WTI oil prices in 2014 averaged about $90 to $100 per barrel (bbl), with Brent oil pricing pushing $110 per bbl. Through all of 2015 and 2016, however, we saw oil fluctuate from $25 to $50 per barrel, with natural gas prices not faring much better. Unfortunately, the desire among many to see oil prices move into the $60 to $70 per bbl range depends on a number of contingencies including: 1) whether OPEC (the Organization of the Petroleum Exporting Countries) will continue to reduce its production target on a stable basis, and 2) whether such production cuts will stabilize oil supplies in light of upstream players in other non-OPEC countries that are itching to drill again.
Despite the unknown, petroleum operators press on and, in many ways, can present opportunities under weaker energy market fundamentals. The opportunities may involve assets in plays that continue to make sense to drill or operate at today’s commodity prices. The opportunities may alternatively be directed upon capturing acquisition-driven value that had not existed at higher commodity prices (i.e., buying undrilled leases or income-producing assets at pricing lows or by investing in companies at valuations driven by lower commodities prices).
This article explores avenues through which these opportunities are often presented to sophisticated investors.
Private equity encompasses direct investments in companies not listed on a securities exchange, and covers a range of opportunities, including startup investments (e.g., seed capital), venture capital (e.g., pre-earnings stage), growth investments (e.g., cash-flowing companies that desire to position themselves for an IPO), and buyout investments (e.g., interests in companies with an eye toward a sale). Private equity offers investors opportunities to achieve competitive long-term returns compared with publicly traded stocks and bonds. Private equity provides return opportunities through its ability to participate in a growing marketplace of privately held companies not available in traditional investor products, as well as its ability, in some cases, to create value by proactively influencing the investee portfolio company’s management and operations. The risks associated with private equity investments in relation to publicly traded investments include the liquidity constraints generally associated with investments in private companies, as well as holding period risks due to the long-term nature of such investments.
There are a number of ways investors can partake in private equity exposure. The first is investing in a fund that specializes in private equity, which is carried out through a partnership or limited liability company known as a private equity fund. In a fund, the sponsoring firm serves as the managing partner or manager, whereas the limited partners/passive members are comprised of institutional investors and high-net-worth families who provide a substantial majority of the fund’s capital. The limited partners or passive members commit to provide capital to the fund, and the general partner/manager then has an agreed period in which to draw upon the committed capital and invest the capital generally in nontraded privately owned companies (with the investment period usually lasting four to six years). The general partner/manager also has an agreed period in which to monitor and manage the fund assets to liquidity, which generally ranges from 10 to 12 years. Each fund, therefore, is essentially a closed-end fund with a finite life. While minimum investment commitments vary widely among these funds, a number of informational sources report that access to the top-tier fund opportunities in terms of prior performance and managerial reputation can require capital commitments from $5 million to $100 million per investment.
Preqin’s Natural Resources Online Data contains information on about 300 North America–focused private equity energy funds that have reached a final close since 2006 and that focus their investment mandate toward equity investment in oil and gas assets. The capital raised in North American oil- and gas-focused private equity funds reached historic highs in 2013 and 2015, with about $40 billion in capital being raised each year. While the $34 billion raised in 2016 is down from the levels hit in 2013 and 2015, this compares favorably to the capital raised from 2006 to 2012, which ranged from $14 billion to $27 billion annually. In 2016, foundations, endowment plans and public pension funds drove the capital supplied to North American energy focused funds at 24 percent, 21 percent and 17 percent of capital supplied, respectively, but with significant private equity investments also made by private pensions, family offices and wealth managers at 15 percent, 6 percent and 5 percent of capital supplied respectively. In terms of investment preferences, 54 percent of North American institutions seeking to invest in energy private equity are planning to make investments in the midstream sector, with 42 percent and 38 percent of such investors planning to make investments within the upstream and downstream sectors.
Prior performance within the oil and gas sector of private equity is highly correlated to the effects that commodities prices have upon asset valuations when capital is deployed. For example, North American funds that focus primarily upon oil and gas and that raised capital from 1997 to 2007 when oil prices were $20 to $60 per bbl posted a median IRR since inception of 17.0 percent. However, the funds that raised capital in 2012 and 2013 and deployed the capital when oil prices were about $100 bbl and higher have experienced an IRR of –24.1 percent. Interestingly, the top five active performing North American energy private equity funds have vintage years between 1998 (Quantum Energy Partners, 41.2 percent net IRR) and 2005 (SCF Fund VI, 26.9 percent net IRR), with the net IRRs of the top performers ranging from 25 percent (ArcLight Energy Partners, 2002) to 138 percent (Quantum Energy Partners II, 2000). While current oil prices, at first blush, appear to be suggestive of a favorable valuation environment for acquisitions and investments, there continues to be a sentiment that valuations remain higher than expected due to the continuing competition for deals (with a manager’s track record within the investment strategy pursued, level of co-investment and deal access being important considerations from a due diligence perspective).
