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    Saturday, September 19, 2009


    Natural Gas Partners (NGP) proposed transactions with Eagle Rock (EROC)

    Natural Gas Partners (NGP) have proposed a series of transactions with Eagle Rock Energy Partners (EROC). These transactions involve:

    1. A rights offering to current holders
    2. An equity offering back stopped by NGP
    3. Sale of EROC’s Minerals Business to NGP with the opportunity to sell to a higher bidder if one arrives
    4. Repurchase by EROC of NGP’s Subordinated units, some General Partner Units and the attached Incentive Distribution Rights (IDRs)
    5. An option to repurchase all of the General Partner (GP) Units
    6. New Equity Incentives for Management
    7. Restructuring of certain terms and conditions in the partnership agreement


    To analyse the proposed transactions we'll use the EROC Valuation from July this year as the base case. The other starting data we need is the end case of the proposed transactions; they can be divided into:

    The total debt repaid as a result of the transactions would be around 250M. That greatly improves the debt to equity ratio and reduces the 2010 discount rates from 17.5% to 11.6%. 2011 onwards discount rates move slightly from 12.2% to the revised 11.6%.

    There are three impacts on cash flows:

    The minerals business produced $2.8M in profit in the six months ending June 30th 2009. Our base case is based on 2009 cash flows so annualizing that to $6M is consistent for comparison. The minerals business earned 31.8M in 2008 and nearly zero in 2007. EROC describes the 2008 results as a phenomenon as they reflect $17M of bonus payments “as a result of the regeneration phenomenon we received an initial royalty payment for 304 new wells”.

    Interest expenses in the base case are $29M per year (they are in fact running slightly less than that now). Debt will be reduced by 31% which should lead to a straight line saving of $9M.

    As described in the initial valuation of EROC, they manage their loan covenants by purchasing in the money hedges. As prices exceed these in the money hedges, EROC net loses money. This was not effectively modelled in the base case but was an inefficient use of cash and not doing this in the future is a benefit even if it’s not quantified.

    The cash flow and discount rate changes look promising. Unfortunately they are offset by changes in shares outstanding.

    The net effect is about 117M shares from 56M today.

    Cash flows are 49% of pre-transactions cash flows on a per share basis. With the reduced discount rate this values each unit based on a dividend discount model at $6.90 from $7.66 in the pre transactions base case.

    Rights Offering

    That’s not quite the end of the valuation. Current unit holders are offered the right to purchase .35 additional units for each unit they hold. They can purchase additional units for $2.50 and will receive a 2 year $6 warrant for each additional unit purchased.

    Valuing the right is easy. It’s 0.35 * (post transaction value - $2.50) = $1.54

    Valuing the warrant is more complicated. One model would be .35 * (post transaction value – strike price) = $0.315. Unfortunately the warrant is only good for 2 years and therefore an option pricing model is probably more appropriate. Using the option inputs provided I’d value the warrant at 41c. As you only get .35 per current unit held then the warrant is worth $0.14.

    This assumes:

    Other considerations

    There are also some intangible benefits of the proposed deal:

    There are also some disadvantages:

    The repurchase of the subordinated units and the IDRs for $35.5M is fair. The subordinated units will receive payouts from 2022 onwards. Discounting that back to today values the subordinated units at $40M. The IDRs appear close to worthless.


    The transactions propose that future accruals of the minimum quarterly distribution cease. Current accruals may remain but they are a moot point once the subordinated units are redeemed.

    Conflicts of interest

    NGP have identified in their offer that these transactions pose a conflict of interests. The conflict will be put to the independent directors. Furthermore the most recent 10k outlines the responsibilities of those directors. While it’s well worth reading in full; you should note:


    It appears, on balance, that this is a fair transaction. It offers NGP a way to convert some long dated opportunities into shorter dated ones. It gives unit holders more short term upside while sacrificing a higher risk/ reward over the next few years. It also creates a catalyst as a result of the rights offering and the resumption of distributions. As valued today, these transactions moderately increase the value of EROC units to current holders.


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    Disclaimer and Disclosure Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness. I am not paid by covered companies. Strategies or ideas are presented for informational purposes and should not be used as a basis for any financial decisions.
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