What is my Carry Worth?

Assume a team of E&P executives with a few ideas and strong industry connections receives a $200-million commitment from an E&P-focused private-equity fund. The team assembles a large, unproved leasehold position at an average cost of $200 per acre and begins geological and geophysical (G&G) spending and later, exploratory drilling.

Further assume a “home-run” scenario where reserves are proved up and a majority of the subject acreage is monetized at over $5,000 per acre. It is not out of the realm of possibility that the management group, which likely contributed only a very small fraction of the upfront capital, might get a payout in excess of $100 million in less than five years as a result of the promoted interest it holds.

According to RBC Richardson Barr research, as of year-end 2011, there were more than 230 E&P management teams backed by PE firms. Is there anything management groups can do at the outset of forming their new entity to minimize their personal tax burdens? Often, the carried or promoted interests received by the management team can be ideal securities for tax- or estate-planning purposes. If transferred early in the venture’s life, the promoted interest will have a very low value relative to its potential future value if successful. This is due to the payout economics and the speculative and high-risk nature of the interest.

While the probability of success for the new entity and, especially, the promoted interest, is highly uncertain, the promoted interest is not worthless, because of the options that are embedded in the interest. Such value can be estimated through option-pricing models.

This article describes one methodology that we use to quantify the fair market value of a promoted interest in a privately held E&P firm.

Valuing promoted interests

Exhibit I: The private-equity sponsor typically receives a return of capital and a preferred return on contributed capital before the management group's carried interest is allocated any remaining profits.

The promoted interests discussed here are financial interests assigned to the management team (the carried party) by PE investors (the carrying party) because the investors believe that the team can generate superior investment returns through their industry expertise and contacts. Promoted interests are designed to incentivize the management team by giving it an increasingly larger stake in the E&P’s ultimate success.

The typical PE structure involves capitalizing the new E&P with equity, almost all of which is provided by funds sponsored by the PE firm. The management team likely will contribute a nominal amount of capital to have “skin in the game,” but their combined capital interest is typically nominal—say 5% or less of total capital. However, if certain return or payout targets are achieved, management’s share of investment proceeds can increase significantly through their promoted interests.

Exhibit II: The third option offsets the incremental profits of the first option beyond the second option’s strike price.

In this regard, the promoted interest is designed to incentivize the management team to create as much value as possible—for the PE investors as well as themselves. It is not uncommon for a management team’s interest to double or triple if the E&P is successful. Exhibit I presents a “waterfall” structure of a PE-backed E&P venture.

PE-backed E&Ps typically fall into one of two value-creation strategies: a lease-and-drill growth-through-drillbit strategy (the focus of this article), where the outside capital will be used to acquire unproved, nonproducing properties (acreage) and attempt to prove up reserves; and an acquire-and-exploit strategy, where the focus will be on using the capital infusion to acquire primarily proved, producing properties.

As the lease-and-drill E&P entity acquires leasehold positions, capital is funded by the PE firm (management pays its pro rata share as well). The E&P entity typically does not put all its eggs in one basket but will pursue two, three or four geological ideas or plays. Also, capital is called to pay its overhead.

A sensitivity analysis considers the amount of capital invested and the amount of time before all plays have been liquidated.

Once capital is called, the preferred return clock starts ticking (the first hurdle in the “waterfall”). In order for the promoted interest to have value, it must generate a return greater than the preference rate. In the lease-and-drill strategy, for the first several years the E&P will be acquiring acreage, incurring G&G expenses, and paying overhead and will not be generating any revenue. A typical timeline for a play may be 12 to 18 months to assemble the acreage followed by another 12 to 18 months to conduct G&G studies and drill exploratory wells. Assuming a successful scenario, it may take an additional six to 24 months before the plays are ready to be monetized.

If the valuation is conducted for estate-planning purposes, fair market value will be the standard. Fair market value is defined as the price at which the promoted interest would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.

A series of options

This sensitivity analysis considers varying volatilities, and analyzes the ratio of the marketable value of the promoted interest relative to the projected amount of capital invested.

We view the promoted interest as a series of options: individual cash-settled call options for each of the plays inside the E&P. A commonly used model to value options (e.g. to determine the premium that a buyer would be willing to pay) is the Black-Scholes Option Pricing Model (Black-Scholes).

Assume that a newly formed E&P receives a $200-million capital commitment from a PE firm to pursue a lease-and-drill strategy for three distinct geological plays. Each year the E&P will require $4 million to cover its overhead. It projects that it will deploy somewhere between $85 million and $170 million (excluding overhead) over a 36-month to 72-month period in three plays (although the commitment is $200 million in this case, it is often reasonable to assume that the entire commitment will not be drawn down). Management’s base-case estimate is the investment of $127.5 million over 54 months.

