EnCap’s valuation of Southland was fatally accurate

A combination of indebtedness and tanking oil and gas prices led to Southland's bankruptcy, not its valuation process.

The Financial Times’s Alphaville column this week called into question the value of PE “mark-to-market” valuations, pointing to EnCap portfolio company Southland Royalty, an oil and gas operator, which has now filed for bankruptcy, having been valued at close to cost only a quarter ago.

Says the FT: “Suddenly, those smooth returns from investments untethered from the realities of price discovery don’t feel as solid as they might have done before.”

The article states that perhaps the reason why the investment was written from almost equal to its investment value to zero in one quarter is because “as some private equity critics have ventured, it’s that markings in private assets are more mark-to-myth than mark-to-model”.

First, not to be petty, but for clarity: mark-to-model is different than mark-to-market, otherwise known as ‘fair value’. Mark-to-market was imposed across investment types after the great financial crisis because mark-to-model was thought to be easy to futz with and subjective – it is based entirely on internal considerations. Think of the liquidity and default assumptions that allowed securitisations of subprime mortgages to retain high credit ratings right up to the mortgage market meltdown in 2008.

But more importantly: it is true that ever since FAS 157 was implemented by the Financial Accounting Standards Board after the crisis (requiring private funds to ‘fair value’ investments on a quarterly basis), there has been no shortage of skepticism as to its appropriateness for certain investments.

Critiques usually centre on the following (the first being, I assume, the argument the FT article is making):

  1. Level three security (like private equity) fair valuations are, in the view of some, just as bad as mark-to-model – they involved non-observable inputs and for illiquid assets there are, by definition, no (or thin) markets to mark to.
  2. Quarterly pricing isn’t appropriate to long term investments, especially ones where the investment thesis revolves around the (risky) development or restructuring of a nascent or poorly run business into something stable and profit-generating, often years down the line.
  3. Mark-to market-can be volatile. Like in Southland’s case.

Oil and gas prices fell precipitously in the third quarter, when energy companies saw some major earnings disappointments. Among them: Royal Dutch Shell (down 15 percent net profit third quarter), Chevron (36 percent drop) and BP (41 percent down). Chesapeake Energy has had some 81 percent knocked off its share price from the same time last year, in large part from oil and gas prices. For a more recent example, Shell issued a profit warning in December that caused its share price to drop from nearly $62 in early January to $56.78 at the time I’m writing this.

EnCap chalks up the very sudden loss of value in Southland to – surprise – the oil and gas price dip.

At least on the face of it (and I could be wrong here, of course), this seems less like a ‘fair value is a myth’ thing than a combination of indebtedness (Southland reportedly owes some $540 million to its lenders) and tanking oil and gas prices. That can be a killer one-two punch, even within a single quarter.

Even if Southland was overvalued in the third quarter of 2019 (and I am not saying that it was), that combo probably wiped out Southland’s cash flow, (as well as the value of its proven reserves, or the oil and gas it expected to extract and sell), creating a liquidity crisis.

If anything, mark-to-market appears to have been fatally accurate in this case.

Graham Bippart is editor of sister publication Private Fund CFOs.