Datasite recently spoke with Sam Merlin, Partner at Hannam & Partners, to hear his thoughts and insights on the energy sector and what lies ahead for the market and dealmaking.
Hannam & Partners is a leading independent investment bank with expertise across the energy, mining, and financial services sectors. Owned by its partners, Hannam & Partners has a proven track record and is known for its honest advice and technical ability to manage complex situations.
The war in Ukraine has created huge disruption in the energy and the oil sector. What are the forces affecting the industry? And how will this impact M&A?
Sam Merlin (SM): The first is capital availability, for a variety of reasons. For instance, there’s ESG pressure on some companies fundamentally pulling out of investing in oil and gas specifically, or having limited scope, or just higher criteria in terms of what they can and can’t invest in. So, with less capital for oil and gas, the deals that need capital are obviously more competitive. Generally, for larger deals it’s easier, and for smaller deals it’s harder, but there is a similar volume of opportunity chasing an increasingly smaller pool of capital. So, that’s pretty important and fundamental.
The second force at play is ultimately tied a bit to Ukraine. It’s just inflation and general costs. Currencies are going down, and inflation is going up.
And this impacts the renewable side, arguably even more than oil and gas. If you had a borrowing base that was ‘X’% over LIBOR, that margin used to be zero, or pretty close to zero or 1%. So, whatever your total interest cost was last year, it likely has just doubled as the base rate, whether LIBOR, SOFR, etc. are all moving towards the 6% range. This means your interest is higher, which has or will suppress equity returns.
For a lot of renewables projects, where you had single-digit equity return, your equity is getting very compressed right now. That means people’s ability to be transacting at the prices and volumes they have been, particularly in the renewables space, is going to be harder. So, either sale prices have to come down or the cost of debt has to go down, and right now the cost of debt is going up and banks are continuing to raise rates every quarter.
On the oil and gas side, it’s a bit of the inverse as for those who are lending or investing it’s the best time in the world because your money is scarce and limited – you can command significant returns and structure products on the deals that you’re doing. Because there is less capital in the system and the cost of debt is going up, it means that those investing in oil and gas right now are in a position to be making almost equity-like returns for a debt-like investment.
Renewables deals came to the fore last year: three of the five biggest EMEA energy deals in H1 2022 were in the renewables sector. Should we expect to see more activity in this sphere going forward, even in light of your comments on the compression of sale price?
SM: 100% yes. There are two trends at play, the first is corporates increasing their activity in this area because they have multiple value levers. It’s not just a financial investor buying a business and making a financial return. It’s BP who bought a renewable natural gas business in the US at 28x LTM EBITDA, which on the face of it sounds a bit crazy, but they have existing gas infrastructure, a trading business, and all the value that comes with that which no one else in the market can. BP’s view is: we can afford to pay that because we have value that no one else can realize. And the blessing and curse for a lot of these integrated oil and gas companies who are now allocating money into renewables is that they’re generating cash hand over fist. That makes it a heck of a lot easier to be investing that into renewables because they’ve got piles of cash they have to put it to work. So, these corporates have a lot of cash and should be able to realize value that no one else is going to – I think the integrated energy companies are going to be big buyers.
On the other end, you have funds, who’ve raised unprecedented amounts of money. Brookfield, I believe raised $18 billion in their climate infrastructure fund. EQT raised somewhere around $15-16 billion. Macquarie closed at $8 or 9 billion. All of these funds are targeting infra-like returns and just between these three you have c. $40 billion of capital purely for climate and infrastructure investments. Where are you going to put that? They’ll find opportunities to invest the capital, so by default, it means bigger deals are going to have to happen, whether it’s take-privates, or whether it’s EIG buying 25% of Repsol, or ENI spinning out their whole renewables division. These are $5+ billion deals where buyers need to transact, so I think the very large end of that deal spectrum will continue even despite the headwinds flagged earlier.
Do you see any contagion between big names joining up on deals or do they want to exist exclusively in those larger transactions themselves?
SM: I think it’ll be similar to what we’ve seen in oil and gas deals historically and currently with large-scale wind and solar, where a party will do a deal themselves and then look to de-risk or leverage post-deal. We saw this with offshore wind assets in New York (and all across the Nordics and UK) where Equinor went in, won the licenses, did some work, and sold down a stake to BP. No one really ever owns 100% of a project, even if it’s the best project in the world because no one wants binary risk. It’s always good to share it a little bit. So, I think you’ll continue to see a lot of 100% deals and a growing secondary market to trade into each other’s assets. We’ll see a lot of this in offshore wind and in hydrogen because you’ll just have natural reasons why you want other parties in those assets, not to mention the costs associated can be quite large.
As mentioned earlier, there’s an increased focus on ESG. How are you seeing this impact your sector specifically and how do you pivot as a firm in terms of giving advice as that landscape changes?
