Appetite for mezzanine funding ramps up in current market

Keith Behrens,Stephens Investment Banking, Dallas

Following a wave of consolidation in E&P companies in the late 2000s and the shedding of assets to delever, seasoned management teams jumped ship, spawning a generation of upstream start-ups. With a keen understanding of niche plays, entrepreneurial E&P companies sought aggressive funding for deals (seeking cash for new drilling projects or acquisitions).

A sector that requires substantial capital, E&P companies have faced an uphill battle in the past year. Although access to credit is improving following the 2008-2009 recession, the post-crisis financial landscape is highly conservative. Fewer commercial banks are willing to provide senior credit facilities to new oil and gas company borrowers and are focused on providing debt capital mainly to existing borrowers. Those remaining active in the E&P space have lowered their borrowing bases based on a more conservative set of assumptions (tougher coverage ratios, lower forecast reserves, lower price decks).

In this environment, E&P companies are handicapped to fund future plans and often encounter reduced borrowing bases sometimes greater than the amount of debt outstanding.

Mezzanine capital financing fills the gap. The few less-restrictive traditional lenders stick to lending mainly against developed producing reserves, and are unwilling to offer enough capital to accelerate unproven drilling projects and rapid production growth.

Backed by solid funding, mezzanine providers have the capital available and risk/reward palate to invest in earlier stage E&P companies. Mezzanine capital can also placate the banks by providing debt to pay down banks' principal, albeit at an overall higher cost of debt.

Pros and cons of mezzanine capital

For projects that carry a higher degree of risk than those financed with senior debt, this type of financing can be a perfect solution. Companies with undeveloped reserves, but fundamentally-strong development plans, are ideal recipients of mezzanine funding. So, too, are companies with successful exploration programs but that are too early for bank financing given the ramp-up in production.

Still other E&P companies, on the hunt for complementary acquisitions, might be prime beneficiaries. And lastly, those companies that need to stretch their equity dollars and pay back bank loans might ponder this alternative.

Another advantage of mezzanine capital: funding appears as debt and can be financed from pre-tax revenue.

Geared toward E&P companies that have $10M to $300M in assets, private mezzanine funding traditionally was considered an expensive, non-pliable financing option. It is true that mezzanine capital typically carries a higher price tag (with the cost of capital, typically near 15% to 20%) than traditional debt options, and requires a higher investment return, in the form of an "equity kicker," than most secured and/or senior lenders. Because the investors have an "upside" component in the form of well working interests and/or equity, they will assume this additional risk since it could result in a substantial future payoff.

However, all mezzanine providers are not created equal; finding the right source can make a huge difference for E&P companies.

Mezzanine providers

Of the 20+ pure upstream mezzanine players that entered the market in the past, only seven to 10 providers remain active today. The global market meltdown contributed to the demise of "mezzanine capital" banking divisions; the survivors are exacting high costs of capital in the 20% to 25% range, as deal competition dissipated.

Mezzanine debt with warrants and kickers are becoming commonplace. In such environment, E&P companies have to do their homework when shopping for capital.

E&P companies should seek out providers offering a lower cost of capital, friendly structure for banks, and no equity kickers if possible. Such mezzanine sources do exist, as a number of providers have publicly indicated their willingness to invest in companies whose assets support $25M to $100M of mezzanine debt.

Mezzanine funding is being specifically allocated to 1)bank clients that are overextended, 2) acquisition financing, or 3)development drilling programs.

E&Ps in the market for mezzanine capital

And there are plenty of E&P/midstream oil/gas companies in the market for a capital infusion. We believe the acquisition market will be strong and could pick up for conventional gas properties. Given the large producing component related to many of these acquisitions, mezzanine financing should continue to be a good funding source. We believe we will also see mezzanine capital used to fund development drilling. Consider the following:

June 2010: A private, Texas-based E&P company secured $125 million in senior secured financing from Beal Bank Nevada, through its affiliate CLG Energy Finance LLC. The credit facility is structured as a delayed draw term loan providing the company with additional capital on a monthly basis to meet drilling and leasing obligations. The credit facility provides funding for the company's development drilling program targeting the Eagle Ford Shale formation in DeWitt County, Texas. Stephens Investment Banking acted as advisor in this transaction.

April 2010: A private Texas based E&P company borrowed roughly $60 million of subordinated debt, which allowed a pay down on its senior credit facility to bring the principal amount down to roughly $80 million. The subordinated debt was unsecured and included no equity kickers. Stephens Investment Banking acted as advisor in this transaction.

December 2008: Dewbre Product Development LP put in place a $50 million secured note mezzanine financing provided by Guggenheim Partners, used to support Dewbre's multi-well infill gas development program in the McAllen Ranch Field in Hidalgo County, Texas. Dewbre is a new E&P partnership formed by Dewbre Petroleum Corp. and Harbor Hill Interests LP.

While several well-known mezzanine funds sit on the sidelines, others have remained open for business; there has even been a very recent surge of new entrants to the market.

The cost of mezzanine capital could trend down with the addition of the newer sources; E&P companies should be on the lookout for the most advantageous funding sources as the mezzanine market continues to evolve.

About the author