By the end of the 1980s, the highly touted upstream master limited partnership (MLP) investments of that decade had become synonymous with Mostly Lackluster Performance-and that was on a good day. Sadly, most yield-hungry retail investors watched their cash distributions gradually dwindle as these partnerships, beset with falling commodity prices and rising costs to shore up short-lived reserves, ultimately became wasting assets. That was more than 15 years ago. Since then, oil and gas royalty trusts, particularly in Canada, have managed to draw favorable nods from investors seeking yield in a low- interest-rate environment. But Canadian upstream trusts, with an average reserve-life index of eight years, have historically relied on acquisitions for growth and that market is getting more expensive and attractive buys, scarcer. Meanwhile, U.S. royalty trusts, with an average reserve life of 11 years, are closed-end structures and hence, do not have the ability to make acquisitions. There is, however, a distinctly different type of yield-oriented, tax-advantaged structure that has recently emerged in the U.S. upstream: the limited liability company (LLC). It debuted in the public E&P space in mid-January via the IPO of Pittsburgh-based Linn Energy LLC (Nasdaq: LINE), and it may resolve many of the investment issues that have dogged the MLP and royalty-trust structures. To say that an LLC is a growth-oriented, flow-through structure designed to distribute cash to investors in a sustainable, tax-efficient manner risks oversimplification. A better way to understand how it works is to focus on how it differs from a traditional C-Corp, a royalty trust and an MLP. Comparative structures A traditional C-Corp. is subject to a 35% corporate tax rate, and if it chooses to pay dividends, a stockholder is subject to an additional 15% tax rate. This means taxes can consume up to half of every dollar a C-Corp. makes by the time it reaches an investor. Comparatively, all of an upstream LLC's distributable cash is taxed only once-at the investor level-plus the majority of that distribution is typically tax-shielded as long as the LLC continues to drill and replace reserves. U.S. royalty trusts, because they are closed-end structures, aren't able to acquire assets, thus their ability to replace reserves and grow is significantly limited. In contrast, an upstream LLC is an open-ended structure, meaning it can grow reserves not only through drilling but also through acquisitions. True, Canadian oil and gas trusts also have the ability to make additional acquisitions; however, U.S. investors in those trusts currently face the hurdle of annual withholding taxes on unit cash distributions, plus dividend taxes in the U.S. In the case of MLPs, the general partner (GP) typically has a 2% economic interest in the partnership but controls 100% of the votes. The LLC, by contrast, doesn't have a GP. Every unit entitles the unit-holder to one vote. Thus, the structure has the fair-governance provisions of a C-Corp. while retaining the tax benefits of a partnership. Also, the GP of an MLP typically has incentive distribution rights (IDRs) which allow the GP, with its 2% economic interest, to receive up to 50% of the partnership's incremental cash flows after certain growth targets are met in terms of cash distributions. In contrast, the upstream LLC typically has no IDRs; thus there are more dollars available for distributions to unit-holders and more capital available to grow the entity through drilling and acquisitions. These are some of the more salient advantages of the LLC structure that Kolja Rockov, now executive vice president and chief financial officer of Linn Energy, saw in late 2004. At that time, he was a managing director and head of the U.S. E&P energy investment-banking practice at RBC Capital Markets in Houston. RBC had just finished leading to market the $115-million IPO of Copano Energy, a Texas-based LLC engaged in gas gathering and processing. Finding a fit "As an investment bank with a strong Canadian presence, we were very familiar with all the oil and gas trusts in Canada as well as the midstream MLP market in the U.S., and thought the LLC structure we engineered for Copano could work just as well for a U.S.-based E&P company-assuming it had long-lived reserves, stable production and low-risk drilling," he says. Rockov shared this idea with Quantum Energy Partners, the Houston-based private-capital provider. Quantum responded that it had among its upstream portfolio companies the ideal upstream LLC candidate: Pittsburgh's Linn Energy. Michael C. Linn, president and chief executive officer of his namesake firm, is currently chairman of the Independent Petroleum Association of America (IPAA). With $15 million of equity backing from Quantum and another $1 million from management, he had formed privately held Linn Energy in April 2003, and immediately embarked on an ambitious acquisition and drilling program in the Appalachian Basin. Through the end of 2005, the man who once painted wellheads and fixed tank batteries for his father's oil company, guided more than $203 million worth of Appalachian acquisitions covering 140,000 net acres. These purchases included 1,914 wells with proved gas and oil reserves of 160.1 billion cubic feet equivalent (Bcfe), 362 offset proved undeveloped locations, 500 more locations with probable and possible reserves, and 780 miles of gathering lines. Through these acquisitions and the successful drilling of nearly 200 wells since inception, the company's total reserves grew by more than 170%, from 69.8 Bcfe in 2003 to around 190 Bcfe in 2005. Meanwhile, it ramped up net daily production from an average 2003 level of 3.7 million cubic feet equivalent (MMcfe) to 21.6 MMcfe in November 2005. The impact on Linn's financials: EBITDA (earnings before interest, taxes, depreciation and amortization) climbed from $2.22 per thousand cubic feet equivalent (Mcfe) at year-end 2003 to $4.05 by September 2005. "When Rockov approached me in 2004 about taking the company public as an upstream LLC, I could see why he thought the structure made sense for us," says Linn. "We had a long reserve life of 29 years, a low 5% to 6% annual production-decline rate, low finding and development costs of $1.21 per Mcfe, a 100% drilling success rate, a large inventory of drillable locations, and an income stream with predictable growth. "Given the recent low-interest-rate environment, record natural gas prices, and