Kimmeridge fund aims to shake up management of crisis-ridden energy industry

Kimmeridge's Dell said the activist fund is an extension of the firm's PE strategy, which focuses on acquiring low-cost oil and gas assets and managing them efficiently – with ESG criteria in mind.

Energy private equity firm Kimmeridge launched a debut activist vehicle intended to radically change the way public oil and gas businesses are run.

Kimmeridge Energy Engagement Partners in May secured more than $100 million toward a $500 million target, according to a Form D fundraising document. Eight investors committed capital, the document showed.

Kimmeridge managing partner Ben Dell told Buyouts the fund will focus on listed exploration and production companies that are “decoupling true financial performance from reality.”

“The US E&P industry is in a time of crisis,” Dell said. “Despite being one of the worst performing sectors in the market over the past decade, it maintains a high reinvestment ratio and a mindset of growth for growth’s sake, volume for volume’s sake.”

The oil and gas industry is facing unprecedented headwinds due a supply glut exacerbated in early 2020 by the Russia-Saudi Arabia price war. On top of this, measures taken to halt the spread of covid-19 eroded fuel demand. While pressures were eased somewhat with recent cuts in output, market analysts do not expect to see recovery anytime soon.

Dell said public E&P executives are responding to deeply-rooted challenges by blaming commodity prices and making plans to grow production back to pre-covid-19 levels. This outlook, he said, fails to recognize that what is happening is “more than a cyclical low.”

Ending the ‘gravy train’

Public E&P executives “mismanaged” their businesses through years of poor capital allocation choices, Dell said. Their unwillingness to change course owes to a compensation system that rewards a growth orientation instead of high returns. As a result, he said, shareholders are “exhausted with the sector” and “voting with their feet.”

Kimmeridge believes a “very profitable industry” can be restored, Dell said, by “ending the gravy train for management and the boards that sustain them.”

Kimmeridge’s activist fund will target three to five E&P companies and drive initiatives aimed at returning capital to investors through sustainable dividends and buybacks. Priority will also be given to cutting costs, reinvesting less, repairing balance sheets and selling assets. Above all, Dell said, compensation will be realigned to support the new imperatives.

In February, Kimmeridge hired Mark Viviano to head the fund. Viviano joined from Wellington Management Co, where he worked for 17-plus years as an E&P analyst and portfolio manager.

Applying PE principles

Dell sees the activist fund as an extension of Kimmeridge’s energy PE strategy. The New York firm invests in unconventional oil and gas assets in the US upstream space. Unlike other firms, which mostly back independent E&P teams, Kimmeridge acquires and operates assets in-house.

A key aspect of the strategy is finding bargains. Kimmeridge buys low-cost oil and gas assets, utilizing little or no leverage in its deals. Assets are also managed cheaply, with scale created through land aggregation and only a few wells drilled to show that reserves exist and can be tapped. It then sells to producers.

The formula appears to work. Funds I, II and III, which are fully realized, generated a combined net IRR of 53 percent, Preqin data showed. In addition, in a tough fundraising market for energy PE offerings, Kimmeridge last year closed its fifth flagship pool at a $800 million hard cap.

Dell said while many private E&P companies share the growth-oriented outlook of their public counterparts, they have not made the same mistakes. This is mostly due to “aggressive” PE owners motivated by a need to “deliver cash-on-cash returns to investors.” He said PE principles will be applied to investing by the activist fund, along with Kimmeridge’s low-cost focus.

Facing up to climate change

The oil and gas industry is also contending with rising international concern about fossil-fuel extraction and its impact on climate change. This concern is shared by an increasing number of institutions, which are reducing sector exposure to achieve carbon-neutral portfolios.

“The energy industry has long been on the defensive about environmental, social and governance issues, with executives arguing they cannot afford to be good stewards,” Dell said. He rejects this perspective as commercially short-sighted.

Kimmeridge utilizes ESG criteria in its PE investing to “build long-term value in projects and reduce risk,” Dell said. He cited as an example the firm’s limited reliance on well drilling, which ensures lower emissions and lower impacts on water, land and wildlife relative to other operators.

Kimmeridge will take the same approach with listed E&P businesses. The activist fund will push companies to meet net-zero emissions over the long run, Dell said, and adopt eco-friendly initiatives, such as discontinuing freshwater use for fracking and zero-gas flaring.

Action item: Read Kimmeridge’s white paper on a new business model for the E&P sector here.