backOil and gas exploration companies no longer have to go door-to-door, or ranch-to-ranch, to negotiate oil and gas leases with individual mineral interest owners. Over the last decade or more, pure-play mineral and royalty interest companies quietly began doing the work for them. A quick internet search generates hundreds of companies aggregating blocks of mineral interests all over the United States. Some of these outfits are small, thinly-capitalized operations, while others are sophisticated, well-funded enterprises with large holdings throughout the country. The large consolidators typically are backed by private equity firms and managed by some of the most experienced management teams in the industry.
As this subsector matures, private equity sponsors of bundled mineral and royalty interests are evaluating dual-track exit alternatives through either a sale or an initial public offering of mineral and royalty interest master limited partnerships (MLPs). These MLPs are tax efficient, non-cost-bearing growth vehicles that may achieve compelling valuations in the public markets by providing attractive yields and long-term growth potential.
This articles introduces the basic concepts governing mineral and royalty interests and explains why aggregating these interests is beneficial to both mineral interest owners and oil and gas producers. Against this backdrop, the article discusses the MLP as a tax efficient structure through which to finance further consolidation as the sector matures. Finally, we highlight important structural considerations for private equity-backed mineral and royalty interest companies to consider as they evaluate the MLP as a vehicle to finance their long-term growth strategies.
Mineral and Royalty Interests
Mineral and royalty interest owners generally are entitled to a portion of the revenue received from the production of oil, natural gas and associated natural gas liquids from the acreage underlying their interests, net of post-production expenses and taxes. Mineral and royalty interest owners are not obligated to fund drilling and completion costs, lease operating expenses or plugging and abandonment costs at the end of a wells productive life.
Mineral rights (or the mineral estate) are legal rights to sub-surface materials including oil, natural gas and other hydrocarbons. A mineral interest owner has the right to:*use the surface as is reasonably necessary to access the minerals (subject to state law principles of accommodation),
*convey all or a portion of its mineral rights or executive rights,
*receive bonus consideration,
*receive delay rentals or shut- in payments, and
*receive royalty payments. When a mineral interest owner leases the mineral estate to a working interest owner (typically the operator), the mineral interest owner will receive a lease bonus for each mineral acre leased, and the mineral interest owner will reserve a royalty generally between a 1/5th and 1/4th, depending on market trends in the basin. A royalty typically entitles the owner to a percentage share of production, or the value derived from production, of oil, natural gas or other hydrocarbons free of the cost of drilling and production, net of post-production expenses (such as gathering, processing and marketing expenses) and taxes.
In addition to a standard royalty retained by the mineral interest owner, the working interest owner may carve out from its working interest a cost-free portion of the revenues it would otherwise receive. This is known as an overriding royalty interest (ORRI). An ORRI may be conveyed by the working interest owner to a land man, to a financier, or to the mineral interest owner to enhance the terms of the lease. An ORRI may have a limited term, and may terminate once the recipient has received a specified cash payment, or it may terminate upon the recipient receiving a specified value of production. As a general rule, an ORRI will terminate if the underlying lease expires and all mineral interest revert to the owner of the mineral estate.
Suffice it to say that there is generally no limit on the manner in which the mineral estate may be carved up however, royalty interests, working interests, and ORRI are the most commonly negotiated mineral interests.
Benefits of Mineral and Royalty Interest Consolidation
Mineral and royalty interest consolidation appears to be creating a more efficient market for negotiations between mineral interest owners and the oil and gas producers with which they contract for consolidated acreage positions. Consider the following potential benefits for oil and gas producers and mineral interest owners:
Mineral Interest Owners
*Aggregators are likely to receive more favorable lease terms, and have the expertise and flexibility to modify terms to encourage development.
*Aggregators have access to proprietary market data and other information.
*Aggregators have increased negotiating leverage relative to individuals.
*Aggregators structure leases to encourage development by producers.
*Aggregators actively monitor and manage inventory of mineral and royalty interests to ensure the economic benefits of the lease are realized.
Oil and Gas Producers
*Producers potentially can lease larger acreage positions from fewer owners.
*Producers benefit from negotiating with sophisticated parties to streamline the process and manage expectations.
*Producers may benefit from proprietary data and market knowledge acquired by aggregators who focus on specific basins.
*Producers reduce administrative burdens by contracting with a manageable number of aggregators, instead of hundreds or thousands of individual mineral interest owners. Given these potential benefits, the trend towards mineral and royalty interest aggregation is compelling. As this subsector matures, we expect many of the mineral and royalty interest companies will benefit from further consolidation in the market. For example, Kimbell Royalty Partners, a Fort Worth, Texas-based owner of oil and natural gas mineral and royalty interests, recently acquired over one million gross acres of overriding royalty interests in the Anadarko Basin for approximately $16 million. As this consolidation trend continues, we believe access to low-cost capital through a MLP will be a competitive advantage for buyers.