the attractive valuations available in the public market, the idea of such an LLC seemed not only compelling but challenging since it would be the first ever done in the upstream." Subsequently, Linn became even more confident in the LLC structure when Rockov decided to join him in March 2005 as chief financial officer. Going public But the road to taking Linn Energy public under this structure was anything but fast track. The first hurdle: pulling together all the historical accounting data required by the SEC. This task amounted to providing five years of financials, including three years of audited financials, explains Rick Brice, a director in the RBC Capital Markets energy investment-banking practice in Houston. "This was something very difficult to do for a company that was only founded in 2003 and that had subsequently grown through nine acquisitions." However, by conducting audits on one of its acquired companies, Linn Energy managed to meet this regulatory requirement. After that, it took the SEC a little time to understand and get comfortable with the LLC structure as it applied to an E&P company. In fact, it wasn't until this January, after all hurdles were cleared, that RBC Capital Markets was able to bring the company's IPO to market. "During the nine-city, eight-day road show we targeted 70% retail investors; 30%, institutional investors. We emphasized Linn Energy's long reserve life, proven acquisition track record, large prospect inventory, drilling success and the low costs associated with operating in the Appalachian Basin," says Brice. "So it wasn't hard to convince investors that the company's production volumes were going to remain at least flat for years to come," he says. "Then on the topic of commodity prices, we explained that the company's production was 94% hedged for 2006 and aggressively hedged out through 2009-thus distributions were safe." Rockov adds that the road-show presentations also stressed the growth focus of the company. One example cited: in 2004, Linn Energy's reserve-replacement rate was 411%; comparatively, replacement rates that year averaged 157% for E&P companies, 53% for Canadian oil and gas trusts and 30% for U.S. royalty trusts. "The point we made was that even though we're planning to distribute 74% of our cash flow to investors, we're retaining enough capital to replace reserves-plus we expect to borrow money and raise new equity to grow through further acquisitions and drilling," says Rockov. "In fact, for 2006, we're forecasting a reserve-replacement ratio of more than 300%." Emphasizes Linn, "We have enough drilling locations that we can continue to grow the company-and still meet distributions-through drilling alone. So we're not relying on acquisitions by themselves to make the company sustainable." Indeed, Linn Energy expects to drill 139 wells this year, mainly in north-central West Virginia and southwestern Pennsylvania. Comparatively, the company drilled 110 wells in 2005 and 90 wells in 2004. Market reaction How well did this new structure play on Wall Street? The mid-January IPO priced at the top end of a $19- to $21-filing range, raising gross proceeds of about $261 million through the oversubscribed sale of 12,450,000 units. The company expected to raise $235 million, selling 11,750,000 units. "Also, while we marketed the offering with a mid-point yield of 8.0%, we were able to price it at a 7.6% yield; this was beneficial to the issuer and a sign that investors liked what they saw," says Brice. RBC Capital Markets and Lehman Brothers were joint bookrunners on the IPO; co-managers were A.G. Edwards, UBS Investment Bank, Key Banc Capital Markets and Raymond James & Associates. The proceeds were used to pay down $122 million of bank debt and to allow Quantum Energy Partners to redeem about $109 million on its investment. Post IPO, Quantum still owns 36% of the company; management, 18%; the public, 46%. Observes Brice, "Investors in the U.S. will generally pay more for growth-oriented partnerships than their counterparts in Canada, meaning they'll accept a lower yield. That's important because it provides the issuer a better cost of capital." Rockov points out that as an LLC's unit price continues to rise in the market, its distribution yield-not the level of its distribution-continues to go down. "This means that the cost of an issuer's equity capital also keeps going down since it has to issue fewer units to pay for current or future acquisitions." Investors were also drawn to the tax efficiency of the LLC investment vehicle. "As long as we're drilling and replacing our reserves, a substantial portion of our cash distribution-typically more than 90% of it-is tax shielded or tax deferred because the unit-holder is getting the benefit of intangible-drilling-cost (IDC) and depletion-allowance deductions," explains Linn. Answering concerns The price for the company to drill and complete a well is currently averaging $250,000 and Linn Energy plans to further control costs by acquiring two rigs, scheduled for delivery this summer. Still, what happens to distributions if interest rates rise and commodity prices head south? "Generally, yield vehicles fight the cost of rising interest rates with growth," answers Brice. "In other words, if an LLC is demonstrating growth-in volumes, reserves and distributions-investors will continue buying its units, which should help keep its yield in line." Also, drilling new wells and increasing production should protect distributable cash flow and offset any decline in commodity prices in the out years. In the event gas prices do spiral downward, Linn is already significantly hedged through 2009, stresses Rockov. That said, he notes there is actually a positive side to any collapse in commodity prices. "In such an event, it's reasonable to assume that we'll be paying less for acquisitions and that we'll still be able to lock in good margins." Case in point: in 2003, Linn Energy paid an average 82 cents per Mcfe for acquisitions, at which time the average one-year forward strip on the Nymex was $5.17. Hedging allowed for an average margin of $4.35 per Mcfe. Is the Linn IPO going to usher in a new wave of upstream LLCs? RBC Capital Markets, which completed more than $14.3 billion worth of energy-related equity, high-yield, convertible debt and M&A transactions in 2005, is certainly looking in that direction. Says Brice, "We're considering the IPOs of a couple of upstream LLCs which could come to market by mid-2006."