The proposed recapitalization was approved by shareholders, despite our efforts to the contrary.
Good luck to all EROC shareholders and thank you for monitoring this site.
The proposed recapitalization was approved by shareholders, despite our efforts to the contrary.
Good luck to all EROC shareholders and thank you for monitoring this site.
Several unitholders have contacted us recently for an update.
The company filed its final proxy on March 30, 2010 and a special meeting has been scheduled for May 14, 2010.
We continue to believe that the current recapitalization proposal is adverse to unitholders’ interests and encourage holders to vote NO.
We have been in touch with large holders, and based on our discussions, we think that the proposal has little chance of passing in its current form.
This website will be dynamic, and we will update it as soon as material new information comes out.
Please read this disclaimer before reading any further on this website.
This website is devoted to the current recapitalization transaction proposed by Eagle Rock Energy Partners, L.P. (the “Company”), which trades under EROC on Nasdaq. This website is operated and administered by Kerrisdale Capital Management. It is not endorsed or approved by Eagle Rock Energy Partners, L.P. or any affiliated entities, and all information contained herein is based on publicly available information.
We are using this website to explain why we believe common unit holders should vote NO to the most recent recapitalization proposal.
Accounts managed by Kerrisdale currently hold EROC, and we may buy or sell shares at any time. We will not disclose our sale if and when we sell, and we will not disclose that we have changed our thesis if we discover something faulty with our analysis at a later date.
If you are an EROC unitholder, we encourage you to distribute this link to other public unit holders. This site and analysis will be updated as revised proposals or other relevant facts emerge.
While this site at http://www.fair-eroc.com is devoted exclusively to a discussion of EROC’s recapitalization proposal, a further analysis of the company and valuations of EROC can be found on our website at www.kerrisdalecap.com/blog.php.
On January 14, 2010, EROC issued a preliminary proxy regarding a recapitalization transaction with its sponsor Natural Gas Partners (“NGP”), and the transaction will likely be voted on by public common holders at some point in the next 6 months. This post will explain why we think the current transaction is adverse to common unit holders’ interests.
EROC owns various oil and natural gas assets, of both the midstream and upstream varieties, and it suspended its dividend in early 2009 due to declining commodity prices and a potential debt covenant breach in 2010. The proposed recapitalization aims to reduce leverage to avoid a covenant default.
We’re going to discuss three scenarios in this post:
1) No Recapitalization
2) Currently Proposed Recapitalization
3) A Fair and Appropriate Recapitalization
We prefer Scenario 3.
Download our analysis here. Page 1 provides a summary of the three scenarios, highlighting, for each of the next 8 quarters, EROC’s (i) forecasted leverage ratio, (ii) forecasted distribution to common unit holders assuming 80% of DCF, and (iii) implied stock price, given the forecasted distribution. Pages 2-4 provide more detailed breakdowns of each of our 3 scenarios.
We have based our scenarios on the projections provided in the January 14, 2010 proxy. These projections have been provided by management, and, as a general rule, we recognize that company-generated projections can sometimes be skewed to support a particular valuation, leverage or event that a given company supports.
In particular, we are confused why 2011 EBITDA in a “transaction rejected” case is $169.7mm, while 2011 EBITDA in the “transaction approved” case is $165.5mm. If the transaction is approved, the Company would sell its Minerals business, which should generate $20mm to $25mm of EBITDA in 2011, based on the Company’s projections. While we understand that the Company is spending more capex if the transaction is approved, the extra cumulative capex of $30mm in 2010 and 2011 appears to generate $15mm+ of EBITDA in 2011, an unusually high return on capital within a year’s time.
But we have no particular insights into the inner workings of the Company and therefore have relied on the Company’s projections in our scenario analyses. Sometimes, company-generated projections are completely objective, and aspire to illustrate an accurate portrayal of a company’s earning power over the projected period. This may certainly be the case with the EROC projections provided in the January 14, 2010 proxy.
Scenario 1: No recapitalization
In a scenario where no recapitalization occurs, EROC would steadily pay down bank debt with free cash flow throughout 2010 and 2011. Under our assumptions, the company would default under its covenants in the fourth quarter of 2010 and first quarter of 2011.
Note that a covenant violation is not all that problematic. EROC’s 2010 EBITDA will be depressed by its 2010 hedges, and per the Company’s projections, 2011 EBITDA will be 20% higher than 2010 EBITDA. EROC is not the type of business that banks would force into bankruptcy, nor would a bankruptcy judge look fondly at lenders who pushed into Chapter 11 an MLP that merely broke a 5x leverage test in a trough year where earnings are depressed by hedges. The Company’s bank group is comprised of revolver lenders, not distressed hedge funds. We would expect a leverage breach to simply lead to an increase in the Company’s interest rate. In addition, a leverage breach would put pressure on the Company to sell its Minerals business to pay down bank debt. As we discuss in Scenario 3, that is exactly the ideal outcome for EROC – namely, that the Company recapitalizes mainly by selling its Minerals business and conducting a fair rights offering / secondary offering to raise some equity to reduce debt.
