Energy levels rising(4)

Traditionally a private equity backwater, last year the energy sector was big news. Investment levels rocketed, huge deals were completed and specialist players raised large sums of capital from eager investors.

“Energy hasn't traditionally been a space for private equity,” concedes Rick Roberge, a partner in PricewaterhouseCoopers' energy team in Houston, Texas. “But in the last three years, their investment has ramped up significantly. We're now seeing private equity play in all sectors of the industry.”

In 2006, private equity deals in the energy sector topped $50 billion (€39 billion) for the first time, according to data provider Dealogic – more than the previous three years combined. The number was boosted by the biggest deal ever agreed in the sector: a Carlyle Group-led consortium's $22 billion acquisition of pipeline operator Kinder Morgan. But there were also more deals than ever before – 104 agreed during the year, a 67 percent increase on 2005.

Rising commodity prices have helped to make the sector more attractive. Although the oil price has rebounded from last summer, when it hit nearly $80 per barrel, it is still significantly higher than 2004 levels. The rise has been fuelled by concerns about the security of oil supply from politically volatile regions.

So too have high-profile success stories. Listed UK firm 3i has been one beneficiary. It made a 5 times return after a £550 million flotation of oil services group Petrofac in 2005, and a 7.3 times return from the £153 million sale of North Sea gas business CH4 Energy to Venture Production in 2006.

“There's a huge amount of interest in the sector at the moment,” says Kenneth McKellar, an oil and gas partner in Deloitte's London office. “In fact it's probably never been higher.”

And the sector shows no sign of slowing down. In fact, given the amount of capital now at the disposal of private equity energy specialists, following a bumper fundraising year, there is every chance that the coming year should see even more deal activity.

In July, energy specialist First Reserve closed its tenth buyout fund at $7.8 billion – a remarkable demonstration of investor appetite for the energy sector. This eyewatering total was not only First Reserve's biggest ever fund, over three times larger than its previous $2.3 billion effort, but also the biggest sector-specific private equity fund ever raised. What's more, according to the firm's chief executive Bill Macaulay, the fund could have been “much larger”.

And that was not all. Elsewhere EnCap Investments, a Houstonbased private equity firm, raised $1.5 billion to invest in oil and gas exploration companies, Canadian private equity firm KERN Partners closed a $450 million energyfocused fund, and the joint venture between Carlyle and energy specialists Riverstone garnered another $4.5 billion from investors. There were new entrants too: Energy Capital Partners, another specialist firm, closed the world's largest sector-specific debut fund at $2.25 billion, 50 percent above its $1.5 billion target.

Investors are keen for more exposure to the sector. Jens Bisgaard-Frantzen, managing partner at ATP Private Equity Partners in Copenhagen, says the underlying trends remain good. “Energy is getting more and more scarce, efficiency is increasing thanks to greater focus, and the overall demand is huge.” According to some estimates, the western world uses about 1-2 percent more energy every year; in the fast-growing economies of China and India, the growth is even faster.

And private equity's operating expertise is growing all the time. Almost all of the big generalist buyout firms now own energy assets, but the success of these latest funding vehicles shows that in this sector, investors like specialist knowledge. Carlyle's hybrid model provides a good demonstration of this – rather than building an internal team, it decided to attack the sector by linking up with Riverstone, a private equity firm started by Goldman Sachs energy specialists. Riverstone brings the operating experience to match Carlyle's transactional experience and extensive contact book.

Specialism can be geographical too. The $300 million GCC Energy Fund is based in Dubai, and only targets investments in the Middle East. Ali Toubia, chief executive of GCC, says: “We're already on the ground. We know the industry, we know the region well, we're very visible and we know how to pick deals.” As such, he is untroubled by the threat of increased competition from international players.

Bisgaard-Frantzen says: “The sectorspecific funds know all the pitfalls, and they have a large dealflow – which you need in order to deploy relatively large sums of money.”

For now, dealflow does not appear to be a problem. First Reserve, seen by many observers as the leading light in this sector, is seeing opportunities across the board, according to investors. “When we did our due diligence we looked at their dealflow, and it was very strong,” says one US pension fund manager who invested in its offering. “They're looking at a lot of good deals right across the sector.”

Having specialised in energy investments for 25 years, the firm can reasonably claim to know the sector better than anyone else – which helped convince investors that it was capable of deploying its huge new fund. “They're setting themselves up as the Blackstone of energy”, says another investor.

First Reserve has successfully completed deals in all areas of the sector, from upstream production to midstream transportation to downstream services. McKellar says: “First Reserve's shopping list is very large – it operates right the way through the value chain. So the broader coverage a business has, the more attractive it will be.”

Generally, McKellar believes midstream companies are the most natural private equity targets. “The oilfield services sector in particular is critical to the development of the sector. The companies within it are very much in demand – and that demand's not going to go away.” He also believes that the big oil companies will start looking at the disposal of non-core assets, now the oil price is starting to settle down. “So there's the potential to see both assets and possibly management teams coming out of majors – which plays perfectly into the hands of private equity.”

So can anything thwart private equity's new love affair with energy? Most managers do not think oil prices will continue to fall, and even if they do it could affect valuations positively. “It's good that oil prices have dropped, because it makes valuations more realistic,” says Toubia, who remains “very bullish” about the sector's prospects.

The key question seems to be whether the top of the cycle is being approached. One investor thinks this may be the case in the US. “We were in the Gulf of Mexico recently, and you can see there's a huge amount of money chasing too few deals.” As a consequence, firms are relying on secondary buyouts or moving out of the area altogether, he says.

Finding quality management to run these companies remains an ongoing problem. “It's a small and very specialist industry,” says McKellar. “Even at senior level you need people with very good technical skills, and there's not too many about.”

Nonetheless, most observers expect another bumper year for private equity in the energy sector. Marek Gumienny, managing director of London-based buyout firm Candover, which recently tripled its money on oil and gas supplier Vetco Gray, says: “The market's still got a long way to come. Geopolitical developments can only have a favourable impact on the oil price.”

Roberge agrees. “We expect to see another big year,” he says. “It's hard to see a scenario where deal activity won't be big in the sector.”