To meet US energy’s huge appetite for capital, bigger companies with access to low-cost high-yield and levered loan markets generally have an easy time raising debt. But for smaller borrowers the supply of debt has actually shrunk while their demand for loans is rising. This can leave these firms with unfilled capital structure gaps and create an opportunity to make senior loans while earning investors an attractive risk-adjusted return from a significant illiquidity premium, says Doug Kimmelman, the founder of Energy Capital Partners.
Does the US energy industry have a strong need for credit at the moment?
Yes. US shale growth is driving heavy continued capital needs – the dollar needs in energy top all other sectors. Drilling technology has advanced dramatically in recent years opening vast production areas needing midstream infrastructure to transport oil and gas to market. Infrastructure spend is on the rise following some $280 billion of investment in US energy in 2015. Meanwhile, bank lending constraints are more pronounced in the energy sector than for other industries.
Where is demand for credit strongest?
E&P activities demand large amounts of credit and receive the lion’s share of lending directed toward the energy industry. The midstream sector also has large credit needs to build out gathering and processing systems, pipelines and storage terminals. Substantial amounts of debt are needed to support fossil generation M&A and probably to refinance newly built gas-fired power plants. Renewables are hungry for capital. Although the federal government has announced plans to pull out of the Paris climate accord, at the state level there is considerable effort to promote renewable power – not just building wind farms and solar power, but also building transmission lines from remote sites. Renewables will also require increasing amounts of developer loans to maximise expiring tax credits.
In addition to these demands for credit for growth capital, there is a wall of debt refinancing coming in the next several years. Between 2018 and 2023 an estimated $160 billion of energy high-yield debt is maturing that was raised around five years ago to fund the start of the shale revolution.
How much credit is available?
It really depends on the size of the company. Some segments of the energy industry do not have enough access to credit. It is not really about credit ratings but about liquidity. If you have $50 million or more in EBITDA, and you want to borrow $250 million plus with a leverage ratio of five times EBITDA or so, you qualify as large enough to tap into the high-yield and leveraged loan market – that market is wide open for business. But if you are smaller, sources of debt are very limited – the high-yield and levered loan markets are unavailable to you. At the same time, middle market companies with annual revenues between $10 million and $100 million comprise some 90 percent of US companies and their demand for credit is on the rise. It really is a tale of two cities: the credit haves and the credit have-nots.
Why won’t banks lend to the mid-market?
Historically, the banks would lend to businesses with a borrowing requirement of less than $250 million, but the core of the issue today is that commercial banks have pulled in a lot of their lending. This is largely because of regulations that have placed stronger capital requirements on the banks. At their peak of activity in 2009, the commercial banks accounted for about 25 percent of leveraged loan issuance. Now their share is no more than 7 percent or so. This creates a void.
The banks are reacting not only to regulation but also to a shrinking of their own risk appetite: they have pulled back from lending to energy mid-market companies because of troubled loans as a result of the commodity price downturn. When a loan is below $250 million, it is very difficult for a lender to trade out of the issue due to lack of liquidity.
If the banks do not want to lend to middle market energy companies, how about institutional investors?
Some hedge funds have been lending to energy companies, but like the banks, they too face liquidity constraints because they need to be able to trade out of those commitments in the event of investor redemptions. In their quest for yield, pension funds, endowments, family offices and sovereign wealth funds are becoming more interested in lending to the middle market because they are longer term holders, have a higher tolerance for illiquidity and are seeking more enhanced yield than traditional, investment grade products yield in today’s environment.
What kind of returns can lenders to middle market US energy companies expect and how does this compare to other fixed-income returns?
When investors look at the fixed-income allocations in their portfolios, they are hard-pressed to achieve much better than returns of 2 or 3 percent because of low interest rates. If you are a trustee of a pension fund with an annual actuarial assumption of returns of 7.5 or 8 percent that has a large allocation of portfolio funds into fixed income, meeting this return target is quite a challenge.
