Commodity prices plummeting. Cash-flow crunches. Balance-sheet challenges. Capital constraints. Equity markets slamming shut.

Many oil and gas companies faced these issues over the past 18 months. One company negotiated the rocky shoals via a highly complex, multifaceted transaction to improve liquidity and simplify its capital structure in the challenging economic environment.

This is the story of Eagle Rock Energy Partners LP and its extraordinary, 18-month-long journey from financial constraints to successful restructuring and recapitalization—in effect, a financial rebirth during one of the worst commodity-price and capital-markets environments in a long time.

MLP Roots

Eagle Rock Energy Partners, Houston, was created from natural gas gathering, compression, treating, processing and transportation assets from sponsor Natural Gas Partners (NGP), a private-equity company that has been investing in energy since 1988 and now manages more than $7 billion in investments across the energy value chain.

NGP took the former Eagle Rock Pipeline public as a master limited partnership in 2006, raising approximately $222 million in net proceeds. At the initial public offering, NGP and the Eagle Rock management team owned 100% of the general partner, Eagle Rock Holdings GP LP, and approximately 56% of Eagle Rock Energy Partners LP.

With NGP's affiliate in control of Eagle Rock's general partner, the MLP pursued a highly focused acquisition growth strategy, both pre- and post-IPO, between 2006 and 2008. Eagle Rock added more than $474 million in midstream assets through the acquisitions of the Brookeland gathering system and processing plant, the Masters Creek gathering system and the Jasper natural gas liquids pipeline; Midstream Gas Services LP; Laser Midstream Energy LP; and Millennium Midstream Partners LP.

In 2007, Eagle Rock created its minerals segment by acquiring Montierra Minerals & Production LP, an NGP portfolio company, for $139.2 million. The acquisition included fee minerals, royalties and working-interest properties from another NGP affiliate as well. Several months later, Eagle Rock added complementary fee minerals and royalties from MacLondon Energy LP, for $18.2 million.

Spending an additional $516 million between 2007 and 2008, Eagle Rock entered the upstream arena through low-risk exploitation and development of mature assets. The initial acquisitions included long-lived producing properties in East and South Texas and in Alabama with the addition of Escambia Asset Co. LLC and Escambia Operating Co. LLC; as well as Redman Energy Holdings LP and Redman Energy Holdings II LP, which were NGP affiliates. With the acquisition of Stanolind Oil and Gas Corp., in spring 2008, Eagle Rock added producing properties in the Permian Basin of West Texas.

"Growth through acquisition allowed Eagle Rock to nearly double its midstream business from 2006 through 2008, while creating two new business segments in the minerals and upstream sectors," notes Eagle Rock chairman and chief executive officer Joseph A. Mills. "In October 2008, we closed on the acquisition of Millennium Midstream Partners, for $210.6 million, boosting our presence in East Texas.

"We financed the Millennium acquisition with a combination of equity to the sellers and approximately $180 million of debt drawn on our credit facility," he continues. "Eagle Rock planned to issue additional equity shortly after closing to get our balance sheet back in line. And then, the market crashed. Gas prices had been falling like a stone. We'd drawn down $837 million on our $1-billion credit facility by the end of first-quarter 2009 and our cash flows were falling as our producer customers dramatically curtailed drilling. Something had to give."

According to Eagle Rock chief financial officer Jeffrey P. Wood, who joined the company in January 2009, Eagle Rock faced several large, immediate hurdles. "Goal No. 1 was to find a way to enhance liquidity without violating our bank covenants," he says. "We had financed at very attractive rates back in 2007 and wanted to preserve those debt instruments. We weren't at risk of bankruptcy, but we risked having to refinance a large debt burden in an extremely challenging environment."

Now What?

As a midstream gatherer and processor, Eagle Rock's revenues depend on upstream companies' decisions to drill. By early 2009, most producers had scaled back their capital spending plans in the wake of collapsing natural gas prices. As a result, Eagle Rock's gathering and processing volumes and midstream cash flows fell off dramatically. "The midstream story was getting uglier by the minute in early 2009. We realized we needed to start siphoning off every dollar we could towards debt repayment," Wood explains.

The company needed to meet its immediate liquidity needs, improve its balance sheet and get back on its growth trajectory. But, how? If its financial situation couldn't turn around by 2010, Eagle Rock would likely violate its debt covenants.

"How do you create meaningful liquidity at a time when the capital markets are closed?" Wood asks. "The industry M&A scene was basically dead at that point. There was such a huge gap between buyer and seller expectations—nothing was transacting."

