After a largely choppy year for M&A in which transactions occasionally have limped along, the fourth-quarter 2022 began at a sprint with more than $10 billion in deals announced in the quarter’s first month.
Muhammad Laghari, senior managing director for Guggenheim Securities’ Energy Investment Banking group said part of that quick start has been about capital: from public company’s cash rich coffers and low leverage to rising interest rates that put pressure on RBL reliant companies.
Laghari spoke with Senior Editor Darren Barbee about some of the trends he sees developing in the home stretch of 2022.
Darren Barbee: We’re seeing a lot of private companies being purchased through bolt-on acquisitions by public companies, whether it’s EQT and Tug Hill, Devon Energy and Validus [and more recently Marathon Oil and Ensign Natural Resources]. What do you make of this trend?
Muhammad Laghari: Given constraints on drilling – supply chain, inflation, investor appetite regulation – companies are flush with free cash flow, and M&A offers a compelling opportunity to grow cash flow per share – the primary driver of any valuation multiple.
Companies have grown to a point where many are in the process of consolidating acreage from private companies right in their backyard. We see that trend continuing while asset prices remain at attractive levels, where strategic buyers take advantage of their cost of capital versus the cost of capital for private equity funds and smaller companies.
DB: What’s the advantage from a capital perspective?
ML: If you're a public company larger than $20 billion in market cap, your cost of equity is approximately 150 basis points cheaper than a company that has less than $10 billion of market cap. That's a huge gap, and the story on the cost-of-debt side is very similar. A single B credit yields roughly 12% to 13%, whereas a triple B credit, which is the first level of investment grade, trades at approximately 6% — a massive 600 basis points difference. So, if you're a big company, the value advantage and premium that you carry is quite compelling.
“Companies have grown to a point where many are in the process of consolidating acreage from private companies right in their backyard.” – Muhammad Laghari, Guggenheim Securities
DB: What about the sellers?
ML: The issue on the seller side is that that gap continues to widen. Their cost of capital continues to go up and is compounded by the fact that most of these companies are dependent on RBL financing, and RBL financing is all SOFR [secure overnight financing rate], based financing. So, variable rate loans in an environment where interest rates are rising isn’t helping.
More specifically, these loans when SOFR or LIBOR [London Inter-Bank Offered Rate] was next to zero, were 3%-4% loans. The base rate is expected to go up to 4% to 5%, and that means your lending interest expense on these loans are shooting above 7%.
That's exacerbated further by banks taking money out of the sector because of headwinds against energy lending and broader concerns with large lenders related to losses on funded bridge loans that will need to be sold in the high yield market.
DB: Not a good environment.
ML: You have this double whammy on the private equity or smaller company side of cost capital going up, access to capital going down, and then these larger operators continue to grow and become more of a force in the market. We see that trend continuing, [with] strategics buying these assets for good value, primarily cash.
At the same time, we are seeing a significant amount of dialogue progress through the sector as well focused on stock-for-stock deals. And the reason for that is volatility. Macroeconomic, geopolitical and market uncertainties impact cash deals causing the bid-ask spread to widen. And stock deals allow both sides to at least share the market risk. You're in it together, making it a relative game as opposed to an absolute value equation.
DB: Are you surprised at the activity we’ve had so far in the fourth quarter?
ML: You could [overall] easily cross $10 billion, if not $15 billion, in announced transactions. And that is without the corporate M&A side, which takes longer, but is still pretty active.
DB: How is that progressing for small- and mid-cap companies?
ML: I think there continues to be active dialogue among small- and mid-cap companies where acquirers can still find relative value. While deals are rarely done for solely scale sake, they have to make strategic sense, there’s no doubt about the advantages of two companies combining to become more relevant to investors.
DB: Is energy going to remain a no man's land for investors, for banks? I’ve heard the theory or assumption that companies aren’t using their cash for largescale deals because it’s a better deal for them to buy back their own stock?
ML: I think there are real pressures on these companies to send capital back out to investors through buybacks and variable dividends. But I don't think that's the core, and certainly not the only reason.
Another reason is that, quite simply, it's not easy to grow. Supply chain issues are very real. Getting labor, getting frac crews, getting equipment, getting pipe is very difficult. These two reasons garner a lot of attention.
I actually think a key reason is that most projects for oil and gas companies represent at least a five-year horizon, if not 10, 15, 20 years. It’s challenging to commit that amount of capital, which these projects represent upfront without knowing what's going to happen five, 10, 15 years from now, especially with regulatory uncertainty and permitting uncertainty and pipeline uncertainty.
It's very difficult to put capital in the ground when there's a lack of visibility.
DB: What do you think about the dealmakers that are beginning to ascribe some value upside, which we saw in the Diamondback Firebird deal? Are we going to see more of that?
ML: We're definitely at that point. If you have assets or a business that you want to sell with inventory like Firebird, you are going to get a lot of interest. The challenge is that is becoming more scarce by the day, particularly in the Midland where Diamondback bought Firebird. It's very consolidated there among the major players. It's very challenging to find those opportunities. So, if you have it, like Firebird did, you're going to become a rare commodity, pun intended.