As commercial banks and Wall Street grew cautious about the oil and gas industry in the last few years, private equity investors played a big role in jump-starting new exploration companies. Naturally they want to apply the most effective strategies of corporate leadership and direction in order to optimize their investment. Their strategies may vary significantly as they reflect the differing outlooks of the specific investors and their ultimate intentions for the portfolio company, whether growth, merger or eventual initial public offering. Nevertheless, these investors share a somewhat unique trait in that most of them are "industry players" themselves who possess not only capital markets savvy, but also energy-related skills, services and contacts that can help their portfolio companies. This level of interest can be a distinct advantage to a start-up E&P company-but it can also complicate the issue of governance and cloud the distinction between a portfolio company and a subsidiary. Ultimately, investors bet on the skills of a management team as much as, or more than, they bet on a product, strategy or asset. That's why they try to create a structure conducive to optimizing that team's performance, not to mention the financial outcome of the investment itself. Here, we look at how three active private equity providers, Enron Energy Capital Resources (ECR), Warburg Pincus and EnCap Investments, approach these delicate matters. Enron Energy Capital When ECR makes an equity investment in a private E&P company, the board consists of representatives from the E&P management and ECR's principals. "Typically, we structure ECR's equity investments in partnerships, limited liability companies and joint ventures that do not use the traditional board of directors-it is just management and ourselves at the table," says Scott Josey, who with John Thompson, comanages ECR. The management team is often the only other shareholder, thus minority shareholder issues that might warrant outside directors do not exist. "We interact with our management teams in an open, roundtable format. Other than quarterly progress reviews, our clients typically initiate a meeting with us to discuss a strategy or action in which they seek our input," says Josey. Steve Pruett, ECR vice president, says, "Before we invest equity, we carefully screens the management team's track record, strength, depth and business plan. We generally seek out the management teams with whom we invest equity. They are people that one or more of us know well. For example, we have known the leadership of Westwin for more than 15 years." Westwin is a new Midland, Texas-based company founded by the former executive team of Arco Permian, which was absorbed into BP last year. ECR closed its initial equity investment in Westwin in October. The E&P industry experience of the ECR principals averages 20 years, and it has both management and technical personnel who can advise management once the deal closes. "We are here to aid the fulfillment of the business plan by setting milestones, which if not met, warrant adjustments to achieve our mutual objectives," Pruett says. In return for ECR's proactive role, the E&P client gains access to Enron Corp. 's commodity marketing, logistics and risk management; asset and corporate divestment services; one-stop capital provision and structuring; and back-office administration. ECR's intent is typically to position for exit in two to four years. "An IPO is not the preferred exit, as it doesn't provide the majority owner liquidity," Josey explains. "However, we have made multiple rounds of investment with clients who have turned over their asset base while maintaining a going concern. "Our philosophy is, if we are in an asset base with extensive untapped exploration or development potential, it is probably not the right time to exit. We monetize an investment when its market value exceeds the risk-adjusted present value of continuing to exploit the assets." Warburg Pincus The strategy of New York's Warburg Pincus & Co. is distinctly different. Warburg generally leans closer to a public-company governance model, largely because an IPO is usually part of its exit strategy. With two recent E&P investments, Spinnaker Exploration Co. of Houston and Lariat Petroleum Inc. of Tulsa, for example, outside directors played an important role. At press time, privately held Lariat agreed to merge into Newfield Exploration Inc., Houston, providing Warburg with a nice exit since Lariat was formed in 1996. Newfield will pay $180 million in cash and stock, plus assume $153 million in debt. According to Warburg senior managing director Jeffrey Harris, Spinnaker's structure was highly innovative for the E&P industry. Although Warburg had completed similar transactions in other industries, Spinnaker was Warburg's first E&P joint venture with a service company, Houston-based Petroleum Geo-Services (PGS). The latter provided equity and seismic data, and divested its position in Spinnaker in December at $29.25, more than twice Spinnaker's initial public offering price. Initially, Spinnaker's board was composed of two directors each from Warburg and PGS, along with Spinnaker chief executive Roger Jarvis. Later, two independent directors joined, with a view toward taking Spinnaker public. On the other hand, given that Warburg was its sole investor, Lariat Exploration's board consisted of two directors from Warburg, Lariat chief executive Randy Foutch and two outside directors. "While a company is private," Harris explains, "we want a reasonable representation on the board, but it may not be controlling representation. In addition, we want management and qualified, talented outsiders present. We don't have a large staff so it isn't sensible to put three or four of us on one board. In any case, a public offering is always easier if you already have good independent directors." At Spinnaker, the outside directors are Mike McMahon, who sits on several E&P boards, and Sheldon Erikson, chairman, president and chief executive of Cooper Cameron Corp. Erikson, who is not an explorationist, is highly regarded for his financial strategy and general business expertise. Most important, offers Jarvis, is Erikson's "great natural leadership. Boards need leadership outside of management to gain a clear view of themselves. Shel provides that. In a tough, strategic discussion, his opinion is credible. Balanced leadership on a board is important." In this particular case, Jarvis knew the individuals he wanted to bring in as outside directors. In other situations, however, start-ups funded by private equity investors find it expedient to turn to executive recruiters to find the right board members, or to assist the newly established CEO by identifying essential members of a new management team, such as the chief financial or chief operating officer. The same principle applies when an investor comes to the conclusion that the existing management needs to be changed. Installing powerful outside executives on boards may lead, of course, to spirited discussions. "When our client boards meet, we have