However, investors prepared to accept some illiquidity can earn a large premium from lending to middle market energy companies. The market might pay you as much as five percentage points extra for a loan to a smaller borrower than for a large one with similar credit characteristics. This means interest rates of between 10 and 13 percent for a single B-like credit. The return can be enhanced through up-front fees as well as potential equity upside participation. Most loans are structured as cash pay interest loans, but in some cases there is a pay-in-kind feature allowing buyers to defer interest payment for a year or two at the beginning of a project. Taking all these factors into account, a total return of 12 to 15 percent is achievable, with a net return of 10 to 12 percent after fees.
We believe this is quite attractive to a fixed-income investor given that the loan is well collateralised by real assets and the enhanced yield is not accompanied by a comparable increase in risk – it is a function of being a smaller, middle-market borrower.
Why is the illiquidity premium so high?
Financial crises and the bursting of the energy price bubble have made many shorter-term investors as well as the banks much more reluctant than before to make loans that they cannot trade out of very quickly.
It sounds as if there is a lot of customisation in middle market loans.
Yes. In privately negotiated, middle market loans, lending is generally highly customised with more protective covenants and investor protections.
Moreover, customisation is often necessary: for example, for situations that have no cashflow, such as a pipeline project that is coming online within the next year or 18 months, or a residential solar business that is rapidly adding new customers. For a loan like this, a payment-in-kind provision might be appropriate, with the borrower not paying any cash interest until the project is fully up and running.
Hedge funds and participants in the liquid loan markets, on the other hand, are less likely to customise as they need to invest into a more standardised product that will have greater liquidity. Because of the need to maintain flexibility to meet potential investor redemptions (private equity or credit investors do not have redemption rights), hedge funds can’t say: “I’ve created a unique private $50 million seven-year bond, but there’s nowhere to sell it because it’s really absolutely unique.”
You have suggested that opportunities in renewables remain strong despite the Trump administration’s rejection of the Paris accord. But what impact will the Trump administration have on energy?
There is a view that this administration is trying to find a way to help businesses grow, to create jobs. That probably means less regulation, and a more stable business environment. The prospect of more regulation during the Obama administration had a chilling effect on new energy investment, so the prospect of less regulation is viewed as a positive. Plans to increase infrastructure spending are also a boon: the Trump administration’s list of 50 key infrastructure projects they want to promote includes transmission lines and pipelines.
How does private equity investment in infrastructure compare with middle market lending in terms of return profile and risk?
There are other opportunities for long-term investors to make money from the energy market, such as the large amount of money raised by some private equity funds for energy infrastructure.
The targeted returns for these infrastructure type funds are in the low to mid-teens, similar to private credit target returns, but we believe that investors can benefit from a much better risk-reward ratio if they lend to the middle market than if they invest in infrastructure through equity (that in many cases is highly levered). We believe it is a much better risk-adjusted return to be a lender higher in the capital structure. Because of this, we are seeing a shift in thinking and private credit is an increasingly attractive alternative for investors who are searching for a somewhat safer, attractive yielding instrument.
How have current energy prices impacted lending?
The volatility of oil prices in the past couple years has hastened the exit by some banks from middle market lending. When many lenders think of energy, they immediately think of volatility and cyclicality. However, consensus seems to be that West Texas Intermediate crude oil is somewhat rangebound between $45 and $55 a barrel. In the most prolific basin in the US, the Permian Basin, oil producers can earn a reasonable return when prices are at this level. This has made lenders a bit more comfortable – “rangebound” is a word that lenders like to hear.
There are, in any case, many sectors within energy much less exposed to price changes, so the question of whether prices are volatile or not is not as relevant. Midstream assets such as gathering and processing systems and pipelines are good examples. In fact, the conditions of oversupply that push down oil and gas prices can be positive for these types of assets because they benefit from high volumes. These sectors are more attractive because they are sometimes ignored by lenders, which concentrate on exploration and production because it is the largest energy sector. Lenders can also make credit investments in power plants that have hedged the price of their feedstock and output.
This article is sponsored by Energy Capital Partners and appeared in the 2017 Investing in Energy Special published in Private Equity International in July 2017.