Oil prices began their steady decline in 2014, but many private equity firms, including Riverstone Holdings, are only beginning to register the pain.
Riverstone affiliate Riverstone Energy Ltd. marked down the fourth-quarter value of certain portfolio companies, recognizing losses on paper for the first time since oil and gas prices began sliding in the summer of 2014. Amid deepening distress in the oil and gas sector, energy investors, including EIG Global Energy Partners, EnCap Investments, Pine Brook and Energy & Minerals Group, also have taken various steps to recognize and mitigate potential losses from their investments.
These steps come in a variety of forms. Some firms have opted to pump more capital into their portfolio companies or sought alternative financing to buy time until oil prices recover. Others have walked away from money-losing investments, particularly if they do not have much equity committed to the companies. Accountants and investors said, however, there is no standardized approach to recognizing losses. Falling valuations for energy companies also are encouraging some buyers and sellers in the energy sector to start transacting, after a hiatus in deal activity driven by commodity price volatility.
Should I Stay or Should I Go?
The oil price slump has left few, if any, private equity investors in the sector unscathed, forcing some firms to make difficult choices.
The most recent weekly restructuring watch list from S&P Capital IQ‘s Leveraged Commentary and Data unit features 44 distressed companies across all industries, and about half of the companies are in the energy sector. Of those energy companies, seven are backed by private equity firms.
PE-Backed Energy Companies on S&P LCD’s Restructuring WatchIn mid-March, for example, natural gas processor Southcross Energy Partners LP said its private equity-backed holding company would seek chapter 11 protection. The collapse of the holding company, backed by EIG, Tailwater Capital and Charlesbank Capital Partners, signals distress in the energy industry has expanded beyond the exploration and production sector into the comparatively insulated midstream space.
“We don’t need to speculate,” said Oleg Mikhailov, partner and managing director at the Boston Consulting Group. “We just need to look at how the debt of some of these companies has traded…We have a few walking dead out there.”
In the face of deepening distress, firms must sometimes decide whether to contribute more capital to their portfolio companies or, in some cases, walk away from them entirely.
Some firms have taken advantage of the shrinking valuations of their own portfolio companies by increasing their stakes in those businesses. Riverstone Energy, which marked down the valuations of several of its portfolio companies, last year participated in a capital raise by its portfolio company Canadian International Oil Corp. by investing $68 million “on very attractive terms,” bringing Riverstone Energy’s stake in the company to 35% on a fully diluted basis.
Pine Brook and EnCap, meanwhile, decided not to invest additional equity in oil and gas explorer and producer Common Resources III LLC as commodity prices remain consistently low, putting Common Resources in runoff mode.
The firms and other investors committed $412.7 million to launch Common Resources III in 2012 to acquire both conventional and unconventional resources across a wide swath of U.S., including the Gulf Coast, West Texas and the midcontinent areas. People familiar with the situation said the company hasn’t drawn down its entire line of equity.
Commenting generally, Joseph D’Angelo, a partner at restructuring adviser Carl Marks Advisors, said companies in shale plays that feature higher production costs or are farther away from pipeline systems may face more difficult choices.
“A private equity firm has to say ‘should I put more money into this company now, or should I wait for oil prices to increase?'” said Mr. D’Angelo. “For every private equity firm that has a company with a production cost that’s marginally higher than the cost of oil, how do you justify putting more money in if you can’t increase enterprise value? It’s also very difficult to sell the assets, because it’s not likely that a strategic buyer will be able to reduce that production cost based on the geology.”
A Tale of Two Accounting Methods
Many firms that continue to hold onto their portfolio companies have recognized losses, at least on paper. However, some have marked down assets more quickly than others.
Riverstone Energy, which co-invests with Riverstone Holdings‘ private funds, marked down the values of four portfolio companies to below-cost levels during the fourth quarter. Meanwhile, EIG marked down the unrealized value in a 2007-vintage fund by 34% for the second quarter of 2015 from the same period in 2014.
One reason firms may vary in timing the write-downs of oil and gas investments stems from the fact those investments are made over the course of a few years, Kelly DePonte, managing director responsible for research at placement agent Probitas Partners, wrote in an email.
The fund’s valuation, therefore, “combines different levels of purchase prices at different points in cycle – and importantly in the oil and gas sector, usually a range of projects with different costs of production,” Mr. DePonte wrote. “The combined impacts mean that different firms have very different cost structures or revenue-sensitivity structures.”