Structuring Mineral and Royalty Interest MLPs
Designing an optimal structure for a mineral and royalty interest MLP requires analysis of the traditional MLP structure and the modifications necessary to accommodate a mineral or royalty focused business. As with most MLPs, the primary objective is to structure an investment vehicle that generates sufficient current cash flows to pay distributions to unitholders, has low capital expenditure requirements to grow its asset base, and has significant long-term growth opportunities to increase cash distributions to unitholders over time. Each company is unique, and there are material, subtle variations in asset characteristics, cash flow volatility, and other considerations that may warrant modifications to the typical MLP structure.
Organizational Structure of MLP
The basic organizational structure of a mineral and royalty interest MLP is substantially similar to other MLPs that have been around for several decades. It involves two tiers, with the MLP being a limited partnership whose sole asset is the ownership of all of the membership interests in a limited liability company or all of the partnership interests in another limited partnership that owns and operates the assets of the operating business.
The general partner of the MLP typically owns a non-economic interest in the MLP, and may own rights to increasing portions of cash distributed by the MLP, which are referred to as incentive distribution rights. Limited partnership interests in the MLP are allocated between the sponsor of the MLP and the public investors. A portion of the sponsors limited partnership interests may be subordinated (so called subordinated limits) in right of distribution payments to the limited partnership interests held by the public. Subordinated units are designed to ensure that public investors receive all of cash distributions to which they are entitled before the sponsor is entitled to receive distributions.
The two tier structure is based upon the desire for operational, legal, tax and financial flexibility. For instance, the two tier structure allows an MLP to effect double breasted financing debt financing at the subsidiary level and debt financing at the MLP, which is structurally subordinated to subsidiary level debt. Additionally, the two tier structure enables the MLP to segregate assets and debt among multiple subsidiaries for operational accountability, liability, regulatory, tax or various other reasons.
Economic Structure of MLP
The economic structure of any MLP is based on expected cash flow from which distributions to limited partners will be paid quarterly or monthly. Limited partnership units in a MLP initially are priced or valued on the basis of an annual yield implied by the stated annual cash distributions to investors. MLPs are generally newly-formed entities with little or no operating history, and projecting cash flow and distributions can be imprecise so MLPs have, in many cases, incorporated a distribution support mechanism into the structure to provide a level of assurance that the stated distribution will be paid.
Subordinated Units. The MLP will issue two classes of limited partnership interests in an IPO, subordinated units and common units. In the offering, common units will be issued to the public investors, and the sponsor will receive both common units and subordinated units that are convertible into common units if certain conditions are satisfied. By their terms, common units are entitled to receive minimum cash distributions before the subordinated units are entitled to receive any cash distributions. Consequently, the sponsor bears a disproportionate risk that there will be a shortfall of cash to pay the minimum distribution on all of the common units and all of the subordinated units that is, there will be less than 100% distribution coverage.
Incentive Distribution Rights. Incentive distribution rights are designed to encourage the general partner (owned and controlled by the sponsor) to operate the MLP in a manner that will increase cash flow from operations and cash distributions to the limited partners. The owner of the incentive distribution rights is entitled to receive an increasing percentage (historically, up to 50%) of the cash distributions above specified levels or targets. The following table illustrates the allocation of distributions as distribution thresholds are satisfied:
Marginal Percentage Interest in Distributions
Total Quarterly Distribution Target Amount Up to 1 st Target (115% of MQD)* Above 1 st Target, up to 2 nd Target (125% of MQD) Above 2 nd Target up, to 3 rd Target (150% of MQD) Above 3 rd Target
Unitholders 100% 85% 75% 50%
GP & IDRs 0% 15% 25% 50%
*Minimum Quarterly Distribution
Again, incentive distribution rights are designed to encourage the general partner to increase cash flows from operations and distribute increasing amounts of cash to limited partners. Some practitioners also suggest that incentive distributions compensate the sponsor for sharing a disproportion downside risk associated with subordinated units. The flaw in this theory is that subordination generally ends (subordinated units convert to common units) when certain conditions are met, while incentive distributions are perpetual.
Considerations for PE-Backed Mineral and Royalty Interest Companies
The MLP offers a flexible platform capable of accommodating a number of structural concerns relevant to private equity-backed mineral and royalty interest companies. For example, there are customary MLP terms that make sense for a corporate sponsor, but run counter to the practical realities of a private equity sponsor. That being the case, there are a number of important considerations and decisions for private equity-backed mineral and royalty interest companies seeking to rationalize the MLP structure to efficiently monetize the investment.
Partial Exit in Connection with IPO
No matter how compelling the long-term prospects are for a particular portfolio company, private equity firms are required to exit investments within a specified period of time and return capital to investors in the private equity fund. Exiting through an IPO initially results in only a partial exit at closing, with the balance of the private equity funds investment to be sold over time on the way to completely exiting its investment.
If possible, a private equity sponsor will structure the offering in a manner that will enable the firm to extract a material amount of cash from the MLP at closing. In some cases, the amount of cash extracted by the sponsor will exceed its original invested capital, with the balance of the equity left on the table to increase returns. Additionally, private equity sponsors frequently sell a portion of their limited partnership interest in connection with the IPO.
