U.S. Energy Needs More Private Equity

The best way to get the attention of a private equity investor is by saying, “Ultra-long-term investment play that requires truckloads of patient capital.”

Not surprisingly, the U.S. energy opportunity has private equity players’ full
attention.

Pitched the right way, the “shale revolution” and the global private equity market seem a perfect match. On the capital side of the marriage are huge institutional investors around the world looking for places other than the debt market to park their money. The North American shale play appeals for many reasons, chief among them a sense of controlled risk mixed with actuarially pleasing potential returns.

On the execution side stands private equity, an industry adept at raising and managing huge amounts of money for long periods. These general partners see an opportunity to become the financial managers of a long-term industrial project that will transform the U.S.A. into Saudi America and, in the process, turn their firms into a new breed of Wall Street giants.

Rising enthusiasm for North American energy investing is evident everywhere. At Harvard Business School’s most recent private equity conference, both of the keynote speakers declared that U.S. energy was the top investment opportunity for their respective firms. After his speech, The Carlyle Group co-founder David Rubenstein was unequivocal in his assessment that U.S. oil and gas was the investment play of the next decade. Carlyle also happens to be raising a reported $7B for energy funds.

The other Harvard conference keynote, Blackstone’s global head of private equity, Joe Baratta, said that energy looms largest as an investment play. For its part, Blackstone raised a $2.5B energy fund in 2012 and further raised its profile with a $2B investment in a Louisiana natural gas export business called Cheniere Energy.

Another megafirm, Warburg Pincus, is raising a separate $2.5B energy vehicle, despite years of insisting that the one-big-fund model was best. Perhaps the firm found that LP interest in energy was so substantial that merely folding this huge industry vertical into the main fund didn’t adequately capture the earmarked capital.

The energy opportunity is transforming the private equity market. Slowly and steadily, energy-focused firms have positioned themselves among the world’s largest GPs. Just about every major private equity firm has added an energy investment business. In the PEI 300 ranking of private equity firms by size, three of the top 20 are energy-focused. (There are no other sector-specific firms in the top 20.) And of the top 20, most, like Carlyle and KKR, have significant energy platforms. Only two firms do not invest in the sector.

Given private equity mega-GPs’ ambitions of growing ever larger, it is possible to see the compelling shale revolution story as a convenient fundraising tool. But today’s energy opportunity really does require more capital. The process used to extract energy from the earth has changed significantly, and the technology is both better and more expensive.

In a wide-ranging interview with Privcap, David Leuschen, a founder of one of the largest PE firms, energy-focused Riverstone Holdings, summed up the current state of affairs. “The shale revolution…is creating exponential growth in the capital needs for the industry. We’re a terrific beneficiary of that. [It’s because of] new production techniques and all the expensive wells that go into horizontal drilling and hydraulic fracking, among other things.”

Private capital is also transforming the energy market. Private equity has advantages, besides just capital (or a talent for gathering capital), to offer the energy sector. The best firms have developed an ability to manage risk with large amounts of fresh capital. This is important in a landscape with so many different variables, from the quality of the rocks themselves to the regulations. Institutional investors are wary of simply handing over capital to energy operators who may have the technical skills but lack a focus on maximizing the return on capital.

Private equity also is in many cases willing to go where big energy is not. For example, as the biggest oil players have moved on from older properties, flexible private equity players have come in, using new techniques to extract what’s left—albeit at greater cost and with greater complexity. Leuschen calls this “sucking on the straw harder,” and says private equity firms are better able to do this than corporate entities.

The revolution in energy is largely characterized by a new ability to extract oil and gas from previously useless rocks. The more difficult the job, the more likely it is that private capital will back it.

Energy loves capital, and capital loves energy. What remains unknown is whether the capital put to work in the U.S. energy sector will generate the kind of returns that adequately reward investors for putting so much of their capital at risk. The average historic performance of energy private equity funds has been very strong, at more than 15 percent net IRR during the past 25 years. Will the newer, more capital-intensive projects produce similar results? This is the question that has everyone at the capital-energy wedding hesitating.