Vito:
Hello and welcome back to Strategic Alternatives, the RBC Capital Markets podcast. This is the second segment on Energy M&A as we lead into our Energy Power Infrastructure Conference coming up in June. I'm Vito Sperduto, Head of RBC Capital Markets US and I'm joined by Tim Perry, Vice Chairman of Global Energy, and Nick Woodruff, Managing Director within our Global Energy team.
Tim and Nick, let's get back at it. Maybe let's start up with one of the things I always think about in the energy space, is that there's corporate transactions and then there's asset transactions. We have one of the leading practices in the acquisition and divestiture space with our Richardson Bar franchise. I know Nick, you've done quite a bit in terms of asset deals and corporate deals over time, but maybe walk us through a little bit the A&D market and also just our relevance in it because I think we are a leader across the board and I think that's helpful to the listeners.
Nick:
Yeah, Vito, thank you very much. I think our results speak for themselves and we typically advise on 30 upstream and midstream divestitures per year. What that means is we're closing about three deals a month and we do this on purpose. It's very purposeful. We're getting market intelligence, we're getting valuations, we're having connectivity to the strategics and the privates. And that really drives real time feedback so folks like CEOs and boards can make proper decisions.
In our practice, we've got 54 Energy bankers dedicated to helping our clients, and 20-plus of those come from industry. What I mean coming from industry is engineers like myself, geologists, et cetera, and that really provides a unique perspective on how to run a business. And then when we combine that with our product partners, it's best in class advice. It's been a really interesting decade to be a part of the franchise and really grow it. Now we've got over a 30% market share in the A&D space, which is tremendous. And that's why Tim was happy enough to join the platform, so welcome aboard, Tim.
Tim:
Great to be here.
Nick:
The A&D space over the last decade has been about a 50 to $60 billion a year market. We had a blip during COVID where it dropped off and we're right back into seeing another 50 to $55 billion a year market. Now as we go forward, we traditionally see 30% of merger value come out through a divestiture over the residual three years. Why is this happening? Is traditionally reallocation of capital, relooking at portfolios, getting rid of assets that no longer compete for capital in the near term, and then bringing leverage down within the balance sheet. This is going to be the next wave of what's driving the A&D in the marketplace, is portfolio rationalizations from the strategics as a part of the corporate side. But as we look forward to the second part of the decade here, 2025 and beyond, RBC really thinks this is going to be more like a 20 to $30 billion market and we just see less strategics around. We talked about that earlier in the podcast.
We see less sponsors and PortCos around. To give you some statistics, six years ago we used to have 42 private equity sponsors. Today we've got 21, so that's a pretty stark contrast, down 50%. And embedded within that, let's look at portfolio teams. There used to be 268 portfolio teams and now we're hovering just over 100. 104, to be exact. We're down 60% on portfolio teams. There's less opportunities from a acquisition standpoint, and that means there's consolidation even on the private side. We're working on a private to private corporate consolidation event right now and helping strategics think about how to come together from a sponsor to sponsor perspective to create relevance in the marketplace and get scale inventory so that they could participate in the corporate to private acquisition side at a premium valuation.
Vito:
Nick, thank you for that. Maybe Tim, why don't we pivot a little bit to what we're seeing on the regulatory front? And maybe just to give some perspective, because I know you and I have spent quite a bit of time counseling clients on the current regulatory environment, which again, we're all trying to get our arms around it, just given a lot of the changes that have been occurring. I think since the FTC and DOJ released drafts of the merger guidelines last year and then earlier this year they've been finalized, it's pretty clear that they're taking a more aggressive approach to merger enforcement and they're going to be taking a harder look in some different measures versus what we've traditionally thought about. And so one of the issues right now is we don't have a lot of precedents to look to. We're starting to see some of the first cases under the current guidelines start their way through the court system. The Kroger-Albertsons deal being one of them that I think we're all watching, especially how they think about the implications on the labor force as they look at the guidelines.
But what's interesting to me, and we always take a look at how aggressive different administrations have been, and the reality is, there isn't much of a difference regardless of what party is in office. In general, if I go back to the early nineties, maybe you had a peak in the early nineties where you'd see second requests in almost 25% of the cases, but generally it's been around 20% of the cases getting second requests since 2001 to now. The challenges have generally been at about 15% as we think about it.