Adds Mills, "We had to evaluate our business from top to bottom, to look for ways to cut costs while exploring strategic alternatives to improve liquidity under such horrible market conditions. We asked ourselves: Does the MLP structure remain the best way for us to create investor value? Should we consider converting to a C-corp in order to access better capital terms? Should we continue to pursue opportunities in multiple business lines? Selling off our operating assets was not an attractive option.

"At the end of the day, we concluded that our existing business model remained sound but could be improved as a result of the difficult lessons learned as poor market conditions dragged on."

Further pressuring overall liquidity, the borrowing-base component of Eagle Rock's credit facility was cut by 35% in April 2009, from $206 million to $135 million. This reduction reflected the impact of continued falling commodity prices on the valuation of Eagle Rock's proved reserve lending base. Eagle Rock was backed up against a wall.

Hard Decisions

Against this background, Mills, Wood and other members of Eagle Rock's executive management team met with the board and NGP. The company had to start channeling more cash flow towards debt repayment as quickly as possible. Hedge positions put in place for 2009 were providing some additional cash-flow relief to help buy time for debt reduction. However, overall debt had to be reduced substantially by the end of first-quarter 2010 to prevent default.

The time had come to cut the common unitholder distribution and free up cash to accelerate debt repayment. "This was a sobering and truly painful moment for all of us, but it was absolutely the right thing to do," says Wood. Eagle Rock had been distributing $0.41 per unit (i.e., common, subordinated and general partner units) per quarter, or $1.64 per unit annually. "We could no longer pay that level of equity distribution responsibly, knowing we were ultimately at risk of default. We believed common unitholders would be best served through protecting the long-term viability of the partnership," he said.

On April 29, 2009, Eagle Rock announced a voluntary, temporary reduction in its quarterly distribution rate to $0.025 per common unit per quarter, or 10 cents annually. This temporary reduction would be in place until commodity prices recovered enough to support renewed drilling. In conjunction with its hedge portfolio, this dramatic move would improve liquidity enough to enable Eagle Rock to remain in compliance with the terms and conditions of its credit facility throughout 2009.

Liquidity and Simplification

The distribution reduction allowed Eagle Rock to accelerate debt payment by $83 million and finish 2009 with more than $60 million of availability. But the company needed a longer-term liquidity answer given the extended depressed industry outlook.

Eagle Rock's three distinct business segments complicated the search for a solution. This diversification was originally intended to broaden the company's potential acquisition opportunities. And while there were synergies between the midstream and upstream sectors, the minerals business was an unusual fit for any MLP.

In addition, Eagle Rock's complex ownership structure often hampered its access to capital markets. NGP owned a significant equity position in Eagle Rock, in most part through Eagle Rock Holdings LP. The latter owned 2.3 million common units and 20.7 million subordinated units and all the equity interest in Eagle Rock's general partner, Eagle Rock Holdings GP LP. In other words, NGP effectively controlled Eagle Rock's general partner and owned approximately 35% of the limited partner units—both common and subordinated—in the MLP.

Historically, Eagle Rock benefited tremendously from the exposure NGP provided for growth through acquisitions, and from the collaboration with transactional and financial professionals at NGP and their significant energy-asset-investment experience. But Eagle Rock's ownership and capital structure included typical MLP general partner equity splits where the general partner was entitled to increasing shares of common unit distributions as certain performance targets were met.

"We needed to simplify our ownership structure in order to focus more clearly on increasing value for the common unitholders," Mills emphasizes. "Two themes emerged by mid-2009: the need for liquidity and for structural simplification. We had to find a complete solution that addressed both needs simultaneously."

NGP chief executive officer Ken Hersh agreed it was essential to simplify. "As Eagle Rock's founder, NGP took its financial support of the MLP very seriously," Hersh explains. "We had, and continue to have, great faith in the Eagle Rock management team. The company had tremendous assets to leverage for greater growth.

"Unfortunately, the MLP was simply capital constrained at that point and its balance sheet boxed it in. A structural cleanup would eliminate some of the different levels of ownership to support recapitalization. We wanted to enable Eagle Rock to stop playing defense and move forward playing offense."

Liquidity Solution

A multi-pronged strategy evolved through negotiations during the next 8 to 10 months. At the core of the liquidity solution was the idea of selling the minerals business. "It was a tough choice. We owned royalty interests in producing properties all over the U.S. That sector generated pure cash flow with no operating costs or capital-expenditure needs. However, because of those attributes, we believed that it would command a premium price in the market despite the depressed M&A environment," says Wood.

NGP committed to purchase the minerals business for $135 million as a back-stop should no entity come forward in a marketed sales process. A significant portion of Eagle Rock's mineral rights were controlled and operated by Black Stone Minerals Co. LP, one of the largest private fee and royalty owners in the U.S. Black Stone jumped in early as potential buyer of the minerals business.

