Mergers and acquisitions are enjoying a rebound. 2012 saw a 10-year high, with 204 deals in the oil & gas industry. More than a dozen deals were done last year in the Bakken and Eagle Ford formations. Conditions are ripe for that growth to continue in 2013, with falling prices for oil and natural gas, and rising costs for production.
Both Ernst & Young and PwC are bullish on the oil & gas sector in 2013, especially on smaller mid-market deals of $500 million or less. To fuel the dealmaking, private equity fundraising was fairly active in 2012, with a 38 percent increase in committed capital raised from the previous year.
An Enlightened Speakers Series event in Dallas brought together three experts in mergers and acquisitions: Terry Fick, Managing Director of the Dallas office of Corporate Finance Associates; Tom Costantino, Chief Investment Officer of Five States Energy; and Alan Barksdale, President and CEO of Red Mountain Resources.
Fick noted that conditions are good for mergers, but said, “While it’s good for sellers, it’s not quite as good for buyers.”
The recession actually helped sellers, Fick said, because buyers like to look back and see how a company performed during bad times. That way, if times get bad again, the buyer will have some evidence of what the company might do. “We had so many good years, it was hard to tell how a company would do in bad times and now we have that memory,” he said.
Sellers also benefit because corporations have been hoarding cash. “You can’t pick up the paper today without reading how much excess cash corporations have today, and that’s good for sellers,” he added.
In fact, the amount of cash in the economy is another driver of value, said Fick. If both corporations and private equity groups have a lot of cash, something needs to happen. With interest rates where they are today, he said, cash is an underperforming asset. “They need to get it out the door and if the choices are to buy a company or build new facilities, today it is faster, easier and quicker to make an acquisition,” Fick said.
All that cash is also good for sellers, because private equity groups can spend more money on acquisitions if they can pay less interest, Fick added. He said the economic conditions aren’t changing much, and figures there is a two to three year window where sellers will have the upper hand. Size, financial performance, management, customer concentration, IP, a company’s competitive advantages – all drive the value of companies. Historically, oil and gas brought lower multiples than other industries, because of the cyclical nature of the business. But things are changing, said Fick. “When you think about what’s going on in the oil & gas industry – fracking, shale plays and other innovation – while the industry has not removed the cyclicality, they are smoothing it out,” he said.
With the rising tide of the economy raising all boats, oil and gas services companies are rising even faster, Fick continued. “This is good time, if you are a business owner, to consider selling if it’s right for you and your company,” he said. “It’s still a good time to buy if you’re one of those companies with more cash, but there are not many bargains out there.”
But he cautioned sellers to take the necessary steps to maximize their company’s value. “How often do you walk into your business and say, ‘Today, I’m going to pretend I’m a buyer and see what a buyer sees?’” he asked. “I suggest you do because some day somebody may walk into your office and make you an offer you can’t refuse.”
Tom Costantino said the buyer had better be able to see return on investment. The Chief Financial Officer for Five States Energy said investors want a return on their
capital and they would like a consistent stream of income from dividends and distributions. To make sure an acquisition can provide that, it has to pass over a series of hurdles.
First hurdle: character. “If you have a reputation in the marketplace that’s excellent, we want to do business with you,” Costantino said. Second hurdle: asset base. “Is it a strong asset base, in a place where we’d like to invest, is it something that’s appealing to us and is it fairly priced?” he asked. Third: an equity component. “What’s your track record? How have you done in the past? Success tends to breed success,” he added.
For Costantino, a narrow focus is the way to go. “There are four primary elements to the oil & gas business,” he said, “exploration, development, midstream and refining and marketing.” His company concentrates on development and midstream – “moving the hydrocarbons.”
Five States is a private equity firm. Costantino said the capital it provides in acquisition deals can take on different forms: all equity, a mix of equity and debt, a mix of senior debt and mezzanine debt and equity. “Equity is the most expensive form of capital,” he said, “and as you add debt to it, your cost of capital decreases and if you’re successful, your rate of return on equity will increase as you add debt.”
When a prospective deal comes along, Costantino says he looks for a strong management team. “We like people with lots of experience because success breeds success, we want deals with people who have skin in the game and we want shared alignment: shared pain and shared gain,” he said. Successful pitches have a well-defined plan, and can tell Five States who to talk to, when to talk to them, and where to find them.
“Sometimes we see people who say, ‘We’d like to do this,’” Costantino said. “It appears to us they are not clear about what they want to do.”
From the standpoint of a producer of oil, Alan Barksdale said his company – Red Mountain Resources – focuses on production, reserves and acreage. Red Mountain is a micro-cap exploration and production (E&P) oil company, that Barksdale describes as “conventional.” For example, they avoid the shale boom, and stick with mature oil fields in the Permian Basin and Gulf Coast. When scouting for acquisitions, he said there are five ways to grow.
First, he said, develop your own properties to foster organic growth. Second, generate prospects by acquisitions through your in-house leasing program. A geologist and geoscientist team identifies a prospect and works with the engineering team to determine the economics of an area and find if it fits with your capital allocation. Third, acquire assets, either by outright purchase or a joint venture drilling partnership. Fourth, a corporate level transaction, which is a traditional merger and acquisition; and fifth, look at competitors, which could range from public E&P companies which could be micro-cap, small-cap, large-cap, independents, MLPs and global integrated companies. Private E&P firms, usually family owned, and private equity sponsored E&P companies could also qualify as competition.
If you’re a small or micro-cap company, competitors are likely to bring the most challenges, Barksdale said. Because large-cap independent, MLPs, and global integrated companies are so large, their cost of capital is significantly lower. Small or micro-cap companies face a higher cost of capital, and it may be more restrictive. Investors still expect the same kinds of return on investment as the big boys. “When an investor is seeking a higher rate of return, your threshold for failure is limiting,” Barksdale said.
That said, Barksdale maintains there are advantages to being a micro-cap company. “First, it takes far less capital to move the needle and you have a flat corporate structure which provides for quicker decision making,” he said. “Then, if you are successful and you do have a model that works, the full gamut of our competitors and everyone else in the industry can be an acquirer.”
“Everybody thinks the oil & gas business is great,” he added, “but you need to be careful not to get caught up in the sex appeal of the business.”
One questioner in the audience asked how hot the market is now in the oil and gas services business. “There is significantly more interest,” said Fick. “I’ve been doing this for 27 years and you see these bubbles that used to be very short, but this one has some legs.”
“High is an understatement,” added Barksdale. “Service costs are generally an indication of the market and you’ve seen a significant increase across the board.”
But even though the market is hot, the speakers said good deals are hard to find. “Overall in a good market like this, people are paying higher multiples and values are up,” said Barksdale. “If you’re a buyer and you’re looking for bargains, you need to go directly to the owners,” added Fick. And then, said Costantino, “use a very sharp pencil” to evaluate risk and discount it to something you can live with.
Then there’s the human side of mergers and acquisitions. How do you deal with owners who are selling their baby?
“The economy needs to be right, the company needs to be right, but more importantly the owner needs to be right,” said Fick. “The owner needs to have a personal reason to make this transaction or he or she shouldn’t be doing it.”
The speakers admitted that right now, there is an “air pocket” in deals. Few people have come to the market since the end of the year, when a lot of so-called “tax deals” were getting done, said Fick. But he added, “We’re seeing activity by sellers who are talking about going to market that will create deal flow later this year and I haven’t seen any degradation in values.”
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