First Reserve may be the oldest energy-dedicated private equity fund having been founded in 1983 by John Hill, an Energy Department undersecretary in the Ford administration, and William Macaulay, an investment banker with Oppenheimer & Company. (In full disclosure, we know Mr. Macaulay and our prior employers did business with First Reserve.) These two gentlemen were early in seeking energy industry investment opportunities, starting during the industry’s first significant bust – the mid-1980s, oil-price-induced collapse. For those who experienced that period, many energy companies were victims of overleveraged balance sheets that were unsupportable when asset values collapsed in response to the dramatic oil price decline orchestrated by Saudi Arabia and the subsequent drop in activity. Often there were solid businesses underlying the debt debris, but many times the good and bad were both destroyed. During the mid- to late-1980s, by working with the banks to restructure loans and through judicious use of the U.S. bankruptcy courts, balance sheets of companies in the energy business were restructured.
First Reserve Billion Dollar Funds Struggling
Several months ago we attended two meetings dealing with energy private equity investing, which we subsequently wrote about. The observations from these meetings are related to the problems highlighted in the article on First Reserve. One of our meetings was a presentation by Michael Ryder, managing director at Blackstone Private Equity Group (BK-NYSE) and head of his firm’s energy investing effort. He and his team were coming off a highly successful $4.4 billion fund-raising effort that needed only six-months, but Blackstone was having a difficult time finding attractive investment opportunities. The new Blackstone energy fund, along with existing buyout funds raised previously, had positioned the firm then with a pool of over $8 billion in uncommitted funds.
The second meeting involved presentations by four energy-focused private equity managers discussing the state of the energy business and the experiences they had gained in managing businesses during a challenging industry period. Some of the interesting points these managers made dealt with what they are looking for in order to deploy their uncommitted funds. They said they were looking for “good businesses that were improperly capitalized.” They also suggested that they were not interested in “bad managements and bad business models.” In other words, these managers want solid companies with outstanding growth profiles that have been overlooked by other investors. What that really means is that they are hoping their judgement of the investment potential for specific deals will prove better than the views of their private equity competitors. If they are right, then time will reward them with outsized investment returns.
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.