Call it a midstream makeover. An affiliate of Tortoise Capital Advisors is breaking new ground by transforming an energy business development corporation (BDC) into a real estate investment trust (REIT). It will hold transmission, pipeline and gathering assets.

The new entity is believed to be one of the first publicly traded energy infrastructure REITs formed. Among the initial steps was a name change late in 2012 to CorEnergy Infrastructure Trust Inc. (NYSE: CORR) from Tortoise Capital Resources Corp., reflecting the title of its management company, Corridor InfraTrust Management LLC. Tortoise is based in Leawood, Kansas.

The cornerstone in the transition to REIT status was a major midstream acquisition involving pipelines and central gathering facilities built by Ultra Petroleum Corp. to service its Pinedale Anticline natural gas field in Wyoming. Far and away the REIT’s dominant asset to date, the midstream holdings were acquired through a newly formed subsidiary, Pinedale Corridor LP.

Structured as a sale-leaseback, the purchase was announced by CorEnergy this past December. The deal gave the firm not only the real property assets but also the requisite 12-month time frame to meet its goal of qualifying for REIT status by the end of 2013. Partnering in the transaction with an 18.9% stake was longtime energy investor Prudential Capital Group.

“We believe we’ve cracked the code on broad, investor-friendly access to U.S. energy infrastructure by utilizing a publicly listed REIT, much like Tortoise Capital did for retail investors with master limited partnerships (MLPs) in designing the first closed-end fund,” said CorEnergy chief executive officer David Schulte during the company’s first quarterly call since the midstream acquisition.

“We’re like a nonoperating MLP,” he said, outlining the company’s objective of providing its shareholders with “an attractive, risk-adjusted return, with an emphasis on stable distributions and long-term distribution growth.”

For investors, the new REIT-structured vehicle represents “a low-volatility, long-duration, inflation-protected energy investment,” he said in an interview. Based on its “stable and modestly growing cash flows over a very, very long horizon,” CorEnergy expects to deliver returns on invested capital of 8% to 10% per annum, including annual distribution growth of 1% to 3%. This would compare favorably with stocks with similar risk characteristics, such as utilities and other REIT sectors.

How transformational was the move from BDC to REIT?

The $228.5- million price for the Pinedale midstream assets compared to the BDC’s portfolio of assets—made up primarily of public and private securities—that were worth some $100 million. To help fund the purchase, CorEnergy liquidated most of its position in MLP securities, raising $26 million. In addition, in a skittish equity market in late 2012 amid “fiscal cliff” concerns, the company raised roughly $74 million by issuing 13 million new shares.

With roughly $100 million from the security sales, CorEnergy tapped two other sources for a further $100 million. It entered into a secured term credit facility for $70 million, and received $30 million from Prudential for its 18.9% stake. Rounding out the remaining $28 million were other equity securities accepted by Ultra, with a market value of $23.5 million, as well as some $5 million in cash.

Of its prior portfolio, essentially the only unchanged assets were certain private securities valued at a little under $20 million, and an investment in a transmission line operated by Public Service Co. of New Mexico, which CorEnergy expects will also qualify as a real property asset for REIT status. The latter, known as the Eastern Interconnect Project, is projected to have nearly a 7% cash-on-cash return over its life—lower than the targeted 8% to 10%, but “appropriate given its lower risk level.”

Underpinnning the transition to REIT status was CorEnergy’s belief that the BDC format offered “too limited a platform to execute its strategy,” a view shared by several other BDCs that have since changed strategies, said Schulte. A REIT structure offers greater flexibility, especially in view of the energy industry’s growing capital needs. Affiliate Tortoise Capital puts the capital investment needs for pipelines alone at $78 billion over the next three years.

“As upstream companies focus on their highest-return opportunities, we expect them to continue to divest, monetize or partner in the ownership of infrastructure assets, so they can preserve capital to fund drilling and exploration opportunities,” says Schulte.

Prudential Capital Group, which has some $13 billion in private debt and equity investments in the energy sector, also sees opportunities for upstream players to recognize value in infrastructure assets that otherwise would lie “fallow” on company balance sheets. Often, however, E&P companies hesitate to unlock the value of assets they view as strategic if in doing so they would risk having to give up control, says Brian Thomas, managing director in the Energy Finance Group of Prudential Capital Group.

Thomas contrasts the approach of certain “control-oriented” investors—often under pressure to monetize assets within certain time frames—with the “buy-and-hold” strategy employed by Prudential and, now, CorEnergy. A buy-and-hold approach “resonates” better with E&Ps considering a strategic asset sale and complements Prudential’s need to match long-lived assets with the similarly long-lived liabilities of its insurance business.

Owners “may not want to sell these assets to someone who theoretically will seek to sell them in five to seven years,” he says. “As a life insurance company, we have very long liabilities, consistent with our business model. Midstream assets are a very good fit for our balance sheet; they’re long-term in nature, generally provide good distributable income, and have very solid long-term intrinsic value.”

Like-minded partners

Even though Prudential has ample opportunity to structure its own private transactions, it had good reason to join forces with CorEnergy on the purchase of Ultra’s Liquids Gathering System (LGS) in the Pinedale Anticline. Prudential knew members of the CorEnergy team from their work at Tortoise as having “like-minded investment interests.” In addition, Prudential had a good relationship with Ultra.

