Every business needs energy, making the energy business the largest business in the world. And an almost unlimited number of opportunities exist to invest in the upstream, midstream and downstream sectors of energy. But whether value is created or lost is largely dependent on an investment team’s strategy and the integrity and skill of the targeted management.

Today, investors find it important to investigate the track record of an investment firm and each of the principals. For example, in the midstream business, the principals must be able to evaluate the probable success of the drilling organization that will furnish the liquids for transporting and processing.

“We are in the midst of building and spending money, and haven't sold anything in 2010 or 2011," says Dheeraj Verma a managing director for Quantum.

What is the track record of the operating company? How large are the reserves and the wells for the gathering system fill-ins or step-outs? These are just a few of the questions investment organizations, such as private-equity providers, must answer before taking action.

The midstream business requires a high level of skills in the financial and technical areas along with experience and understanding of the entire energy business. Some investment firms like to invest primarily in start-up entities, while others prefer aggregating small properties into a larger, more efficient company. Still others try to find a balance of unique risk-reward characteristics of the two strategies.

Complimentary sectors

In Houston, Quantum Energy Partners LP, an investment firm composed of individuals from varied financial, technical and professional disciplines, sees midstream investing as an area of profitable and reliable return on investment.

“We currently have about $300- to $500-million allocated to midstream,” says Dheeraj Verma, a managing director for Quantum. In addition to being active in Quantum’s upstream and power investing, Verma is one of the senior partners of the firm and oversees all midstream investments.

Founded in 1998, the firm manages more than $5.7 billion of equity. The team targets looks for proven management teams that possess a clear vision and whose companies have sustainable competitive advantages within well-defined segments or strategies in the energy industry.

This year, the firm has been actively looking at new companies and management teams and “will be investing hundreds of millions more during the next twelve to twenty-four months,” says Verma. He has a positive outlook for the midstream sector, which Quantum defines as operators with gas storage, pipelines, gathering and processing facilities.

“Our advantage is that we have upstream companies we can compliment with midstream, so we invest in areas and businesses where we can add some insight or value, based on our upstream expertise,” he says. "We take a five- to ten-year view when we look to invest.”

The firm is opportunistic, managing its investments according to strategies, not timelines. “Some years we may spend $500 million to $1 billion, and some years we may not spend anything. It depends on the opportunities available. Our initial investment is usually in the $100- to $400-million range in any one deal. That's our sweet spot," says Verma.

This year, Quantum plans to invest in companies building natural gas storage assets and processing plants in shale plays. Many of its portfolio companies are spending building greenfield facilities rather than acquiring infrastructure.

Currently, the firm is working the midstream space through two of its portfolio companies—Quantum NGS Holdings LLC (QNGS) and Ceritas Energy II LLC.

Quantum partnered with Dr. Larry Bickle and Andy Lang, two midstream veterans, to form QNGS. They invest in natural gas storage projects in the U.S. and Europe. Through its subsidiary companies, Merchant Energy Partners and Icon NGS, QNGS pursues projects that are at various stages of completion, including attractive greenfield candidates, prospects in early-stage development and existing facilities that are underutilized. Recently, QNGS entered into the construction phase of its East Cheyenne Gas Storage facility in the Rocky Mountains.

The second is a gas-gathering and processing company namedCeritas Energy II LLC, led by Richard Sherrill. Also based in Houston, Ceritas Energy is focused on developing and operating its midstream assets in the Marcellus shale region.

"Those are folks that we are proud to be in business with,” Verma says, referring to the two major players. Yet, more midstream business is ahead. “Right now we are looking at a couple of other companies to back.”

At present, Quantum is holding on to its investments and hasn’t executed any exits recently. “We are in the midst of building and spending money, and haven't sold anything in 2010 or 2011," he explains.

Although Quantum has a solid portfolio, it didn’t come without a fight. "One of the challenges in investing in midstream is competing with lower cost capital. When you think of MLPs today, the capital markets are giving them an even lower cost of capital than usual. Also, there is so much upstream activity going on, we have to make sure we are building the right infrastructure for the right play.”

Meanwhile, many MLPs are “investing heavily in the midstream business to chase dividend growth,” he says. The real question is: Is there too much money chasing too few assets? For some projects, the answer is yes.

“Some MLPs are trading at yields that are overly optimistic and do not reflect the underlying risks in their businesses,” he warns. “Over the past year or two, some of these MLPs have paid a high valuation for buying assets. Are those MLPs going to be able to make those acquisitions work?

“We are a disciplined and patient investor, so it makes it very interesting to watch and try to predict how sustainable these high multiples are that some are paying for these assets," he says.

New fund

Elsewhere, another private-equity provider also ties its investments to the upstream and midstream sectors. Based in Dallas, Energy Spectrum Capital was founded in 1996 to manage private-equity funds that make direct investments in companies that acquire, develop and operate energy assets.

“We have worked with many smart, honest, hard-working and successful managers. Finding them is the key,” says Energy Spectrum Capital’s partner, Ben Davis.

