Upstream E&P startups

Hurdles exist, but start-up E&Ps can and do acquire assets and secure funding

JOSEPH C. DACHES, FORT WORTH, TX

START-UP E&PS FACE many hurdles and for many, those hurdles will be insurmountable, but a select few will cross the finish line acquiring assets and securing funding. Even if a new start-up management team obtains an LOI, even in the very best basins, it many not be enough to guarantee capital funding. To complete the process and secure capital funding, the management team must demonstrate a proven track record, appropriate industry experience, and the management team's capability to execute on a business model vetted through the prospective capital partner.

Funding

For a new E&P startup team, acquiring private equity (PE) sponsorship is akin to finding the Holy Grail…many are searching, but few will find it. The elusive and exclusive prize of PE sponsorship goes to the exceptional team with a proven track record and not individuals, no matter how experienced or talented the individual(s) appear to be. So how can a new team without a proven history of creating value and solid investor returns secure PE funding?

At a minimum, the startup team should be able to demonstrate a technical understanding of pricing and risk and how sensitivities to pricing, cost and well economics will affect value of the transaction at purchase and exit. Additionally, management will need to be experienced and be able to demonstrate how their experience will correlate to value.

PE firms, will rightfully expect the teams they support and sponsor to possess the requisite industry experience. Additionally, successful management teams need to possess an appropriate work-ethic, integrity and egos that do not prohibit success. The management team will also need to demonstrate how they will successfully execute diligence and how they will successfully integrate the asset (Ops, Land, Engineering, Accounting, etc.) with minimal miscues on governance and compliance.

Sourcing prospects

As important as funding is for a new management team, it is equally important to possess the ability to successfully source E&P assets. This takes a combination of strong industry relationships, hard work and occasionally some old-fashioned luck.

Finding risk-appropriate E&P prospects that match the goals of a management team and also align with the expectations of a PE sponsor can be tricky. For a startup looking to take down their first acquisition, it can be especially complicated. Practically speaking, the informed startup management team will thoughtfully establish minimum criteria to be considered before a full evaluation of a prospect begins. The startup E&P team will want to be opportunistic, of course; however, they should have a target and focus with minimum acceptable criteria thresholds. Prospect screening criteria should include a management view on operated vs. non-operated properties, producing with development opportunity, PDP run-off, etc., and they will also identify a general set of risks that are acceptable and also a set of risks that might deem a prospect to be a non-starter.

If you're not in the energy industry, you might hold a view that oil and gas professionals are risk takers. While it is true that energy professionals embrace business risk, it is also true that we spend a lot of resources and time evaluating risk. The oil and gas industry possesses some of the brightest minds dedicated to the science of geology, engineering and finance in order to understand and measure risk and, where appropriate, how to mitigate definable risk.

A startup team fully capable of evaluating geology, engineering, operations, accounting, land and finance issues is rare and exceptional. Unfortunately for startup E&P teams, risk assessment and evaluation is most often the Achilles Heel. Teams recognizing shortcomings or holes in their internal expertise will and should rely on third-party experts. Teams that don't recognize their shortcomings…well, they will have a host of other issues.

From the perspective of evaluating prospects, it would be prudent to establish thresholds of acceptable levels of risk and as I pointed out above, it will be equally important to possess the resources capable of the evaluation. From a risk perspective, it is the combination of expertise and experience that allows startup teams to successfully navigate through risk assessment as well as the value of the prospect. By way of example, some teams will identify a prospect possessing retrograde condensate characteristics and consider this risk a non-starter while other teams may see this as a manageable risk that has appropriate upside value.

Once a prospect has passed the initial screening, the heavy lifting can begin. The geoscience team can begin determining water and oil saturations, porosity, structure and formation continuity, and the engineers, land, operations, legal, finance, and accounting teams can begin to take their respective deep dives. A successful team will work together to identify risk, value, viability and opportunity.

One of the principal goals for a new E&P startup will be to keep the pipeline of prospect opportunities full. As you can imagine, it is important that a new startup utilize all sourcing options available to them. While is not practical for a team to evaluate every opportunity that comes their way; however, there is benefit to reviewing as many as possible prospects within their target basin. Many of the prospects have proprietary information that is only available through the execution of a confidentiality agreement between the seller and the potential buyer. In addition to evaluating the specific prospect, this proprietary data can be of great benefit when considering future prospects within the same basin. This detail analysis performed by the management will further increase team basin knowledge and expertise.

One sourcing option is the utilization of E&P A&D shops. Typically, these processes include proprietary technical information that is somewhat "gussied" up for selling at the highest possible price. Obviously, the burden remains with the buyer to work through technical risk to evaluate purchase price value as well as exit valuations. Once the startup team settles on a bid value, they will need to present their value and view of the asset to their potential PE partner. In order for a bid to be supported by a PE firm, the bid will have to be at a value that enables the PE firm to meet their internal hurdles for exit IRR and MOIC. A pre-tax exit IRR of 35% and a minimum of 3.5x MOIC are common, which can push the cost of capital for a startup E&P company utilizing PE funding well north of 10%. With PE return hurdles embedded in a bid, the startup E&P company will likely struggle to win a bid when competing against a public company whose cost of capital is lower at around 4-6%.

What is interesting is that many of the middle-market companies who would otherwise be engaged in reviewing these transactions are not able to participate because of limited access to capital and financing and/or dealing with liquidity problems stemming from the drop in commodity prices. Having said that, there is still plenty of competition and the public companies who are in the market acquiring assets in plays like the Permian are aggressively acquiring—and their shareholders are rewarding them even when they set new high-water mark metrics, flowing BBL and acreage values. This factor alone puts the startup E&P company in an unenviable position in these highly desirable basins, and in certain instances, has created unreasonable seller value expectations. The prices achieved on these transactions virtually eliminate PE funding as a capital option.

where do startup teams source acquisitions?

Many opportunities can come from sellers who are not running their assets through an A&D shop and this is the most likely scenario for a startup to match prospect with PE capital. To find out about these opportunities, the startup team must tap into and develop its network of relationships within the industry, from oil and gas professionals to banks, attorneys, engineers, etc. Doing so takes a combination of finesse, patience, and time. The startup team must reach out to these individuals and let others know who they are, what they are trying to accomplish, and how the team will secure funding for an acquisition.

An example of a prospect that might be sourced in this space could be asset owners looking to quickly transact for liquidity reasons, or when their ability to fund a capital budget is limited. There are many examples of why these assets don't go through an A&D shop, but the key is the ability to quickly get through evaluation in order to close on the opportunity. In many of these instances, you begin with a simple map, an LOS statement and, if you're lucky, an internally developed reserve report. There can be real gems in this scenario, but there can also be dogs and goat pasture.

The good news in these scenarios is that the bid to ask spread will not be as wide as it would be if the asset was in an A&D shop process. While the seller will most likely be aware of the high-water mark pricing, not having the same level of competition for an asset will allow for a better takedown point for the startup team.

Let's not forget the auction houses and web sites. The opportunities presented in these venues are from all types of clients ranging in an even larger variety of value. The auction processes can be efficient and quick.

Without a doubt, there are significant hurdles for a start-up E&P company to cross; however, start-up E&P companies can and do acquire meaningful assets within current market conditions. With a talented team of hard working, like-minded individuals who play off each other's strengths and have the maturity to recognize where they need help, a startup team can be successful in acquiring assets and securing capital funding.

ABOUT THE AUTHOR