Energy silos

The energy industry in the US is a mature one, to put it mildly. Although new technologies abound, many assets are nearly crumbling and are in dire need of new ideas and resources. As such, NGP Energy Capital Management is set up to provide capital across the many opportunities that present themselves in companies new and old, large and small, through equity or debt instruments.

Kenneth Hersh, the co-founder and chief executive officer of NGP, has also clearly spent a great deal of time pondering a far less mature industry ?private equity. While today many aspects of the energy business need to be reimagined, in private equity, it is as if the original blueprints are still being drafted, depending on the firm and mindset of its founder.

Hersh makes the case that his firm, for one, is well ahead of most franchises in creating a structure for growth, success and longevity ?investing in energy or otherwise. Core to this structure is what he describes as incentives for people to stay focused and to stay at NGP. This has involved Hersh setting aside a great deal of ownership in his firm for the rest of the professionals, including the administrative staff. He is certain this sharing is in the best interests of NGP and, by extension, himself.

?I have friends who run firms and they are way wealthier than I am because they've concentrated more ownership at the top,? says Hersh. ?They think I'm nuts. But they tolerate the turnover. I love the fact that I can walk in, and if a couple of offices are dark, I don't have to worry that my guys are off talking to our LPs and operating guys [about joining in a spin-out].?

While Hersh predicts that some turnover may well be the result of further growth at NGP, he says the firm has not experienced any personnel defections in its 18 years in business. ?That is unheard of in the private equity business,? he says.

Gas prices
The NGP of today is the product of carefully considered expansions, but its founding was characterized by a ?dead wrong? market bet and a ?silly name,? says Hersh.

When Hersh, a former Morgan Stanley energy investment banker, co-founded what was then called Natural Gas Partners in 1988, he and his partners, as the name implies, were focused on the price of natural gas, specifically that it would go up. ?The conventional wisdom was that low natural gas prices were discouraging new production and encouraging new demand,? remembers Hersh. ?The thesis turned out to be dead wrong ?natural gas prices went down for seven straight years.?

Before being proved wrong, however, the new firm lined up an investor, insurance company Equitable, which committed $100 million.

The group was brought together by legendary investor Richard Rainwater, who also tapped David Albin, John Foster and Gamble Baldwin. Baldwin, a former First Boston veteran, has since passed away.

Hersh jumped at the opportunity to join the group, but had to spend one more year in Stanford University's MBA program before joining Natural Gas full-time. In the early years, only Rainwater and Hersh were based in Texas, while Albin, Foster and Baldwin worked from a Greenwich, Connecticut office.

While the key commodity price sank, the new GP group found its capital and expertise were in high demand. A real estate collapse, the savings and loan debacle and a number of other factors dried up liquidity in the energy market. More importantly, many good companies with good management were in need of capital and gearing for growth regardless of the price of natural gas. ?Our phone was ringing off the hook. We were the only game in town,? remembers Hersh.

The firm's initial investments eventually yielded a 30 percent gross IRR, allowing NGP to launch a series of new investment platforms with an expanding roster of investors. Hersh says his firm has never had a down fund.

Natural Gas Partners has remained the core private equity group within NGP, as well as the manager of the most capital. Last year the group closed a $1.3 billion fund (€966 million), its eighth, and will likely launch a new fundraising this year with a target of at least $3 billion. If successful, the next fund will place NGP not only near the top of the private equity energy market, but among the several dozen largest private equity firms in the world.

Argument for silos
As the firm's private equity businesses have grown steadily larger, NGP has stamped its brand on a growing family of related strategies. Hersh says he has consciously rejected the one-big-fund approach to investing in favor or organizing his firm into distinct ?silos,? each of which is run by highly incentivized and focused managers. Currently NGP Energy Capital has five silos (see box below).

Besides Natural Gas Partners, there is a co-investment platform enabling limited partners to directly invest alongside NGP, an energy technology fund manager, an infrastructure investment group and a publicly traded business development company, which makes senior and subordinated loans to oil and gas companies. At press time, NGP Capital Resources, which went public in late 2004, had a market capitalization of roughly $300 million. The company was one of only a few BDCs to make it to IPO amid a wave of similar efforts from private equity firms following Apollo Management's successful listing of Apollo Investment Corp.

Much of NGP's growth has happened very recently, given the firm's relatively long life. Its technology group was launched in 2005 and its infrastructure fund is currently raising capital. The new private equity fund will likely raise more than NGP has over its life as a firm.

Each silo has its own investment committee, but Hersh is chairman for all silos. Each has its own dedicated management team and these teams have ?a tremendous amount? of their net worths invested in their own silos, says Hersh. On top of the various groups, NGP has created a participation fund so that managers have exposure to other NGP strategies.

Splitting up the several strategies is a better structure for retaining and motivating management, argues Hersh. ?Rather than raise a mega fund and do all facets of energy under one umbrella, I feel it is much more sustainable to have individual segment specialists with their own dedicated pools of capital, but with common oversight,? says Hersh. ?It is very identifiable who their investors are and what their returns are.?

Hersh argues that, no matter how successful a private equity firm is, those that assign different sector specialists to the same pool of capital will invariably see some team members dreaming of spinning out to realize better economics. This is a structural problem within private equity, he says.

?If you bury a $10 million energy technology investment inside a $3 billion fund, it will get lost,? says Hersh. ?If it does really well and the rest of the fund does less well, the people who were in charge of that particular investment will feel slighted because their investment got drowned out. Unless you have identical IRRs, somebody is going to dilute somebody else's returns. That's an inherently unstable business model.?

NGP Energy Capital Management

Biography: Kenneth Hersh
Hersh is the chief executive officer of NGP Energy Capital Management, a firm that oversees the management of five different investment strategies. He leads the firm from its headquarters in Irving, Texas. He was a co-founder of the firm, then called Natural Gas Partners, in 1988. Prior to this, Hersh worked in the energy group of investment bank Morgan Stanley, where he specialized in oil and gas financing and merger and acquisition transactions. He is a member of the Independent Petroleum Association of America and serves on its capital markets committee. Hersh graduated with a BA, magna cum laude, from Princeton University in 1985 and earned an MBA from Stanford University in 1989.