Private equity is in “the front seat” of today’s booming oil and gas market, according to Daniel Revers, Managing Partner at energy-focused private equity firm ArcLight Capital Partners. While competition has increased as GP after GP has entered the energy space, the “opportunity set has exploded” for investing in energy assets.
In a fascinating conversation with Privcap, Revers discusses why his firm has moved away from power assets in favor of oil and gas opportunities; how more and more LPs are growing interested in the space; and why energy investing requires a combination of different alterative investment strategies. He also reveals what separates GPs with deep expertise from ones that are more likely to participate–and overpay–in auctions; explains why politics is his “least favorite risk;” and outlines the perils of interstate pipelines.
Privcap: How has your firm’s strategy evolved with the changing oil and gas markets?
Daniel Revers, ArcLight: So when we started off for 12 years ago, we had a big focus on power. And power was a driver of a lot of our investor opportunity. And as they'd developed alternative sources of fuels, meaning oil and gas primarily through conventional drilling, it's unleashed a myriad of investment opportunity around the infrastructure for that. And interestingly, it's driven down the price of gas, where power is becoming much less interesting place to invest.
And it's challenging to find a place in North America where people are making any money in power. The markets aren't developed to allow people to get paid for capacity. The energy margins, given the very low price of natural gas, has crushed both the dark spread, which is the coal spread, to gas and the spark spread, which is the gas spread, to electric power prices.
So our focus has gravitated a bit towards the midstream area, where we've built out to date literally tens of billions of dollars of infrastructure to support this drilling with possibly hundreds of billions of dollars still to come. And so we're spending an awful lot of time there. And it's both the oil infrastructure, which is probably a little bit newer.
Unconventional plays have come behind the unconventional gas plays, although they're using exactly the same technologies. And so we spent a lot of time in gas, and now we're migrating into the oil infrastructure. We see an ascent opportunity, particularly in some of the more developing basins, like the Bakken, the Utica, and perhaps the Mississippi Lime.
Privcap: How far along are LPs in terms of interest in, and understanding of, energy investments?
Revers: We've been at this 12 years. And the focus, it's been slow coming. And literally, it's been wave after wave of LP that's finally gotten to energy.
As you might imagine, 12 years ago the early movers were the university foundations and endowments. They tend to be the early adopters. We're seeing public pension plans, some corporate pension plans, now getting into energies. So there isn't a single answer that question, because everybody's up the learning curve in a little bit different way.
But the topical questions are what is really going on? What is this gas boom all about? What is going on with renewable power? The things, honestly, that you read the New York Times, that's where people get their initial thoughts about energy. And when you're talking to someone who has no experience and really very little in the way of energy investments, the questions are about that deep.
As they bring in consultants and the like, the consultants in my opinion at least are still looking at energy a bit through the lens of a buyout. They don't really know where to put energy. Are we special situations? Are we infrastructure? Are we buyouts? Are we growth capital?
And the answer is, literally, all of the above. And you might even throw in venture capital. When you get into things like for renewables, you're during start up businesses.
So I think everybody's feeling out there way. There's a lot of offerings out there. 12 years ago we started, there might have been 10 firms out there that were quote unquote "energy specialists." I think you could multiply that by at least 10 in 2012.
And everybody's got a different story and different take on the market. So I really feel LPs are trying to feel their way through it. And I think a lot of them are defaulting to brand names-- which is good for us, we've been around for 12 years-- but also to some of the offerings being put out by people like Blackstone, and KKR, who are very good sort of buyout shops that set up separate energy funds. And so I think the bulk of the people are going into that. But there's a lot of learning to still be had in part of LP community.
Revers: With many more GPs starting energy-focused funds, how has that impacted competition for deals?
Revers: To be perfectly honest, it wasn't that hard a decade ago. There was 10 of us out there. We were competing against a lot of people, but they tended to be regulated utilities, global energy companies, rather than private equity firms. And they kind of think and act the way we do.
So it makes it a much more direct competition for those assets. We don't have any strategic reason to be in a certain business line. It's all about what kind of returns could we get for investors.
So it's become increasingly more competitive. The opportunity set has exploded, though. Private equity was a four-letter word back in the late '90s, in terms of the energy space. There was very little being done in the space. And if I walked into a CEO or CFO's office and said I'm a private equity guy, they'd show you the door pretty quickly.
If you see what's going on right now, there's a lot going on this business. And I mentioned, the mainstream play-- there's literally hundreds of billions of opportunity there, similar in the upstream play. Power still has a role here, obviously. And private equity is literally in the front seat of most of those opportunities. I mean, you can't pick up the paper any day now and don't see a big deal in energy space that's been led by a private equity firm.
