EnCap, After All These Years

Leslie Haines, Oil and Gas Investor

EnCap Investments celebrates its 20th anniversary this year, having funded 158 start-up and early-stage energy companies, and helping to create the energy private-equity model along the way.

Last December, EnCap Investments LP closed its 13th oil and gas investment fund with capital commitments of $2.5 billion from 150 institutions—many of them repeat investors. At the time, it was the largest fund ever raised with an upstream E&P focus, and it was At press time, EnCap had already committed $1.5 billion oversubscribed. of Fund VII to 18 portfolio companies—eight are led by management teams that EnCap backed previously.

A baker’s dozen of funds is good luck, for this year marks the Houston- and Dallas-based company’s 20th anniversary. Through two decades, EnCap has closed institutional funds aggregating $6.5 billion, backing 158 companies with growth capital and strategic support. Two-thirds of those investments, and 11 funds, are “essentially fully realized” with the results consistently exceeding the funds’ return targets.

The four founding partners run the firm collectively. Each helps raise money, each is actively involved (along with the 16-person investment staff), in looking for and evaluating new companies to back, and each helps manage the organization. David B. Miller, Gary R. Petersen, D. Martin (Marty) Phillips and Robert L. (Bob) Zorich have known each other for about 35 years. The quartet worked together in the energy-lending department at the old RepublicBank Dallas during the 1970s. Miller, Zorich and Petersen left the bank to get into the oil and gas business in 1980, and then they got back together in 1988 to form EnCap.

Perhaps their most serious disagreements are in football season. Phillips is quite happy to point out that his alma mater, Louisiana State University, has been the reigning BCS football champion twice in recent years. Miller is a Mustang from Southern Methodist University and Petersen is a Texas Tech Red Raider. Zorich, on the other hand, graduated from the University of California at Santa Barbara. All four have advanced degrees as well.

EnCap is one of two or three firms that, in the 1980s, invented the business model of aggregating private equity from institutional investors to back early-stage E&P companies. That model has gained wide acceptance.

In 2008 the firm will broaden its horizons, as it is raising its first midstream-dedicated fund. It is partnering with Flatrock Energy Advisors LLC, a San Antonio-based midstream-consulting firm, with the latter winding down its advisory business to manage the new fund once it is closed later this year.

Still loyal friends after knowing each other for 35 years, the EnCap partners almost finish each other’s sentences. Oil and Gas Investor met with them recently to learn about what’s new and what’s changed.

Investor After 20 years together, what’s new at EnCap?
Miller I think I can speak for all of us when I say it’s hard to believe it’s been two decades.
Phillips Probably, the most significant event recently is we’ve initiated the marketing process for EnCap Energy Infrastructure Fund I, which will be a $750-million to $1- billion fund targeting midstream investments.
Management of this fund will actually be conducted in a partnership between EnCap and Flatrock Energy Advisors, a group of midstream experts out of San Antonio and Oklahoma City.

Investor Why the midstream push at this time? You’ve made a few midstream investments before.
Phillips We think the midstream space complements our upstream activities and it’s a sector where we have had success historically, albeit on a limited scale. The limitation frankly has been that we just haven’t had the human or capital resources to dedicate to the space, given the level of activity in our historic core business. That’s why we are so excited about the association with Flatrock. This partnership allows us ­­to take advantage of Flatrock’s contacts, expertise and experience in the midstream. At the same time, we will be in a position to contribute on the risk-management, capital-markets and strategy fronts without diluting our dedication to the upstream market.
Petersen Flatrock is led by three partners, Billy Lemmons, Bill Waldrip and Dennis Jaggi, who each have more than 30 years experience in the midstream. Flatrock has been in the advisory and consulting business for the past eight years, but they will discontinue that business and dedicate their entire organization to EnCap Energy Infrastructure Fund.
­­Zorich This broadens our business substantially. We’ve had great success historically in the upstream but the contact base in midstream is different and it has nuances that the Flatrock people know better than we do.
And those guys believe, like we do, in the fundamentals and bottoms-up evaluation. They each have incredible direct experience in the midstream, so we think this will be unique in the business, combining their knowledge with our upstream deal flow and fund-raising ability.
Phillips We also think Flatrock is a good cultural fit with EnCap.

Investor Were your institutional clients asking for more midstream ideas?
Zorich There has been a demand from them after we told them we’re doing this. Response so far has been very positive.
Miller They all buy into the concept that, with all the drilling in resource plays, there will be tremendous infrastructure needs. We think the risk-reward equation in the midstream space will be very similar to the upstream, which is also compelling.

Investor Have you looked seriously at funding any alternative-energy ideas?
Petersen No. Wind and other alternatives—those are still somewhat unproven. Upstream and midstream is probably where we’ll remain focused. After all, that is our background.
Zorich Of course, we’ve looked at the economics of that and at international ideas, as any person would. The economic opportunities in alternative energy are not as attractive to many outside of the public market.

