Private Equity

4 Introduction to Private Equity in the Energy Industry Private equity funds are pools of institutional money (from sources such as endowments, pension plans, foundations, and high net worth individuals) that typically invest in privately owned businesses. Some private equity funds target underperforming businesses and look for turnaround opportunities while others focus on backing top management teams who can build and grow a business from the ground up. Private equity firms have raised more than $200 billion for energy investments since 2014, including at least $50 billion specifically for investments in shale drillers, 1 leading to a significant presence of private equity-backed companies on the buyer and seller sides of oil and gas transactions. If a counterparty in an acquisition transaction understands the private equity fund structure, business model, and strategic goals, it can more effectively negotiate a transaction that meets the needs of both parties. The manager of a private equity fund (generally the general partner of the fund) is paid both a management fee from the institutional investors and a carried interest after certain investment returns are met. The investment returns at the private equity fund level generally require a specified internal rate of return to have been generated on the institutional money prior to the carried interest being paid to the general partner. In the oil and gas industry, the portfolio company structure is a common investment structure for a private equity fund. In this structure, the private equity fund invests equity capital in an entity jointly owned by the private equity fund and a team of experienced industry professionals (the management team). This jointly owned entity is called the portfolio company. The management team usually makes an equity commitment that is personally meaningful to them but a small portion (typically 1% - 10%) of the equity commitment of the private equity fund. The management team is generally compensated by the portfolio company in the form of a modest salary and bonus (modest when compared to the salary, bonus, stock incentive plans, severance arrangements, and other benefits provided to public company executives) and further incentivized by an equity incentive interest known as a "carried interest" or "profits interest." This incentive interest is paid to the management team out of the net proceeds of the portfolio company after the capital members (i.e., the private equity fund and the management team with respect to their capital) earn certain investment returns, called the "waterfall." 2 The investment returns require a certain internal rate of return or a certain return on investment, or a combination of an internal rate of return and a return on investment. An internal rate of return represents the average annual return generated by an investment. A return on investment is simply a multiple of the invested capital. Time matters when calculating an internal rate of return but not when calculating a Sarah E. McLean, "Considerations for Oil and Gas Transactions Involving Private Equity-Backed Buyers and Sellers," 65 Rocky Mt. Min. L. Inst. 6-1 (2019). 1 Collin Eaton, "Private Equity Poised for Oil Growth as Public Companies Pull Back," Houston Chronicle (Mar. 30, 2018). 2 Although certain private equity portfolio company structures do not include the management team paying part of the incentive interest with their equity, in the author's experience that is a less common structure. This can be an important feature, among many other important terms, on which a management team should focus when the team is comparing term sheets and waterfalls from multiple private equity funds. Oftentimes, the comparison is not "apples to apples" because of the various approaches taken by different private equity funds.

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