How Do Oil and Gas Investors Pick Entrepreneurs? Vice Versa?

Oil and gas entrepreneurs need more than just a brilliant idea to attract investment, and investors have to offer more than just money.

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Private equity and venture capital firms are just as important to the evolution of the oil and gas industry as the leading operators and service companies. This became evident during the oil price crash when public equity opportunities disappeared and lenders shied away from the industry amid scores of bankruptcies.

Illustrating the point earlier this year was Wil VanLoh, founder and CEO of Quantum Energy Partners, who boasted during the NAPE Global Business Conference that his firm would “look really similar to a superindependent” if it were to aggregate all the companies in which it’s currently investing, which altogether tally 2.3 million net acres, 350,000 BOE/D, and 32 rigs working across the US and Canada.

With the backing of private investment, entrepreneurs who previously worked for companies such as Shell, Anadarko, Halliburton, Baker Hughes, and even smaller, lesser known entities have applied their unique skills and ideas to find, develop, and produce the latest generation of prolific oil and gas fields quicker and with less money than ever before. But finding those innovators who are actually capable of turning their dreams into reality is difficult. And when you’re the firm tasked with bearing the financial risk that comes with backing fledgling companies that hope to break into an already volatile industry, you tend be choosy.   

Enter Charlie Leykum, founder of CSL Capital Management, a 10-year-old private equity firm that builds and acquires controlling interests in oil and gas service and equipment companies. It’s currently launching its $1.5-billion Fund III as well as a special-purpose acquisition company, which raises capital from public investors, enabling them to participate in private equity purchases.

“So much of what we do is finding not just an individual or a group of individuals who are technically or commercially really savvy,” but finding a “harmonized, well-working team,” Leykum said during the SPE Gulf Coast Section’s recent Innovation Entrepreneurship Symposium. CSL only considers business plans where a team is either in place or assembling with “a subject matter expert who’s the key decision maker” as well as technical and operations personnel. Together, they must have a firm grasp of the challenges and risks involved in building a business.

When looking at possible investments, CSL wants technical leadership in a market. When CSL invested in a fracturing company in the early 2000s that ended up successful, Leykum said, the firm partnered with a major service company’s “lead fracturing executive for the business line” whose skills and expertise could solve—and had solved—unique challenges in different basins.

CSL probes for entrepreneurs with “past entrepreneurial tendencies,” asking, “Has this person launched a new product at a larger company? Have they launched a new service area? Have they been part of a team that’s gone into a new geography to start a new footprint for an existing company like Halliburton, Schlumberger, or Baker [Hughes]?” It also prioritizes those who show a commercial instinct, Leykum said. “They may be a great technical domain expert. They may have been part of a commercializing team. But are they really financially shrewd? ... Do they really understand the unit economics of their business?”

Startups to Shine at Conference Event

SPE and the Rice University Alliance for Technology and Entrepreneurship are sponsoring a “Startup Village” at SPE’s annual conference, featuring a cash prize competition in the morning and expert presentations and table discussions in the afternoon.

The Energy Startup Competition is a fast-paced contest showcasing some of the best emerging energy technology companies. The event will take place on 25 September at the SPE Annual Technical Conference and Exhibition in Dallas.

Each company will have 5-8 minutes to provide information about their company and technology to a group of venture capitalists, angel investors, and industry leaders. In the afternoon, participants will have an opportunity to ask questions and gain insights from investors, industry representatives, and veteran entrepreneurs.

To learn more, visit Startup Village.

Adapting to Change

Sean Ebert, partner at oil and gas technology venture capital firm Altira Group, said that while both are important, he focuses more on the business model than the team in the selection process. “First we have to have that product-to-market fit, especially in oil and gas. The second dimension of what we do, is we’re investing at the point when companies are scaling, which is statistically the highest failure point for any growing company. So we have to have as a core competence the ability to adjust and change out management. It’s never fun.”

Ebert said Altira has closed deals that included formally signed letters for CEOs that say, in effect, “When the time comes, you are probably going to be replaced.” This is because the organizational structure of a tiny startup can differ greatly from what that company becomes a couple years down the road. Is the CEO of a 10-person startup capable of overseeing a 100-person company, essentially two completely different organizations?

“When a company is below, say, 30 people, everybody sort of knows everything,” he said. “It’s a family. Everyone has their hands in everything. People can attend all the meetings they want. And once you break through that inflection point, things change dramatically. Process begins to matter. People can’t know everything. The whole skill set, the sophistication of the organization, the back office—all these things change.”  

Providing a direct link between operators and technology startups, Altira’s latest fund includes institutional investors as well as big independents Pioneer Natural Resources, Apache, Devon Energy, and EQT. The goal is to identify “the biggest problems they’re facing in the field that aren’t being met by the Schlumbergers and the Halliburtons of the world,” Ebert said. “By being an indirect owner in our portfolio companies, we can really force-fit that relationship between the customer and the vender” so the customer can play a role in shaping how products and services evolve to meet their needs.

