To successfully match financing structures to the specific transaction being undertaken, it is critical for exploration and production (E&P) companies to consider all the options. Of late, in addition to traditional debt and equity raises, a new solution is in favor. E&Ps are also choosing the convertible debt and preferred financing option, which has seen increasing transaction volume in the oil and gas sector.

The potential benefits of convertibles are many. As a debt surrogate, the convertible market can offer lower debt service costs. As a proxy for equity, it can minimize dilution. Convertibles can also be customized to fit issuers’ needs. And, when doing strategic acquisitions, in many cases the buyer can access overnight financing to minimize market risk.

“It’s another source of funding that, depending on the company’s objective, could be characterized as either cheap debt or as premium-priced equity,” said Andrew Apthorpe, global co-head of convertible and equity-linked origination at RBC Capital Markets. He has spent the past five years building the firm’s convertible and corporate equity derivatives business in New York. “In the capex-intensive E&P business, having an understanding of all sources for capital formation is a prudent strategy in anyone’s playbook,” he said.

“Dollar for dollar, there are fewer shares underlying a convertible transaction than when offering a comparably sized common equity raise, which can add tremendous value in higher share price scenarios,” said Andrew Apthorpe, global co-head of convertible and equity-linked origination at RBC Capital Markets.

In the E&P sector, companies have recently issued convertibles in the wake of strategic moves to acquire properties that complement their existing assets nearby. In August, Rex Energy Corp. sold a 6% convertible perpetual preferred stock for proceeds of $161 million to fund its acquisition of Marcellus Shale properties from Royal Dutch Shell. Earlier in the summer, Penn Virginia Corp. closed an offering of a 6% convertible perpetual preferred stock, raising $325 million to fund an acquisition and accelerate its Eagle Ford Shale development. This followed a deal by Sanchez Energy Corp., also in the Eagle Ford. It issued a 6.5% perpetual convertible preferred stock, raising $225 million to help buy properties from Hess Corp.

Maximum flexibility

What are some of the key features attracting E&Ps to issue convertible perpetual preferreds?

“A common theme across all our recent raises with E&Ps has been management teams’ desire to fund drilling programs or strategic acquisitions with the maximum balance sheet flexibility afforded by a perpetual instrument, but with an eye to minimizing shareholder dilution through a sale of equity at a premium to prevailing prices,” said Apthorpe. “The conversation usually commences with learning in what way the CEO or CFO believes the market undervalues the company’s stock, and concludes with a desire to retain the perceived upside over the intermediate to longer term.”

When advising teams on capital-raising alternatives, Apthorpe cites various factors to consider ahead of selecting a convertible raise. These include an appreciation of the relative cost of capital in different share price environments over the life of the instrument, including any impact it might have on earnings or cash flow per share. In addition, an advisory will help issuers understand the likely reaction from various market constituents, be they shareholders, fixed income investors, research analysts or rating agencies.

Frequently, it takes additional time to familiarize potential clients with convertible instruments. “There is certainly a learning curve for convertibles, as the default within energy has historically been to simply issue either senior notes or common equity,” Apthorpe said. “However, we find that when we work with various finance teams—in some cases over many years—they reach a point where they are comfortable with the nuances of the transaction.

“That’s not to say it’s the answer for everyone; rather, once these securities are issued and on the balance sheet, issuers have found them to be far less complex than initially perceived.”

There are two major variables when issuing convertible preferred: yield (the preferred dividend, divided by the issue’s liquidation preference) and the conversion premium (the conversion price divided by the price of the underlying common share price). From an issuer’s perspective, an obvious attraction of the convertible market lies in the degree to which an E&P might attain lower interest costs (versus, say, high yield) in exchange for an option to convert into the underlying stock at the agreed conversion price.

Naturally, there is a trade-off when doing these deals. Higher yields are typically associated with a lower option value (via a higher conversion price and conversion premium), and lower yields are typically associated with a higher option value (via a lower conversion price and conversion premium).

Conversion premiums vary, but generally represent a material premium to the underlying common stock price. Recent terms reflect premiums for preferreds of typically more than 20%, although some have been as high as 30%.

In a bullish scenario, the interests of management and shareholders are clearly aligned.

