September 01, 2016

As a result of complex capital structures’ long presence in the oil and gas industry, the value differential between senior and junior equity securities is a frequent topic of conversation among industry insiders. Deriving such a differential is often challenging, particularly because junior share classes are rarely traded in public markets. In cases of yield-oriented investment vehicles where relative subordination among senior and junior equity is tied to periodic distributions, the question of value differential is further complicated. There are numerous well-accepted models for valuing securities with subordination features in the event of the sale or liquidation of a business, but there are far fewer models for measuring the detriment of ongoing cash flow subordination for equity instruments. This issue is especially relevant in cases where owners and management teams are contemplating capital structure reorganizations. How can these parties determine how much value is received, transferred or exchanged with the introduction of cash flow subordination features?

In the context of the oil and gas industry, master limited partnerships (“MLPs”) with common and subordinated unit structures provide a convenient lens through which to analyze this topic. Accordingly, this article presents a model that quantifies the value differential between senior and junior equity securities, specifically in instances where relative seniority relates to recurring, periodic cash distributions.

The capitalization structure of an MLP and the resulting economics are unique as compared with other public entities, due largely to the fact that the key terms of security classes revolve around periodic cash flow distributions. Generally, an MLP is required to distribute all excess cash flow on a periodic basis, as governed by its partnership agreement (as opposed to any specific tax or other requirements), subject to management’s determination of appropriate cash reserves for items such as debt service and working capital requirements. Although MLPs also maintain specific tax objectives and advantages for investors, this article focuses primarily on the mechanics of how distributions are made to investors, without regard to specific tax issues.

For many MLPs, securities sold in public markets are senior in priority with respect to cash flow relative to securities retained by the pre-IPO owners of the company. Specifically, publicly traded partnership units are usually referred to as “common units,” and owners of the old equity retain “subordinated units,” with equity split roughly evenly between the two classes. In this context, common unitholders are entitled to minimum periodic distributions prior to the payment of distributions to subordinated unitholders. Accordingly, subordinated units are inherently subject to more risk relative to common units.

Under this structure, MLPs specify their intention to distribute a minimum level of periodic distributions, typically referred to as the minimum quarterly distribution (“MQD”). Key terms of a representative MLP capital structure are outlined below:

**Common units**- Issued to the public via IPO
- Maintain senior claim on distributions up to the stated per-unit MQD, with unpaid MQD accruing to the next period
- Split distributions over and above common and subordinated MQD pro rata with subordinated units

**Subordinated units**- Privately owned by pre-IPO equity owners
- Subordinated to common units’ MQD
- Maintain stated per-unit MQD after the payment of common MQD, but unpaid MQD does not accrue to the next period
- Split distributions over and above common and subordinated MQD pro rata with common units
- Convert to common units upon the satisfaction of certain conditions sometime in the future, typically three to five years (i.e., the subordination period)
- May convert to common units at less than a 1:1 ratio if predetermined levels of MQD are not achieved

**General partner (“GP”) interest**- Responsible for management of the MLP
- Historically retained 2.0% of partnership equity

**Incentive distribution rights (“IDRs”)**- Form of carried interest owned by the GP or related entities
- Make payments tied to a percentage share of distributions over and above predetermined levels of cash flow
- Are complicated in their own right and are not the primary focus of this article, though a similar framework can be used to value them

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The nature of the payout structure results in asymmetrical payments to the common and subordinated units, depending on the level of available distributions. As Figure 1 illustrates, potential payouts are classified by three per-unit cash flow scenarios:

- In high cash flow scenarios, both unit classes receive the MQD
- In lower cash flow scenarios, the common units receive the MQD and the subordinated units do not receive the full MQD (and “lose” the portion not paid)
- In even lower cash flow scenarios, the common units receive a portion of the MQD (the unpaid portion of which accrues to the next period) and the subordinated units receive nothing

In light of the asymmetry of potential payments to these security classes, it is necessary to use derivative instrument pricing techniques that appropriately capture these relevant rights and preferences in the context of future cash flow relative to the MQD. Accordingly, it is helpful to implement a model that uses Monte Carlo simulation to generate a range of potential cash flow outcomes for a company. The outcomes then can be translated to a valuation of the subordinated units relative to the common units.

Monte Carlo simulation is a modeling technique in which an uncertain variable or variables (in this case, future levels of periodic cash flow) are identified and assigned an expected distribution of potential outcomes. The simulation randomly changes the uncertain variable or variables thousands of times, based on the specified distribution. The simulation produces a set of projected results (in this case, thousands of potential outcomes for future quarterly cash flow) that can be used to calculate the value allocated to the common versus subordinated units, according to the partnership agreement. Averaging the output from Monte Carlo simulation yields the expected value allocated to each unit class, which then can be discounted to a present value equivalent in order to derive an indication of value.

