Private Equity Grapples With 'Impediments' to Exits

The Issue

The upstream deals market has seen a boost in activity thanks to the strong rise in commodity prices that began in the latter half of 2021. In the US a number of those deals have involved the takeover of privately backed entities, such as Chesapeake’s recent purchase of Chief Oil and Gas and Earthstone’s buyout of Bighorn Permian. But while private equity (PE) is expected to play a continuing role in the deals market this year, the sector is also grappling with a changing market. Upside potential and drilling inventory are out, whereas cash flow and financial discipline are in. That has some PE-backed companies changing how they see their assets.

Making Money in the Meantime

How PE cashes in on its oil patch investments is changing, a fact noted by executives at Houston’s recent Private Capital Conference. Gone are the days when a PE backer could rely on an IPO or trade sale a few years down the line to cover the costs of its investment in an oil company. “If I'm going to go put $400 million dollars into something and sell it six years from now, I need to make my money along the way. I really can't count on some massive exit to cover it,” Joseph Small, head of US Oil & Gas Acquisitions and Divestitures (A&D) at CIBC, said.

In addition, PE-backed companies are also having to address risks associated with environmental, midstream, and plugging and abandonment (P&A) concerns to attract increasingly selective buyers. “Buyers do not like obligations,” RBC Richardson Barr Managing Director Rusty Shepherd said. “And that obligation can take the form of P&A, it can take the form of an obligation to drill, an obligation to reduce flaring. All of those things are impediments to getting a transaction done in a way that you feel is most efficient and most beneficial.”

ESG Pressure

Public-listed entities are feeling the pressure from investors and other stakeholders to improve their environmental credentials. But that feeling has rippled out to private companies that need to prove that their assets will fit in with buyers’ environmental, social and governance (ESG) strategies. “ESG now impacts all access to capital,” Pickering Energy Partners’ Dan Romito said. “Your insurance, your banking, your equity is all heavily influenced … by your ESG profile.”

Romito also noted that ESG will be part and parcel of transactions going forward.

“I don't think it's going to be explicit,” he said. “I think it's not necessarily going to be the first or second thing. But probably the third [or] fourth thing. What we're observing is in the due diligence process, understanding if this deal is going to be accretive day one to the ESG profile.”

Chesapeake and Chief

Chesapeake’s recently announced acquisition of Chief offers an example of a takeover of a PE-backed company by a publicly listed company that focused on cash-flow generation and ESG credentials. The Chief deal boosted Chesapeake’s cash flow per share from $20.65 to $22.65 and the enlarged company is expected to generate $9 billion in free cash flow over the next five years following the deal.

On the ESG side, the merger is also expected to drive a 15% reduction over 2020 levels in Chesapeake’s overall methane intensity. Chesapeake has publicly committed to lowering its carbon footprint, including a pledge to reduce methane intensity to 0.09% company-wide by 2025.

The acquisition may also provide the cure for a particularly sharp headache in the Marcellus Shale: limited takeaway capacity. Chesapeake CEO Nick Dell’Osso said the company would gain more access to incremental delivery points, including greater egress out of the basin.

A Place for PE

On the flipside, PE buyers are expected to play a big role in the A&D market this year as large public-listed companies shed assets to clean up their ESG figures or high-grade their portfolios.

Shepherd predicts a “more muted” but still active deals market in 2022. “As you think about the A&D market, it's really going to be driven by [companies with small- and medium-sized market capitalizations] looking for a more efficient model and PE opportunistically continuing to acquire,” he said. “And then where's that supply [coming] from? It comes from those larger companies that are going to be more focused on ESG. And it comes from … M&A, where core and a single entity becomes noncore and combined entity.”

Indeed, PE has already started to pounce on public-listed assets. Last week, EIG-backed Maverick Natural Resources scooped up conventional properties in the Central Basin Platform (CBP) of the Permian Basin from ConocoPhillips for $440 million. ConocoPhillips said that while the assets were “strong,” they did not compete for capital within the company’s portfolio.

Conventional Outlook

Both Shepherd and Small described conventional assets as a “honey hole” for private investment, especially in the CBP. “It really fits the private equity model to a 'T' in a lot of cases,” Shepherd said. “It gives you a nice free cash-flow profile, with opportunities to reinvest back in the ground in low-risk development projects.”

Rystad Head of Shale Research Artem Abramov compared the environment for conventional assets to that of 2016-18, when interest was biased toward unconventionals, which led to mature assets trading at a significant discount. “We did see some outflow of PE capital from oil and gas in the last few years, but many specialized energy PE firms simply do not have sufficient capital allocation opportunities without domestic oil and gas,” Abramov said, noting that the consensus supercycle outlook for commodities and discounted valuations for conventional assets mean that the returns potential “is too attractive to be ignored.”

Abramov said that there have been recent conventional deals in Alabama, Mississippi and the Appalachian Basin, and that he expects to see more in legacy Texas, Oklahoma and Rockies fields this year.