Mezzanine Financing: Portal to Profits

Recently, Arthur, Don and I, along with members of the Five States staff, have been meeting with investor groups throughout the country. We have been explaining the business plan of our capital partnerships and reporting on the ongoing activities and results of our currently active funds. What we have learned as we have committed capital to FSEC Fund 1 and those projects have matured, is that each project has yielded interesting insights about the clients with whom we are investing, while also providing opportunities to enhance the profitability of individual deals and to participate in financing other developing oil and gas projects. As we anticipated when we modified our business plan in 2007, the business of providing mezzanine financing is proving to be an effective means of opening doors to relationships that would not otherwise have been available to us.

The basic strategy of Five States is classic and fundamental: provide capital on projects in which we would like to own an interest. We provide capital to operators who need funds for making acquisitions, drilling development wells, buying lease equipment, constructing pipelines and gathering systems, and for other capital needs, while placing our investment in a preferred position. During the period funds are employed, Five States receives monthly interest payments and most of the revenue the project generates, before any payments are received by the operator, thus reducing our overall risk. When Five States recovers its committed funds and interest payments, it also receives an additional financial benefit. Most often this takes the form of a working interest in the production, but sometimes it may be a net profits interest or some other previously contracted fee. The ultimate objective of Five States is to accumulate equity interests in long-life, high-quality producing oil and gas properties. Therefore, we are always interested that the “residual interest” earned will have value for ourselves and our investors for years into the future.

For Five States, success in achieving our anticipated economic target depends largely on two factors: the character and ability of the operator to effectively manage the project, and the credit quality of the collateral available to guarantee the loan. An early decision about the operator and his staff’s reputation, knowledge, experience, and history is often sufficient to deter us from devoting excess time analyzing and evaluating the collateral.

Fortunately, during the more than 25 years of purchasing oil and gas properties, Five States has developed a highly qualified team of reservoir and operational engineers, financial analysts, and staff. These same people analyze the producing properties pledged as collateral with the same diligence and expertise they used in analyzing properties for acquisition. Although we never enter into a transaction with the expectation of foreclosing on the operator’s collateral, we need to ensure the collateral is of sufficient value to provide recovery of our loaned funds should it become necessary to do so.

The type of “bonus” opportunities that can occur in mezzanine financing are exemplified by two projects that evolved in the current partnership. One was a request to provide mezzanine financing to participate in drilling as many as 40 horizontal wells within the limits of a known East Texas field. Upon analysis, the capital required was more than the applicant was comfortable borrowing. As a result, Five States financed the borrower for as much as he needed, and Five States allocated partnership funds to also participate in drilling as a working interest owner. The partnership’s projected rate of return is estimated at 19%, and may prove even higher.

Another project involved a request by a company to participate in drilling unconventional Bakken wells in North Dakota. After review, we authorized a $16.2 million loan to be drawn from an $85 million facility, to be expended over a period of two or three years. However, soon afterwards, the borrower sold its position in the project to a third party, who paid off the Five States loan and plans to drill the field with the third party’s own resources. We would have preferred the initial borrower to remain as owner since the wells would have generated more revenue to Five States, but for us the transaction was profitable as a short-term investment. The partnership’s realized rate of return was 56% (about 28% “cash on cash” with the high IRR due to the short investment period).

The two lessons we have learned thus far are that by having funds available to offer for mezzanine projects, we attract “deal flow” that often provides associated opportunities to enhance the economic returns of a project for both parties. Second, the relationships and mutual trust developed with operators during the period of examination and negotiating one project often results in the operator bringing other projects to Five States for funding or participation that we may not otherwise learn about.

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