Energy 'Capitulation' Will Hit in 6 to 12 Months -- Intervale Capital's Cherington
What does Intervale Capital, a private equity firm based in Cambridge, Mass., know about oilfield services?
Quite a lot, it seems, having invested in everything from drill bits to completion tools. With the advent of hydraulic fracturing, oilfield services has become more of a manufacturing business, and Intervale managing partner Charles Cherington has experience with that.
Before co-founding the firm in 2006, the University of Chicago-trained private equity executive ran two smaller funds, Paratus Capital Management and Cherington Capital, which were focused on small buyouts in manufacturing as well as in transportation and energy (including electronic sensor maker Oeco Holdings, which was sold to Danaher (DHR) - Get Report in 2003 and is now part of Meggitt (MEGGF) ).
But oilfield services is pretty much all Intervale does now, and it's currently investing out of its third fund, which closed in February of last year at $495 million, surpassing its $400 million target and bringing its total funds raised to $1.3 billion.
Despite the downturn in oil prices, Intervale has been quite active, making add-on purchases for portfolio companies Team Oil Tools, Tier 1 and Recapture Solutions, investing in oil and gas explorer Bayou City Energy and turbine maker FlexEnergy and buying a stake in drilling and production waste hauler American Disposal Services.
Last fall, as oil prices began swooning, it managed to sell its stake in Scottish offshore oil and gas services provider Proserv to Riverstone Holdings for what analysts thought was a tidy $750 million ($400 million to $500 million of which went to the firm, the rest to co-investor Weatherford International (WFT) - Get Report ).
Its other portfolio companies include Aegis Chemical Solutions, Allied Oil & Gas Services, Antelope Oil Tool, Benchmark Completions, Certus Energy Solutions, Energes Oilfield Solutions, Epic Lift Systems, Torcsill Foundations, TRF Energy Solutions, FCG Chemical and Soane Mining.
The 52-year-old Cherington, who lives in Cambridge with his wife and three sons, recently spoke with The Deal's Claire Poole about how his portfolio companies are faring and where they and the industry go from here.
The Deal: Intervale has been quite active recently, with your portfolio companies making acquisitions and your firm backing new management teams and even making acquisitions. What are you seeing in the marketplace in this environment of lower oil prices?
Cherington: We did some deals last year before the Saudis' fateful decision not to cut production, but we're not doing anything now on a platform basis. We don't think things will turn around until 2017. Maybe in midstream, but the core completions and drilling business is in terrible shape right now. Cash flows will be negative in the next year and a half and it's hard for buyers and sellers to agree on price.
It's hard for sellers to realize it's not 2014 anymore. You want to invest in the ninth inning, when there's a brighter cash flow horizon. There's been lots of looking but very little investment, which is true of our peers as well.
The Deal: You did have some exits before oil prices fell -- the sale of Proserv to Riverstone and the 2012 sales of Ulterra Drilling to Esco for $325 million and Casedhole Solutions to C&J Energy Services for $272 million. What would you say was your biggest success?
Cherington: All three of those deals had great outcomes for our investors. Proserv was a longer hold, eight years, as it started out as a much smaller company, whereas Casedhole and Ulterra were three- and four-year holds. We were able to work through the cycle and both generated excellent returns on money. What's significant, we managed all three through the downturn, at the bottom of the cycle, which didn't look great.
You have to be cognizant of the fact that it's a cyclical industry, you have to manage through the cycle and you have to have adequate capital and not overpay.
The Deal: What are you doing now with some of your portfolio companies given the difficult market? Did your firms get squeezed like the rest of the industry?
Cherington: There will be consolidation and severe cost cuts, but we think we should remain cash flow positive. Rig counts have dropped 60%, pricing on average has dropped 25% and 40% of the market has left. The markets have been extinguished for everybody. It will take a long time for companies to merge or die.
U.S. production has started to decline, and when it declines enough, you'll start to see a recovery, which will probably take another year at least. There's more pain to come, so you have to be more disciplined about cost and management and have the liquidity to grow when activity increases again.