Says Tom Carter, Black Stone chairman and chief executive officer, "Black Stone was the natural buyer to consolidate our holdings in key regions. It was an attractive business with a steady revenue stream. We had expressed interest in purchasing Eagle Rock's minerals business during an exploratory meeting held nearly a year earlier. The recapitalization proposal was the catalyst to finally get the deal done."

Simplifying the Structure

MLPs are complex structures with multiple levels of ownership. Subordinated units provide downside distribution protection for the common units and are typically structured for conversion to common units after three or so years.

Eagle Rock's restructuring and recapitalization plan called for the elimination of one level of ownership. "Our intent was to make this a simpler, more 'common-unitholder-friendly' company," Wood says.

NGP agreed to contribute the existing incentive distribution rights held by the general partner, as well as the 20.7 million subordinated units held by Eagle Rock Holdings, to Eagle Rock. Upon unitholder approval of the plan, Eagle Rock would cancel both the incentive distribution rights and subordinated units and eliminate one layer of ownership.

Key to these transactions was NGP's willingness to allow Eagle Rock to acquire its own general partner. The agreement included an option for Eagle Rock to purchase NGP's 844,551 outstanding general partner units and thereby take over control from NGP in exchange for one million newly issued common units. The option to acquire the general partner would trigger an expansion of Eagle Rock's board of directors as well as a commitment to hold annual unitholder meetings. With the addition of two new independent directors, common unitholders would elect the majority of Eagle Rock's board of directors for the first time under the new plan.

Rights, Equity Offerings

With capital markets virtually shut in during 2009, a rights offering seemed like an elegant solution to access additional capital. NGP and its affiliates agreed to exercise all of the rights received on the 9.5 million common and general partner units they controlled to support Eagle Rock's capitalization effort.

In addition, NGP agreed to backstop, for a period of time, up to $41.6 million of an Eagle Rock equity offering, to be undertaken as needed. In exchange for all of NGP's contributions, Eagle Rock would pay NGP a transaction fee of $29 million in the form of 4.8 million common units, upon completion of the equity offering or the expiration of the back-stop commitment.

Conflicts Committee Invoked

NGP had such a large presence in nearly every part of the restructuring and recapitalization proposal that the conflicts committee of the board of directors, made up from the independent members of Eagle Rock's board, was invoked early in the process to ensure the best interests of the common unitholders were served.

The conflicts committee reviewed each version of the evolving restructuring plan as negotiations continued throughout the rest of 2009. Energy investment bankers from Madison Williams and Co. were hired to advise the committee and issue a fairness opinion.

Says Madison Williams managing director Robert Lane, "Unlike many of the acquisitions by MLPs of their general partners, this transaction was anything but cookie-cutter. The complexity and number of moving pieces was high, but it still came down to two basic questions: Were unitholders better off, from a financial point of view, for doing this transaction? And was what they were receiving worth at least as much as what they were giving up? Thanks to some serious and thoughtful negotiations by all parties, we were able to get to a position where the answer to both questions was a definitive yes."

By year-end 2009, Eagle Rock, several affiliates of NGP, and Black Stone had reached a definitive agreement that passed muster and garnered special approval from the conflicts committee. The sale of the minerals business and the full exercise of the rights offering were expected to provide approximately $225 million to Eagle Rock, exclusive of transaction fees, to reduce debt. Borrowed amounts could be reduced further from proceeds of a potential equity offering done at a later date, if needed.

The restructuring was done, but now even harder work was beginning—to explain such a complex plan to common unitholders in simple-enough terms to gain approval and implement the plan in first-half 2010.

Preliminary Proxy

Eagle Rock filed a preliminary 364-page proxy on January 14, 2010, asking unitholders to approve the definitive agreements between Eagle Rock and various affiliates of NGP, as well as between Eagle Rock and Black Stone for the sale of the minerals business. Several amended filings later, Eagle Rock issued the final proxy to all unitholders on March 30, 2010, calling for a special unitholder meeting on May 14, 2010, to approve all the various, but interrelated, components of the plan. This required majority approval of all outstanding common units held by unitholders unaffiliated with NGP or its various subsidiaries. The initial special meeting was adjourned, to reconvene one week later to allow more time to solicit proxies from unaffiliated unitholders.

"NGP, our largest unitholder, was prohibited from voting, so to obtain a quorum we had to reach a majority of our public unitholders," says Wood. "Most of our units are held by individuals, not institutions. As a result, we dedicated a lot of time to working the phones to making sure our investors understood the intricacies of this complex deal."

