We have been attempting to wind-down and liquidate Five States Energy Capital Fund 1, LLC (“Fund 1”) this year. Until the last few weeks we thought we were on schedule to do so. However, for reasons discussed in this article, we do not expect to be able to do so until next year.
We plan to propose in 2018 that the producing properties owned by Fund 1 be contributed to Five States Legacy Fund, LLC (“Legacy”), a new entity, in exchange for units in that entity. We plan to simultaneously propose the consolidation of the three Five States legacy partnerships, Five States Consolidated I, Ltd., Five States Consolidated II, Ltd. and Five States Consolidated III, Ltd. (“Cons 1, 2 & 3”) into Legacy. We are targeting the consolidation to occur effective December 31, 2018.
We originally anticipated completing the consolidation by December 31, 2017. However, issues involving Fund 1 require it to exist into 2018. Consolidating Cons 1, 2 & 3 into Legacy in 2017 then adding Fund 1 assets the next year does not make sense economically or administratively.
Fund 1 Liquidation
The Rule 144 holding period (six months from the acquisition date) for the Plains All American units (NYSE: PAA) received from the sale of Advantage Pipeline has lapsed. However, we were informed in late October by PAA counsel that, although the PAA stock is marketable, they will not transfer shares without the Rule 144 “legend” until April 2018, the twelve-month anniversary of the Advantage sale. We anticipate distributing the PAA stock to Fund 1 investors as soon as the legend is removed in April 2018 or shortly thereafter.
We also learned in late October that the Great Northern Midstream (“GNM”) lawsuit, which involves the distribution of the remaining escrowed sales proceeds, will likely not settle before year-end. Therefore Fund 1 will not receive the remaining cash or final K-1 from GNM until 2018.
Following the PAA distribution, the remaining assets of Fund 1 will be cash and receivables, and an interest in North Permian Well Service (“NPWS”). This asset is currently “on the market”.
All net cash and proceeds from the various sales will be distributed to the Members. If consolidation is approved, producing properties in Fund 1 will be contributed to Legacy.
Investors who choose to stay will receive a pro rata share in Legacy. Those who wish to liquidate will be paid their pro rata share in cash.
Cons 1, 2 & 3 “Reconsolidation”
This proposed consolidation is the same process used when we formed Five States Consolidated I, Ltd. in 2000, Five States Consolidated II, Ltd. in 2005 and Five States Consolidated III, Ltd. in 2009. Continued depletion has reduced the production volume from the partnerships over the last decade. The retrenchment in oil price over the last several years has reduced the cash flow from each partnership. General and administrative costs are consuming a material part of the cash flow from each partnership.
Cash Tender Option
The remaining value to some investors in the various funds is small after twenty or more years of distributions and depletion. We recognize that some investors may elect the “tender” purely from a “size” perspective. Others may no longer wish to participate in oil and gas investments.
Investors who do not wish to participate in the consolidation will have the opportunity to “tender” their interests for sale for cash at the time of consolidation. The valuation for the tender will be the same as the values used in the consolidation.
If necessary, we will raise capital through the sale of units in Legacy to generate cash to pay to exiting investors who choose to tender. Management plans to participate for its pro rata share in any additional funds raised.
The producing properties that are owned by the four entities are the type of assets we continue to target for new investment. We believe a “restructure” that results in a financially stronger entity is advantageous to all involved. We estimate attractive quarterly distributions relative to the liquidation value of the assets following the consolidation. We also believe there is significant potential for increased returns from continued development of these assets and from the possibility of higher oil and natural gas prices over the long-term.
Investors in any of the four entities who do not wish to participate in the consolidation will be offered a cash liquidation option. For those who elect the cash option, we believe that the lack of transaction fees and the appropriate risking of undeveloped reserves results in an attractive exit.
For regulatory purposes, Legacy must be composed only of working interests. Legacy will not include any securities such as notes receivable or LLC interests.