In addition, Mr. DePonte wrote firms may base their valuations of companies on a forecast of what they believe are “longer-term equilibrium prices” of oil and gas, rather than spot prices for such commodities.
Alan Stevens, a certified public accountant and a partner at consulting firm BDO, added the different accounting methods firms adopt, as well as the different commodity prices firms use to measure their valuations, lead to different ways of recognizing losses from oil and gas assets.
Mr. Stevens said some firms follow what is commonly referred to as a full-cost accounting method, while others adopt a successful-efforts method. The two methods lead to, among other things, different ways firms recognize asset impairments.
Firms that use the full-cost method would calculate impairments using the historic average prices of oil and gas, whereas those that adopt the successful-efforts method would use forward prices of such commodities, said Mr. Stevens.
“It really all comes down to prices,” he said. “That creates a divergence.”
Mr. Stevens added that in a declining-price environment like the current one, firms that adopt the successful-efforts method would recognize losses sooner than ones that use the full-cost method because forward prices would be lower than historical averages.
Opportunity Amid Chaos
Although the pain caused by low oil prices contributed to a steep drop in deals in 2015, some firms said they continue to find attractive opportunities and expect to see more in 2016, particularly for distressed investors.
In 2015, private equity firms made eight majority investments worth a total of $1.54 billion in the U.S. oil and gas industry, down from 16 deals worth $4 billion in 2014, according to data provider Dealogic Ltd. Deals outside of the U.S. also experienced declines in 2015 over 2014 levels (see chart on page 12). Dealogic’s data only include platform investments and don’t include purchases of producing properties or lease acreages.
In some cases, private equity firms said transacting is a bit easier for deals outside of the U.S. European asset manager Unigestion (US) Ltd., for instance, recently made a first investment out of the firm’s direct investing fund, financing U.K. oil and gas company Zennor Petroleum Ltd.’s efforts to roll up assets in the North Sea.
“The energy market has repriced more quickly outside the U.S. than in the U.S.,” said Federico Schiffrin, a director in Unigestion‘s direct investing business. Mr. Schiffrin said he believes that is because the U.S. capital markets are deeper and more robust than those elsewhere, enabling companies to refinance their debt. Bank lenders to energy borrowers also don’t want to foreclose on oil and gas assets and become operators themselves, making the banks more lenient to borrowers, said Mr. Schiffrin.
There are some initial signs that even in the U.S., deals may be picking up, particularly for distressed plays or companies with overlevered balance sheets. Clearlake Capital Group in March recapitalized oilfield services outfit Global Energy Services LLC, which operates at 50 locations, primarily in the Permian basin. In a news release, Clearlake cited the Permian basin’s “resilience” in the current commodity price environment as part of its investment thesis.
Private Equity Investments in the Oil and Gas SectorChallenges remain for investors in the U.S. Blackstone Group’s credit arm GSO Capital Partners, for instance, hasn’t invested any capital into a joint venture with publicly traded LINN Energy LLC, said Donald “Dwight” Scott, a GSO senior managing director. After the joint venture was formed in June, LINN ran into liquidity issues, resulting in its announcement in March that LINN was skipping interest payments on certain bonds. LINN also said it isn’t in compliance with the covenants of its credit facility, and that its auditor KPMG LLP has raised doubt about LINN’s ability to continue as a going concern.
“Everything has fallen out of bed during that period,” said Mr. Scott. “It’s been hard to get any assets into the joint venture.”
A LINN spokeswoman didn’t return messages seeking comment.
The deepening distress, meanwhile, has created new credit-investment opportunities. Such opportunity first emerged during the spring of 2015, though further declines in oil prices after that have raised questions about whether or not some investors jumped in too early. Now, amid diminishing liquidity, more companies have resorted to private equity firms for funding. Clayton Williams Energy Inc., for instance, in March announced a $340 million term loan from Ares Management.
Although GSO’s joint venture with LINN may be in limbo, the market dislocation is creating opportunity for GSO to provide structured credit to companies seeking liquidity, said Mr. Scott.
“Our origination business will be very busy during the second half of 2016, as companies get their capital structures in place or position themselves for survival or to prosper,” said Mr. Scott.
–Laura Kreutzer contributed to this article.
