Private equity investors have seen a veritable blossoming of midstream energy deals. The sector is undergoing a renaissance in its own right, and investors are eager and willing to jump on board and pair management teams with capital in order to gain entry into burgeoning plays. Firms like Morgan Stanley Private Equity, Quantum Energy and Highstar Capital, much like modern-day Medicis, are helping fund this midstream renaissance movement with well-timed capital, and see huge potential for future growth in 2012.

In a recent update, Kayne Anderson Capital Advisor's senior research analyst, David LaBonte, detailed his enthusiasm for the midstream sector. "For the majority of people that have been invested in energy infrastructure for a while, it may be surprising to hear us say that we think we are only in the second or third inning of a ball game that will likely go extra innings. The reason why we think we are early is because this is a new game. Five years ago, it was thought that the U.S. had not had enough natural gas to meet anticipated demand. That view has obviously changed," he says.

The onshore industry's shale windfall has been both profound and exciting to those who have not seen such growth opportunity in onshore production in decades. "Shale gas production has seen a four-fold increase since 2008, and could represent 60% of total production by 2035. All this new production has a direct and very evident impact on the midstream industry. New projects are necessary to get product of these basins to demand centers. New pipelines have to be built," LaBonte says.

"Movements of natural gas, crude oil and natural gas liquids (NGLs) are changing, creating a tremendous growth opportunity for energy infrastructure companies that will take place over the next 10 to 20 years. There are going to be large expansions where new multi-state pipelines are going to be built. All of these projects are underpinned by long-term contracts, which provide great cash-flow visibility."

Exactly how much capital is at stake? "A recent study we looked at says that $250 billion will need to be spent on energy infrastructure from now until 2035. Putting that estimate into perspective, $250 billion is almost equivalent to the aggregate market capitalization of the MLP sector today. That's huge," he says.

Other private equity firms such as Morgan Stanley Private Equity, Quantum Energy Partners and Highstar Capital IV LP weighed in on their outlook for the midstream renaissance, and what they expect from 2012.

Morgan Stanley Private Equity

Morgan Stanley Private Equity, a division of Morgan Stanley Investment Management, has invested nearly $7.9 billion of equity across a range of sectors, including the energy industry. In August 2011, the company made an investment in Denver, Colorado-based Sterling Energy, a midstream infrastructure company with assets and operations in the western U.S. It represents the fourth company that Morgan Stanley Private Equity has formed with key members of the Sterling management team dating back to 1992.

According to John Moon, a managing director with Morgan Stanley Private Equity, investing in Sterling Energy made sense because it offered an attractive opportunity to support growth in two flourishing shale plays. "The Sterling Energy investment involves gathering and processing in the Niobrara in and around Weld County, Colorado, in the Denver Julesburg Basin. It also includes gathering and processing in the Bakken, in the Williston Basin in northwest North Dakota. This is an exciting deal we completed in August of last year and one where we have already added more capital to support the tremendous growth opportunities we are seeing in both basins."

The equity invested will help propel a multi-year construction project to extend and expand Sterling Energy's Ambrose system gathering for Bakken-Three Forks producers in northwest North Dakota and its Yenter system serving Niobrara producers in northeast Colorado. In fact, according to Moon, new infrastructure and private equity have gone hand in hand as of late. Private equity investors like Morgan Stanley Private Equity are targeting underutilized assets to enhance profitability, and in turn, provide capital relief to operators struggling with the demand for more infrastructure.

"One leg of our broader energy strategy is to acquire mature underutilized assets or companies and supercharge them with capital and management talent that allow them to grow and flourish in their attractive end markets," he says.

"There are a number of fields that have been deemed mature, past their prime and in decline. Now with shale technology, these areas have witnessed a complete renaissance. So the strategy we have employed is to acquire mature assets built at a time when the fields they were servicing were much larger and look to acquire them to redevelop more scalable and expandable platforms," says Moon.

This process of finding assets also requires a careful assessment of the management team, which is not a simple task. Management teams deserving of capital need to have specific characteristics in order to qualify as good targets for investment.

According to Moon, "Characteristics that we look for include relevant, best-in-class experience. We are constantly looking for people who know what best-in-class practice is in a given situation. Management also needs a conservative disposition. The long-term prospects for the energy industry are tremendous, but how people manage volatility in the interim is an important part of the equation. Strong management combined with a conservative capital structure are two critical risk management strategies in the energy business."

