December 1, 2016
Interviewed by: David Snow
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Why Flexible Capital Rules in a Volatile Energy Market

The head of energy investing for distressed specialist WL Ross offers deep insights into the current state of the oil and gas market, describing a cohort of energy producers that are “asset rich and cash poor.” Shaia Hosseinzadeh also analyzes the withdrawal of banks from many corners of the energy market, as well as the need for flexible investment structures.

The head of energy investing for distressed specialist WL Ross offers deep insights into the current state of the oil and gas market, describing a cohort of energy producers that are “asset rich and cash poor.” Shaia Hosseinzadeh also analyzes the withdrawal of banks from many corners of the energy market, as well as the need for flexible investment structures.

Flexible Capital in a Volatile Energy Market
With Shaia Hosseinzadeh of WL Ross & Co.

David Snow, Privcap: Today we’re joined by Shaia Hozzeinzadeh of WL Ross. Shaia, welcome to Privcap today; thanks for being here.

Shaia Hosseinzadeh, WL Ross & Co.: Thanks for having me.

Snow: Of course, WL Ross is very well known for its success in industries that have seen dislocation and distress. You’re a private equity firm, and you lead the energy group within WL Ross. So I’m fascinated to hear what you’re seeing in that industry. Obviously, it’s seen quite a lot of dislocation and distress. Let’s start with how busy you’ve been the past 12 months; what have you been doing?

Hosseinzadeh: Well David, this is a very unique time in the energy sector. It’s a generational opportunity for us. There have been three things that have been happening that you don’t normally see across a given cycle. Number one, we found a tremendous amount of resource here at home – something like the equivalent of Saudi Arabia – in our backyard in West Texas. Number two, a lot of the growth in shale gas and tight oil has really been financed with the proliferation of easy credit and high oil prices. And that credit is now retrenching. And number three, we’ve seen something like a 60% reduction in the price of oil itself.

So we’re in a really good place in the cycle right now and as a firm, we have a rather flexible capital model.

Snow: Directly following the drop in oil prices about three years ago, what happened in the aftermath of that collapse? Did you get the level of distress that you expected?

Hosseinzadeh: Well default rates have been picking up gradually. They’re something like in the teens right now and in 2015 they were in the low single digits. And that’s not unusual. The first cohort of companies that typically go into bankruptcy and default, they tend to be the companies that had bad – they tend to be the companies that have problematic assets, even when the oil prices were high. And so with a decline in oil prices, they’re the first to go in. As we’re now going into the second and third innings of the down cycle, we’re starting to see a number of companies that are starting to deal with maturity, refinancing issues.

Snow: You talked about the current investment environment as being sort of a once in a generation opportunity. Clearly you’ve seen commodity cycles before in energy. What was different about this swoon compared to previous ones?

Hosseinzadeh: If you go back to the early 2000s or even if you go back to the 1980s, the ‘80s were a supply shock. The 2000s and 2008 were really a demand shock. But even if you compare the current downturn with any of those and somebody were to come to you and say, “Here’s a pool of money. We’d like you to go out and invest it; oil prices are down.” You’d have been fairly limited in the number of places you could have invested that money. It would have been in the North Sea perhaps, Brazil off shore, Prudhoe Bay, Alaska. Today we have an enormous abundance of opportunity here in the lower 48 and onshore.

And the other difference is, when you look at a shale well, chances are that you are going to drill and that the risk is not that you won’t find oil. The risk is that you’ll drill and find that you have no return at the end of it cause you’ve spent too much money. And that is a asset class that private equity should have a tangible advantage in because we’re good at understanding capital allocation, driving efficiencies, watching cost and consolidating. And that’s a very different business model than version 1.0 where it was a lot more about wealth counting and finding oil.

Snow: To what extent are banks willing to find credit to private equity transactions in the energy space right now?

Hosseinzadeh: If you look at the last 10 years, the banks were a staple in the financing for oil and gas companies. Roughly $0.50 of every dollar of debt that was raised was provided by the banks. And a lot of those accesses are now being reversed under the weight of regulation and low oil prices. So the banks are retrenching, and some of the companies that need liquidity the most are being affected the most by it. So getting bank financing for an M&A deal today is much more difficult, particularly if you don’t have the cash flow to begin with. So a lot of us, both in the private equity business and elsewhere, are having to get creative about how we fund other companies that we buy.

Snow: Well let’s talk more about that, getting creative. To what extend does innovation play a role in helping to distinguish you as a potential buyer of an asset.

Hosseinzadeh: A lot of these companies are asset rich and cash poor. And so traditional valuation metrics, traditional financing sources, become a little bit more complicated to put in there. And this means for us in the private equity business, we have to be a little bit more flexible in our model and a little bit more thoughtful about how we structure our investments in the companies. They can range from structured facilities to buy, acquire and build land positions for companies that may not have that access to the capital today. It can be things like drilling, joint ventures to fund high-quality acreage without putting on-balance sheet debt. Or it can be things that are a little bit more packaged that that. But the fundamental feature to this has to be to be able to solve a problem as opposed to simply buying an asset.

Snow: Talk about what do you see coming next for the energy market?

Hosseinzadeh: Where the Saudis and the GCC for the time being are committing to more for market share policy as opposed to a price stability policy, I think it’s fair to assume that volatility is here to stay.

For us in the private equity business, the markets don’t like volatility. Usually volatility is accompanied by valuation compression. And so where you think about where we are in the cycle right now, we’re in a really good point in the oil cycle. And you can’t say that about too many other industries. Oil is selling at a pretty significant discount relative to the replacement cost of where reserves can be replaced on a global basis. Valuations are down quite substantially across the board. There’s some pockets that have had run ups. And then on top of that, the demand for capital far outstrips the supply for it. So when you look at the combination of those three things, it really makes for an attractive interest for those of us that are allocating capital in the private equity sector.

Snow: There are many private equity firms going after energy. What’s unique in the way that you’ve structured your platform to invest in the energy sector?

Hosseinzadeh: I think what sets our model apart is how we are able to go after the opportunity set. We have a flexible capital model that means that we can invest across the balance sheet on the one hand. On the other hand, we have a dedicated and specialized team that focuses on energy. And we’ve developed that sector expertise to understand what going on subsurface. We’ve invested the time and effort to build the relationships in what is otherwise an insular industry. And when we get into a dialog with a seller, a family-owned business or a company that’s looking for some financing solution, we’re able to bring to bear that interdisciplinary approach to unlock whatever levers there are to drive value for the company and do that in the most flexible way versus a traditional model of line of equity or just a buyout.

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