Benefits to forming Legacy include:
- Continue to hold high-quality long-lived properties for Income and Appreciation. We would resume quarterly distributions to all investors.
- Decreased general and administrative costs. The savings are primarily attributable to a material reduction in the combined professional fees (tax returns and audits).
- Enhanced property diversification. As properties in the partnerships deplete, the remaining value of each partnership becomes concentrated in a smaller number of properties. Consolidating the partnerships will increase the well, field and geographic diversification, providing the partners with diversification closer to that of the original partnerships.
- Low Average Debt Ratio. The debt ratio of Legacy following the consolidation is estimated at about 30% – 35% of the value of the properties. A senior debt ratio of 50% is considered normal.
- Improved operational decision-making. Consolidation allows us to make prudent capital expenditures to enhance the long-term value of partnership assets, without as much concern for the impact on quarterly distributions. This mitigates the predicament of being hindered from making large capital expenditures when warranted because the size of a partnership has decreased.
- Improved administrative efficiency. Several properties are owned by more than one entity. Consolidation will increase administrative efficiency.
Valuation Methodology for Consolidation
The price proposed for the consolidation will be the present value of the producing properties owned by each entity using current oil and gas price assumptions and a 10% discount factor, increased or reduced by outstanding debt, hedge positions and working capital. There are no imputed transaction costs or fees. Each entity will be allocated a pro rata share of Legacy based on these values.
For example, if a fund is valued at $200 and the total value of all entities is $1,000, then the investors in that entity would be allocated 20% of Legacy. The valuation of the properties in each entity will be audited by an independent engineering firm. Details on valuation will be distributed upon completion of the audit.
Legacy will have debt in its capital structure. The debt of the partnerships participating in the consolidation will be assumed by Legacy. In addition, Legacy may borrow funds to acquire additional properties in the future. The total debt of Legacy is estimated to be in the range of 30% of total asset value.
Legacy will assume the existing hedge positions of the four participating entities. The hedge positions are included in the economic analysis. The settlement value at the time of closing will be “netted” from the allocation value.
Investors and financial advisors will receive a Private Placement Memorandum for Five States Legacy Fund, LLC. They will also receive a schedule of their pro rata share of the calculated value of their interests in the entities being consolidated. Investors will be asked to vote for the consolidation. They will also be asked to indicate whether they will participate in the consolidation or liquidate.
Following are approximate dates anticipated in the consolidation process:
June 2018 Private Placement Memorandums distributed
August 2018 Ballots from all investors due back to Five States
December 2018 Effective date of consolidation
Five States senior management continues to believe that high quality domestic oil and natural gas properties are an attractive long-term component to a diversified portfolio. Jim and I plan to continue operating Five States into the foreseeable future for ourselves, our families and our investors who share our expectations and investment philosophy. We believe that we are on the cusp of a very good period for making new oil and gas investments.
As with previous major corrections in the oil and natural gas markets, the rationalization of value has taken years. We are seeing credit tightening by many banks, tighter regulation of oil and gas loans by the OCC and bankruptcy of competitors. We are also seeing capital rationing returning to the oil and gas markets, resulting in more conventional properties coming on the market than we have seen in a decade. These are the conditions that are best for value investors like Five States.
Continuing to hold the portfolio of high quality long-lived assets through Legacy is consistent with that philosophy. This proposal provides a good option for all investors. Those who share our philosophy and expectations can continue to participate in owning these assets. For those who do not share our philosophy and expectations or who no longer wish to be invested in this sector, this proposal will provide a liquidity option over the next year.
The economic benefits of forming Legacy to “holders” include reduced overhead, no “dead deal cost” and strong understanding of the undeveloped reserve potential in a long-lived portfolio of producing properties. For those choosing the cash tender option, there will be no commissions or fees burdening the sale, and the valuation includes appropriate risking (good value) of the undeveloped reserves and avoids the risk of discounted valuation on the sale of the small working interests.
We hope you will join us by endorsing this proposal as we work through 2018. Please call me at (214) 560-2569 with questions or comments.