First Reserve's warning lesson

When the Public Employee Retirement System of Idaho assigned negative IRRs to First Reserve Corporation’s $7.8 billion and $8.8 billion buyout funds in December 2014, it highlighted how a shift in investment strategy had damaged a private equity firm’s long-term record and capital-raising capabilities.

First Reserve’s decision to move its focus from smaller energy deals to bigger investments nine years ago has generally been an unhappy one, with the firm’s management candid about what went wrong.

A focus on investing larger amounts of equity via the raising of ever larger funds, coupled with extending investments into new areas, hit the firm following the raising of its $7.8 billion 11th fund in 2006. Its previous 10 funds had been focused on buying smaller companies for consolidation within the energy value chain – namely upstream, equipment and services, midstream and downstream. The new approach was to fund larger investments in power, renewable energy and financial energy-related investments.

“What happened in parts of our industry was that as consolidations continued it took more dollars to do the same kind of deals that we had been doing. Consolidating bigger companies required bigger cheques to do so,” says Cathleen Ellsworth, managing director at First Reserve who heads the firm’s investor relations activities.

“What didn’t work out for us was adding that fourth energy sector in the 2006 to 2008 time frame. That took our focus away from our core areas of expertise.”


First Reserve’s $1 billion investment in coal-fired power company Longview Power in 2006 and Sabine Oil & Gas in 2007 were two deals that ran into trouble. The former filed for bankruptcy in August 2013, the latter on 15 July this year.

Its investment record bears out the performance dichotomy. Six of the firm’s larger deals that exceeded $500 million in equity have generated a negative 18.7 percent IRR for the GP, compared with the 101 platforms below $500 million in equity that have collectively produced a 29.7 percent gross IRR, according to sources.

First Reserve is by no means the only US private equity firm to raise large funds to support single and multi-billion-dollar-plus transactions. It was a common trend in the heady years of high liquidity before the global financial crisis.

“We saw that GPs were able to raise money very quickly and substantially more than they were able to raise before,” says Tom Keck, a partner at StepStone, a consultancy that advises limited partners on private equity fund commitments.

“If a brand name firm is raising a fund and there is a lot of demand in the institutional limited partner base, general partners are often willing to raise more capital and larger size funds to accommodate their investors’ interest in a particular fund.”

The stumbles hit investor demand for First Reserve’s 13th buyout fund, which closed at $3.4 billion, well below its $5 billion target. But the firm secured the support of several investors in its infrastructure funds, according to Ellsworth.

Lessons learned, First Reserve has returned to its core competence of sourcing smaller deals. It is back pounding the pavement for upstream, production service and equipment-oriented businesses and aiming to hit its ‘sweet spot’ of making equity investments of $250 million per deal. In December 2014, the firm committed that amount to buying oil and gas gathering company Navigator Energy Services.

“We believe it’s more valuable to be prudent than optimistic at this point in the cycle. For new investments, the landscape has changed, and there will definitely be different winners and losers from a year ago,” says Ellsworth. “The recipe for success is to find the right opportunities, with strong managers and execute on those.”