So a lot more competition, a lot more opportunity. And the way to really make sure that you don't overpay, is stay of the auctions. And this is where we're seeing, at least in my opinion, people sorting themselves out.
There's firms that have long dated experience, a lot of deep knowledge of the industry, and the ability really to create some of their own value. And I think those firms tend to find their own deals. And we would put ourselves there. We don't participate much in auctions.
And then in the auctions, I think by definition, you're going overpay. And I'd say that wasn't a fatal decision 10 years ago, because there's enough value on the table, where if you overpaid, you'd still do OK. And I think right now we're seeing that overpaying can be fatal, at least in terms of making any kind of return. I think if you're in the right kind of assets-- and it's one thing I like a lot about energy-- is that there is some downside protection by owning something that's of value, that has a very long useful life. If you underwrite, and we use that debt term around our investments, because I think you can underwrite an energy investment, where maybe you can't around a retail deal or a telecom deal.
Privcap: What are the most important points for LPs to consider before choosing a GP to manage energy investments?
Revers: I think the couple things that we think about and LPs seem to resonate with LPs is deep, asset-level knowledge of this business. Corporations in this business come and go, but the assets stay around for very long time. And having a very granular knowledge of those assets is important. That's step one.
Step two is OK, I know about those assets, but where can I extract value from them that's not obvious. If it shows up in a pitch book for an investment bank, that's kind of the one everybody's going to get, right? So you need to think about where that is.
And this is where I think energy's very interesting, because there's a lot of silos of value that you can drill down into. And we sort of break them into a couple of buckets. One is operationally. And that's probably the most obvious. A lot of LBO firms will go into operational expertise. And energy is very, very specialized.
Secondly is commercial. And this is probably the most legally intensive businesses there is in terms of counter party contracts, hedging and the like, and really looking at assets, and seeing how they're encumbered in contractual structures. We look to unlock those structures and find value.
There is an ability to create value around finance. And that's sort of LBO's 101. I'm not sure this is an accurate statement, but I know it's close-- about 20% of the traded debt in the United States is traded in the energy space. So it is the most debt-intensive industry there is.
And it's really an interesting industry in terms of the type of debt that's used. Mezzanine's used, reverse-based lending. Leasing's done. So it's very complex in understanding that we view that as part of our toolkit.
And then the last one is understanding the political and regulatory environment. This is an industry that probably is the most regulated. And you could watch a very good deal that you've done all the commercial, operational, financial work-- good work done there-- can be undone by the stroke of a pen.
And you need to be very wary of that. You need to be at the federal level, at state level, understanding what those regulations are today. And more importantly, where they're going through what should be a relatively long hold period in these assets. These are long-dated assets.
Privcap: How do you mitigate regulatory and political risks?
Revers: It's my least favorite risk, because it is unhedgable. I can hedge interest rates. I can hedge commodity risk. I can do a lot of things. But I can't hedge politics.
So it's the one that we probably worry about more than anything. It's also one that you could probably do the least about. And all we can do is be knowledgeable and don't bet the farm on a regulatory deal. There's been a lot of transactions that input through the market, particularly utility area, where they were based on a rate deal with a political body that they don't care if a private equity firm's come in to by this.
They're going to take their own time. They care about their voters and their rate payers. They don't care about a rate of return.
So I think staying away from ones are just blatantly regulatory and then being very knowledgeable. We don't lobby. All we do is stay aware. We have consultants that help us at the federal level and say, here's where legislation's going. This is what people are talking about. And you should be aware of that.
And then you need to go into these 50 different states, because most of them regulate energy both at the federal and state level. And you need to understand what's going on state level. And then in many instances, you need to know what's going on at the local level. All politics is local, as Tip O'Neill used to say. And you can get crossed at the local level.
So really understanding that, and where that gets really tricky, is near the realm of interstate pipelines electric power that's being transmitted through power pulls. The PJM power pool now runs from the state of Illinois all the way to New York City here. And so you're crossing numerous state jurisdictions in trying to figure out what's the regulatory scheme around selling power in that market? PJM is a well-thought out power pool, probably the best in the US. But we're still fighting regulatory battles all the way.
So it's just being very aware of it is all you can do. And really trying not to make directional bets on where politics are going. OK, Barack Obama gets reelected, we're going to be in this. I don't think that really works. We're trying not to put too much in any one of the variables that we consider making investment.