June 10, 2014
Interviewed by: David Snow
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How Energy GPs Build Platforms

A partner at EnCap Investments and the CEO of energy portfolio company PennEnergy Resources describe the process of staging capital in an upstream energy deal.

A partner at EnCap Investments and the CEO of energy portfolio company PennEnergy Resources describe the process of staging capital in an upstream energy deal.

How Energy GPs Build Platforms

Private Equity and Energy Operators

David Snow, Privcap: 

We’re joined today by Rich Weber of PennEnergy Resources and Jason DeLorenzo of EnCap Investments. Gentlemen, welcome to Privcap. Thanks for being here.

Jason DeLorenzo, EnCap Investments: 

Thanks for having us.

Snow: Both of you are energy experts. You are at EnCap, a private equity firm based in Houston. You are at PennEnergy, an operating company based in Pittsburgh. You have partnered to build a company, PennEnergy, using capital from EnCap and, of course, you have investors around the world. I’m interested in how the capital is actually deployed into the types of investments you make, with Rich’s company as a good example. You’ve committed $300 million for now to PennEnergy yet, in the kinds of private equity deals your firm does, you don’t just put in all $300 million or you don’t use $300 million to make a big acquisition; you call it leaking in the money. Can you talk about how the capital initially gets deployed and the communications you have as you decide to further deploy capital?

DeLorenzo: Great question, David. To contrast the way our model works versus buyout: in buyout deals, obviously big acquisitions happen and all the money goes out at one time. We’re trying to partner with high-quality management teams like Rich Weber and PennEnergy and we make a capital commitment based on a business plan the guys present to us.

Two-and-a-half years ago, we bought off on Rich’s business plan and the great team he had put together to build a company in the Marcellus shale. The $300-million commitment initially went toward covering overhead and building the staff of the company to succeed in the future while they went out and found transactions to acquire and/or lease. As they come to the board on, let’s say, a quarterly basis while the board is meeting and as they have opportunities to deploy capital that fits with the business plan we’ve all agreed on, we advance the capital.

As I said, it was overhead for the first couple of years primarily. But actually, in this case, PennEnergy came up with a sizeable transaction in the first year. So, we acquired some land, some proven reserves in Pennsylvania that Rich can talk about, in the end of year one; it was roughly a $100-million transaction. So, we advanced a decent portion of that in the first year and we’re still in a position where we have a lot of capital left on the $300-million commitment to support a drilling program, but the difference between the buyout model and our model as we advance capital as the opportunities come into the company to capture.

Snow: Rich, can you talk about the kind of communication that takes place between you and EnCap as you’re building out your business? What do they want to know? When key decisions come to invest more capital, what do those decisions rest on?

Weber: We try very hard to be as transparent as possible on what’s going on with the business and where we’re planning to take the business. We believe transparency does two things: (1) it ensures that we get the best advice and coaching from the guys at EnCap, and (2) we set up expectations such that there’s an anticipation of how we’re building the business. It takes a lot of communication. We obviously have formal board meetings, but there are many more conversations in person and over the phone as we build our business.

Snow: What are some of the key metrics? Is it like the performance of individual wells?

DeLorenzo: You buy something and you have a pre-drill estimate of what the rates of return will look like. In other words, what it’ll cost to drill a well, what kind of reserves will come out of the ground and what cash flow it will generate. Then, as we go drill wells and see the actual performance versus the pre-drill estimate, we then make decisions to potentially deploy more capital. We say, “This is as good or better than we thought, so let’s put our foot on the accelerator here and get this developed quicker.” Alternatively, there are situations obviously where the rates of return or the drilling program present some challenges. We have not had those instances at PennEnergy because the Marcellus shale is such a known reservoir in the areas where we’re applying. But in other areas, you can come across opportunities where it’s unclear what’s causing different things to happen so you pause, you try to bring in a partner and some alternative source of capital to diversify risk, and you go deploy capital elsewhere in a known area. We’re always measuring actual results versus pre-drill estimates to determine the next round of capital and where it should it go.

Snow: For a project that’s generating revenue, generating the energy sought, what do you do with that capital? Is it put back into the business? Do you pay a dividend to your investors? What are the choices?

DeLorenzo: Great question. We are really growth equity at EnCap. We’re starting with a management team and a business plan and no assets and we’re trying to grow an opportunity set that will be attractive one day in the sale market. So, in this growth equity phase where we’re taking it from zero to a couple of billion dollars for the ultimate sale, you are constantly feeding the company capital early days equity, later stages some moderate amount of debt. You’re always reinvesting that cash flow to continue to develop the growth of the business.

Snow: I would imagine an important part of the business plan is estimating a certain amount of revenue that can be put back into the business and therefore decrease the amount of equity capital you need to put in.

DeLorenzo: Absolutely.

Weber: Absolutely.

Snow: So, things are on plan with PennEnergy in that regard?

Weber: Things are on plan. We project our cash flows on a monthly basis for the next couple of years. We watch it very carefully. We’re constantly trying to anticipate our need for capital and where that capital will come from.

Snow: It sounds like PennEnergy is going gangbusters, but in cases where things are not going to plan, what goes wrong? Is it unforeseen commodity-price changes? Is it that the land you acquired just isn’t yielding the kind of energy that was estimated?

DeLorenzo: It could be any of those. We’re operating in an industry that has very volatile commodity prices. Ultimately, the rates of return on a drilling project are the primary factor that affects the commodity price you get for the commodity you sell. For example, in 2008, oil went from $130 a barrel to about $35 and gas went from $12 down to $3. It’s recovered a bit, but not a lot. Commodity prices are a big piece of it. The other piece would be the reservoir. It can cost more to drill a well than you think; the reservoir may give up less oil and gas than you think or it may be something on the completion side. You may be able to drill longer lateral or put more frack stages or more clusters together to get more oil and gas out of the ground. So, the completion technology, particularly over the last five years has affected the economics as well.

Snow: Where’s PennEnergy as a project now? What percentage of the capital has been deployed to get to where you want? Are there any big milestones coming up?

Weber: We feel we’re well along the way toward a successful enterprise. We’ve acquired about 70,000 net acres. As of today, we’ve turned in two wells, but we’ve drilled 10 additional wells that will be turned in here shortly. We’re moving more toward our execution phase in terms of development. It’s our desire to have an asset that is fairly substantial in scale, but where we have de-risked and essentially proven the acreage from a development standpoint and, more importantly, have built the infrastructure to allow a buyer of company to accelerate development, which is so important in getting value.

We’re far along down the road. You asked a question earlier about how cash flow comes into play. We’re fortunate with the Marcellus shale—it’s a very low cost of development and the wells are very profitable. Cash flow will become a very substantial portion of our source of capital on a go-forward basis. And we have probably invested around 75% of our commitment so far. Again, because of that initial investment, we’re going to have access to cash flow as well as bank financing to fund our growth going forward.

Snow: So, hopefully a successful exit is down the road and, after that round-trip when Rich is done, would your firm consider backing him again? Is that done quite a bit in this industry?

DeLorenzo: It is. We’d like nothing better than to re-back Rich and Greg and the team at PennEnergy. In fact, over 60% of our teams we back in our funds over the last three to four funds have been repeat management teams.

Snow: You’d be open to that?

Weber: No question. What’s important is we’ve built a team we think is second to none in the Appalachian Basin, in the Marcellus shale. Everybody we’ve hired is the best at what they do. I like to say I didn’t even look at a resume. We knew everyone we brought in.

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