In our No Recapitalization scenario, shareholders would receive no distribution until after 2011, due to the Company’s covenant violation and high leverage throughout 2011.
Here is what Scenario 1 would look like under our assumptions:
A more detailed breakdown of the calculations behind this summary box is provided on page 2 of the attached materials.
- In a No Recapitalization scenario, leverage is reduced to 3.9x by 4Q11, providing a sufficiently low leverage ratio by the end of 2011 for distributions to be re-instated, in our opinion. Management has stated that it would prefer a leverage ratio of 3.0x to 3.5x, an opinion which we respect and which leads to our preference for our Scenario 3 over a No Recapitalization scenario
- Distributable Cash Flow for 2011 would be $112mm, implying $1.93 per common unit of distributable cash flow. At a conservative 75% payout ratio, we achieve $1.44 of distributable cash flow. If we apply an 11% dividend yield to that distribution, we arrive at a stock price of $13.13, which is 208% greater than the current stock price
- While a status quo situation would delay a common unit distribution until at least the end of 2011, the resulting distribution, when it occurs, would likely lead to a stock price at least double today’s current prices
Scenario 2: NGP Proposal
The most recent NGP proposal has seven parts:
1. For each common unit, all common holders will receive a 0.35 detachable right to acquire, for $2.50 per right, (i) a common unit and (ii) a detachable two-year warrant. The warrant will be exercisable at $6.00 per share. The rights offering will be used to pay down debt.
2. If EROC’s Conflicts Committee determines it is in the best interest of the partnership, EROC will complete a secondary public offering. The secondary offering will be either (i) no more than $105mm at a price not less than $3.10 or (ii) no more than $140mm at a price not less than $3.40. NGP has agreed to backstop up to $41.6mm of the secondary offering at a price of $3.10 (note that the current EROC stock price is north of $6.00, so NGP is offering its backstop at a high 50% discount).
3. The subordinated units and incentive distribution rights will be effectively cancelled.
4. EROC will pay a subsidiary controlled by NGP $29mm in either cash or in EROC common units approximately equivalent to $29mm. Note that if EROC receives its distribution in shares, it will also receive a right and warrant associated with those new shares.
5. EROC will be granted the option to purchase its general partner in exchange for 1mm common units.
Let’s isolate the value that NGP is adding to this transaction:
First, the rights being contributed to common holders have nothing to do with NGP.
Second, in terms of the secondary offering, NGP is offering to backstop the secondary offering at $3.10, which equates to a 50% discount to EROC’s trading price of $6.31 as of January 12, 2010. Thanks, but no thanks – we’re sure there are hundreds of hedge funds and private equity firms that would be willing to backstop an EROC secondary offering at a high 50% discount.
Third, in terms of the contribution of general partner units and incentive distribution rights, EROC is an MLP that will have $1.65+ of arrearages by the time any transaction closes. The GP’s incentive distribution rights are the least of common unit holders’ concerns, and a negligible amount of value is being created by the contribution of the GP and the incentive distribution rights to the limited partnership.
So what remains? In our view, NGP is essentially canceling its subordinated units in exchange for $29mm (plus associated rights/warrants if they receive the fee in shares). These subordinated units are not worth $29mm+. With $1.65+ of arrearages ahead of them, the subordinated units will be underwater for 5+ years. We at Kerrisdale believe they are worth very little.
We do not think that this transaction makes sense. In our opinion, NGP is asking for $29mm for providing virtually nothing of value to EROC. Common unit holders should vote down the NGP proposal.
Below is our summary leverage, quarterly common unit distributions, and implied stock price assuming an 11% dividend yield, given the following assumptions:
• Full participation of rights offering
• No secondary equity offering and no exercise of warrants
• Contribution of GP to the EROC LP in 4Q 2011
A more detailed breakdown of the calculations behind this summary box is provided on page 3 of the attached materials.
- Compared with the no-restructuring scenario, the NGP proposal allows the company to re-instate distributions in 2H 2010.
- However, the implied share price is lower than in all periods projected in Scenario 3, which we will discuss next.
- This is mainly due to the $29mm transaction fee NGP is assessing for the currently proposed restructuring.
Scenario 3 – Sell Minerals business and Rights Offering
We suggest a simple recapitalization as follows:
1) Sell Minerals business to Black Stone for $174.5mm
2) Conduct a rights offering whereby all common holders will receive a 0.5 detachable right to acquire, for $2.50 per right, a newly issued common unit.