Exit strategies, in the midst of this flourishing industry, have largely remained unchanged, however. "Morgan Stanley Private Equity has made a series of investments in the energy sector back to 1992, and the exit strategies have typically involved MLPs, which are logical owners for large, already up and running infrastructure."

“One leg of our broader energy strategy is to acquire mature underutilized assets or companies and supercharge them with capital and management talent that allow them to grow and flourish in their attractive end markets.” — John Moon, managing director, Morgan Stanley Private Equity

And, according to Moon, the role of private equity is still as simply elegant as it has ever been. "A key role for private equity in the midstream sector is to acquire assets that are inappropriate for MLPs because of the volatile nature of their existing business and convert them, either through re-contracting or other types of activity, to create more stable, yield-oriented businesses that better suit MLPs. A different private-equity scenario is the greenfield situation where an existing management team partners with a private-equity firm to build new infrastructure. With the passage of time, the development of these assets and the contracts that fall behind these assets can become very attractive to public MLPs and other strategic buyers in that segment of the business."

One of the patterns that the industry will continue to see, according to Moon, is newbuild situations. "Historically, much of the North American midstream energy business has been about better utilization of existing assets. Now, with supply basin dynamics changing so swiftly, this will no longer be the case.

"For instance, there has been a renaissance going on in the northeastern U.S., and that renaissance is going to require different demands on infrastructure than have historically been the case. There are some seismic shifts going on in the way that oil, natural gas liquids and natural gas are being distributed in this country. The speed in which this is happening is incredible. There are basins that are real game-changers. Five or six years ago, people didn't realize these basins could produce the way they have, and now there are billions of dollars of follow-on investment required for infrastructure. It's striking, and of course, very profitable."

Quantum Energy

Quantum Energy Partners is a private-equity provider for the energy industry, and has contributed multiple investments in the midstream arena, with portfolio companies such as Ceritas Energy II and Merchant Energy Holdings LLC. With $6.5 billion of equity under management, it invests across the energy value chain in partnership with knowledgeable management teams.

William Montgomery, managing director at Quantum, feels that management teams will be the key to private equity deals in the near future. Without a solid team, he insists, there is simply no point in investing.

"We look for a chief executive and a team that we like, trust and admire. All three of those are important. We also look for a proven track record. You would be surprised how many people make it to our office and get to a meeting, but don't really have a track record, or have it, but don't do a good job of articulating it," Montgomery says.

Respect for capital is also a major criterion to consider. "We are looking for people that will be careful with our money, who will treat it like it's their own. They have got to realize that we will have to have a quarterly board meeting, we are going to have to ask questions and we are going to have to monitor our investment. We are going to spend a lot of time with them. In the end, of course it's their company, and we want them to run it."

But, in turn, Montgomery cautions that private-equity companies need to be able to stay the course, even in environments that turn risky. Funding companies, such as midstream companies, requires some give and take from both sides. "You need a firm that will stay the course through commodity cycles. It's a cyclical business, and you have to make sure you are with someone who is not going to pull the plug when times get tough, when for example, gas prices get low."

However, Montgomery's outlook for private-equity investment in the energy sector is enthusiastic. Project counts are on the rise, oily and liquids-rich plays are steadily profitable and there is a definite need for more midstream projects. "We think that there is going to be a continued steady drumbeat of private-equity monetizations. There is also a decent amount of initial public offering (IPO) activity that is coming to fruition. The class of energy IPOs for 2012 is going to be off to a good start."

Like Moon, Montgomery believes that there are still private-equity firms looking to enter into newer unconventional plays. "I think private equity is still looking for entry points into key unconventional plays. We get a lot of people talking to us that are looking at Utica and Mississippi Lime deals. I think everyone in the industry is trying very hard not to pay what looks like retail prices for that entry and really have some angle or way to de-risk what we know about the play before we write those big checks," Montgomery notes.

"The fund-raising in the private equity community is very active and I think that I can say it's gaining a great deal of momentum right now. By our count, there are 12 to 15 of the larger, energy-focused funds that are out raising fund sizes that will add up to $15- to $20 billion. I think you are really going to feel pressure to deploy that money. There is just a crushing amount of money coming into the sector."