“For a maiden voyage, it was a good opportunity to work with parties with which we’ve already had long-term relationships. I think that helped a lot,” recalls Thomas. “You work through the challenges and tailor something that meets people’s priorities without compromising your own.”

The $228.5-million purchase took the form of a sale leaseback, under which UPL will continue to operate the assets for an initial 15-year period. Options exist to extend the lease for five-year periods. The triple net lease provides for a base rent of $20 million per annum, subject to adjustments for inflation based on the CPI. The lease also includes an additional “participating rent” based on the LGS assets’ volume growth. Total rent (minimum plus participating) is capped at $27.5 million per annum.

While Thomas says Prudential would have considered structures other than a REIT, “we look at this as good fit. Having this type of arrangement, in which a REIT holds a gathering system, provides greater certainty of revenue stream visibility over a very long horizon.”

A major factor attracting both CorEnergy and Prudential to the deal was not only the LGS asset itself but also the quality of the reserves behind the system.

The asset includes more than 150 miles of underground gathering pipelines, while the latest available Energy Information Administration data, from 2009, place the Pinedale Anticline among the top five U.S. natural gas plays, based on proved reserves. Ultra’s estimated proved reserves in Pinedale and Jonah fields were 4.3 trillion cubic feet (Tcf) equivalent as of December 31, 2011, while proved, probable and possible (3P) reserves were esti- mated at 10.2 trillion equivalent, according to reservoir engineering firm Netherland, Sewell & Associates, which has identified an inventory of more than 5,000 future drilling locations.

CorEnergy chairman Rick Green emphasizes the importance of having made “a thorough and deep examination” of not just the LGS assets but also the reserves backing them. You have “a very high-quality asset behind the LGS,” he says. And all the better, he notes, “because at the end of the lease, they turn operations of the LGS back to us; we own it. You take a very serious look at this as an owner, not a financier.”

Even in a low-gas-price environment, the LGS assets “are supported by economically attractive, long-term reserves,” Thomas says.

In addition, Ultra has a strong record of stewardship of its Wyoming acreage and a good working relationship with the Bureau of Land Management, Thomas says. In 2008, the BLM mandated the use of a full-field liquids gathering system for natural gas produced in the Pinedale area. Previously, water and condensate from producing wells were trucked out.

With Pinedale primarily a dry-gas reservoir, the LGS assets mainly involve gas gathering and the separation of water and some condensate. The system, running at about 80% of capacity, can be expanded incrementally by adding separators at a relatively low cost, if necessary. “The LGS is really a utility system that manages water coming out of wells in an environmentally and economically smart way,” says Green. “This happens to be a new one in very good shape.”

Schulte notes that CorEnergy’s interest in REIT-qualified real property assets, such as pipeline, gathering, storage and transmission assets, does not include processing assets. Current IRS regulations are limited to “conduits and vessels,” separate from “conversion” assets. Since processing could be considered a “conversion” asset, it would be “too uncertain” to acquire and lease processing assets in the absence of a specific IRS ruling.

Schulte says CorEnergy has additional transactions under “preliminary review” ranging from $50 million to $200 million. With CorEnergy having a market cap of less than $200 million, he acknowledges there may be an element of its “boot strapping” its way up to larger opportunities. With debt at the lower end of a preferred range of 25% to 50%, plans to enter into a revolver agreement with a bank group may open the door to smaller, accretive acquisitions.

Schulte is confident of adequate investor appetite to grow the energy REIT. First, income needs of individual retirement accounts (IRAs) and other tax-exempt monies represent a huge pool of capital that can own REITs. By contrast, IRAs tend not to hold MLPs to avoid the UBTI (unrelated business taxable income) issue. In addition, both REITs and utilities have wide institutional ownership that CorEnergy can tap into as its market cap grows.

“We’re small right now, but we believe that as we grow in size, there will be an institutional audience that will benchmark us appropriately against similar low-volatility, long-duration, inflation-protected equity investments,” Schulte says. “One of the things we’ve demonstrated to the market is the appetite of larger institutions, like Prudential, for the kinds of investments we are making. And that would enable us to do larger size acquisitions than on our own.”

Having a major transaction behind it is an important landmark for CorEnergy, in light of the new sale-leaseback framework in an energy REIT. “It was a complex negotiation that built a partnership as opposed to just executing a transaction,” Green says.

“The first deal is always the hardest,” Thomas says. “Hopefully, it sets a template for future parties to consider. Once you have examples in the market, and a track record for getting them done, a larger universe of people will consider that as an option for assets they might like to monetize.”

Expanding use of the REIT structure in energy infrastructure would not surprise Thomas. He says it may be viewed as another vehicle that can “expand” rather than simply “reallocate the pie of capital.” As for the MLP sector, “I don’t think this is something that steals opportunities from the plate of traditional MLPs. It’s supplemental as opposed to a substitute.”

Schulte says growth in the MLP sector tends to be driven by expansion or by integration of assets into an existing MLP network. “But not all energy and midstream opportunities are that type,” he says, and where divestitures are motivated mainly by monetization, “a REIT provides a better fit for that type of asset.”

Whatever the next move is for CorEnergy, Schulte says the combination of acquisition and financing used to grow the company would have as a priority, accretion to existing shareholders. Taking up existing bank capacity and tapping possible preferred or joint-venture financing may be on the agenda. But Schulte says he is “very circumspect” about possibly accessing the equity market—unless to do so would allow CorEnergy to raise distributions from its current level of $0.50 per annum.