great debates about hedging," reveals Harris, with a laugh. Another discussion topic that often leads to clashing opinions is employee and executive compensation. "Our role on the board is to be general facilitators and quality control checkpoints," says Harris, "not to manage the company. That's what our management team is supposed to do. Our primary role is to give them the confidence to be aggressive." Jarvis praises his board for supporting the management team and letting it run the show. "Spinnaker came out at a competitive time," he says, "followed by an extended gas price decline. That was when our board was at its finest. They told me, 'We've seen enough to like what you're doing and we want you to do more, not less, while the market is down,' even though we were working with high-risk undeveloped assets." Venture capital by its very nature operates in a way that is contrary to common logic. "Spinnaker was a new company with no production," Jarvis explains. "Gas was down to $1.80 from $4.00, but Howard Newman [Warburg vice chairman] told me, 'You should be spending money like a drunken sailor!' Our pose was to be aggressive and they reinforced our instinct to be more aggressive." Lariat's Foutch will remain as president of his firm, soon to be a subsidiary of Newfield. He says he feels just as strongly about his outside directors, Dan Dienstbier and Chris Woessner. Dienstbier serves on the board of Dynegy and offers practical E&P and distribution experience. Woessner's career was spent at Arco and Aquila Energy. Both respect Foutch but do not hesitate to speak their minds. Foutch provided a seasoned perspective for the creation of Lariat because he had started his own successful entrepreneurial company, Colt Resources , without investors or outside directors. Colt made money for Foutch and his ultimate equity investor, First Reserve Corp. "In terms of maintaining excellent business practices, however," says Foutch, "I felt it could be myopic to operate without good outside directors. They are critical; they help the company work for the good of all the shareholders." Foutch suggests that sometimes the CEO doesn't recognize that a potential problem could become severe without the outside directors' perspective. "The right board," says Foutch, "will help you maximize shareholder value, stay on the business plan, and proactively evaluate opportunities and problems. But it shouldn't pick drilling locations for you!" Foutch's business plan for Lariat called for one director with oil and gas operating experience, with another involved in deciding successful strategies (not necessarily for companies involved in oil and gas), who knew business development and could "grade our paper" on strategy. In his previous E&P venture, Foutch says he did not plan adequately for the tremendous success Colt did not install systems to support growth. Lariat saw similar success when acquisitions tripled its size twice in four months. This time, however, both investor and outside directors came through with the solutions to the problems that arose, from systems expansion, to compensation plans, to employee handbooks. Foutch firmly believes that if a CEO wants good advisors and is willing to do what it takes to get them, good directors are available. Although, he adds, there are also too many managers with good boards who don't use them. "You don't get good advice if you only interact with your board once a quarter," he says. EnCap Investments Houston's EnCap Investments also is a well-known provider of third-party capital to the oil and gas industry. According to managing director Gary R. Petersen, the E&P start-ups in its portfolio begin with boards made up of representatives from EnCap and management. Outside directors are not added until the company is about to do an IPO or merge with a public company. EnCap's portfolio investments are companies making acquisitions or developments involving proven properties. "Our deals are usually proven reserves plus an element of exploration to give upside sizzle," reveals Petersen. "But we don't depend on exploration for our return." EnCap began 13 years ago as a mezzanine project financier and has become a corporate, rather than a project, investor. Its commitment tends to range between $15- and $40 million. It likes to control the board of a start-up. Says Petersen, "Generally, we have three out of five directors on the board because we want to exercise control over deals done and exit strategy." Thus, EnCap is the opposite of the passive investor. "We are hands on," he says. "We help management determine which properties to invest in." And yet, that does not mean that management has little freedom to act on its own. "But if it's a $50-million company and they're about to buy a $30-million property, we will help make sure it fits the company, it makes sense and they're buying it the right way." By the time a portfolio company is about to undergo an IPO, EnCap directors have had the opportunity to gauge how management performs over time. They are ready to dilute their board presence and cede control to potentially realize a higher return on the investment. "We don't strong-arm management or force them into our exit strategy prematurely," explains Petersen. "We reach an agreement that's comfortable for everyone." Petersen recalls that EnCap wanted to exit a portfolio company a year ago, but management insisted that they hang on. "Now look at gas prices," observes Petersen, cheerfully. "They were right. We were wrong." There is no single right answer-it all depends on the goals of the E&P company, and of its investors. Enron ECR structures investments so returns can be realized without the need to take the company public. There is ample direct oversight and a generous sharing of corporate expertise. EnCap may be more hands-on than ECR, playing a major role in deciding which properties the client company should buy. ECR often exits by gradually liquidating the investment through production payments from the company. EnCap generally exits by diluting its presence on the board as the company enters the process of public ownership, but outside directors are not added to the boards of EnCap's portfolio companies until they file for an IPO, or a merger is imminent. Warburg steps back a pace or two and, with an eye, in most cases, towards a public offering, encourages the early addition of outside directors to portfolio companies. "We don't have a monopoly on brains and talent," says Harris of Warburg. Decisions concerning the direction of a start-up or portfolio investment, and the appointment of outside directors, are issues that can prove vital to successful culmination of the investment strategy. The importance of selecting the right talent and experience to name to a board of directors, is an aspect of the investment process that should not be underestimated. M Steve Raben and Stephen D. Newton are managing directors in the Houston office of Russell Reynolds Associates , a leading international executive search firm that assists public and privately held companies in identifying and attracting talent.