Despite the current slump in oil prices, there has been a general uptick in private capital flowing into the oil patch. With the view that the worst is behind us and that prices have relatively settled, many of the biggest names have piled into the opportunity to invest in distressed energy companies. While investment opportunities abound, it is no secret that a disproportionate number of assets that sit on the market today are not up to par, and any financial sponsor seeking to deploy capital would be well-advised to conduct thorough due diligence to separate the wheat from the chaff. While critical, no amount of diligence can remove risks inherent to the oil and gas industry completely, especially in a continuing low-price environment. However, such risks certainly can be reduced through structured investments that incorporate two risk-mitigating mechanisms: diversification and staged financing.
Portfolio diversification is a familiar concept that can be applied readily to oil and gas investments. By aggregating investments in multiple, potentially attractive areas with different operators, a financial sponsor can create a buffer against potential risks associated with choosing the right plays and right operators at the right times. Funds generally have sought some form of this diversification in the past, but with so much private capital chasing few exceptional deals, many of those who are used to being in control or significant minority investors now find themselves, either out of necessity or plan, diversifying through co-investments with other funds. Such co-investments give financial sponsors the opportunity to team up and get in the door where they might not have had the opportunity, to leverage each other's diligence, technical expertise and connections and to potentially reach better assets than they would have otherwise. Additionally, in these times when distressed players focus keenly on sending positive signals to the market, some companies are adding extra weight to bids from teamed-up sponsors or those who show a willingness to do so. Note that while diversification and co-investment come with various benefits, if a financial sponsor seeks to diversify too much, its capital may be stretched too thin and it may be relegated to the ranks of minority investors. However, such a sponsor can regain some modicum of control by incorporating certain customary minority protections, such as veto rights in connection with material matters, into the investment documents.
Like diversification, staged financing too can be deployed effectively by private equity funds seeking to mitigate the risk of investing in the oil patch. Essentially, for certain types of transactions, a reduced phase-one commitment serves as a test run. If preliminary performance is as expected, the fund has the option and flexibility to deploy incremental capital into a now potentially less risky venture. If, however, preliminary results do not live up to expectations, the fund is under no obligation to move to phase two. Note that even if preliminary results do not live up to expectations, staged financing offers a financial sponsor the potential leverage to re-negotiate the deal structure if it so desires. At the end of the day, staged financing is a great strategy to create a mid-term checkpoint, which ensures some control over the investment process.
In sum, while certain risks associated with investing in the oil and gas business cannot be removed completely, they can be mitigated through thoughtful diversification and staged financing strategies. A carefully-structured private equity investment might not change the price of hydrocarbons, but it may help secure an overall productive portfolio, which can have a powerful impact on returns.
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