“Dollar for dollar, there are fewer shares underlying a convertible transaction than when offering a comparably sized common equity raise, which can add tremendous value in higher share price scenarios,” said Apthorpe.

“For simple illustration, if a company avoids issuing a million shares by choosing a convertible, that value saving continues to grow as the share price appreciates, yet the interest on a convertible remains fixed over the life. That sort of cost-benefit, break-even analysis is compelling in an upside scenario, offering a cheaper cost of capital than common equity.

Convertible preferred financings are on the rise in the oil and gas sector.

“Alternatively, if share prices don’t cooperate, there is no debt maturity to be concerned with in the case of a preferred,” he said. “In the case of a bond, however, the securities would simply redeem for cash after, say, year five or year seven, essentially at what in hindsight was very cheap debt, with interest savings of often 300 to 600 basis points below a comparable high-yield financing.”

But, within a broad spectrum of those key variables, is there much flexibility to craft convertibles to suit the issuer’s specific preferences and execution needs?

“It’s a bespoke instrument,” said Apthorpe. “While there are inevitable yield and premium sensitivities among the buyer base, we try to customize our underwritings to best match the objectives of both buyer and seller, and then put the paper away into long-term, stable hands. Managements often want the highest conversion premium available, which can dovetail with the needs of some of our cross-over, equity-income investors that value the ability to play up and down the capital structure, particularly in size [greater than $250 million].

“Alternatively, dedicated convertible or cross-over common equity investors looking for an enhanced risk-adjusted-return profile will be more sensitive to conversion premiums, given their views on company valuation. This creates an opportunity for those issuers looking to trade off premium for yield, thereby reducing interest expense and maximizing proceeds for deployment into, for example, shale plays at very attractive IRRs [internal rates of return]. The economics of the underlying business tend to far outweigh any interest expense in this low-rate environment.”

Having a wide range of convertible buyers makes it more manageable to customize a convertible issue or execution strategy to meet the specific needs of a potential issuer, according to Apthorpe, an 18-year pioneer in the convertibles market. A deep Rolodex of fundamental buyers is a significant factor in the rapid ascent of RBC’s convertible securities franchise, which led underwriting of convertible perpetual preferred issues by the E&P sector with a market share of 82% for all such issues dating back to 2012, according to Bloomberg.

“Coming off the 2008-2009 financial crisis, we elected to focus our primary underwriting efforts on fundamental buyers as a way of differentiating our franchise,” he said. “Unlike competitors with a heavy concentration of hedge fund clients, we now, as sole bookrunner, routinely place over 75% of any mandate with fundamental [long only] investors. That said, there are also times when we take a more balanced approach via a placement with both fundamental and technical [long/short] investors, mainly with offerings outside energy.”

The ability to place such issuance on an overnight basis—eliminating market risk for the issuer—has been a factor in several recent E&P issues.

Sanchez Energy has offered two convertible perpetual preferred issues, in each case on an overnight, riskless basis. The most recent, which helped finance its $265 million purchase of the Cotulla properties from Hess Corp., was a Section 4(2) private placement of 144A eligible securities. A key feature to this structured solution: the registration exemption allowed Sanchez to access the market ahead of the company’s ability to produce pro forma financials for the acquisition.

Thus, Sanchez could announce its completed offering simultaneously with the acquisition. The $225 million offering was then upsized and priced with a 6.5% preferred dividend yield and a 10% conversion premium to an unaffected last sale price, equivalent to 33% of Sanchez’ equity market capitalization. RBC served as sole structuring adviser and sole bookrunner for the offering.

“Listening to the acquisition opportunity, we went all-in on finding our client a solution that would overcome their constraining factors,” Apthorpe said. “We responded with a highly innovative execution strategy that delivered Sanchez and its board committed financing in hand. Knowing they had the support of capital markets, but without having exposed themselves to share price risk, Sanchez was in a position to approach Hess across the bargaining table from a position of greatest strength. This was reflected in the very positive market reaction to this transformational acquisition.”

