Investors in the energy sector are increasingly looking for investment opportunities providing yield, dividends, distributions, and return of capital. For those seeking the investment protection of a debt claim but with contractual yield in the low-teens and equity-linked performance upside, evolving market conditions are increasingly supportive of mezzanine debt and other "structured" capital as a relevant source of funding for middle-market upstream (i.e. exploration and production) companies.

Many of those upstream firms are increasingly focused on sustainable production, cash flow stability, and conservative use of leverage. Broad industry trends involving capital availability, coupled with shifting views on the pace of energy transition, conservation, and the evolution of demand has led the capital that historically funded those activities to re-evaluate where to re-deploy - and what form of capital minimizes volatility risk and maximizes investor returns.

Experienced institutional capital, which is well-positioned to navigate the growing priorities surrounding responsible investing and climate concerns given ESG-oriented standards act as key pre- and post-investment criteria, has begun to fill the funding gap with capital tailored to address the needs of an essential industry. In response, institutional interest in conventional energy continues to channel away from equity-led, capital-gains-oriented investments towards opportunities that demonstrate lower volatility of returns and losses and higher visibility of cash yield and investment return protection. It's a trend that fits well within an industry itself that is maturing, reducing prioritization of year-over-year growth, and focusing on the sustainability of production and visibility of free cash flow.

A short-term shift has gone secular

A fundamental shift in capital sources available for upstream energy companies to fund various business operations began several years ago. What began initially as a short-term response to sector volatility is quickly migrating towards a secular trend. Historically dominant funding sources - primarily commercial banks and public and private equity - have continued to withdraw from the sector. The acceleration of this trend has served as a catalyst for a recalibration of asset values and investment return expectations and has opened the door for alternative sources of capital - importantly, institutional forms of capital - to fill a growing funding gap.

This shift has also created an opportunity for investors to consider different risk-return investment profiles within the industry and will likely be a trend that continues for some time. Recent surveys of domestic upstream independents highlight the increasingly important role that debt from alternative capital providers is now playing versus the traditional bank market.

As traditional senior debt lending participants exit the market, underwriting parameters and lending advance rates have also contracted and the role of junior capital (mezzanine/preferred equity) as an equity bridge has become more common. That's especially true for assets that are moving deeper into the lower-risk, but more capital-intensive, field development drilling phase.

The importance of junior capital

Junior capital as a form of financing is most often used to augment senior borrowing capacity in connection with the acquisition of a more mature proved developed producing (PDP) dominant asset package by junior operators or to accelerate development drilling efforts during advantageous price environments. Increasingly, equity owners are looking at this form of capital as a means of avoiding down-round common equity valuation events for short two-to-five-year term funding needs that exceed senior borrowing capacity. Private equity sponsors are also seeking additional junior capital options to fund their development pace as the M&A market is increasingly rewarding PDP-weighted asset valuations and fund sponsors are facing both investment life and fund portfolio concentration limits.

With contracting senior advance rates and fewer market participants, debt and equity roles across the entire capital stack are being recalibrated. Rather than simply adding more debt to operator balance sheets, junior/mezzanine investments are largely being asked to fill funding voids created by a bank lending market in retreat - but with greatly improved yield and cash-on-cash return expectations.

Properly utilized, junior capital serves as a bridge that allows operators to access capital viewed by senior lenders as sufficiently "equity-like" but is less dilutive than issuing additional common equity. This form of junior capital runs along a spectrum from senior subordinated unsecured to preferred equity.

The scale, well maturity, and capital deployment strategies for upstream assets to be financed ultimately dictate the form of capital most appropriate. Unlike common equity investments, upstream mezzanine is typically underwritten to allow for full repayment through existing free cash flow within a three- to five-year timeframe. This approach avoids reliance on an enterprise sale for ultimate repayment and also addresses institutional investor concerns regarding energy transition and its impacts on investment performance.