Private Equity Funds Enter Oil Patch As Regulations Usher In Opportunity

Often regulation is viewed reflexively within the hedge fund community as a negative, the complexity and obfuscation contained 2,300 pages of Dodd-Frank being the target of a significant amount of vitriol. But the regulation may be creating opportunity for fund managers, particularly in the oil patch. Michael S. Minces, co-founder of Blue River Partners, observes the most attractive place for private equity fund managers to congregate is in the U.S. oil patch. This is where traditional bank lending on overly speculative or highly leveraged situations has been curtailed due to Dodd-Frank regulation. This opens the door for less regulated entities to originate creative loan structures and participate in markets where banks are no longer allowed.

Private equity firms providing distressed loans to keep U.S. energy independence alive

Private equity firms traditionally participated in distressed debt loans in the secondary market, where banks would conduct due dilligance on the borrower, qualify, originate and package the initial loan, which was then sold to private equity. What has changed relative to Dodd-Frank — creating an opportunity for more nimble firms — is that private equity funds are now originating and packaging the loans and either keeping them on their books or selling them on the secondary market.

The emerging situation is helpful to fund managers looking for potential investment returns as well as providing assistance to the U.S. in its quest for energy independence.

According to the Loans Syndication Trading Association, there are approximately $1.2 trillion leveraged loans outstanding in the United States. Non-bank lenders provide roughly $850 billion of this financing. While alternative lending is often considered a high risk lending market, as of November 2015, the default rate on US leveraged loans is 1.27%, well below the historical average of 3.2%. Today’s default rate is largely due to default of oil & gas companies, which comprise 4% of the S&P/LSTA Leveraged Loan Index and are the subject of much of the interest from private equity firms. S&P Capital IQ LCD noted that in the first three quarters of 2015, 34 percent of leveraged loans were used for acquisitions, 28 percent were used for refinancing, 18 percent were used for buyouts, and the rest were used for other purposes. These loans are a significant portion of the economy’s growth engine and could be particularly critical to keeping alive the nascent shale oil business in the U.S.

Private equity funds had been familiar with evaluating the quality of loans when they participated on the secondary market and they are now shifting these skills into primary lending. “There are now enough managers in the alternative asset management space that truly understand lending that now they understand the nuance in evaluating risks (to speculative situations),” Minces said. “There has been an evolution in direct lending and this is part of that trend.”

 

Oil patch players could be headed for difficulty that requires lenders who take a long-term view

A recent Goldman Sachs report noted that most U.S. oil producers are not well hedged going into 2016 and bankruptcies could begin to mount. For fund managers, this means taking a longer view on the investment and having the willingness to tolerate short term pain as losses due to low oil prices mount. Minces said fund managers are looking in the oil patch and working out creative loan structures that help the business get out of debt and stay afloat during troubling times.

“Private equity funds can take distressed loans and have a lot more flexibility with how they deal with a borrower and get more creative with how they can refinance a potentially failing situation in such a way the borrower can actually get caught up,” he said, citing the lack of banking regulation for hedge funds to enter speculative markets as causation for this new opportunity.

“Private equity fund managers are looking at the situation from a 10 year perspective,” Minces said. When asked if this was a situation where certain private equity firms were buying when the equal of blood and emotion was on the street, Minces concurred that the price of oil and the severe distress in the market was seen as having the potential for mean reversion. “Some fund managers see oil trading near $33 and think the price will be higher in the future, it is just a matter of time.”

Private equity funds are those that are best suited to enter this market due to the ability to lock up investment capital for seven to ten years. He noted hedge funds generally don’t have the required investment lock-ups for the sometimes long-term commitment, as investors can be wanton to withdraw their investment when the fund performance falters, which could be the case with an oil turnaround model. With oil at recent lows and a large number of companies in the oil patch currently distressed, “this opportunity is well suited for fund managers with a ten year execution plan,” Minces said.