Think of industry sectors that missed out on the big private equity boom of the late 1990s, and you will soon come across a sleeping giant: energy. One of the biggest industries in the world ? broadly defined, the sector accounts for around 20 per cent of world GDP ? energy has been all but neglected by nearly all private equity managers.
According to data from Venture Economics, 1999 and 2000 combined saw a mere $2.5bn of US private equity capital go into the sector, against $75bn deployed in Internet investments for instance. Venture Economics research also indicates that between 1997 and 2000 US venture capitalists invested no more than 2 per cent of total capital raised in energy.
There are a number of reasons for the sector's longstanding lack of appeal to private equity, the most critical one being its cyclicality due to notoriously volatile commodity prices, particularly in the key areas of oil and gas. Stuart Winton, a director of the structured finance team at Bank of Scotland in Aberdeen who works with equity sponsors in the sector, says: ?Investing in oil and gas requires focus and knowledge of the industry. If you invest at the right time in the cycle you can do very well, but it takes commitment to build a portfolio.?
This is not an area where it is prudent to put a lot of leverage on companies
Graeme Sword, head of 3i's Aberdeen-based oil and gas investment team, agrees that cyclicality is an inescapable fact of life in energy: ?You've got to be prepared to see an investment through at least one downturn, and often hold deals for long periods of time.? Both are concepts many private equity firms prefer to avoid.
The fact that cycles are difficult to predict means that conventional LBO investment strategies are to be handled with care in energy projects. Says John Reynolds, co-founder and managing director of Lime Rock Partners in Westport, Connecticut: ?This is not an area where it is prudent to put a lot of leverage on companies. The last thing you want to do is put a ton of debt on an energy company and have it in a difficult position when the market inevitably turns down.?
As a result, with the exception of 3i in Europe, none of the generalist private equity houses have a significant presence in the sector. In the US, First Reserve enjoys a pre-eminent position as the leading private equity firm committed to large buyouts in the sector. The firm, which like Lime Rock is based in Connecticut, manages $2.5bn across four dedicated energy funds and has a 20-year history of investing in large transactions such as the $1.5bn buyout of Dresser Inc., an equipment and service provider, from Halliburton in April 2001.
In the development capital segment, financial investors are thin on the ground as well: ?People thinking of private equity have the impression of management reviewing piles of terms sheets from numerous venture capitalists and selecting their capital providers?, says Reynolds' colleague and co-founder of Lime Rock, Jonathan Farber. ?That's the diametric opposite of how we conduct business.?
In Europe, whilst there isn't a market for large LBOs in the sector yet, a small group of European brand name investors including Bridgepoint Capital, Barclays Private Equity and the private equity arm of HSBC have put in sporadic appearances in the sector's mid-market. More recently, Scottish house Aberdeen Murray Johnstone Private Equity put its name on the map with a £10m growth capital investment in Tuscan Energy, a new North Sea oil operator.
But by far the most engaged European player is 3i, whose oil and gas team manages a $500m portfolio and has for years enjoyed a firm grip on mid-sized buyouts and development capital deals. According to Alistair Gardner, who works with Winton at Bank of Scotland, 3i are the most significant player in the sector: ?They have stayed in the market throughout the downturn, they have more industry knowledge than anyone else, and they are benefiting substantially from portfolio plays.?
3i's Sword says the group's strength derives from its international network of investment professionals, managers and service providers, its contacts with industry and its balance sheet, enabling it to absorb any cashflow issues that may occur during the life cycle of an investment.
But if providing private energy companies in Europe with capital is indeed a market that has long been dominated by 3i, the question is how long this will remain so. The firm itself has arguably done enough in recent years to motivate potential rivals to seek entry into the sector even though the barriers are widely regarded to be high. Its oil and gas team completed four successful trade sales from portfolio companies in 2001, and in March 2002 even succeeded, alongside co-investors Lime Rock, in taking Venture Production, a fast-expanding oil and gas business in Aberdeen, to floatation on the London Stock Exchange at a market capitalisation of £185m, the first LSE oil and gas IPO in over two years.
Oil price stability?
It is also not clear whether there is a new IPO window opening up for oil and gas companies generally. In March of this year Portugal's stateowned oil and gas utility postponed its IPO citing unfavorable market conditions. In February Asco, a 3i backed energy supply chain business, pushed back a planned flotation on the New York Stock Exchange.