SM: Good question. A lot of oil and gas companies now have corporate mandates and requirements on reporting what their carbon footprints are and what their plans are to reduce those emissions. Pretty much everyone’s doing it. The variability is really high. Does it mean anything? I think a lot of that is debatable, as while some is high quality but a lot is just lip service. What is demonstrable is a lot of the oil and gas companies are starting to get their debt and financing instruments linked to cutting their carbon emissions. We’ve seen a lot of loan instruments where, if you can show you’re cutting your emissions year on year, you get savings on your interest. That will incentivize someone to do something – why pay more interest if you can lower it?
You’re also seeing companies being more proactive in terms of the projects that they do to offset their carbon emissions, with localized, nature-based solutions and carbon capture and storage (CCS) projects. For instance, these projects can have strong environmental and positive community impact, but you also get the carbon credits that go with it. For CCS, as there is a cost for having emissions, you’re seeing a lot of companies integrate their projects with multi-pronged carbon strategies. So, not only are you seeing some of the financial instruments starting to push and incentivize people to change, but you’re seeing the companies do it themselves. Because if “I” can spend money here, and save money at the same time, all while having a net positive environmental impact, that’s all real and positive.
I think you see it as well in terms of the strategies of where companies are moving. Are they going to go the Shell and BP route and become broader “energy” companies, owning globally significant renewable power assets? They’re all doing it differently. Some of the Europeans are going more power-focused, Chevron is going more biofuels, hydrogen, and CCS-focused. They’re finding niches where they have the know-how and the infrastructure to deliver results and make money. Knowing there is a finite life for oil and gas – you can’t create what doesn’t exist, so once it’s not there anymore your business has to continue to pivot and grow.
Chevron has done probably one of the best jobs of it. They’ve made multibillion-dollar investments across the value chain plus significant investments in R&D and clime tech. They’ve led one of the largest hydrogen projects in the US. They’re now one of the largest biofuel producers in the US. So, really across the value chain, you see some of those singles and doubles, to use a baseball term, and you also see bigger investments and kind of money driving what some of the oil and gas companies are doing in that space.
What’s your short- and medium-term outlook going into next year?
SM: It’s a very high-risk environment. People aren’t feeling good about the world. It’s a bear market, as you have a lot of uncertainty. You have all of the Russia-related macro themes from the extreme end (war and military escalation) through to the practical end (grain and food shortages, cost inflation, and a country-wide diaspora). Governments are underwriting (to a massive extent) energy bills and trying to subsidize in a rising rate environment where these governments are having to take on more borrowing or increase the tax rate to pay for the spending.
A lot of these macro forces are negative and are risks to a different degree, which all makes everyone a little bit jittery.
You don’t really see a lot of good news on the horizon to give people comfort and stability. And banks have said they’re going to continue to raise rates 25bps each quarter going forward. So, the next year doesn’t look particularly positive from a macro bit.
What that means from an opportunity perspective is those who are in the structured and mezzanine lending game are as happy as they could possibly be. Traditional lending banks are going to be closed and risk-off – they’re just not going to lend money, it’s too volatile. Why commit to something when you can just wait? And the mezzanine lenders will say, “Great, I’ll take that risk. We’ll price it into our facility and we’d be happy to lend to you at an attractive price!”. So, I think that that continues quite strongly.
This ultimately means public markets are more likely to be closed than open. When there’s a lot of risk and volatility, it makes it harder for these investors to get comfortable with price. We did see an IPO in the oil and gas space get off last week in Ithaca Energy, which while it priced at the bottom of the range, it still priced and raised capital no one else has been able to do in a long time. That’s really impressive. And they did it in mid-November. So, really good on them.
For the next year, I think public market activity is going to be limited. It’s going to be a lot of private acquisitions. It’ll be more structured, private credit. I think the big deals that we spoke about earlier will continue because they’re bigger than the macro at the moment. They’re kind of ‘10-year’ long-term visions
Even for some of the private equity funds that have money, it becomes a potential “take private” opportunity for the markets. If the markets remain pressed for either access or liquidity, it becomes a very good buying opportunity for private equity to say “thank you, please!”, we’ll kindly take you private, as what’s the alternative? Do you want to put more money in? Probably not if there’s a cash bid on the table.
We are seeing the highest amount of cash redemptions right now from investors since the financial crisis. So, you’re going to see activity, but in a much different way. It’s not going to be traditional senior debt and public market M&A and ECM activity. I think it’s a much more structured credit environment with take privates and private equity deals. You don’t need to be value sensitive. Growth businesses and tech businesses will struggle because of the need for money, when there’s not a lot of that kind of equity capital out there right now. Businesses that are generating revenue and EBITDA are going to be the ones where people focus on the money that’s in the system.
Sam Merlin spoke with Frazer Campbell, Datasite. Datasite is a leading SaaS provider for the M&A industry, empowering M&A professionals around the world with the tools they need to succeed across the entire deal lifecycle. For more information, visit www.datasite.com.