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| Feature |
Risk & Reward Retrospective
John Ferry
01/01/2006
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7. Oil & Gas Private Equity
Crude Investments November 2004, page 94.
With crude oil prices soaring because of rising demand and geopolitical
instability, some niche energy private equity players have made a killing. “We
had a company that we put less than $50 million of equity into 18 months ago,
bought $350 million worth of assets for it, and just sold it for $800 million,”
says Wil VanLoh, cofounder of Quantum Energy Partners, a Houston private equity
company.
 But returns like that only come with taking a massive amount of
risk. Private equity firms that focus on energy place their money with
small exploration and production drilling ventures, or they may invest in
oil-related service and technology businesses or pipeline companies. The idea is
that with their leaner overheads, they can make money from reserves too small
for the big players to bother with. Quantum, Dallas-based Gas Partners and
Westport, Conn.-based Lime Rock Partners are some of the private equity firms
active in the area.
THEN AND NOW
While private equity deals in the energy sector continue to be
very lucrative for those firms with the requisite expertise, the recent rush of
capital into the
sector has pushed acquisition multiples up to the point where
much of the smart money is hanging back. If the price of oil falls much below
its autumn 2005 highs, current multiples could prove far too rich. |
Hurricane Katrina did not severely dent the energy
private equity market, because most of these investments tend to be onshore.
VanLoh notes that the increase in demand for oil-related exposures is working
against those already in the market. “Everybody thinks they’ve got to be in
energy now,” he says, “and so they’re bidding up the prices on these [private
equity purchase] deals. For the established, private equity, energy-focused
funds, we’re looking at the market and saying that these prices aren’t
justified.”
Ironically then, despite high energy price levels, VanLoh says
his company has been reluctant to make new investments over the past year. “We
have literally seen case after case of deals where the valuation in our minds is
anywhere from 25 to 60 percent higher than where we would price it,” he says.
Anyone wishing to step into the market now needs a strong constitution. “You
almost have to argue that oil is going to be somewhere between $70 and $100 a
barrel for the foreseeable future just for these deals to work out OK,” VanLoh
says. “But we believe oil is probably going to average somewhere between $40 and
$60 in that time.”
8. Business Development Corporations
Private Equity’s Wide Embrace December 2004, page 96.
Business development corporations—essentially companies that are set up by
private equity firms to tap the public stock markets to raise long-term
investment capital from a broader base of investors—were all the rage in 2004,
when more than a dozen leading investment firms filed to publicly offer stock.
But the products fizzled when investors stayed away in droves, turned off by
high fees and the negative arbitrage (i.e., they raise the money before
investing it productively, as opposed to how traditional partnerships only call
capital when it is needed) inherent in the structures. “They have been having
some tough times,” points out Thomas Herzfeld, a Miami-based investment advisor
specializing in closed-end funds.
THEN AND NOW
Business development corporations looked like an interesting way
for investors to obtain liquid exposure to leading private equity firms after
Apollo Advisors successfully raised $930 million in 2004. But investors soon
realized the deals’ high fees and negative arbitrage made them a losing
proposition. Only a few ever limped to market. |
Elizabeth Fries, a partner in the fund
formation group at Goodwin Procter, an investment company in Boston, notes that
interest in business development corporations (BDCs) has fallen dramatically,
and no new issues are expected to come to market soon. “I don’t think this will
be the big opportunity for private equity firms to go public that people thought
it would be,” she says.
The prospect of gaining a private equity-type
exposure through a publicly traded, liquid investment seemed enticing for
wealthy investors back in 2004. Fries notes that private equity firms’ interest
in BDCs grew after a leading partnerships, Apollo Advisors, raised $930 million
in April 2004. “Private equity firms then rushed to market to try to capitalize
on the opportunity they perceived to be there,” she says. But, she adds,
“Investment banks decided they didn’t want to underwrite the products anymore
because it was a retail product with such a high fee structure.” BDCs charge an
upfront load fee (in the case of the Apollo deal this was 6.25 percent), as well
as annual management fees of 2 percent. In retail terms, this is very high.
Another aspect that puts retail investors off is the fact that once listed, the
products trade at a discount, given the fact that private equity ventures draw
down capital as and when needed before returns, if any, are made.
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