There is a tide in the affairs of men.
Which, taken at the flood, leads on to fortune;
Omitted, all the voyage of their life
Seth Klarman Tells His Investors: Central Banks Are Treating Investors Like “Foolish Children”
"Surreal doesn't even begin to describe this moment," Seth Klarman noted in his second-quarter letter to the Baupost Group investors. Commenting on the market developments over the past six months, the value investor stated that events, which would typically occur over an extended time frame, had been compressed into just a few months. He noted Read More
Is bound in shallows and in miseries.
On such a full sea are we now afloat,
And we must take the current when it serves,
Or lose our ventures.
Being a contrarian means you drink upstream from the proverbial herd.
Buying what is out of favor, hammered down in price … emotionally tough to do.
But how low is too low?
Buying something because it is cheap relative to all-time highs in no way implies it cannot go lower.
Of course the rewards for getting in at historic lows AND holding tight through the inevitable ups and downs, is usually enough to make the hardest man quake, can be EPIC.
Take the most recent boom/bust cycle in Energy.
I have used Range Resources, an Oil and Gas E&P company as an example.
(I have never held an interest in the company).
Distressed Energy Investment
A super human feat, BUT had one bought and held from 2000 to 2008 they would have achieved an 8,000% return;
From 2000 to the fated top of 2014 +10,141%.
How can such spectacular gains be achieved by said company?
Only 2 ways really:
- An increase in the price: earnings ratio – the amount investors are willing to pay for a $1 of earnings. This is more a symptom of sentiment and emotion, and higher prices tend to spur the animal spirits which cajole investors to pay yet ever higher multiples.
But 1 is not really controllable by the company. So instead companies focus on:
- Increase the ‘E’.Increasing earnings can be achieved through higher revenues and /or higher margins.
The beauty of a boom cycle is the ability for a company to ‘acquire’ revenues and earnings through M&A.
Gorging on Debt
As animal spirits ignite, a company’s access to cheap liquor, aka. Debt, increases exponentially.
Thus leading us to the main cause of boom / bust cycles – cheap credit.
Take a look at how two other Resources co.’s increased their liabilities from 2008 onwards to fuel M&A! (I have no economic interest in either of these).
When the punch bowl is removed … in this case a supply glut leading to lower Energy prices … it leads to the inevitable bust.
And when it comes to picking up the pieces and buying distressed assets away from public equities, here are 3 rules we abide by:
1. WAIT AT LEAST 2 YEARS AFTER THE EQUITY MARKET MELTDOWN
Public markets are emotional beasts. Oscillating at the whims of human emotions. Thus, stock prices adjust rapidly and in many cases long before the enterprise’s economics change.
So anyone looking for distressed energy purchases should know that it would take at least 2 years for hedges to roll off, offtake agreements to expire and debt maturity walls to be breached.
Thus those lip smacking bargains won’t emerge until management are FORCED to sell them and a public market dislocation often lead to a private market dislocation by up to 2 years. [Think about the 2007-2010 real estate bust]
Thus the dislocation in energy that began mid-2014 may finally be mature enough for debt gorged E&P companies to start getting REAL … which is why we focused our scouting talents on that great country we call Texas to see what bargains may be found.
2. The TEAM is the Most Important Element in a Distressed Investment
(Names changed to protect the innocent)
It’s the right team you need to find!
The assets are selling cheap already.
But the team has to have the pedigree, the know-how, the access and the awareness of where the bodies are buried so to speak.
The magic occurs when excellent stewards of capital meet world class operators which happen more readily when the music stops and the actors get reshuffled based on talent.
Such has occurred on the Riverdale / Halcyon deal.
The business end is handled by Kim John and Thomas Peabody.
- Both gentleman, with decades of experience as investors, structuring transactions in the upstream energy industry.
- More specifically at Big Alternatives – a large hedge fund.
Supported on the operations end by a capable team of veterans:
- Geoffrey Hide – CEO -25 year’s upstream energy experience. Served as CEO of publicly traded Destin Resource. Built teams of experienced industry veterans and has worked to locate and finance non-marketed transactions across Texas, Louisiana and Oklahoma.
- Rick Regal – 35 years engineering experience overseen assets in Bakken Shale, Woodford Shale, Eagle Ford and Onshore Gulf Coast … U of T.
- Anhauser Miller – 25 years’ experience upstream operations. Worked at Koppies Corp. for 14 years during which the company experienced exponential growth in production and reserves and became one of the largest privately held E&P companies in USA. And my favorite about Anhauser … an AVID Rugby Player at Life College.
[yeah – ok that’s an Oil Pump not a Gas Well – but a great pic nonetheless along my travels in the Eagle Ford]
Bonsai Inc. was one such listed entity which owned as non-core (read as neglected), the non-contiguous rights to an 8,000 acre Gas field in the Eagle Ford basin in South Texas.
( Anecdote: Driving in South Texas was the first time I saw jumbo sized car lots filled with Border control vehicles yikes!!)
Originally, vertically drilled out by BP in the 1980s these Giant Producing fields had been flipped a few times and were on their last Cigar puffs so to speak.
Producing approximately 9.0 mmcfe/d, the fields contained 111 wellbores with greater than 12 year remaining reserves.
65 Wells were non-operating and had been shut in due to no basic maintenance. Bonsai’s MO was if it’s producing – good leave it alone, if it’s a problem shut it down, no CAPEX.
3. Know the Entry, Value Add, Exit Strategy BEFORE You Invest
The best way to explain this would be to think about flipping a fixer-upper house.
- Buy on the cheap:
- Purchase Price is $25m
- EBITDA before improvements is $4.5mm per year
- So purchase price ~ 5x Cash Flow.From a historical perspective this implies that the valuation is for PDP (proved, developed and producing) reserves only and does not include any probable undeveloped reserves a refreshing change from boom times of 2013/14.
- Hedge at least 85% of current production to lock in prices and reduce commodity price risk.
- Locking in a margin of ~$2.30/Mcf profit at close.
- Identify recompletion and workover projects to increase production without drilling any new wells.This is where your operations team makes a HUGE difference. In this instance the well logs were so extensive they almost filled up a Semi trailer … a treasure trove of information that will help identify and prioritize remediation projects:
- Soap Jobs – pump soap into wellbore at specific levels to unclog pores;
- Changing chokes;
- Acid jobs;
- Replace gathering and filtering system with cheaper membrane units (used to sweeten the Gas – remove Sulphur);
- Optimize compression;
- Swap non-producing wells with nearby driller to create contiguous field.
- Double monthly cash flow from increased production within 12 months
- Use cash flow to pay down senior secured debt as quickly as possible.
- Exit to a strategic buyer 12 – 18 months after PDP remediation projects
Preferred Equity Economics
Suffice to say this section is proprietary so we won’t go into great detail … plus it may be boring.
But the point remains, buying a distressed asset ‘right’ provides the opportunity to make multiples of your capital within 1+ years.
So much for the efficient market hypothesis!
So how do you find these opportunities?
Well that’s why we should be talking ……
Thank you for reading my post. I regularly write about private market opportunities and trends. If you would like to read my regular posts feel free to also connect on LinkedIn, Twitter or via Atlanta Capital Group Investment Management.
Nothing in this article should be interpreted as a recommendation to buy any security. Please conduct your own due diligence.
Greg Silberman is the Chief Investment Officer of Atlanta Capital Group Investment Management [ACGIM]. Atlanta Capital Group Investment Management specializes in creating custom private market solutions for RIA/Family Office clients.
Advisory Services offered through Atlanta Capital Group Investment Management.