Energy and Private Equity, Part I

I RECENTLY HAD occasion to deal with some people who are involved in the “private equity” (PE) side of the energy business. I am bound by a confidentiality agreement not to say too much about the details of their project. But I was surprised at how much money these people controlled, the quality of the management team, and the scope of their ambitions in the energy arena. I know that many of our readers are financially sophisticated and probably know quite a bit about the topic I am discussing. But I also thought that some Whiskey & Gunpowder readers might be interested in learning more about PE and other investment instruments. So that is the subject for today.

What Is Private Equity?

What is PE? In a broad and general sense, PE is a term that commonly refers to any type of “equity” investment in an asset, but in which the underlying equity does not trade freely on a public stock market like the New York Stock Exchange or Nasdaq. Also, in a general sense, PE refers to the manner in which the funds have been raised, namely on the private markets. Many people use the term “private equity” interchangeably with the term “private equity funds,” which are committed pools of managed capital, raised from private sources.

Currently, some PE funds invest across a broad spectrum of industries. KKR, Texas Pacific Group, Blackstone, and Carlyle are well-known names in this area, and there are many others. Some PE funds focus on investments in particular industries, such as energy, technology, or health care. In many instances, PE firms invest in companies listed on public exchanges, by buying up the stocks and taking them private. But PE might also purchase a company from private holders, such as an individual or family (often as part of a succession plan), or from a closely held group of owners who want to cash out.

Spectrum of Investment Methods: Not a Hedge Fund

PE funds are part of a spectrum of investment methods. For comparison, let’s look at how PE differs from hedge funds. Hedge funds are vehicles that work with an investment of pooled funds, almost always open only to “accredited investors.” (See the end of the article for a short discussion of accredited investors.)

PE tends to take a relatively long-term view of investing, such as a four-eight-year horizon (and sometimes even longer), for reasons that we will review toward the end. In contrast, a hedge fund usually is focused on short-term trading opportunities, with traders using instruments such as arbitrage, swaps, derivatives, and other forms of financial leverage. In many instances, and again unlike the case with PE, the hedge fund traders might have little fundamental knowledge of the companies or industries in which they are conducting their trading, but to them it does not matter. The hedge fund traders are following the trading action, the price movement, and the overall market volatility in an effort to capture short-term gains.

Hedge funds usually charge a performance fee against both the principal within the fund, and any gains over time. Despite much criticism of their short-term view of just trading in and trading out of stocks and other ownership instruments, hedge funds have grown very much in size and influence on both the public securities and private investment markets. (Last summer, I discussed hedge fund investments in the mining business, in an article entitled “Money, Mines, and Nickel,” published Aug. 1, 2006.)

Private Equity, Ventures, and Places Where Angels Tread

PE also differs from venture capital (VC). PE focuses on more mature companies or business efforts. VC, in contrast, invests in the early stage of startup enterprises. Thus, there is relatively more risk associated with the VC investment. Typical VC is provided by professional or institutionally backed outside investors, infusing cash in exchange for shares (and often one or more seats on the board) of the company that is being assisted. VC finds its place in the market because the enterprise under consideration is usually too risky for standard capital markets or sizeable bank loans. But while VC is usually high risk, it can offer the potential for above-average returns.

VC funding is a step up from what is called the “angel investor.” An angel is an individual or pool of funds that provides capital for a business startup, except it does so at an earlier stage than does the VC. That is, someone starts a business in the proverbial garage, or otherwise on a shoestring and a prayer. Not a few businesses have been started using the line of credit on a founder’s personal credit card. Angels and their capital are said to fill the gap in startup financing, between what are known as the “three Fs” (friends, family, and fools) of seed money, and the more discriminating VC.

As most people who have ever tried can attest, it is usually difficult to raise more than a few hundred thousand dollars from friends and family. (You might get lucky with the fools, but even that will eventually come to an end.) At some point, the fact is that red ink is thicker than blood, and your friends and family, and even the fools, will shut you off. The standard in the industry is that most VC funds do not consider investments under about $1-2 million. Thus, angel investment is the common second round of financing, in the range of about a quarter million to couple of million dollars, for startup companies with great hope, if not high growth prospects. Typical for startups, angel investments carry high risk and need to offer very high returns on investment (ROI).

The fact is that a large proportion of angel investments are completely lost when early-stage companies fail. Thus, professional angel investors look for investments that have the potential to return at least 10 or more times their original investment within about five years. Angels tend to be an expensive source of funds, but cheaper sources of capital such as bank loans are usually not available for most early-stage ventures. And after the initial five-year development period, the angel is looking for an exit strategy such as an infusion of cash from VC, or an initial public offering of stock (IPO) or other acquisition. That “other acquisition” may also be a sale to PE.

Private Equity Takes Over

So whether it is a former startup that grows and eventually sells out to PE or a mainstream, old-line firm that gets bought out from a major stock exchange, PE moves in to take over. Private equity funds typically control management of the companies in which they invest. Often, PE brings in new management teams that focus on making the company more valuable. At least that is the idea.

Critics, of course, have a less charitable view, which can be boiled down to the accusation that PE takeovers are little more than “strip and flip” operations. That is, the new guys take over and promptly lay off lots of personnel (usually, goes the claim, they lay off the ones who know how to run the business). Then the new guys sell the good stuff, load the company up with debt, and bail out by selling the corporate carcass to gullible investors who are too dumb to know any better. There have been quite a few examples of this kind of relatively destructive PE management activity in the past few years (one fast-food chain that shall remain unnamed offers a Whopper of an example), but then again, one can cite publicly traded companies that have financially engineered themselves into the dirt as well (Sunbeam and the mercurial “Chain Saw” Al Dunlap come to mind). As is the case with many things in this world, however, the truth depends upon the situation. Nothing is all good or all bad.

In the second part of this two-part article, I will discuss further the role of private equity in the development of energy resources in the U.S.

Until we meet again,
Byron W. King

March 20, 2007

The Daily Reckoning