Common unitholders approved the plan on May 21. Ultimately, approximately 67% of the eligible units participated in the vote. The vote in favor totaled 21.7 million units, representing approximately 78% of all votes cast.

With approval of the plan finally in place, implementation began immediately.

Rights offering raises $54 million. Eagle Rock announced the launch of its rights-offering program on the same day the plan was approved. The company distributed freely tradable rights pro rata to holders of record on May 27, 2010. Each whole right allowed the holder to purchase one common unit for the exercise price of $2.50, as well as one warrant to purchase one additional unit for $6. The rights were distributed to unitholders beginning on June 2 and traded publicly until close of business June 30, 2010. "The rights offering was tremendously successful and dramatically oversubscribed," says Wood.

NGP reduces overall ownership percentage of Eagle Rock. NGP surrendered all 20.7 million outstanding subordinated units and incentive distribution rights, which Eagle Rock subsequently cancelled. In exchange, Eagle Rock issued 4.8 million common units to NGP in a private placement, priced at $6.01 per common unit. While NGP remains Eagle Rock's largest unitholder, ownership was ultimately reduced from 40%, held mostly in subordinated units, to approximately 24% of the MLP common units following restructuring.

Eagle Rock receives $174.5 million from sale of minerals business. The sale of the minerals business to Black Stone closed on May 24, 2010.

Eagle Rock acquires its general partner. On July 28, 2010, Eagle Rock Energy Partners delivered official notice to Eagle Rock Holdings that it was exercising its option to acquire its general partner entities per the terms of the plan. Eagle Rock issued 1 million common units to Eagle Rock Holdings and cancelled the 844,551 general partner units outstanding on July 30, 2010.

Equity offering backstop expires. On September 21, 2010, NGP's commitment to backstop an Eagle Rock equity offering expired.

Eyes on the Ball

Says Ken Hersh, "Eagle Rock's management kept everyone's eye on the ball to move these complex, time-consuming negotiations forward for more than 10 months, at the same time they were also running several ongoing business segments."

A number of complex side issues included the need to secure an amendment to Eagle Rock's revolving credit facility to modify the definition of "change of control." This allowed Eagle Rock to acquire the general partner from NGP without triggering a potential default event under the debt covenants.

Success Metrics

By any number of metrics, the Eagle Rock restructuring and recapitalization program was the comeback story of the year. The company's debt level at the start of 2009 was $837 million. As of September 30, 2010, its debt stood at $515 million, so the leverage covenant, as calculated under Eagle Rock's credit facility, was 3.6x trailing 12-month EBITDA.

Common unitholders who chose to stay the course throughout the past 18 months have been rewarded. On April 30, 2009, the day after announcing the distribution cut, units fell from $6.23 to $3.67 per unit. On December 21, 2009, the date the definitive agreement was signed, units traded for $4.90 per unit. By May 21, 2010, when investors approved the restructuring plan, the common units were trading at $6.01. By close of business November 12, 2010, Eagle Rock common units were trading at $7.38 per unit and holders who participated in the rights offering had additional value in the form of publicly traded warrants that were trading at $1.68 per warrant.

The end of Eagle Rock's temporary distribution cut is in sight. The management announced on July 28, 2010, that it would recommend to the board of directors an increase of the quarterly distribution from its current annualized rate of $0.10 per unit to $0.60 annually per unit beginning with respect to fourth-quarter 2010, payable in February 2011. This proposed cash distribution level was designed to allow Eagle Rock to retain a meaningful percentage of available cash to fund future organic growth and further strengthen its balance sheet through debt repayment.

s early as third-quarter 2010, Eagle Rock returned to growth-through-acquisition mode, announcing plans to acquire additional interests in producing properties in southern Alabama for $4.2 million. Eagle Rock already holds a significant interest in the wells and operates nearly 100% of them.

On the midstream side, Eagle Rock acquired additional gas-gathering systems and related facilities in Wheeler and Hemphill counties in the Texas Panhandle from Centerpoint Energy Field Services Inc. for some $27 million in October. The purchase expanded the company's core presence in the Granite Wash play.

Despite the continued challenges of soft natural gas prices, the future looks bright for Eagle Rock and its investors.

"Throughout this entire process, Eagle Rock management walked a tightrope," says Ken Hersh. "They were able to balance the interests of a significantly large unitholder with the needs of an independent board, third-party advisors and an unaffiliated unitholder base that needed a very complex deal explained in order to approve the proposal. All unitholders benefited for the long-term under this new plan. What the Eagle Rock executive team accomplished in the end was nothing short of phenomenal."