And so, one of the things we have seen a stark drop in, especially since about the 2010 period, is that we used to see a more constructive dialogue between the agencies and the companies in terms of coming to a settlement, a presentation of remedies, and there being more a back and forth dialogue. I think one of the key takeaways recently has been that that sort of negotiation is happening a little less these days, but what's your perspective from the energy sector? Because obviously there's been a high volume of transactions and certainly we're seeing some indicators as to how the FTC and DOJ are treating the energy sector.
Tim:
Well, first, before I tackle the regulatory issue, I just want to digress for a moment, really to compliment Nick and the entire RBC team. They have had an incredible A&D practice for a couple of decades now, but with the rise in corporate merger activity in the sector, they've really tackled that extremely well and increased market share significantly. If you look at seven of the last eleven corporate deals, RBC has been an advisor. And frankly for some of the same reasons, the firm has had success with respect to A&D, and that's it. Having such a great technical team, a lot of clients like to work with us. It is an engineering and geologist driven sector.
It's also true having that insight of how companies are thinking about strategies or where they want to buy assets, where they want to sell assets, that's given us a lot of unique insights relative to other investment banks out there, and indeed a lot of access to corporate C-suites and boards, and I think as companies contemplate corporate transactions. We've had a really great track record over the last couple of years and certainly are hopeful that we'll continue, and frankly expect that will. With respect to the regulatory environment, we've been quite fortunate in the energy industry and upstream energy industry to have had regulatory issues around environmental, which has been a real challenge, but less so in terms of thinking about merger competition. That has changed in our sector quite a bit in the last couple of years.
Now it's very much front of mind of boards and M&A. Part of that, you just look at the recent track record. Five of the last seven corporate mergers have had second requests, and that's really new to the sector. We didn't have that as of a couple of years ago or before that. In the second request, every single deal has gotten approved. So in that sense, I think people continue to be optimistic and positive. But the second request of people who haven't been involved in it, it's very, very intense and it causes significant delay of companies. Usually as much as six months, and that's six months where companies in a rapidly consolidating environment have to step back a bit and can they still participate during that time. It is a very big top of mind issue. We've been involved in several transactions where these have come up and have worked with the companies in terms of finding solutions so that transactions can go forward. Again, all of them have been successful so far and we are hopeful that that will continue, but it's a very important issue.
Vito:
Tim, as you highlight, I think the critical part for our clients, both in whether it's the energy sector or just overall, we've been guiding a lot of them that these are now issues that you have to consider at the front end or earlier in the transaction. Certainly in many cases, it might make it a transaction that you don't consider if you're very concerned about an elongated regulatory process or a regulatory process that might not end in a positive fashion for you. And then that timeline, you need to plan and be able to withstand a longer timeline between sign and closing, which again, you can't follow through on your plans from a consolidation perspective and you need to operate as two separate businesses, the risks on employees and the like. And so those are all things that you need to take into account as we're looking at transactions. Certainly we're spending a fair bit of time on this topic and making sure that clients are well-educated on it.
Nick:
Vito, I think one thing to add on that is we work extremely closely with management teams on assessing risk and creating remedies along with council on potential opportunities. I think it's very important to realize part of the remedies might involve divestitures or different solutions at boards or information sharing rights, for example. And helping management teams and boards understand impacts to synergies on a transaction if we have to go divest certain business units. Understanding is the juice worth the squeeze ultimately, when you factor in more time and potentially less pro forma assets. That's something we're really in the trenches thinking through, educating management teams and boards on so they can make the right decisions.
Vito:
And ultimately guys, I think the motto that I've had for many years, and certainly I know you guys have espoused the same to your clients is, good transactions get done. Certainly when transactions are planned for strategic reasons and not just a purely financial gain and the like, I think those deals get done, and we find a way to structure those for clients. It's great to hear that. Maybe let's talk about some of the headwinds. We'll get into the artificial intelligence topic after this, but as you think about the headwinds, Nick, you mentioned sort of having commodity prices line up at the right levels, we just talked about regulatory. Are those the main topics or what else is out there that concerns you that you hear from clients as they're thinking about transactions? We talked a little bit about geopolitical instability, but that impacts the commodity prices obviously.
