In Callon’s case, the private equity firm Kimmeridge Energy Management Co. bought its debt in a deal that included royalties. Far bigger names are also targeting energy debt on the notion that the sector has been mispriced.
“When you have hedge funds making major commitments in support of energy M&A, that must mean that they have a view on commodity prices that is above the curve,” Pete Bowden, global head of energy and power investment banking at Jefferies Financial Group Inc., said in an interview.
Bowden added that these deals are supported by funds including Oaktree Capital Management, Elliott Investment Management and Sixth Street Partners, who are coming off the sidelines in response to five years of underinvestment in oil and gas.
The kinds of deals that alternative lenders, also known as shadow lenders, will finance will run the gamut. It could involve both equity and debt capital, including structured debt transactions, preferred equity offerings, mezzanine debt placements and asset-level joint ventures, according to Bowden.
Head for Exits
Even with rising prices and enhanced deal flow with the sector emerging from the coronavirus pandemic, banks have grown wary and are cutting their exposure. Mounting losses and bankruptcies during the past year, coupled with investor pressure to address environment, social and governance concerns, has led banks to spurn new projects, prune their client lists and, in some cases, head for the exits.
There are $271 billion in loans outstanding in the sector, according to data compiled by Bloomberg.
When this happens, a hedge fund typically picks up the portfolio at a discount. Last July, Houston-based lender Hancock Whitney Corp. announced it had agreed to sell $497 million of energy debt to funds backed by Oaktree for $257 million.
Since then, banks including Bank of Montreal and ABN Amro Bank NV have been selling all or portions of their portfolio. BMO said in December that it was winding down its U.S. oil and gas investment banking business and will focus on assets in Canada.
This week, Amro announced that it was selling $1.5 billion in debt to Oaktree and Sixth Street Partners and withdrawing from oil and gas lending in North America. That portfolio encompasses loans to 75 energy companies.
Alternative lenders have taken the view that banks were in such a rush to strike deals that they adopted a one-size-fits-all model that failed some smaller companies with less-mature assets in lower-quality basins. That meant a lot of debt could have been priced incorrectly or loosely by the banks. Lenders in the space are deploying second-lien capital at interest rates of 9% to 12% that, from a credit-risk perspective, should be 5% to 7%, some investors said.
The ability to offer terms simply to chase returns distinguishes those lenders from banks, which historically offered asset- or reserve-backed loans to secure more lucrative investment-banking returns through mergers or initial public offerings. Even when traditional lenders are willing to provide a loan, the process can be arduous, said Lucas Spivey, a partner at the law firm Kirkland & Ellis.
A banker seeking investment committee approval last year might have faced, in addition to concerns about unprecedented volatility, worries that company would get dinged for not being more ESG focused, Spivey said.
“Company owners have witnessed that first hand, and they’ve sort of changed their minds on how they view these alternative lenders, and as a result they’re gaining ground,” he said.
Many funds targeted the Permian and Eagle Ford basins because of the higher returns and lower regulatory risks of operating in Texas. In May, Laredo Petroleum Inc. sold 37.5% of its reserves in its legacy leasehold in Reagan and Glasscock Counties to Sixth Street for an initial $405 million to help finance its purchase of Sabalo Energy LLC from EnCap Investments LLC.
Paul Singer’s fund Elliott has been active in the Permian, too, as part of a group of lenders that bought oil and gas assets in Breitburn Energy Partners’ bankruptcy in January 2020. Elliott created a new company out of the bankruptcy, Birch Resources, that owns the new equity and a second-lien facility, a relatively high-ranking debt in the firm’s capital structure, that yields around 10%, according to people familiar with the matter.
An Elliott representative declined to comment.
The flexibility to invest across the capital structure gives hedge fund newcomers the ability to generate higher returns earlier than their rivals. With deal flow likely to increase as oil prices rise and travel resumes, creative financing is set to become a mainstay, Jefferies’ Bowden added.
“That is going to keep going for six or nine months,” he said. “The back half of the year is going to be extremely busy.”