As private equity fund investors acquire their interests as limited partners, the pass-through income, gains, expenses and losses associated with the portfolio investments will be subject to the passive activity rules set forth in Section 469 of the Internal Revenue Code. While distributions from the portfolio operations can be a source of recurring income for private equity investors, holders of such investments will typically realize a substantial majority of the value from their investments in the form of capital gains through a sale to, or merger with, a competitor in the same sector, sale to another private equity investor, or through a subsequent public offering.
Investors also can get exposure to private investments through a pooled fund of funds. Similar to private equity funds, these investment vehicles are structured as pass through entities, and the minimum capital commitments in these programs can range from $250,000 to $500,000. The advantages of investing in fund of funds are greater diversification, access to several experienced fund managers, less cash commitment and heightened due diligence work. The drawback of an investment in a fund of funds is that investors will have to bear two layers of fees at both the portfolio fund level and the fund of funds level (with a 1 percent to 2 percent management fee and 10 percent to 20 percent carried interest applied at each fund level). While the standard 2/20 manager compensation structure has been prevalent at the private equity fund level for many years, fee arrangements below the norm are becoming more prevalent in recent years.
A third way for investors to have access to private equity investment is direct investment in privately held companies. However, compared with investing through funds, direct investments require a much larger outlay of capital to achieve similar diversification and exposure, a different skill set, more resources, and different evaluation techniques. This strategy is often suitable for well-capitalized institutional investors and family offices. For most investors, the use of private equity funds or a fund of funds will be the most practical alternative to achieving intelligent private equity exposure in terms of required capital and investment diversity.
MASTER LIMITED PARTNERSHIPS
MLPs are publicly traded companies structured as limited partnerships that engage in upstream, midstream or downstream operations. A majority of MLPs today are midstream and downstream, but public MLP upstream products that engage in drilling and lease development have grown in number. Investors who buy the public MLPs want regular income that comes to them on a tax-preferred basis. MLPs are managed by a general partner that receives a 2 percent interest in the equity of the fund, with investors as a group controlling the other 98 percent of the equity. The general partner also receives incentive distribution rights. The incentive distribution rights incentivize the general partner to distribute as much of the MLP’s cash flow to investors as possible. The general partner’s share of cash flow above a preferred investor distribution (e.g., 7 percent to 12 percent) varies depending upon the investor distribution.
MLPs are pass-through entities whereby income and deductions are reported at the individual investor level. Special tax legislation adopted in 1987 carves out an exception for certain publicly traded partnerships engaged in natural resource development, production and transportation. Public MLPs are passive income generators due to the nature of the income (i.e., which is normally operations-driven income) and the nature of the interests being acquired by investors (i.e., limited partner interests). Note that passive deductions in a public MLP product only offset passive income of that product. Therefore, if an MLP investor has excess passive deductions from the investment that exceed income, those deductions must be suspended and can be used to offset income from the underlying MLP for several years.
MLPs evolved over a number of decades to become concentrated in energy-related operations. The MLP product count attributable to upstream, midstream and downstream energy activities was 31 percent of the public MLPs in 1990, with the real estate, restaurant, and hotel industries accounting collectively for 43 percent of the market in 1990. More recently, natural resource–related MLPs were reported as representing 84 percent of publicly traded partnerships listed on U.S. exchanges, with real estate accounting for only 4 percent.
The energy segment of the MLP industry has a collective market capitalization of about $400 billion, which has contracted over the past 36 months. At the high-water mark of oil prices, Kayne Anderson reported in August 2014 that the market capitalization of MLPs was close to $600 billion, with market capitalization contraction to about $300 billion occurring in 2015 and the first quarter of 2016 due to downward oil pricing movements. Over the past year, however, the MLP market has regained ground due to a stabilization of oil prices at a $50 bbl level. Energy-related industries continue to dominate the MLP market in terms of capitalization.
MLPs have offered a competitive total return on investment through the combination of a high tax-advantaged yield plus real growth in income via distribution growth. In February 2017, the Alerian MLP Index reported a dividend yield of 6.9 percent for the 43 companies it followed. While MLPs have outperformed investments such as REITs, public equities and bonds in 2016 and generally over the past 10 years, MLPs underperformed such assets over the past three and five years, due to commodities pricing reductions.
