PRIVATE EQUITY FUNDING
Private equity (PE) Funds are invested in unlimited private companies, buyouts of public companies which results in delisting of public equity. The PE funds are the consolidated investment where the institutional or retail investors provide the capital for private equity, and the capital is utilized to fund new technology, make acquisitions, expand working capital and to support and strengthen a balance sheet[1]. The unlisted private companies go for PE funds when the company is unable to plug in capital by issuing equity or debt instruments or VC.
PE funds are made in companies which are well established in its industry (known as mature companies) operating in traditional business in return of ownership stake or equity. PE Funds has Limited Partners and General partners. The Limited Partners have limited liability and owns 99% of shares in the fund. The General Partners execute and operate the investment, does not have limited liability and owns 1% of shares.
The strategy used by the PE funds is to increase the value of business by engaging in management, direction of the company and acquiring the controlling interest in the operating company or the portfolio company. Some PE firms take non-controlling shares (known as minority investment) in startups/young firms having high growth perspectives or fast growing companies having stable cash flows. Some PE also invest in distressed or stagnant companies but have growth potential. PE in distressed companies will change the management, improve the financial performance, acquire all the shares of the company and after two or more years will sell and exit from the investment with a good amount of profit.
PRIVATE EQUITY FUNDING IN OIL AND GAS-
Since 2014, Private equity firms have raised more than $200 billion for energy investments as well as minimum $ 50 billion in share drillers[2] which led to the existence of private equity companies in oil and gas. The number of private equity investments in oil and gas was twice between 2002 & 2012. During the year of 2008 financial crisis the activity dropped, the number & value of deals has been rising dramatically, driven by the recovery in credit availability, difference in the ratio of crude oil to natural gas prices, and a renaissance in shale resource plays that has produced the highest US oil production in 20 years. The current situation is in contrast to the earlier where activity was conducted by rising the prices of oil and gas and a leverage bubble which outbreak in financial crisis in 2008[3].
The demand for the capital in the oil and gas industry is growing which private equity funds are trying to meet. The demand has also led to particular targeted funds having different return portraits rather than the leverage buyout returns (LBO’s). The oil and gas investment comes under risk profile from high reward means high risk to low-risk deals.
The PE funds cycle starts with a money pool (where each member gives the same amount of cash). Fund managers of PE funds are also known as general partners (GP) who seek potential investors to provide private equity funds. The fund managers are paid management fees from the investors after investment returns and interest is given. Before paying interest to the GP a given rate of return needs to be generated on return on investment at PE fund. The general partners exit portfolio companies by selling the ownership and paying back the investors. In PE, investors provide capital and assign management rights to general partners. GP invests in portfolio companies to increase the value of investment once the deal is structured and negotiated. The GPs help to enhance the operational efficiency and the capital structure and sometimes become the board member and strategic planning of portfolio companies.
The portfolio company structure is the most common investment structure for PE funds in the oil and gas industry. PE fund and investor invest equity capital in this structure in portfolio companies owned by the management team and PE fund. The management team which consists of expert professionals makes a small amount of equity commitment of the funds. The portfolio company pays the management team by way of bonus, stock, salary, other incentive, ‘profit interest’, equity incentive, ‘carried interest’ etc. After the PE fund and management team in relation to the capital brought by them earn a specific internal rate of ROI, the management team is paid incentive out of the net proceeds of the company. The returns need a mixture of ROI & internal rate , or separately ROI, or internal rate of return on investment. ROI is a profitability of an investment whereas internal rate of return is yearly return made on investment. While calculating internal rate ‘time’ is kept in mind and not in return on investment. To earn the adequate profit interest the management team and PE Fund needs to obtain the specific return on investment.
The PE funds funding is required for many reasons, one of the common reasons is to raise the funding of equity and lack of skill and proficiency. The capital given by PE fund to team has certain costs included in it, the cost like cost on capital, restriction on non-compete, lack of funding control, other material business decisions, time commitments, and non-compete restrictions); however, management teams perceive the value of their relationship with a private equity fund to outweigh those costs[4]. Management team perceives relationships with PE funds not only for the benefits arising out of profits interest but also to take advantage as PE funds have relationships with different financing sources, banks.
CHALLENGES
As the world is still depending on natural sources of energy, there are small and big issues that are affecting the worldwide industries. The oil and gas industry is going through a big downfall. The oil and gas industry investment within the power resurgence is anticipated to shift steadily therefore new tech is hoped to rush from upstream to midstream refinery operations, infrastructure, and petrochemical facilities. The managers in upstream of the oil and gas industry focus on measuring the risks, new innovation, effective and efficient operation. The issues the oil and gas industry is facing comes at an appropriate time when the industry is facing some notable opportunities[5].
1. Deterioration in Fiscal Terms
The fluctuation in revenue and expenditure administration of the nation has put pressure and created uncertainty in the oil and gas investment policy and financial strategy causing a $2.3 billion decline in tax revenue, this led to fall in operation of drilling and production. The oil and gas industry needs a stable and anticipated administration.