However, such IPO uncertainty notwithstanding, there are a number of factors attracting new entrants to energy investment. Observers agree that on a macroeconomic level, conditions are currently more benign than they have been for some time, and the outlook is encouraging as well. In an industry where the single most important variable driving investment decisions is commodity pricing, the current oil price of between $18-25 per barrel provides a playing field that bodes well for private equity investment.
?If the behaviour we're seeing from OPEC and Russia at the moment continues then the oil price should remain stable for the next 18 to 24 months, which gives everyone a comfort factor?, says Winton at Bank of Scotland. Such stability allows management involved in buyout situations to settle down and concentrate on executing their business plans, a luxury that few take for granted.
One of the typical challenges facing management is to execute a global expansion strategy. An international presence reduces the price volatility that an oil producer, for example, will be exposed to, because commodity pricing differs from region to region depending on what kind of drilling technique can be used, and what kind of regulatory framework applies. As a result, secondary transactions to buy and build internationally are often an integral part of expanding growth companies that are working with equity sponsors and debt providers.
For buy and build strategies to work, acquisition targets at affordable prices need to be in the market. According to Bank of Scotland's Gardner, with quoted service companies' share prices having fallen post Sept 11 they are no longer able to pay sexy multiples by offering their own paper to vendors. Instead vendors are now a great deal more interested in discussing divestment opportunities with private equity sponsors than they were 15 months ago, when the oil price was high and operators enjoyed a high share price, large cash reserves and strong balance sheets.
Another source of dealflow are technology-driven growth companies, which currently benefit from two important trends.
First, ongoing consolidation among producers and services providers has meant that capacity utilisation along the energy chain is considerably tighter than it was 15 years ago, be it with respect to raw oil production, US natural gas production, refinery utilisation or oil service asset utilisation. ?Where you would have had utilisation levels of 50 to 60 per cent 15 years ago, you now find 90 per cent plus, which means that new capital investment will have to be put into the market to grow assets and build new infrastructures?, says Reynolds at Lime Rock.
Second, opportunities also derive from an increasing focus amongst oil producers and service companies on greater efficiency and cost reduction, as this stimulates technological advance. As Lime Rock's Farber points out, operating an oil rig in the North Sea can cost up to $500,000 a day. New technologies that can help reduce rig time will trigger significant savings. ?Between 1990 and 2000 the money spent by the big oil companies on early stage technology has declined by roughly half in real terms, which has left the playing field more open for smaller, high growth companies that are now becoming the innovators of the 21st century?, says Farber.
Where these innovators possess genuinely groundbreaking technology, they become to some extent immune to the cyclical nature of the markets that they operate in ? a crucial characteristic for investors such as Lime Rock, as it reduces the need for them to time the market and hence their investment risk.
Many of the true innovators are likely to hail from Europe. Among the world's centres of oil and gas production, the North Sea is considered the toughest environment for companies to operate in. Sea conditions are harsh, and producers are having to drill deep into high pressure ground formations. On top of that, the demands of the prevailing regulatory framework are substantial as well. These demanding conditions mean that new technology solutions tend to get developed in the North Sea first. Indeed, as 3i's Sword points out, ?if a technology works in the North Sea, it works everywhere.? In other words, investee companies active here are likely to enjoy attractive export opportunities.
This is a factor in 3i's success in oil and gas investing, and it also explains why Lime Rock has invested over 40 per cent of the $105m fund it closed in 1998 in Europe.
Lime Rock's 1998 fund was its first – in order to launch it, founders Farber and Reynolds had quit their careers as energy analysts at Goldman Sachs ? and its success is likely to inspire other practitioners to take a long and hard look at energy investing. Lime Rock, having built up significant minority positions in 12 investee companies, is close to getting the fund fully invested and, after three completed realisations, has returned over 90 per cent of its capital to investors.
Graeme Sword at 3i also takes an optimistic perspective on the market going forward, albeit with a caveat: ?The question is where will the next generation of investee companies come from? Many of the companies that were set up in the 1990s have now been sold, and finding new ones could be a challenge.?
If this prognosis is right, renewable energies might soon enjoy a greater share of the limelight. 3i, for one, appears to be preparing for this eventuality: the firm has completed four investments in renewables already. The energy sector is not only big but also adaptable and its evolution looks set to throw up further opportunities for informed equity sponsors.