"Our midstream focus centers on pipelines, gathering systems and processing plants,” says one of the firm’s partners, Ben Davis, who serves as a director on the boards of three Energy Spectrum portfolio companies.

“We have in excess of $500 million currently invested in existing portfolio companies, and we have an additional $1 billion to invest. We will invest the new $1-billion fund over the next four years when we see good opportunities with seasoned management teams, such that money doesn't necessarily go out at an even pace of $250 million per year."

Ever the optimist, Davis expects to see better investment opportunities in 2011 than he and his partners saw in 2010, “which was still a good year for investing,” he says.

"In our new fund, Energy Spectrum Partners VI LP, we will typically invest $50- to $125 million in each portfolio company,” he explains. Yet, the initial investment can be as little as $1 million, as long as there is the opportunity to invest at least some $50 million or more, over time, he explains.

Much like other private-equity firms, Quantum knows that the most important element of successfully investing in midstream is finding seasoned, entrepreneurial management teams, and Davis says the firm has been “very fortunate” during the past 15 years.

“We have worked with many smart, honest, hard-working and successful managers. Finding them is the key,” he says.

The opportunities come from meeting the needs of producers, by building, owning and operating value-adding pipelines, processing plants, gathering systems and other midstream assets. If the producer's needs are being met, then the investment returns will follow, he says.

Cheap capital

Headquartered in Boston, ArcLight Capital Partners was formed in 2001 by Daniel R. Revers and Robb E. Turner. The firm has managed more than $6.8 billion through its four investment funds, including some $1.3 billion in upstream oil, gas and coal assets and related service businesses through 18 deals, and about $1.7 billion in gathering, processing, storage, refining and related service businesses in 12 deals

Today, ArcLight has nearly $2 billion invested in midstream assets with a total enterprise value of more than $7 billion.

“This year, we will invest opportunistically across the entire energy value chain—production, midstream, power and other downstream assets,” says Revers. “While we have no specific allocation to midstream assets, our pipeline suggests that we will invest several hundred million dollars in midstream assets this year.”

ArcLight invested a similar amount in the midstream space in 2010. “In fact, beginning in 2007, we have been able to source and close many attractive midstream investments as a result of the burgeoning gas and oil shale plays in North America.”

“Underlying commodity risks, such as absolute price, time spreads, basis spreads and crack and frac spreads, are being underpriced by the uninitiated, which could come back to bite them,” says ArcLight Capital Partners co-founder Daniel R. Revers.

Looking forward, the firm expects to invest “several hundred million dollars” in midstream assets in 2012. Typical investments range from $100- to $200 million, although it recently committed $500 million to a midstream investment that may ultimately exceed $1 billion.

“We like companies that are early movers in opening up new production areas, with the scale and market presence to create attractive, high-return, organic capital investment opportunities,” he says. “We like companies that have the commercial capabilities to fully leverage the value of their infrastructure, which can create incremental value to both customers and owners. Most of these companies are focused on the emerging onshore unconventional natural gas-based plays, but we also see significant infrastructure opportunities around emerging onshore oil plays.”

In February, ArcLight exited a major investment when its portfolio company, SG Resources Mississippi LLC and its primary asset, the 40-billion-cubic-foot Southern Pines Energy Center gas-storage facility, was sold to Plains All America Storage for $750 million.

Like Quantum Energy’s Verma, Revers agrees that cheaply priced capital can be a challenge to private-equity firms, saying, “Given the health of the debt and equity capital markets, capital is relatively abundant and cheap right now.”

Revers explains that the current round of quantitive easing has lowered the cost of capital and has allowed many uninitiated investors to participate in the market—particularly the gas markets. It has also postponed or eliminated “a day of reckoning” for some “lower quality participants” who were facing liquidity issues, he says.

“Underlying commodity risks, such as absolute price, time spreads, basis spreads and crack and frac spreads, are being underpriced by the uninitiated, which could come back to bite them,” he warns.

“I believe that navigating these risks requires deep financial, operational and commercial skills to earn an acceptable risk-adjusted return, because simple financial arbitrage is not available.”

He sees the best opportunities in high-value, large-scale, long-lead-time projects. Such projects create barriers to entry that advantage long-term industry investors with deep industry relationships such as ArcLight. “Flexible private capital can do things that public capital cannot,” he states

When evaluating investment opportunities, ArcLight’s managers look for strong base cash yields supported by favorable contracts; multiple value creation based on cost, revenue and organic growth levers; and the availability of multiple exit options.

Just 10 years ago, the midstream sector was “a fairly boring corner” of the energy world, say the executives. But during the course of the past decade, it has grown into a very prominent investment segment of energy. Gas and oil shale plays are attracting numerous private-capital providers to the midstream world, including buyout funds, infrastructure funds, energy-focused private-equity funds, and even some of the big sovereign wealth funds and foreign pension plans. Now, by most accounts, such firms are in it for the long haul.