Nick:
I think it's a great question. And one thing I'd like to introduce is you've got internationals and IOCs that are now coming back into the United States. They've taken a pause over the last five, six, seven years during some of this early consolidation wave. Now we've got some interesting interlopers that we're thinking about. As we think about that in addition to the other headwinds that you're asking here, what are the biggest headwinds is a question that we often get at a board discussion. It's finding the right counterparty that has the asset that can extract value. It's better, not just bigger, and you've got to have access to capital. You've got to find the right opportunities that are complementary. We traditionally are seeing opportunities with pro forma synergies that are 5, 6, 7% of pro forma market cap. So, quite material. And then having the right management teams and the right athletes, the best athletes, to extract the synergies and the value that are going to be in for the next 5, 10, 15 years to run the businesses.
I think finding the right counterparty and understanding where we're at in the commodity cycle, we think there's going to be a little bit more consolidation in the gas front as we start to see the LNG wave prop up pricing closer to that $3 level. We've seen some consolidation on the gas side, but it's been equity, equity and bringing the cost structure down, or trying to fix balance sheets. We would expect a little bit more improvement on the gas consolidation front once we get a healthier gas price. And then from an oil perspective, it's finding the right asset fit and diversification is back in vogue.
Vito:
Maybe Tim, before you jump in, I wanted to just add a statistic that I saw last week that's pretty interesting to me. Nick, you mentioned the internationals looking again at the US market from an energy perspective, and it's highlighted by the fact that if we look at year to date volume, the volume where the US is the target market is at a 35 year high. Just under two thirds of all transactions from a dollar volume perspective had the US as the target market for year to date, so through the first four and a half months of the year, and that is a 35 year high. Typically we're seeing that number kind of balance at about 45, 50%. And so it's pretty interesting to see it pop up like that. It just highlights because again, this is the most desired market and it is where folks are focused. We know that, but it's even more so today. And it's even more when you start looking at larger transactions, sort of the $5 billion plus deals, 81% of those are in the US. And so it just kind of highlights the points you're making as well.
Nick:
And I think when you go look at the European majors versus the US majors, there's about a two turn disconnect on value and that's driven by a whole multitude of different reasons: allocation of capital, regulatory headwinds, et cetera. But it's hard to argue whenever you go look at some of those statistics. When you've got a friendly fiscal environment, you've got private equity, you've got a oil field service group and midstream gathering, it really enables development in the United States compared to other parts of the world. Oil and gas is not going away, so I think some of these guys, the pendulum is swinging a little bit back in the direction of further investing in areas that warrant capital.
Vito:
Awesome. Tim, From your perspective, any additional thoughts in terms of the headwinds we're seeing?
Tim:
Sure. The headwinds, it's kind of interesting, and we touched on this in part one of the podcast, which is the sector really is trading at a very low valuation relative to the S&P 500. If you kind of think about it, if it's trading at six times EBITDA, does that mean really what's your free cash? And your free cash flows in the low teens, should you wait for a time when the sector gets into a better relative valuation if you're relatively optimistic about the commodity? Which most people are, both in oil and then particularly in natural gases, as Nick touched on. That's part of the reason frankly, we've seen so many transactions for stock for stock. Most of the transactions on corporate deals have been on stock. Because then it gets really into, well, maybe my valuation is at a lower multiple than I really want to trade at, but I'm also trading into a company that probably is trading in a lower valuation in the sector.
And one thing that the boards and the C-suites generally agree on is that you do need bigger companies today. We need more trading liquidity in this sector. Again, you need more bigger companies with respect to handling all the regulatory issues. We do have a shortage of tier one inventory here in US onshore. In fact, over long periods of time, we likely are going to see US companies start to look outside the lower 48 and start to expand again, perhaps offshore, perhaps internationally, and all that means bigger companies. I think there's a consensus there that that won't change. Then it's really getting into are you trading your stock for a stock that you really like or is the combined company that much better? And so it really gets into those kinds of issues.
Vito:
That's great. Well, look, it wouldn't be a podcast without talking about artificial intelligence. As I've let it be known in the past, I'm an avid user of ChatGPT to rewrite long notes since English is my second language and it helps clean up my grammar. I'm not sure if that's the most efficient use of artificial intelligence, but it works for me. But all that aside, maybe how is AI affecting demand for energy? What are you seeing? How are clients using it? I mean, it's certainly topical.
Nick:
It's certainly topical and it's probably the biggest buzzword that we're hearing, not only on CNBC and other financial publications on TV, but also with clients. Whenever we think about it, data centers, how do you supply them with power? And it's 24/7 base load power that's needed to go through and run these places and all the power and analysis that's behind it. Whenever we think about LNG and exporting gas, those are 10 plus year duration projects from FID to developing the facilities to actually exporting the gas. Now, whenever we think about AI and data centers, you're talking about years. 1, 2, 3 years before we see an uptick in base load demand, and that's right around the corner.
