While there really was nothing unique in the observations they shared about the investment process or the desirable criteria, the scary fact was (is) the volume of private equity money seeking a home in the energy industry. According to Mr. Ryder, energy private equity investing as a percentage of total energy sector merger and acquisition activity had climbed from under 2% in 2000 to over 20% in 2014. During the first quarter of 2015, the energy private equity funds were investing at that slightly greater than 20% rate until the announcement of the $70 billion BG Group (BG-NYSE) and Royal Dutch Shell (RDS.A-NYSE) deal. We have not yet seen updated figures so we don’t know how the current state of the industry may have changed in the second quarter.
As the First Reserve article pointed out, the increased size of the investment pools forced the group to abandon its proven strategy of making smaller investments in smaller enterprises. First Reserve was forced to increase the size of its investments, meaning it needed to invest in larger deals. This investment shift is an economy of scale issue. To hold to its original investment philosophy, First Reserve would have had to make many more investments in each fund stretching the human resources of its investment team. It would have also potentially diluted the potential investment returns anticipated when putting the fund together, although given the performance of those funds a broader pool of investments might have provided them with better results. At the same time it was being forced to alter its investment strategy, First Reserve may also have been a victim of the “feeding frenzy” among energy private equity funds and non-energy new entrant private equity funds that could have inflated deal valuations. That feeding frenzy may have been the biggest problem if one believes that since the financial crisis in 2008-2009, the energy industry has been in a long-term downturn, just as happened during the 1980’s. We remain concerned about the magnitude of private equity money seeking investment opportunities in the energy business. We concluded our prior article on energy private equity funds with the following observations, which we still believe are correct.
“The uniformity of thinking among private equity players is a bit scary. Group-thought is usually not a successful strategy. The volume of public capital is not only surprising, but discouraging if one believes the industry needs to experience pain before a true recovery can begin. Lastly, in looking at the presenters and the audience, there were very few present that experienced the 1980’s forced re-structuring of the energy business following the bullish experience of the 1970’s. In our discussions that day, we encountered another old-timer who referenced the 1980’s downturn starting in 1982, three years before when most who look at the industry’s history think it began. We were there then, and this guy had it exactly right. This industry is headed for significant change.” In our view, the industry’s changes are just now beginning to emerge.
Here is a link to the full report.
The energy sector has gone through a decade long investment cycle predicated on developing previously uneconomic resources that were justifiable at a price structure above $40 and more often above $60. It is reasonable to expect that more than a little of that investment capital was used to bring resources into production with a considerably higher price point. As a result the natural progression for a sector going through a consolidation is rationalisation.
Low interest rates and an abundance of liquidity and a dearth of investment opportunities with a competitive yield mean that private equity firms have succeeded in raising record quantities of capital for buyouts. However it is questionable how favourable the prices they achieve will be when so much money is chasing a limited number of opportunities. This may prolong the rationalisation process and allow higher-cost producers survive longer than might otherwise have been the case.
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