That crushing amount of capital will determine which projects make it off the drawing boards and into the ground. "The hardest time to invest is always now," he says. "The question is, is now the time? We believe it is."

Highstar Capital

Recently, Caiman Energy LLC, an EnCap Flatrock Midstream portfolio company, completed the second of two recent financings, adding more than $1 billion to help fund its planned expansion of midstream infrastructure in the Marcellus shale.

New York-based Highstar Capital and two of Caiman's existing limited partners were part of the deal, and made joint equity commitments of up to $300 million. The equity will give Caiman more than enough capital to help build out its existing infrastructure in the Marcellus shale.

This isn't the first equity commitment Highstar has contributed to the midstream space, and won't be the last. Michael Miller, partner at Highstar, feels that the company will likely continue to invest in the midstream sector well into 2012, due to the shale-play success of producers.

"You are likely going to see that private equity in midstream is going to be moving, and will be closely correlated with where the upstream E&P production is going. So what you are seeing is that as long as we are in a low-gas environment, which I think we will be in at least through 2012, that infrastructure buildout in dry gas areas will slow down. I don't think you are going to see a lot of new opportunities there. People who have money committed to those areas will continue to build out what they have to build out, but I don't think you are going to see a lot of announcements for large private-equity deals going to build out infrastructure in areas like the Haynesville shale."

Thanks to the low gas price environment, which will likely stay flat for some time, producers are looking to increase their margins with an uplift from NGLs and crude. These areas are receiving increased focus, and oily or liquids-rich plays are hubs of activity as a result.

"These areas like the Marcellus, Utica, Bakken, Eagle Ford, Granite Wash and the Permian Basin have not seen that kind of activity before, so you will see infrastructure being built out in those areas. You'll probably see more midstream buildout on the oil side than you have in the last couple of years because that is where the growth is going to be. In the Utica right now there is a lot of projected drilling activity, but there is little infrastructure activity planned, so looking at management teams and projects in that area is going to be a big focus going forward," Miller says.

“I think there is an increased need for somebody to come in after the development process has started, who is comfortable supplying growth capital, either as equity or preferred equity in size, because these are all capital-intensive endeavors.” — Michael Miller, partner, Highstar Capital

In addition, the onshore focus, still considered to be in its infant stages for some basins, has provided capital partners like Highstar Capital with a window through which to help midstream teams realize the construction of such capital-intensive projects. "With the growth of the shale plays, there is a lot more opportunity to invest now, more than ever. Also, I think the game is shifting from a leveraged buyout strategy, where you look for opportunities to do a classic leveraged buyout, to one where the greatest needs are development and growth capital," he says.

According to Miller, there a lot more people out there looking for teams to get positions in these various plays. "We look for senior management who has sat in a chief executive's chair before, and we also like to see management teams who have experience in working with private equity, who can get things moving and manage the growth," he says.

But, Miller notes, in addition to initiating these pairings with management teams and assets, there is also an advantage to follow-on investment. "I think there is an increased need for somebody to come in after the development process has started, who is comfortable supplying growth capital, either as equity or preferred equity in size, because these are all capital-intensive endeavors," he says.

Highstar Capital's recent equity deal with Caiman is one example. Though it was not the group that found and helped unite a management team with initial capital, the growth of the company was such that it offered an opportunity to secure another tranche of follow-on investment.

"They needed that capital structured in such a way that they recognized the value that had already been created and the risk that they had already taken. They continued to preserve what they regarded as fair upside but at the same time rewarded an investor like us, who was still facing risk, but a different kind of risk than what you deal with on the development and startup side. I think you are going to see more deals like that happening. Because in a lot of cases, the folks that fund development manage risk by spreading their capital across a larger number of deals," notes Miller.

According to Miller, many equity companies go for a portfolio effect, wherein they may invest in 10 startups initially. If as many as four work out well, then the portfolio, managed properly, does well. "The rewards on the winning side exceed the losses you are taking and can generate an attractive rate of return. But if you spread your capital over a large number of plays, when some of those plays start taking off, often you need to bring other capital in to help fund the rapid growth and expansion. That's where we played a role, in that transaction," Miller says.

"The energy business is constantly changing. Sometimes it changes in ways you don't expect and sometimes it changes in ways you do. You need to be both knowledgeable about the industry and how it works, and also flexible because opportunities open up where they haven't been expected before," he says.