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Cast adrift: What next for PE-backed oil & gas companies?

Oil rig workers
Exit opportunities for funds exposed to the oil & gas market have been severely impacted by the drastic drop in oil prices over the past two years
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The drastic drop in oil prices over the past two years has had enormous ramifications for the global economy, let alone companies operating directly within the sector. Kenny Wastell investigates what options are open to institutional investors who went all-in on oil & gas

In the 18 months between June 2014 and January 2016, the price of a barrel of Brent Crude oil dropped from $115 to less than $30. This has broadly been attributed to an oversupply brought about by four factors: weak global economic activity, the continued rise of alternative fuel forms, external geopolitical developments and an increase in US production. While the effects of this price fall have been felt widely across most industries, it stands to reason that none have been impacted quite as acutely as the oil & gas sector itself.

Private equity players have typically shied away from investing in exploration and production, given its incredibly high costs and the cyclical nature of commodity markets. That has not stopped many GPs investing heavily in the services segment though, which as a rule is less dramatically affected by short term fluctuations and market volatility. Yet even this supposedly more resilient sector has felt the sheer force of the prolonged and drastic drop in oil prices.

"When you look at average earnings at the EBITDA level – particularly in the services sector – these have declined by almost 50% since the end of 2014," says Lincoln International's newly appointed managing director of valuations and opinions Tomas Freyman. "There is an absolute correlation between the performance of the segment and the oil price. When companies stop exploring, which is uneconomical for some wells at these levels, they turn the tap off for services. At the very least they will renegotiate terms, given that a lot of agreements are initially written in such a way as to afford explorers that flexibility."

When companies stop exploring, which is uneconomical for some wells at these levels, they turn the tap off for services. At the very least they will renegotiate terms" – Tomas Freyman, Lincoln International

Consequently, H1 2016 is on course to be the quietest period of private activity within the sector in almost 15 years, according to unquote" data. With the market bereft of dealflow, it raises questions about the number of options open to GPs yet to divest assets they first backed five to seven years ago.

On this front, 2016 has, to date, delivered just one exit in the segment, with Phoenix Equity Partners selling a majority stake in portfolio company Ashtead Technology to Buckthorn Partners and the Arab Petroleum Investments Corporation. By comparison, 2015 appears, at first glance, to have been more encouraging with 13 exits implying a relatively healthy landscape. However, that optimistic note is tempered somewhat on deeper inspection: three of these exits saw the portfolio company in question entering into administration or, worse still, liquidation.

Of particular note was HitecVision-backed subsea services company Reef Subsea, which declared bankruptcy in February 2015, reportedly inflicting a NOK 500m loss for the GP. At the time the company's CEO Duncan Macpherson told Norwegian newspaper Bergens Tidende market conditions had proved too difficult, despite restructuring and cost-cutting efforts.

The drill is gone
Similarly, Sun Capital Partners was forced to write off its investment in Aberdeen-based well engineering and construction company Applied Drilling Technology International (ADTI) in May 2015. The partnership had lasted just 16 months when the GP took the decision to let the order book run out and close the business – though unquote" understands Sun Capital was able to recover its investment.

An industry insider told unquote" these deals offer insight into the type of companies private equity players will struggle to sell. Typically, assets that are heavily exposed to the North Sea, where the cost of extraction is particularly high, will be more difficult to divest than those with clients in other regions. The aforementioned Ashtead, for example, has a presence in Houston and Abu Dhabi, serving regions where the oil industry remains relatively resilient due to the comparatively low costs of extraction.

Another factor that understandably puts pressure on portfolio companies is the degree of leverage used to secure its acquisition. Our source explained that an increasing number of companies are struggling to adhere to loan covenants and are subsequently forced to explore the viability of amend-and-extend transactions. However, in the case of private-equity-backed assets, their ability to secure such agreements is very much dependent on the age of their owner's fund.

The market tends to overexaggerate valuations, both on the downward trend and on the up. So the valuations of these businesses are probably lower than they should be" – Tomas Freyman, Lincoln International

There have, however, been some instances where private equity players have been able to generate reasonably strong returns from oil & gas investments in recent months. LDC, for example, made a 2.4x multiple when it sold Bifold Group to listed trade buyer Rotork for £125m in August 2015.

Nevertheless, according to Lincoln's Freyman, so long as institutional investors are able to hold onto assets and ride out the current market volatility, they will do everything within their power to do so. Across the sector as a whole, he explains, "the hits could be substantial, given how some of these businesses have been performing."

But while the exit market appears worryingly restricted at present, there is an argument that depressed valuations could provide an opportunity for private equity players willing to take a calculated risk on the sector. "If you're a buyer, it's a great time to be deploying capital in the oil & gas services sector," says Freyman. "We're certainly closer to the bottom of the market in terms of oil prices than to the top. The market tends to overexaggerate valuations, both on the downward trend and on the up. So the valuations of these businesses are probably lower than they should be."

Seizing the initiative
Indeed, low prices are a factor that investment firm Guinness Asset Management is aiming to capitalise on. The firm has recently appointed two energy specialists to its investment team, as it prepares to launch a fund focusing on the oil & gas exploration sector. The investor cites "cyclical lows" resulting from a recent glut in production, which it attributes to the emergence of the US fracking industry. It is aiming to make returns of 20-25% per year from investments in listed companies and intends to do so by adopting an asset aggregation strategy.

On the private equity front, Dunedin portfolio company EV Offshore – an Aberdeen-based services company – has recently displayed its optimism for the future by bolting on software company Epidote. Yet EV Offshore itself has extensive operations in the US market and has laid bare its intention to rapidly expand in the Middle East.

Another private equity firm to have recently invested in the sector is Norvestor, which acquired Norwegian oil well integrity company HydraWell Intervention. However, this display of faith also comes with a caveat: the company operates in the plugging and abandonment market in addition to the well repair and infilling segment. Norvestor has expressed its confidence in these markets specifically because of the current oil price environment.

This seemingly renewed appetite for assets could potentially drive valuations higher, creating a more favourable exit market for institutional investors, according to Freyman. Yet he adds this may also be dependent on GPs' acceptance that they will have to cut their losses as "it certainly won't make up for the drop in values these funds have experienced."

Private equity has a strong track record of growing companies through international expansion. For those who have done so with oil & gas assets – particularly with minimal dependency on leverage – the future may yet be rosy. For others, there remains a real threat of being cast adrift.

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