Wednesday, October 27, 2010

Circling in the Sky - Friend or Vulture?

Private equity firm KKR announced yesterday that it had formed a partnership with RPM Energy, LLC, a company formed by a couple of former Jefferies investment bankers (Wall Street Journal article).  The new venture, called RPM Energy Partners, LP., will seek investment opportunities in the "Big Six" shale plays (Barnett, Haynesville, Marcellus, Eagle Ford, Woodford and Fayetteville).  The principals correctly recognize that there is huge opportunity to drill for gas, but capital is constrained.  This is especially true for the smaller and mid-sized companies that don't have the heft of the larger publicly traded entities.

KKR has been one of the few private equity players in the shale "space" in recent years.  It scored a big win in its investment in Marcellus driller East Resources, which was sold to Shell about a year after its investment.  It is also an investor in the Eagle Ford Shale through Hilcorp Energy.

This is a shrewd move by KKR.  Like most private equity companies, it is sitting on A LOT of money that it needs to get invested.  Gas production is a capital hog, so it's a good match.  On top of that, the gas market is in the toilet, so there are few competitors for the investments - other than foreign producers wanting to learn how to drill shale - so investment valuations won't be bid up substantially.  With a poor near-term outlook for commodity prices, the public markets don't have a taste for natural gas investments.  Private equity companies have a longer time horizon, so they can weather the valleys to be able to ascend the peak later.  It is perfect timing for private equity to invest in natural gas.

But there is a darker side.  While I'm no expert on the oil and gas industry, I do know the private equity industry well.  I've expounded upon my thoughts on private equity in the past, so I'll try to keep repetition to a minimum.  While I think this is a good investment vehicle for the industry, it is one that should be viewed with care.

I don't think that making minority investments and joint ventures it is KKR's preferred model.  These guys are takeover artists.  Their preferred model is the leveraged buyout (LBO).  Since the credit markets for LBOs has dried up and because the company recently went public, KKR has been forced to find other ways to deploy capital.  Private equity firms make money by 1) raising lots of money (and charging a +/- 2% "management fee") and 2) investing lots of money (ultimately earning +/- 20% of the investment profits).  It's a lucrative model for the principals of the firm (although not so much for the public shareholders of the firm - a topic for another day), but it only works if they can get the money in and out of the door.

I am of the belief that this investment vehicle yield a few buyouts.  KKR doesn't want to buy too many companies because that would skew their portfolio, but I think they will take a company or two private and maybe roll up a couple of smaller independents.  Making minority investments is not their style.  They want to run the show.  They aren't called "masters of the universe" for nothing.

LBOs of public companies are something of a slippery slope for existing shareholders.  Buying up all of the publicly owned shares will be done at a premium to the current trading price, so many investors will look on that as a positive.  But the valuation will be a discount to what the company is truly worth.  Likely, the market will have a low short-term value on the company that does not reflect its true intrinsic value (just listen to every CEO on an investor conference call - they are saying the same thing).  Ultimately, the shareholders are forced to sell at a discount to the company's real value.

Usually the big winners in an LBO (other than the investment firm) are the company's managers.  The ones that stay (and usually those are the ones who ushered the buyout deal to completion) have the potential for big gains because they are part of the next stage of "value creation."  Public shareholders are out once they sell.  Their only chance to get back in is if the company has an IPO, but that will be at a much different valuation, for sure.

While an LBO firm has a longer-term vision than the stock market, it is usually not longer than five years.  At that point the company will be sold or it will reemerge as a public company.

Anyone who follows E&P stocks can name a handful of smaller companies that are struggling.  These are the prime targets.  Expect to see some joint ventures of prime acreage and/or some buyouts.  If gas prices stay low, the days of going it alone will be limited for many of the publicly traded independents who don't have good access to the capital markets and don't have the luxury to sit on the sidelines until the storm passes..  I've got my eyes on a couple of companies in the Haynesville Shale.  To me, the only question is when, not if.


Anonymous said...

Interesting article...


Anonymous said...

This would be great if they go with Natural Gas... Maybe other areas around the North East would do the same thing

Robert Hutchinson said...

Re: the Baltimore Sun article - It certainly would be easier and faster (and cheaper) to build natural gas. The plant could be up and running before the nuke plant is financed, even with the loan guarantee.