The leading manufactures in the oil and gas industry need to take steps urgently in order to stir up the investment needed and the issue the industry is facing is entry of new technology. The present tax policies are extremely rigid which is affecting the growth of the industry. Recently, China is the country which has imposed a 5% tax on crude oil on the US which led to decrease in imports of US crude oil. Brazil is among few countries who is worried about revenue and expenditure administration.
2. Illiquidity
The investment in PE funds is illiquid because of the long term investment view usually 10 years till any return on investment or internal rate of interest is realized. This usually limits the investors to exit from the investment. Investing in PE funds the major risk is the illiquidity. Despite illiquidity in PE funds, PE funds are self liquidating i.e after a certain number of years, the net cash flow is positive whilst the net asset value decreases. [6]
3. Funds instability in small companies
The new challenge that the oil and gas industry face is getting financing on their terms. The investors before investing look at the company profitability, growth of company, the debts, goodwill, return on investment, For some reason some company feels difficult to meet the requirement which is the one of main reasons of instability in funds of company. Independent companies need to cross these barriers as there is instability and foreseeability than the other companies like oil and gas where inflation and price risk is there.
4. Conflict of Interest
The interests of the private equity company conflict with the fund it manages, and the limited partner invests in the fund. Private equity companies can manage multiple private equity funds and multiple portfolio companies. Foundations usually pay for consulting services to private equity firms. Subsidiaries of private equity companies can also act as service providers for funds or portfolio companies. Advisors must fully disclose all conflicts of interest between them and the funds they operate in order to obtain consent.
For example, the U.S. Securities and Exchange Commission (SEC) filed several lawsuits involving the adviser’s alleged refusal to disclose certain conflicts of interest related to the funds it manages. Advisors can benefit from a variety of relationships, including relationships with members and portfolio companies. From the funds they manage and their investors. For investors, it is important to understand and be aware of the conflicts that may exist or may occur when investing in private equity funds[7].
5. Issue of equity and risk
For many independent oil and gas companies, issuing equity is still the only option for pure exploration because of the lack of proven reserves, poor credit capacity and cash flow difficulties. Regarding unsafe investments, investors after the 2008 financial crisis are still very shy. In many cases, they lost confidence in exploration companies in this crisis, and this confidence has yet to be fully restored. Natural gas projects in this context don’t just rely on regular funding, but also be creative. Some of their innovative strategies include mergers and loan agreements with service providers, and a focus on more business.
OVERCOMING THE CHALLENGES
Although the financial crisis of 2008 has long been reflected in the rearview mirror, it has shaped this generation of lenders and investors in a way that is difficult to raise capital for exploration and other expenditures. In seeking more innovative financing solutions, many new lenders have emerged to fill this gap. Of course, this is also due to the increasingly fierce competition for these funds. In addition to these problems, companies also face different resource allocations. This means that the credit transactions of small and medium enterprises are not satisfactory. Likewise, risk reduction remains a key factor in these decisions. However, there are many ways to improve financing in all areas of the oil and gas industry. In many cases this is also possible. The potential for this growth is extraordinary.
CONCLUSION
The recent recession in the oil and gas industry has challenged private equity firms to protect their investments and expand their company portfolios. However, those who want to invest in new capital can benefit from the current low prices for a longer period of time. After the oil crisis in mid-2014, private equity firms hoping to buy low-cost energy assets raised more than $100 billion. During this time, banks abandoned weaker borrowers and began to get rid of their loan portfolios. Then, independent companies had to file for bankruptcy, while other companies quickly dumped their assets to make ends meet. In an industry where cost reduction and debt service are paramount, the need for growth and working capital is more important than ever, and private equity firms are ready to fill this gap.
[1] James Chen, Private Equity, Investopedia, April 30, 2020 Private Equity Definition (investopedia.com) <https://www.investopedia.com/terms/p/privateequity.asp>
[2] Collin Eaton, Private Equity Poised for Oil Growth as Public Companies Pull Back,Houston Chronicle, March 30, 2018 <https://www.houstonchronicle.com/business/energy/article/Private-equity-poised-for-oil-growth-as-public-12792385.php>
[3] The US Revolution, The role of private equity in oil and gas, PWC, February, 2013 – <https://www.pwc.com/gx/en/oil-gas-energy/publications/pdfs/pwc-usenergy-revolution-role-of-private-equity-v2-pdf.pdf>
[4] Sarah McLean, Private Equity Oil & Gas Transactions: Insights from Buyer and Sellers, mondaq, January 29, 2020 <https://www.mondaq.com/unitedstates/corporate-and-company-law/888084/private-equity-oil-gas-transactions-insights-for-buyers-and-sellers>
[5] Oil and Gas Industry Challenges and Opportunities in 2021, Linchpin, March 13, 2021, <https://linchpinseo.com/challenges-facing-the-oil-gas-industry/>
[6] Is private equity really illiquid? Self-liquidation of private equity portfolios, Capital Dynamics, January 2016 <https://www.capdyn.com/Customer-Content/www/news/PDFs/capital-dynamics_white-paper-self-liquidation_jan16-en.pdf>
[7] Private Equity Funds, Investor.gov, <https://www.investor.gov/introduction-investing/investing-basics/investment-products/private-investment-funds/private-equity>
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