Another deal executed overnight—which thus avoided the risk of underlying stock slippage from “launch to pricing” dates—was Penn Virginia’s $325 million convertible perpetual preferred offering in June. The deal’s initial marketing range was 5.5% to 6% in dividend yield and 22.5% to 27.5% in conversion premium. Final terms for the offering, which was upsized from an originally filed $250 million size, were a 6% dividend yield and 30% conversion premium (or “6%, up 30”). The offering represented 35% of Penn Virginia’s market cap at the time of sale. RBC was again the sole structuring adviser and had the sole book-running role.

Later in the summer, Rex Energy also tapped RBC as sole bookrunner in its overnight convertible perpetual preferred offering to raise $161 million. The offering followed what the company described as its “highly strategic acquisition” from Royal Dutch Shell of some 207,000 net acres in Rex Energy’s Butler Operated Area in Pennsylvania. The new acreage offers a “complementary fit” with the legacy 107,000 net acres held by Rex and adds some 240 drilling locations to the inventory of drillsites it has in the Marcellus/Upper Devonian play.

Final terms of the offering were a preferred dividend yield of 6% and a conversion premium of 25.2%.

Rex thus diversified its investor base by issuing a convertible perpetual preferred stock, tapping into an equity-like instrument at a premium to the prevailing share price. Rex was signaling “an indirectly bullish view of the share price,” said Apthorpe. “It’s basically saying, ‘We’re willing to pay a dividend in view of the intrinsic value we perceive in terms of upside in our share price.’”

A billion overnight

The convertible market is by no means confined to the onshore E&P arena.

Deepwater player Cobalt International Energy accessed the convertible market in late 2012 and in May of this year. Despite a negative cash flow profile at the time of sale, Cobalt offered investors exposure to an attractive portfolio of oilfield prospects in the deepwater Gulf of Mexico and West Africa. In regard to its choice of security, CFO John Wilkirson stated on the company’s first-quarter 2014 conference call, “We continue to monitor the capital markets with a preference for structures that minimize costs while providing long-term flexibility. The issuance of any primary common equity remains our least preferred capital market alternative.”

Cobalt’s most recent offering looks to have achieved just that via a rare, 10-year convertible note offering raising $1.3 billion—the first E&P convertible offering greater than $1 billion to be presented on an overnight, riskless basis. The notes afforded an attractive 3.125% cash interest cost and a 25% conversion premium. In addition, the notes’ structure gave the company flexibility to call the paper away from investors after five years, subject to the Cobalt share price trading in excess of $30 per share, about 60% above the $18.45 share price at issue. The deal was placed almost 90% to fundamental buyers through RBC’s distribution. Again, RBC was the lead bookrunner and sole marketing agent, while Goldman Sachs was a passive joint bookrunner.

Looking ahead, in anticipation of rising interest rates, Apthorpe is optimistic that the convertible market will continue to find favor. With some $1.5 trillion of high-yield bonds issued in the past five years—some of which will be approaching maturity in two or three years—the pressure will be on management teams to find alternative instruments to refinance maturing paper, he said.

“The risk for corporate bonds, particularly within the energy sector, now that it accounts for approximately 20% of the high-yield market, is that we find ourselves in a higher interest rate environment two to three years from now, and that should bode well for convertible issuance prospects in general,” he said. “Finance teams focused on managing their weighted average cost of debt, and therefore impact to earnings, should naturally be attracted to the relative value offered through convertible bonds.”

Apthorpe noted a rule of thumb that for every 100 basis point (1%) increase in rates for high-yield bonds, the convertible market will participate only to the tune of around 25 to 50 basis points (0.25 to 0. 50 of 1%).

“The relationship doesn’t track one-for-one on the upside,” he said. “As a result, in a rising rate environment, such as was the case in 2004-2006, one saw primary convertible issuance increase by approximately 25%. This would be a healthy reversion to the mean as U.S. convertible issuance has been trending at only 50% to 55% of pre-crisis levels.

“By contrast, we’ve seen high-yield annual issuance triple. So, while rates have remained low for many years post-crisis, negatively impacting convertible issuance as a whole, I’m upbeat on future issuance levels, given the prospect of higher rates two to three years from now when earlier high-yield issuance will be maturing.”

Whether or not Apthorpe is right remains to be seen. In the interim, capital-intensive E&Ps have the opportunity to familiarize themselves with the differentiated source of capital that convertibles offer over and above traditional avenues of high-yield, common equity or asset sales.