Investor What has changed in the days since you formed EnCap?
Zorich If you compare and contrast Day One with 20 years later, it’s our reputation in the business. Twenty years ago, no one knew us when we made a phone call. The phone calls are different today.
Miller We’ve built a real franchise over the past two decades. EnCap’s track record now spans 13 funds, and we can demonstrate to the institutional community that we’ve been able to generate attractive returns across multiple cycles in the industry.
Petersen Twenty years ago we were just trying to pay the rent!
Miller In 20 years, we’ve seen evolved thinking on both sides of the table. The institutional community has had more experience and investment success in oil and gas. The other side of the equation is that the energy industry itself has embraced the private-equity model. Twenty years ago, the term “private equity” didn’t exist.
Phillips Twenty years ago when large independents merged, the corporate leaders would typically seek executive roles in the merged entity or other, similar independents. Today their options are broader, and if they have an entrepreneurial bent they will explore starting a new company with private equity.

Investor And how has EnCap’s strategy changed?
Miller In the beginning, we had three mezzanine funds, and three reserve-acquisition funds in partnership with Frank Pitts (of Pitts Oil Co. in Dallas), until about the mid-90s. But in 1994 or 1995 we transitioned into private equity, because we felt that it had diversified risk and better aligned our interest with the management of our portfolio companies. The past seven funds, representing about 90% of the capital we have deployed, have been private equity.
Petersen With other competitors, we actually helped create the private-equity market. Many of these E&P companies opt to go with private equity now and that whole arena is increasing in size.
Miller Early on, we did a lot of project financing. Today, it is always about building a company where we’re involved in and exposed to everything the management team is doing.
Petersen Our mezzanine funds and the first two private-equity funds were project-oriented. But private equity funds III through VII were corporate-oriented.

Investor What was the most unusual deal you’ve done?
Zorich Well, they all start out normal. (Everyone laughs.) Then the market changes or some other external factor comes along.
The latest example is companies that have anything in the Haynesville shale have done unusually well almost overnight. I don’t think we’ve ever seen anything like this. It’s like just 10 limited-production-data points have created tons of nonproducing acreage value. I did a simple calculation. If you have 100 miles by 100 miles of Haynesville shale acreage and you paid $30,000 per acre, that’s $200 billion of acreage!
Petersen One thing we like to cite is Plains All American Pipeline. We found the pipeline deal for Greg (Armstrong, chief executive and chairman) and it helped him transition to what Plains All American is today. Before that, he was E&P and we had invested in him. Now it’s a $10-billion company.
Phillips We have backed 158 companies and 106 of those have gone full cycle—that is, we organized and capitalized the start-up company, agreed on a strategy with the management, executed on that strategy and built the asset base, and then exited, typically with a sale (as opposed to an IPO, which EnCap has done on a few occasions). The institutions have watched this model succeed for a number of years.

Investor You must have it down to a science.
Zorich Yes, but every deal is customized to fit the needs and experience of the management teams and be appropriate for their level of expertise. We have 50 management teams out there operating currently and they are geographically dispersed and “maturity dispersed.” By that, I mean some are just starting out this year and some are finishing up today and will then repeat the cycle.

Investor You have a lot of repeat teams.
Zorich About 50% of our business is repeat business. With whom would you rather do business than guys you made money with yesterday? These teams are the bricks in EnCap’s foundation.
Miller We are backing Laredo Energy for the fifth time, Plantation Petroleum for the fourth time, George Solich at Cordillera Energy for the third time, and Bob Boswell at Laramie Energy for the second time.

Investor Why start a company five times—why don’t they go longer and get bigger?
Zorich It’s risk management. If you can sell your assets for a risk-adjusted value that is bigger than you think it should be, then you sell.
These E&P companies that we back create opportunity sets for the larger public companies that aren’t as agile as they are. These larger asset sets require more capital and more time to develop than they have, but those assets end up being great opportunities for the public buyers. Look at what Chesapeake Energy has been able to do with those Lobo assets in South Texas that it bought from Laredo Energy—twice.

Investor How have E&P start-ups changed in the past 20 years?
Petersen They are more oriented to developing resource plays now. They used to all pursue the acquire-and-exploit business model.
Miller Another thing is, today we are typically making $100-million-plus equity commitments to these start-ups, so we are looking for guys who can build a $500-million to $1-billion enterprise over a three- to five-year time horizon. That takes vision and a high level of energy.
Phillips We’ve really been privileged to work with some incredibly capable and driven management teams over the years.

Investor What advice do you give the start-ups who are new clients?
Zorich We try to listen first. If we think it is appropriate to provide advice, it would be in the area of risk management. But we give the benefit of the doubt to each other and to our portfolio companies’ ideas. We learn something every day. At 30, we thought we knew everything.
Phillips To the extent we’ve had experience in a specific area or situation, we try to give our management teams the benefit of that. I think at times we can really contribute to the value-creation equation, both with respect to managing certain risks and maximizing value at exit.

Investor Did you ever think you’d be raising a $2.5-billion fund someday?
Zorich We never dreamed we’d see $100 oil!
Petersen It’s been fun. When we hire a new person, we tell them that we intend to have fun.

Investor How do you all manage to get along?
Petersen We are friends. Each of us has a different personality, but we’ve made it work.
Zorich If it is not based on mutual respect, it’s not going to work.
Miller Going all the way back to our time together at the bank, we have all four been intense and ferociously competitive, but not against each other. EnCap is a partnership, and no one person is the king here. Over 35 years, we’ve developed a very strong sense of loyalty to each other.
Phillips We’ve all learned that you can’t take yourself too seriously. Lots of times your partners are right. We’ve seen success with a number of different approaches.
Miller We all still enjoy doing deals. The landscape and opportunity set changes all the time, and our institutional partners pay us to find attractive investment opportunities in an ever-evolving market.