a primer
Over the last 15 years large “money pools” – pension funds, college and other endowment funds, and large insurance companies and banks – have grown significantly, and the amount of money they manage is huge.
For pension plans alone, recent studies peg worldwide assets at US$25 trillion. The California Public Employees’ Retirement System (CALPERS), perhaps the most famous pension fund, reported total assets of $240.9 billion as of March 31, 2008.
Money pools have become creative in their search to increase investment returns and lower risk. Many money pools have diversified from traditional asset classes such as stocks and bonds into private equity funds, mezzanine loan funds, hedge funds and real estate (“alternative investments”). In late 2007 CALPERS announced that it would shift 11% of its portfolio into alternative investments and away from traditional investments.
Most money pools allocate funds to specialized investment funds that are staffed by professional investment managers. In the energy sector these investment funds generally range in size from $200 million to over $30 billion, and their typical investment size is $5 million to over $500 million.
Because of the excellent investment returns that the energy sector has generated (Bloomberg shows that the latest 5-year annualized stock returns for US oil and gas producers was 28.9%), institutional investors will continue to seek investment opportunities in this sector.
Creative financing options
How can smaller energy companies benefit?
Earlier we talked about the various forms of traditional financing and their respective advantages and disadvantages. Institutional financing can eliminate all or most of the funding problems encountered by smaller operators and allow them to execute their expansion and development plans.
Depending on an operator’s unique situation, they face a variety of financial challenges. For example, a large amount of land may be leased in an attractive field, but the bank’s collateral requirements may prevent adequate funds being advanced to drill the field.
Another common situation is an operator who desires to drill a large number of wells in an attractive play, but its network of individual investors and industry partners are “tapped out”. We also see energy service companies with rapidly increasing revenue, but they are in a cash squeeze because higher levels of inventory, receivables and/or equipment are needed to satisfy their growing customers.
Institutional financing can often solve these problems.
The three types
In essence, there are three fundamental types of institutional finance – senior debt, mezzanine debt, and equity.
Senior debt
Senior debt is generally secured by the assets of the subject project, and will carry advance rates of up to 100% of the market value of the assets financed. In some cases, e.g. early in a project, senior lenders will overadvance in order to accelerate growth. In return they will require some upside or equity participation. These deals are typically mature in three to five years, with the repayment schedule tailored to the budgeted cash flows.
This type of financing is the least expensive, with compensation to the lender primarily in the form of interest and fees paid on the debt. In cases where the lender is well secured and cash flow is anticipated to accelerate later in the project, investors may agree to add interest payments to the principal amount in lieu of cash payments (“PIK” interest) for a period of time.
Senior debt usually has financial covenants that are more restrictive than mezzanine or equity financing. However, we always make sure our clients have a reasonable covenant cushion to allow for cash flow deviations.
Mezzanine debt
This is usually structured as a hybrid between senior debt and equity. For projects that carry a higher degree of risk than those financed with senior debt, this type of financing can be a perfect solution.
We often utilize mezzanine debt structures in high growth situations. For example, a fledgling E&P project may have big expectations, but initially the funding need may exceed the asset value. 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.
While generally not as restrictive as senior debt, mezzanine debt will have financial covenants that are based on the financial proformas. As with senior debt, the financial covenants have a cushion built in and allow for normal business events.
Equity
This type of financing is the most flexible, but is also the most expensive. There is typically no maturity and/or investors generally will not require any fixed payments of dividends, but there may be provisions that provide for distributions once certain performance hurdles are met.
This is a good fit with management teams that have little or no assets to contribute or with projects that are relatively risky, but have the possibility of a big payoff in the future.
Desired projects and situations
First and foremost, investors desire management teams with strong track records. It is important to tangibly outline the accomplishments of the management team and their ability to create value. A key aspect to this is high ethics and honesty in management’s past business dealings.