Despite the performance of the overall MLP market over the past year and 10 years relative to other asset classes, there are risks which should be taken into account prior to considering MLP investments (as amplified by MLP returns viewed over the past three years):
- MLPs have commodity price risk, which affects businesses operating in the oil and natural gas production, gathering and processing, and coal sectors.
- There is some equity market correlation. While MLPs had historically low correlation to other asset classes, there has been an increase in the correlation of MLPs to equities since the 2008 financial crisis.
- The market capitalization of public MLPs is small relative to other asset classes. Liquidity becomes a greater concern if trading volumes drop dramatically during periods of stress.
- Increases in interest rates can negatively influence investors’ total returns. The fact that many MLPs use leverage to build asset bases, while using free cash flows to pay investors’ distributions, highlights the interest rate risks.
While capital funding in 2016 was down from prior years (i.e., $300 million in 2016 compared with about $700 million to $800 million in 2010–2014), there continues to be appetite for retail syndicated programs designed to provide tax deductions, income or value through drilling or acquisitions. These programs are structured as pass-through entities and are usually marketed to accredited investors through private placements. When RIA-advised clients and family offices place subscriptions, the investments are provided net of commissions and other marketing costs (i.e., 8 percent to 10 percent cost range usually), which enables these investors to acquire interests close to net asset value.
Drilling accounted for a majority of retail syndicated capital in 2016. These programs are designed to provide investments whereby about 75 percent or more of the investor’s capital can be deductible from income taxes in the first couple years of the investment through special allocations of intangible development costs to investors. Investors determine the active or passive character of their intangible development costs by electing to participate in the program as a limited partner or as a general partner. Investors also get the benefit of depletion deductions that can shelter about 15 percent of an investor’s gross production income from income taxes. Drilling partnerships also seek to provide long-term cash flow from oil and gas production revenues. The drilling capital raised from investors in 2016 will generally be put to work in west Texas, New Mexico and in parts of the Anadarko Basin and STACK Plays in Oklahoma.
Similar to private equity funds, retail syndicated acquisition partnerships are structured to provide investments that will deliver value from weak commodities prices. The strategy is to provide value to investors in the form of income and asset growth by focusing upon purchases of producing or undeveloped leases at a time when market developments present opportunities for favorable capital expenditure outlay. These programs can also focus upon a diverse universe of other assets that may include leased minerals or royalties in properties that produce hydrocarbons, disposal wells, gathering systems and infrastructure assets, or equity interests in energy-focused companies.
As the investors in the acquisition-focused partnerships will not have material participation in the partnership and will come in as limited partners or non-managing members, they will be subject to passive activity limitations in relation to the income and pass-through capital deductions associated with the program investment activities. The mineral interests and leasehold investments of acquisition partnerships also give rise to depletion deductions.
Acquisition programs also can offer opportunities for investors to acquire interests in leased minerals and royalties through like-kind exchanges that enable investors to sell real estate and acquire interests in the program assets on a tax-deferred basis. While working interests in oil and gas leases and associated production can technically qualify for like-kind exchange treatment under IRS Code section 1031, a substantial majority of the assets acquired in these programs tend to be leased minerals, royalties and overriding royalties, as income-producing assets with long-term investment periods are favored for these products.
Performance of retail syndicated programs have lagged institutional-backed private equity and MLPs, but a select number of retail programs have proven their investment concepts, or are reasonably positioned to do so. Factors contributing to good performance include timing of the sponsor’s entry into a play, sponsor’s capital at risk, sponsor compensation fairness, sponsor relations with proven project developers, and the sponsor’s experience in areas of drilling. Conversely, factors contributing to poor performance include the presence of promoters in the retail channel and programs driven by a year of high intangible development cost allocations.
Despite the weakness in oil and gas pricing over the past two years, oil and gas continues to provide the world’s 6.9 billion people with 60 percent of their daily energy needs. Fuels such as oil and gas keep us warm in cold weather and cool in hot weather; they cook our food and heat our water; they generate our electricity and power our appliances; and they take us by car, bus, train, ship or plane to places near and distant. Thus, while technologies may change, our need to be energized demands a vibrant energy industry capable of fueling our needs and desires. In turn, the capital needs of energy producers should continue to present a variety of alternatives in private equity, MLPs and retail syndicated investments for years to come.
Brad Updike (firstname.lastname@example.org) is an attorney and director with Mick Law P.C.