For a technology firm, the backing gives them a direct link to operators who can test their products in the field. Ebert emphasizes, however, that Altira’s operator partners “aren’t interested in incubating technologies. They want something with a clear path to build an organization large enough to serve them in a basin, probably within a year to 2 years,” Ebert said. “The core risks that we take on are scaling and adoption.”

Unconventional Approaches  

Gary Petersen, cofounder of upstream private equity pioneer EnCap Investments, said his firm prefers management that’s competent yet unconventional, citing operator Paloma Partners as one of its more unique portfolio companies over the years. During its early days, Paloma’s management team scooped up acreage in the then-red-hot, crowded Barnett Shale by finding and leasing land beneath overlooked areas such as theme parks, “and then they’d block it up, change it around, and trade it out. We’ve probably backed [the Paloma management group] five times and they made money every time.”

Founded in 1988, EnCap has invested in 240 companies across the upstream and midstream spaces. Its latest upstream and midstream funds together total more than $10 billion. “We became a bridge of sorts between the oil and gas industry and the financial institutional industry,” Petersen explained.

Once it has chosen an entity to invest in, EnCap’s job becomes risk management from that point forward, he said.

While EnCap is among the largest private equity investors in the upstream space, “we’re really a venture capital firm,” he said. “Nine times out of 10 we will back a management team with no assets,” which he considers less risky than committing money to a team with an asset that might not work out. “We like to go into an area and sort of stair-step our way up” by starting with a small acquisition, drilling some wells, and bolting on more acreage thereafter. “We think that’s a safer way to play the oil and gas industry than putting out $600 million all at one time and making a big acquisition.”

Noting that EnCap doesn’t invest directly in technology, he marveled at the technology deployed by its port­folio firms, including Eclipse Resources, which drilled an 18,600-ft horizontal well named Purple Hayes in the Utica Shale a couple years ago and has since drilled several others that length.

Looking ahead to future fundraising efforts, the country’s sentiment toward hydrocarbons will continue to impact investment in the industry, warned Petersen. Some 90 university endowments have invested with EnCap, several over multiple decades, but that’s changing. “Some of the Northeast schools—you can only guess who they are—in the last fundraising effort said, ‘you’ve got a great track record, but our students are protesting so hard against oil and gas that we can no longer invest in the industry.’ That concerns me and it should concern all of us,” he said.  

What Should Startups Look for?

For the entrepreneurs fortunate enough to have multiple options for financial sponsors, Leykum believes three main criteria should be followed. First, is there an alignment of interest in terms of strategy, people, and culture? “Because of the style of investing where we’re building a company over time with capital being deployed over time, we view ourselves as sort of in the cockpit with that management team or entrepreneur,” he said.

Second, what is the track record of the fund? “Maybe that sponsor has created a great track record in buying businesses cheaply and not really doing much after they buy that company or buy that asset. So there’s really not that much business building after that first transaction,” he said.  

Third, where is the fund in its life cycle? “Time horizon is a very important aspect of private equity. It can be really positive or it can really negative,” Leykum said. CSL’s funds typically take on a 10-year lifecycle in which the first 5 years are spent finding new investment opportunities, with the latter 5 years serving as “the monitoring or harvesting period,” which consists of exits such as going public or selling to a strategic investor. In other words, entrepreneurs that get in early have “a longer runway” to create value.  

Leykum said CSL and executives of its portfolio companies begin collaborating on exit planning in the second or third year. He said CSL has had only one instance in its history where a CEO disagreed with a decision to pursue an exit.

“It was in a market where, when we underwrote the investment, 2 years later the market had changed significantly for that specific consumable used in the completions process,” he said. “And it was a situation where we had a prospective buyer that came out of nowhere and was willing to give us a very nice, profitable, attractive” internal rate of return. He said the CEO later looked back at the situation and was thankful they had decided to exit when they did.

Entrepreneurs should perform their due diligence on an investor in the same way an investor thoroughly vets the companies they plan to back, Ebert said. He noted that Altira-backed firm Agile Upstream went so far as to search for unsuccessful Altira legacy companies and their former CEOs on LinkedIn.

Ebert advises entrepreneurs who are considering starting a company and partnering with an early adopter or strategic partner to never sign a right of first refusal with a service com­pany that enables it to either invest or block an exit. “And if you do that with Big Red or that ilk, they effectively own your company, and I’m always surprised at how common that is,” he said. “We’re dealing with a situation like that right now, and it’s so disheartening to the entrepreneurs.”

When teaming with an operator or service company, Ebert suggests the startup have an employee “fully embedded within that organization” because they have a better understanding of the technology, they are in front of the customer, and they can work to drive adoption and uptake.