Traditionally offshore projects, it's an eight year life cycle from an FID to first cashflow. Onshore shale is a matter of quarters, three to six months. Whenever we think about how we're going to go power the data centers and all of the AI power generation, RVC sees anywhere from an 8 to a 15 BCF demand growth through the rest of the decade to fuel base load power. And all of a sudden a sleepy industry is now renewed with green shoots, as you said, on power demand and where's that going to come from?
Short cycle shale is certainly a application. We've got permit reform that certainly needs to enable some of the growth, but we've got a resource here and we think that's going to really drive demand growth and different opportunities in the market over the next three to five years.
Tim:
Yeah, Vito, maybe I'll touch on that a bit. First of all, let me just say the listeners can't see you, but I can doing this podcast, so I know that you're not a chat bot. You're actually the real person asking the question, so that's reassuring to me. No, all joking aside, it's quite amazing AI and it comes up in almost every conversation we have. I think one of the exciting things, as Nick talked about, is on the demand side, particularly with natural gas and power demand. But the other thing I'd say which we think is also equally exciting is what it's going to do for the cost structure of companies. If you think of the energy industry, it's an extremely process-driven highly capital intensity with extremely long lead times to obtain oil and natural gas.
Those cost structures through the benefit AI can probably become much more efficient. The industry has become much more efficient. Drilling days are now probably one-third what they were five to ten years ago. It is a commodity, the end of the time, and it already gets to who can produce that commodity at the lowest cost. The exciting thing about AI is what it will do for the internal processes of all these companies. And quite frankly, we're just starting on the very beginning of that, but I think all the companies are quite excited what it will mean for being able to reduce the cost structure of their organizations and make better decisions.
Vito:
Great, gentlemen. Why don't we close up the podcast with the following: I mentioned earlier that we have our Global EPIC Conference coming up. That's our Global Energy Power Infrastructure Conference on June 4th and 5th in New York City. Clearly you're going to have a lot of clients there, a lot of investors. I'll turn it to each of you and maybe give me one theme, two at most, that you think are going to be the key items that are going to be talked about at the conference. Who'd like to start?
Nick:
I think we're going to have a big sector rotation. If you think about over the last 15 years, and Tim talked about the S&P 500 value allocation by sector, technology's gained 11%, energy's lost 9%, and we're sitting here at 4 or 5% of the S&P 500. There's fewer companies in energy. We've got stronger management teams, healthier balance sheets, more durable inventory, and that's what's driving the corporate M&A. We've got robust return of capital in the mid single digits to low double digits. I really think that is going to drive a sector rotation. We're going to see an uplift in valuation, and that's going to drive further interest from the investor standpoint. We've seen a 15% uptick in the valuations of these companies compared to the S&P. I think that's a huge level of interest from the long-onlys and the hedge fund world at our conference that will be discussed.
Tim:
What I would say Vito, first of all, I'm tremendously excited about it. It really is one of the leading energy-focused research conferences in the world. As you said, some of the leading energy companies and their C-suite officers will be there, so it's going to be exciting couple of days in New York.
I think two of the major themes would be, one, a lot of what we've been talking about in this podcast is what's the outlook for M&A activity? We continue to expect that will be robust, as we've talked about for many of the drivers of this podcast. And then the second thing I think really is getting back to the long-term outlook of the commodities, which I think is very positive. We talked a lot about natural gas as a power source for LNG and AI. Talking about oil for a second, I think again, the demand for oil as a commodity and really using it for energy around the world continues. I think one thing we haven't touched on the podcast today, but really as we see here in the US and in Canada, is really the ability to produce oil in a very economical way, competes with the rest of the world, and energy security is hugely important. And so I think companies are very cognizant of that, and I think there'll be discussion around that, given the political instability around the world that unfortunately we've been seeing over the last two years.
Vito:
Well, gentlemen, it's been a great conversation. I know our listeners and I learned quite a bit in terms of what you're seeing out there. And look, it's always helpful perspective to get an insight in terms of what you're talking to clients about on a day-to-day basis. And given the volume, I think no two better people to talk to. Thank you so much for being on the podcast, looking forward to the conference in about three weeks time, and we'll be chatting more. Tim, Nick, thank you.
Tim:
Great, thank you.
Nick:
Thanks for the time, Vito.