We consider each tranche of capital investment as a separate, new option—one that must generate a return over the preference rate in order to have value. On the sixth month of our hypothetical firm’s operations, the company completes the acquisition of the leases for its first play (Play 1) for $22.5 million. Another hypothetical option is formed six months later, when G&G expenditures and drilling costs amount to another $22.5 million. A third hypothetical option is formed six months later, as additional drilling and completion activities are funded. Two more sets of three options are formed as Play 2 and Play 3 are developed.

We use Black-Scholes to calculate the values of each of the options on each of the investment dates. Black-Scholes requires five inputs: asset price, time to maturity, strike price, asset volatility, and risk-free rate.

The asset price (or asset value) input for each option is the amount of capital that is projected to be invested in each tranche of each play on each of the investment dates. For E&Ps pursuing an acquire-and-exploit strategy, traditional asset/reserve valuation methods may be used to develop the asset values for each option. The time to maturity is the time remaining until the expected monetization date of the plays.

The strike price for each of the options is the capital invested plus allocated general and administrative expenses compounded at the preference rate over the time to maturity.

Typical marketable values of the promoted interest for newly established lease-and-drill E&P firms.

The risk-free rate is the forward yield on government bonds with a maturity date corresponding to the time to maturity.

For a lease-and-drill E&P, we generally estimate asset volatility based on the enterprise value volatilities of publicly traded E&P companies with a high ratio of unproved reserves to proved reserves. Obviously there exist significant differences between publicly traded E&P companies and PE-backed firms, so subjective adjustments to the volatilities of the guideline public companies may be necessary.

Once the values of each of the options are derived, we must discount the individual option values to present value using a discount rate that reflects the underlying risk of the assets. The discount rate should also consider that the economics of the promoted interest are based on the performance of the E&P firm on a holistic basis, which our multi-option model approach fails to consider.

The payoff structure of the promoted interest complicates things. The option value must be allocated between the management team and the PE investors. Also, the sharing percentage of the promoted interest changes over time depending on the success of the venture. We tackle these issues by modeling several sub-options for each play’s existing hypothetical options.

Upon maturity, the holder of a standard call option receives 100% of the positive difference between the price of the underlying asset and the strike price of the option. On the other hand, in our scenario, upon returning the preference rate of 8%, the promoted interest will receive only 25% of any distributions up to the point where the promoted interest has received a 25% annualized return. Following that point, the promoted interest will receive 35% of any further distributions.

The payoff of the promoted interest can be modeled by using a combination of several hypothetical call options. This synthetic position can be achieved by:

• “Buying” a call option that receives 25% of any payoff with a strike price equal to the required preference return;

• “Buying” a call option that receives 35% of any payoff with a strike price equal to the point where the promoted interest has received a 25% annualized return; and

• “Selling” a call option that receives 25% of any payoff with a strike price equal to the point where the promoted interest has received a 25% annualized return.

The combination of these three assets is pre- sented in Exhibit II. As can be seen, the third option offsets the incremental profits of the first option beyond the second option’s strike price.

It is important to use sensitivity analyses to consider the amount of capital that may ultimately be invested, the rate of capital deployment, and the time until liquidation. Sensitivity analysis of different volatilities is also important. Exhibit III presents a sensitivity analysis where we have considered the amount of capital invested and the amount of time before all plays have been liquidated.

Exhibit IV presents a similar analysis with varying volatilities. We also analyze the ratio of the marketable value of the promoted interest relative to the projected amount of capital invested to provide a sanity check of our conclusions . Based on our experience, the ratios on Exhibit V are typical of the marketable values of the promoted interest for newly established lease-and-drill E&P firms.

To determine the fair market value of the promoted interest, we would also consider a hypothetical buyer’s inability to control the operations of the E&P firm and the lack of marketability of the interest.

Conclusion

Promoted interests in PE-backed early-stage E&P companies are highly complex securities. They are also highly speculative. Although speculative, these securities are not worthless. Nonetheless, at inception, promoted interest warrants a significantly reduced value relative to the potential returns that it may generate. Accordingly, if properly implemented, promoted interests can be very effective securities to be used in estate planning.

Alan Harp is a senior managing director and Bradley Gates is a managing director at HFBE Inc., a national business valuation and financial advisory firm with offices in Houston and Dallas.