Mezzanine Finance for Independents: How to Keep Your Project Moving SIPES Houston, TX August 22, 2013 Overview . About Five States . Why Review Financing? . What is Mezzanine? . Cost of Capital . Case Studies ABOUT FIVE STATES Five States Energy Capital, LLC •Five States Energy Company, Inc. 1985 •Acquires operated and non-operated working interests • Five States Operating Company, Inc. • Operates Five States’ interest properties 1985 • Total Energy Asset Management Services (TEAMS) • Oversight of portfolio asset properties 2004 • Five States Energy Capital, LLC • Provides mezzanine capital to independents 2007 Why Review Financing? Independents % Allocation of Time Activity % of Time Research & Culling Data 35 - 65 Project Development 10 - 20 Project Financing 20 - 50 Administration 10 - 20 Why Review Financing? Independents’ Sources of Development Capital • Available Cash • Cash Flow from Previous Activities • Sell Down of Promoted Interest • Cash Flow from Current Project • Convert Working Interest to Override • Bank Loans • Convenient Sources • Mezzanine Financing! WHAT IS MEZZANINE? What is Mezzanine? . Fills Gap Between Senior Senior Asset Backed Debt Debt and Equity . Subordinate in Priority of Payment to Senior Debt MEZZANINE . Senior in Rank to Equity . Stretch Debt . As With Banks, Advances Usually Based on Proved Equity Reserve Base Mezzanine typically fits: . Development drilling programs . Acquisition financing . Infrastructure financing . Bank clients that are over extended (but typically still solvent) Capital Structure in Oil & Natural Gas Transaction • Advantages – Not a sale of equity – No loss of control of company – No requirement to sell on a schedule – Puts up majority of development capital with minority stake in project – Appears as debt; can be financed from pre-tax revenue – No board position required Companies with Efficient Capital Structures Expected Typical Private Equity Structure . Returns (% of total Assets) (%) Senior Debt 50% - 75 % 5% - 12% Mezzanine 20% - 30% 13% - 25% Equity 15% - 30% 25% + Source: Management Magazine, Bond Capital COST OF CAPITAL Relative Costs of Financing Options Banks Mezzanine Private Equity Lowering Cost of Capital Company Capital Structure. (% of Company Value) 50% 80% of company Equity 60% value can be Mezzanine released in Cash Bank Debt 100% 20% 50% 20% Case 1: Traditional Case 2: Typical Debt Case 3: High Leverage Weighted Average Cost of Capital 35 % 19 % 11% Return on Equity 12 % 21% 40% Source: Management Magazine, Bond Capital Underwriting Process 1 • Initial Investment Criteria Check Oil, gas, and midstream deals are sourced in the marketplace through • Engineering Analysis industry contacts and intermediaries 2 • Financial Analysis ~50% pass initial screening for further 3 evaluation • Operations / Legal / Land Analysis ~5-10% pass due diligence 4 and term sheets are issued • Term Sheet Issued ~2-5% are 5 closed and become part • Final Due Diligence of the portfolio 6 • Close Investment 7 Typical Term Sheet Interest • ~12% coupon • ~25% WI Back-in at Payout Term 3-5 years Facility Determined • 90-100% PDP By: • Discounted PDNP and PUDs • Land/Leases Structure Very fluid What Do Lenders Look For In A: Borrower? Deal Structure Business Plan Track Record Equity Participation Collateral (PDP, PUDs, Leases) Reputation/Character Collateral Higher Risk Moderate Risk Lower Risk • “PUD” • “PDNP” • “PDP” Proved Proved Proved Undeveloped Developed Developed • Leases Non-Producing Producing ~10% ~25% ~90% CASE STUDIES Financing Package – Bakken Appalachian Acquisition Package Pipeline Construction – West Texas Financing Package - Bakken . $85mm Mezzanine Debt Financing for Development of 14,000 Acres in North Dakota • $16.2mm initial advance with remaining funding to occur over time • 45 producing wells and need for funding to keep pace with rapid development of the area • Senior note @ 6.25% – bank revolver structure (30%) • Junior note @ 12.50% – mezzanine structure w/ BIAPO* (20%) Note: Photo for illustration only. *BIAPO: Back In After Pay Out 24 Appalachian Transaction (WV & OH) Collateral PDP and PUDs Term 5 years Interest Rate 12% Origination Fee 1.0% Equity Component 25% at term or repayment • Option to purchase 25% of assets for cash equivalent of loan amount at closing Hedging 75% Pipeline Construction Advantage Pipeline – West Texas Pipeline Construction Advantage Pipeline – West Texas • Location: Pecos, TX to Crane, TX • Length: 75 miles • Cost: $60 MM • Deal Structure: $17.5 MM equity financing Summary . Mezzanine can be a good fit for: – Companies focused on acquisition and development – Especially when there is existing production – Companies needing to pay down bank debt . At end of term: – Company is left with majority of equity – Greater profit potential Five States Energy Capital, LLC Mezzanine Finance Market .