There's always more to a good deal than meets than eye, buyers, sellers and advisors counseled during a recent industry forum on acquisitions and divestitures. Discipline, patience and strict screening criteria are keys to a successful transaction. But it is after the fact, after the closing celebration, that true value is created. "As I look back on failed acquisitions, the thing I see most often is new operational challenges. The buyer is spending more on operating the properties than was expected," noted Mark Fuqua, senior vice president and manager of energy lending for Comerica Bank-Texas, based in Dallas. "Particularly with a big acquisition, geographic proximity is good. We've seen problems when people stray out of the areas that made them successful." He was one of several speakers at the "Executive Forum: A&D Strategies and Opportunities" held in Dallas in September. Oil and Gas Investor and Wellspring Partners co-sponsored the event. Right up front, three factors affect reserve valuation risk in any pending acquisition. Buyers always account for the first two-actual reserves estimates and the risks associated with operating costs and capital access. But the third risk comes from side effects that may be unforeseen, and that occur after closing. "What will the acquisition do to your organization, to your operations and the philosophical side of it?" asked Bill Kazmann, president of LaRoche Petroleum Consultants, Dallas. "Can you, with your current staff, capture the value you intended?" Under the banner of reserves evaluation, Kazmann reminded attendees that there is more to LOE (lease operating expenses) than meets the eye. Cost complications may ensue after the deal closes. "If the seller has 'neglected' the property for the last 12 months in favor of other projects, then the LOE numbers you're given may be lower than what you'll experience. People generally ignore the noneconomic properties within an asset package and it takes the buyer time to identify them and figure out if he will keep those properties and how to work them." Recurring and nonrecurring costs, remedial repairs and capital costs may be necessary that the seller did not undertake in the months prior to the sale. Buyers easily forget to allocate these hidden costs to the wells they buy, according to Kazmann. Too, buyers must factor their company's in-house capabilities. As a small and high-powered staff grows, it usually reverts to the mean or average. "Buyers always overestimate how fast they will take action and underestimate the costs. They fail to ask if there are enough rigs out there to do what they want to do on the acquired properties, if they have staff limitations, or have to change their databases or other internal systems." Capital views "Rarely are acquisitions made in a vacuum," noted David B. Dunton of EnCap Investments LLC. "They have to have something about them that makes them strategic and attractive within the context of the larger company strategy. The most important component of any deal is successful development of the properties, that you are not just buying PDPs. You've got to sell more barrels than you bought to make money and demonstrate to an eventual buyer that you have a repeatable play." Dunton said that to create value, acquisitions must have several key components: a geographic focus, attractive purchase economics, and be followed by successful development of the properties to capture their upside potential. EnCap thinks a company needs to have about $150 million of assets before it heads into multiple basins, as it is difficult to be really proficient in more than one area until a company is larger. The market now pays a premium for size, he said, with packages greater than $25 million commanding more dollars per barrel of oil equivalent. EnCap has invested more than $1 billion in 80 independents since 1998, and just closed its latest fund, EnCap Energy Capital Fund IV, with $650 million. Because private equity funding sources such as EnCap want an exit strategy, they think that as a company grows, it must always build toward the end game-selling or merging with another entity to deliver value to the shareholders. "An athletic seller has rock-solid PDP reserves and is ready for someone else to walk in the door. You have to be on your toes," he said. In the past few years, the motivation for making an acquisition has changed, and it may change further, said Rodney Mitchell, principal with The Mitchell Group, a private equity investor. "The rules of investor engagement have changed. The growth idea is dead and value investing will return. Every company wanted to be bigger, and Wall Street certainly fueled that need," he said. "Now what can be said about that is bigger is not necessarily better, it is just bigger. It does afford greater access to capital and the ability to pursue deeper, more complex plays. Today, acquisitions are being spearheaded by the need for production growth-many companies are having difficulty replacing their reserves." He cited data from EOG Resources, which projects that domestic gas production of about 52 billion cubic feet per day currently will fall to 47 Bcf per day by the second quarter of 2003. He expects that in the future, acquisitions may be driven as much by the need for manpower as any other reason. "If a company can acquire technical expertise and retain them, it may be money well spent." The Mitchell Group doesn't like to see a buyer trumpet the PUDs it has acquired, only to write them down quietly two years later. Exploitation of those reserves is what turns a deal positive or negative, he said. It doesn't like to see a buy venture too far from home-such as when a company with expertise in the Permian Basin or Rocky Mountains "ventures into the water, and leaves with less money." "And, we hate to see business risk increased by overleverage. We hate to see a company go beyond 50%." Mere growth, or strategy? Buying a property for growth alone is not the smartest thinking, the speakers emphasized. It is critical to know how the deal will enhance overall strategy in the longer term. "I have seen lots of companies trying to make an acquisition just to grow, without understanding what type of company they are and how that will fit, and can they actually develop it, given their manpower and cash flow," said Scott Rees, president of Netherland Sewell & Associates. "The guys who win are the ones who go in there and get the reserves out of the ground and not just buy cash flow. But be careful-if a seller has already cut costs by half, don't go in thinking you'll cut them by half again. It's not likely to happen." Acquisitions have been the primary engine for growth at Comstock Resources because they add size, and more important, provide the seed for additional development and exploration exposure, said Mike W. Taylor, vice president of corporate development for Comstock. From 1994-2001, the firm grew its proved reserves 457% to 566.2 billion cubic feet equivalent. It accomplished that by evaluating more than 1,200 deals, making bids on 89 of those, and closing only 12, he said. "This M&A business requires turning over a lot of rocks. We look at an average of three ideas a week...and only close 1% of the deals, so we consider a 99% 'failure rate' to be a success," Taylor said. Good opportunities are not always apparent, he said. In 1991, for example, Comstock bought a one-well field in Louisiana that has produced a lot of gas, and is still producing 8 million cubic feet per day.