People are very bleak at the moment. Every cycle turns, but what makes this one different is the rate at which production is declining -- it's higher than it's ever been before. We're setting the stage for the next major upcycle. It's hard to imagine that when you're in utter misery and starvation. But when it comes, it will be an upcycle that has a huge call on U.S. oil in particular, as we're the only country that can produce 4 million more barrels per day over a decade.
We've become the new Saudi Arabia, the new swing producer.
The Deal: Will your companies be alive?
Cherington: Yes they will. We're well capitalized; we can withstand a downturn of years. We've done it in the past.
The Deal: Tell me about Team Oil Tools, which has been doing add-ons recently.
Cherington: We've owned it for seven years and it's performing much better than the market. It's captured market share, has a bunch of new patented products and is focused on completion products and services. If you can help people complete wells more effectively, they'll give you more business in a down market.
The Deal: Tell me about your investment in Bayou City. What's your play there?
Cherington: There's always been an opportunity for a private equity firm focused on oilfield services to collaborate with an E&P [exploration and production] fund. We're looking at a lot of oilfield services companies and not investing. But in E&P, there are great opportunities right now to buy discounted assets.
There's an embarrassment of riches. Borrowing bases will get re-determined, which will affect loan facilities. Hedges will fall off next year that were bought at a higher basis and companies will be forced to sell assets by banks and financial players needing to exit. That will continue for a year and a half.
The Deal: Tell me about FlexEnergy. What's the thesis there?
Cherington: FlexEnergy does micro turbines. These are engineered turbines with a technology out of Ingersoll Rand (IR) - Get Report that cost it $200 million to develop. They are extremely reliable and low noise and burn gas from the wellhead for distributed power, or small onsite generation capacity, 250 kilowatts to 5 megawatts. They require very little maintenance and love the cold, so they're good in places like Canada.
It's been a great solution in the Bakken shale, taking flare gas and generating power for pump jacks. It saves money because operators don't have to invest in hookups.
They're in the manufacturing and leasing business and looking at doing business in North America and the rest of the world. But they're more focused on the distributed power market, which is not correlated with the cycle and growing very rapidly as people get away from centralized power. There are lots of places around the world that don't have grid reliability.
The Deal: Are any of your companies at risk of restructuring?
Cherington: There will be injections of capital into companies that have bank lines. We're working with lenders and we've been able to get restructured credit facilities across all three portfolios. We have a lot of dry powder.
The Deal: So you're putting more money into them?
Cherington: In some cases, yes. For those with more exposure to the cycle, it's hard to hide. It's likely that half of our companies will need more capital support.
The Deal: Has competition become more fierce for investments with all the private equity money out there?
Cherington: There is more competition but I wouldn't characterize it as fierce. It's still small companies around the world that operate in oilfield services. It's such a vast universe, so even with the growing number of companies in the space, our deal flow is primarily proprietary.
The Deal: Where do you think oil prices are headed?
Cherington: No idea. I have a policy of not making predictions. All I can guarantee you is that I will be wrong.
It's not that just too much is being produced, but inventories are higher than normal. Once those ease, then you'll see movement.
There's a huge lag effect in these cycles. By 2018, we'll be undersupplied because current processes will have stifled spending so much that there's not enough oil. It's been that way 105 years.
The Deal: Except for a few large deals and some asset sales, the oil and gas deal-making business has been pretty slow. Under what conditions do you think it will pick up?
Cherington: There will be a lot of asset sales from Halliburton (HAL) - Get Report -Baker Hughes (BHI) and some from Cameron (CAM) -Schlumberger (SLB) - Get Report . In the smaller market, there's a ton of deal flow right now, with smaller companies that operate in one or two basins and a founder who has been through several downturns before and can't stomach another one, including letting good people go. You have people putting up the white flag. We could merge them into one of our portfolio companies.
Bigger companies are capitulating, and it will take another six to 12 months of cash burn on their part before they're ready to negotiate to sell, which will be a late downturn game. There will be fatigue, and when it starts to get really old, and they'll be motivated to get deals done. We're not there yet.
The Deal: Will we see more investments from your firm before the end of the year?
Cherington: Probably not on the platform side. We'll continue to look at add-ons and deals in the production space, if they arise, which are less cyclical. We feel we're getting paid today for not investing too early in the down market. The later you invest, the better you do.