Whatever the case, an IPO almost never results in a complete exit by the sponsor, which means that registration rights and the priority of those rights are critical. In connection with the IPO, private equity sponsors should negotiate highly favorable registration rights with the power and flexibility to access the market in a variety of circumstances. Remember, mineral and royalty interest MLPs are non-cost-bearing vehicles so it is not anticipated that these MLPs will have significant capital needs beyond acquisition capital.
Cash Distribution Pol icy
Given the cash flow profile associated with mineral and royalty interests, a sponsor and its advisors will decide what cash distribution policy makes sense for investors, either minimum quarterly distributions or variable distributions, and whether distributions will be paid monthly or quarterly. It is too early to predict where the market will lead us at this point. For example, Blackstone Minerals, L.P. stated a modest minimum quarterly distribution, and provided forecasted distribution increases through 2019. On the other hand, Viper Energy Partners LP, with a very small public float and a large affiliate corporate sponsor, elected to pay variable distributions quarterly. Kimbell Royalty Partners LP, a roll-up of various mineral interest owners, also elected to pay variable distributions quarterly.
Historically, it was a valuation issue whether an MLP promised a minimum distribution or stated that distributions would vary from quarter-to-quarter. That is, variable distribution MLPs generally paid a higher yield relative to MLPs promising a minimum cash distribution. Whether that remains the case for mineral and royalty interest MLPs is unclear.
Assets Contributed to MLP
Private equity sponsors will have to decide whether to contribute all or a portion of the mineral and royalty interest housed in one or more portfolio companies to the MLP in connection with the IPO. If the sponsor decides to contribute less than all of the interests to the MLP, what objective criteria will be used to determine which assets are suitable for the MLP and which assets are not? The public market will likely respond favorably to contributed assets with current cash flows, and assets that represent inventory likely to be developed in the near term to grow production. It may be more prudent to contribute assets in more active basins to the MLP, and retain assets in more prospective areas.
Of course, the return horizon for the private equity fund may dictate that all interests be contributed to the MLP to decrease the timeline for a complete exit of the investment.
Cash Flow Analysis and Projections
The cash flow analysis of the MLP assets should drive structuring terms. The structuring team should analyze carefully the historical financial statements and forecasted financial statements of the MLP to determine whether various distribution protections and incentives may be warranted. For example, a mineral and royalty interest MLP with a high concentration of assets in the Permian Basin, the DJ Basin, or the SCOOP/STACK plays may be viewed as more stable from a historical and forecasted cash flow prospective than assets in the Marcellus Shale. Therefore, it would not be unreasonable for the sponsor to suggest that subordination is unnecessary, or that a smaller percentage of units should be subordinated.
Subordination and Subordination Period
As discussed, subordinated units are a distribution support mechanism designed to ensure that public investors receive the promised minimum distribution before the sponsor is entitled to receive any distributions. Obviously, if the MLP is structured with variable distributions, as opposed to minimum distributions, then subordination is unnecessary. Even for MLPs structured with minimum distributions, subordinated units are not necessarily mandatory or even appropriate. Whether to incorporate subordinated units into the structure depends on an assessment of the historical and projected cash flow associated with the assets in the MLP. The stronger the cash flow profile of the MLP, the less likely there is a need for subordination.
Incentive Distribution Rights
For a private equity sponsor, it is questionable whether incentive distribution rights make any sense at all. Recall that, among other suggested motives, incentive distribution rights are issued to encourage the general partner (owned by sponsor) to increase cash distributions to limited partners over time. Normally, it takes several years or more for the general partner to begin to benefit from its incentive distribution rights. Barring unanticipated market conditions, private equity sponsors have fully exited the investment by that time.
Again, often times the practical reality of the investment horizon of a private equity sponsor will dictate what structure and incentives make sense to the sponsor.
Hedging Strategy
Mineral and royalty interest MLPs are not immune from declines in commodity prices. Rather, these entities typically require less leverage to grow the asset base, and the non-cost-bearing nature of the assets allow for greater flexibility in a low commodity price environment.
Whether to hedge production (and what percentage of production) will depend on a holistic evaluation of cash flow profile of the MLP assets and, to a large degree, market sentiment about the direction of commodity prices following the public offering.
Growth and Development Prospects
Most MLP investors expect equity appreciation and distribution growth over time. To meet these expectations, MLPs must have the ability to source accretive acquisitions or pursue low-cost organic development activities. For a mineral and royalty interest MLP, this means: (1) potential additional acquisitions from the sponsor in the future; (2) encouraging additional development of mineral and royalty acreage in its current inventory; (3) pursuing third-party acquisitions from producers with large mineral and royalty interest holdings; or (4) acquiring other mineral and royalty interest consolidators. The bottom line is to realize the benefits of the MLP structure growth opportunities must be compelling and ultimately realized.