We think that if the NGP transaction is voted down, EROC will take the next step to simply sell its Minerals business and use those proceeds to repay bank debt. Combined with the company’s healthy free cash flow generation, a sale of the Minerals business should be sufficient to bring EROC to a manageable leverage ratio and to restart distributions in the second half of calendar year 2010.
There is no reason that the Black Stone transaction has to be conditioned on the current NGP transaction being consummated.
If management prefers a leverage ratio of 3.0x to 3.5x by year-end 2011, we support a rights offering to raise the additional necessary cash. In our scenario analysis, we have assumed a rights offering on the same terms as currently proposed in the current transaction.
In the event the Company does not raise enough equity capital through the rights offering, we support a small secondary offering at a 10% discount to the current share price. We believe that the Company does not need NGP’s offer to backstop a secondary public offering at a 50% discount in order to complete it.
Here are our forecasts under an alternative scenario involving (a) the sale of the minerals business, (b) 0.35 rights to purchase 1 common share for $2.50:
A more detailed breakdown of the calculations behind this summary box is provided on page 4 of the attached materials.
As we can see, a simple sale of the minerals business and a $50mm capital raise via a rights offering should be sufficient to bring the company to a manageable leverage ratio.
- Similar to the NGP Proposal scenario, this alternative recapitalization allows the company to re-instate distributions in 2H 2010.
- However, the implied share price is higher than in all periods projected in Scenario 2.
- This is mainly due to the removal of the $29mm transaction fee NGP is assessing for the currently proposed restructuring, which we believe is unwarranted.
Other Things We Don’t Like
We don’t understand the rationale behind the $6 warrants. If NGL prices rise or EROC otherwise performs well operationally, EROC will not need the additional capital to reduce leverage. If NGL prices decline or EROC otherwise performs poorly operationally, the share price will decline and shareholders will not be able to exercise the warrants, even though that precisely is when EROC would need additional capital. Warrants are used for a variety of reasons, most often to incentivize certain parties or as consideration to out-of-the-money stakeholders. None of those rationales apply to the warrants issued here. Warrants also create unnecessarily complicated capital structures and an overhang over the stock price.
We strongly advocate the removal of the $6 warrants.
Rights and Shares associated with the $29m fee to NGP
Under the current recapitalization, if EROC chooses to pay its fee to NGP in shares, NGP would also receive 1 right and 1 warrant commensurate with its newly issued shares. Given that we are opposed to the $29mm fee to NGP, we are doubly opposed to NGP receiving a right and a warrant to go along with the $29mm in common units it would receive.
Restructuring Scenarios Conclusion
The currently proposed transaction to restructure Eagle Rock Energy Partners, LP redistributes value from common unit holders to Natural Gas Partners in an unfair manner.
Currently, NGP is providing negligible value through its secondary offering backstop; its contribution of highly out-of-the-money subordinated units and incentive distribution rights; and its proposal to transfer the GP units to EROC in exchange for 1mm common shares. In exchange, it is asking for a $29mm payment.
We would expect that if the current transaction is voted down, the Company’s Board of Directors has a fiduciary duty to go ahead with a more fair and appropriate recapitalization involving the sale of the Minerals business and a rights offering. If the Board chooses not to propose a modified restructuring simply because common unit holders were unwilling to support an unreasonable fee to EROC’s sponsor in the initial restructuring proposal, we believe that the EROC board would be breaching their fiduciary duties to common unit holders, and would be exposed to potential lawsuits.
In terms of the likelihood of the current transaction being approved / rejected, we would note that the transaction must receive the approval of a majority of all common unit holders not affiliated with NGP, the Company’s general partner, or any related affiliates.
We don’t view the current transaction as a choice between getting an unfairly reduced distribution in 2010 versus having to wait for a more fair distribution in 2012/2013. There is no reason why common unit holders cannot demand a fair distribution in 2010, via (i) a sale of the Minerals business and (ii) a rights offering. The way to make that demand is to vote NO to the current transaction that EROC has proposed to common unit holders.
We have the utmost respect for Natural Gas Partners and the co-investors in its various funds that own NGP subordinated units. But we don’t think that EROC should pay NGP $29mm in exchange for its worthless subordinated shares / incentive distribution rights and its unnecessary backstop… unless EROC is equally willing to buy an old sofa chair we currently have languishing in the Kerrisdale Capital office. We are willing to sell our sofa chair for $29mm, and would be fine with either cash or newly issued EROC common units (at a 10% discount to the ten-day trading average, please).
Please send all relevant inquiries, on either EROC or our sofa chair, to email@example.com.
Kerrisdale Capital Management
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