Energy funds have been notable for their absence in recent years, the commodity crash of 2014 has cast a long shadow. The strong correlation between the value of operating companies and the oil price, which has made a slow and stuttering recovery, has meant LPs have had to wait a long time for limited distributions. Naturally, the demand for new fundraisings in the sector has been lackluster.
Preqin data show that natural resources fundraising in Q3 of $8.2bn is the weakest showing in over five years, $7.9bn of this attributed to energy funds specifically. Future demand may also be wanting.
Coller Capital’s recent barometer indicates that climate change concerns may reduce the amount of capital available for PE investment into fossil fuel assets; more than a third (38%) of the LPs surveyed said they intend to cut back on commitments to oil and gas funds over the next five years.
This aversion to carbon-intensive assets helps to explain why energy funds have been one of the slowest growing areas of an otherwise abundant secondary market. It’s too early in the year to know how 2019 performed, but energy fund volume market rose a modest $200 million in two years to $2.2 billion in 2018, according to Campbell Lutyens, as buyers and sellers struggle to find common ground on pricing amid oil price fluctuations and an uncertain outlook for the sector.
However, this has the potential to change. ESG matters have been brought into sharp focus in recent years, with endowments, in particular, facing a chorus of calls to action. Campaigns emerged on US college campuses in 2010, students urging divestments from the fossil fuel industry, with much success.
In July the University of California system, which as of June 2019 had $126bn in assets under management (AUM), announced in a Los Angeles Times op-ed that it will commence unwinding its fossil fuel exposure, in what is believed to be the single largest action to date by an endowment to pull out of the industry.
The PE context
As the largest slice of any prudently balanced portfolio, the lion’s share of this ongoing divestment movement will inevitably concern traditional assets, public stocks, and investment-grade bonds. But in our conversations with endowments, the message is clear: there is an appetite to move away from carbon assets.
How meaningful might this be? Preqin estimates that there is $229.9bn in AUM in natural resources funds, timber, and agriculture representing a minuscule fraction. This is 3.4% of total private capital AUM. Of course, part of this will be dry powder rather than net asset value (NAV) inventory available for potential sale.
To reach an approximate figure, we can also look at PE’s total NAV (i.e., AUM minus dry powder), estimated to be in the region of $7.5trn as of 2017; 3.4% of this total would equal $255bn.
So there is somewhere in the region of $250bn of energy fund NAV on investors’ books. Endowments account for around 5% of PE fundraising, which would indicate $12.5bn of potential PE fund stock that this class of LP could be looking to sell. If that came to market and traded in a single year, it would lift the PE secondary market by close to 18%, give or take.
This represents the upper end of the likely available assets, from endowments at least. After all, some of the largest and most visible of them have decided against divestment altogether, despite protests from their students and alumni. These include Ivy Leaguers Harvard and Yale, respectively, the second- and fourth-largest such trusts in the world with a combined $98.6bn of AUM.
That said, these numbers say nothing of the pension funds and even PE funds of funds that may be looking to leave fossil fuels behind, as their institutional LP bases increasingly prioritize ESG matters. This could significantly add to deal supply.
To buy or not to buy
Proponents of the fossil fuel divestment movement argue that selling such assets symbolizes the need for change, as much as it is a judgment on the forward-looking viability of these companies. Even if California University’s decision was motivated not by ethics but what it sees as judicious long-term financial risk management, it is safe to say that demand for fossil fuels isn’t going anywhere anytime soon.
Nearly two-thirds (64%) of the energy mix is accounted for by fossil fuel sources, and the increase in renewables capacity is mainly being absorbed by higher energy demand, led by a growing global population and consumption.
From a more short-term perspective, the price of oil, although volatile, is up over various timeframes, from 3 months to 5 years. Therefore there is a valid investment case for buying such assets (at the right price, of course). If the oil price recovery can sustain, bid-ask spreads are likely to narrow. This, in theory, would increase levels of energy fund trades in the PE secondary market.
For many prospective sellers, buoyant oil prices represent the promise of a potential reward for their patience over the last five years. Prospective buyers, meanwhile, may find the speculative nature of energy funds and their close oil price correlation too much to stomach. For secondary funds with their own LPs to think of, wading into ESG-unfriendly waters may be another consideration that keeps them at bay. But with a cohort of divestive LPs rethinking their portfolios, this is an area of the growing private equity secondaries market that warrants close attention.