Institutional investors like growth situations where management has a well reasoned business plan and the properties and opportunities are attractive. Examples of situations investors like include:
- Development of proven resource plays and emerging plays where other companies are active or desire to be
- Energy service companies that have strong revenue growth and established market niches
- Enhanced recovery projects that utilize waterflooding and other stimulation methods
- Established companies where management desires a cash payout for their equity stake
- Acquisition of producing properties or established companies that have attractive growth prospects
This is far from an exhaustive list, but rather some of the most common situations we run across.
Requirements, characteristics
Here are some fundamental requirements for institutional financing deals:
- Detailed business plan to include proforma lease acquisitions, a drilling plan, new areas/markets for expansion and/or new products
- Resumes of key managers
- Past track record – for E&P companies the well drilling history is important; for service companies results from past and present business initiatives should be outlined
- Unique aspects of a company or a management team, e.g. management’s ability to extract hydrocarbons from an area where no one else is very successful; ability to lease large chunks of land in high demand areas; a proprietary technology in high demand by the market
- Detailed financial proforma with reasonable assumptions that reconciles with the overall business plan
- Science and lease maps showing PDPs, PUDs, other drill sites, leases with other operators and nearby pipelines and other transportation
- For service companies, revenue and profitability by customer and by product category over a 2 to 3 year period; customer lists detailing the top ten customers, and lists of accounts payable and accounts payable
- Corporate records and historical financial statements that are organized and complete
- The company or management team must have “skin in the game”, i.e. something of materiality at stake (e.g. leases, PDPs, PUDs, working interests, company assets, cash, ownership stake, etc.); this aligns the interests of management and the institutional investor
Characteristics of institutional financing:
- Companies and management teams are able to secure their funding requirements for the next 3 to 5 years in one transaction
- The economics are typically far better than “third for a quarter” or “friends and family” financing terms
- In most cases there are no personal guarantees or pledges of assets other than the assets financed
- Many investors will combine senior debt, mezzanine debt and/or equity in a “one stop shop” format; this is advantageous since working with one party is generally easier than working with multiple groups
- Depending on the perceived risk, investors will require some “upside” generally in the form of well working interests or equity in the subject company; often management can “earn in” additional equity based on the performance of the project or company
- Funding is advanced periodically, usually monthly, according to a budget submitted by management
- Investors generally like to cash out, or “harvest”, their investments within 3 to 7 years of the initial funding
A growing market
Institutional financing is a nice fit for many smaller energy related companies. In many cases institutional financing closes the gap that exists when funding from “traditional” sources is not sufficient.
At a conference in New York City earlier this year, we observed over 40 presentations by public companies of various sizes. Most of the smaller companies had many attractive prospects to drill, but cash flow and bank debt were insufficient for an aggressive drilling program. Thus, their growth and value creation efforts are stunted.
In many of these situations institutional financing would be the ideal solution. Private companies that have “outrun” their financing sources can also benefit from institutional financing.
However, before entering into an institutional financing arrangement, management must be highly confident that their goals and strategies are in sync with the investors.
Institutional investors are likely to continue accelerating their investment activity in energy. The combination of large, unsatisfied capital needs and attractive expansion projects for upstream, midstream, and downstream companies provides institutional investors with many excellent investment opportunities.
About the Authors
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Sam McNeil [smcneil@rc-advisors.com] is a managing director at River Capital Advisors, an asset management and investment banking firm based in Chicago and Charlotte. He has 26 years of finance and investment banking experience. McNeil has a bachelor’s degree and an MBA from Virginia Tech.
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Peter G. Perna [pperna@rc-advisors.com] is a principal at River Capital Advisors. He has over 20 years of investment banking experience with a business focus in the areas of structured finance and energy. He holds a bachelor’s degree from the University of Michigan and an MBA from the Ross School of Business at the University of Michigan.
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Gregory J. Roti [groti@rc-advisors.com] is a senior analyst at River Capital Advisors. He has a broad business focus in numerous sectors including energy. He holds a BBA from the Ross School of Business at the University of Michigan.