The first step in the valuation process is to develop a mathematical framework for simulating the uncertain variable — future periodic cash flow — which is assumed to follow a geometric Brownian motion (“GBM”) process. GBM is a continuous-time stochastic process used to model variability in future asset prices and is the most widely used model for such purposes. Specifically, a GBM, S(t), satisfies the stochastic differential equation, dS(t) = µS(t)dt + sS(t)dW(t), where W(t) is a Wiener process, and the expected return µ and volatility s are assumed to be constants.

In this case, the main inputs required for implementation of Monte Carlo simulation are as follows:

- Expected case future cash flow over the subordination period, where such expectations can be taken as the median of analyst estimates, to the extent the subject company has sufficient analyst coverage
- Volatility of future cash flows, which can be determined based on a synthesis of different data sources and considerations, including
- Equity volatility of the subject company, which can be translated into the volatility of the subject company’s assets and cash flow
- Volatility of the subject company’s historical cash flow
- Hedging activity of the subject company, which should be considered to the extent the company’s cash flow is highly dependent on movements in commodity prices of oil and/or natural gas

- Partnership agreement terms, including key economics such as
- MQD structure between common and subordinated units
- Subordinated period
- Conditions for conversion of subordinated units

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**Cash flow volatility:**An analysis of the relative value between the subordinated and the common units will be sensitive to the volatility of future cash flows. Because subordinated units are equivalent in value to common units in high cash flow scenarios, and because they have materially disparate value in low cash flow scenarios, higher volatility will translate to higher risk for the subordinated units and a lower relative valuation (or a higher discount) relative to the common units.**Coverage:**Higher cash flow coverage with respect to the combined MQD of the common and the subordinated units will lead to lower overall risk for both unit classes and a higher relative valuation (or a lower discount) for the subordinated units. The calculations in Figure 2 show that coverage of common units is nearly double that of coverage of subordinated units, implying significantly less risk for this security class. To the extent coverage on the subordinated units increases to levels materially higher than 1.00x-1.25x, this risk differential starts to narrow.**Subordination period:**The longer the subordination period of the subordinated units, the higher the discount relative to the common units. Similar to volatility, a longer subordination period results in wider tails for the range of simulated cash flow, leading to increased risk for the subordinated units.

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This section contains a case study illustration to determine the value of the subordinated units of a representative public MLP. The five steps of the analysis are as follows:

- Simulate various levels of future cash flow, using assumptions for (a) base case expected growth and (b) volatility
- Allocate cash flow in each simulation path to the common and the subordinated units, based on their respective MQDs and subordination features
- Calculate the subordinated units’ conversion ratio at the end of the subordinated period and apply the resulting fully diluted ownership of each security class to a calculated terminal value
- Calculate the present value of periodic MQD payments and the terminal value of each security class
- Calibrate the model to the value of the publicly traded common units, resulting in a value for the subordinated units

Based thereon, the required inputs and assumptions for this analysis are outlined below and in Figures 2 and 3:

- Total common and subordinated units outstanding
- MQD: For simplicity’s sake, the illustration and the MQD are annualized
- Base case expected cash flow: This is taken as the median of equity analyst estimates over the subordination period
- Cash flow volatility: This analysis uses 25% annualized volatility, which considers the fact that the subject company is highly hedged over the next few years (note that since 2010, West Texas Intermediate [WTI] oil and natural gas have experienced price volatility of approximately 33% and 43%, respectively, per S&P Capital IQ, Inc.)
- Conversion of subordinated units: Conversion is equal to the lesser of (X) 1:1 and (Y) year five distributions per subordinated unit divided by the year five MQD
- If cash flow is not sufficient to meet the MQD in year five, the subordinated units convert at a ratio less than 1:1
- Discount rates: A detailed discussion of discount rate estimation is beyond the scope of this article, but this analysis assumes the following:
- The required return on equity for the common units is calibrated or solved for such that the common units equal the publicly traded price
- The required return on equity for the subordinated units is assumed to be equal to the required return on equity of the common units, plus a spread of 5.0%

Figure 4 shows the range of results for the subordinated units, assuming a publicly traded price of $20.00 for the common units in all cases and running 10,000 scenarios. As Figure 4 illustrates, the discount relative to the common units ranges from 20.0% to 36.0%:

Providing further sensitivity analysis, if the base case expected cash flows are decreased by approximately 10.0% (leading to aggregate projected coverage closer to 1.00x), the base case discount relative to the common units increases from 29.0% to 34.0%.

In analyzing financial instruments with structural cash flow subordination characteristics, it is often difficult to determine the value differential between senior and junior instruments. On the surface, there may seem to be little value differential if the subject company anticipates meeting required levels of MQD. Regardless of the level of coverage, however, risk that cash flow will not be sufficient to meet required MQD payments always exists. In the case that cash flow truly is not sufficient to meet these payments, the value of subordinated units can be penalized significantly. The flexible model presented herein for quantifying the detriment of owning subordinated units is sensitive to a handful of key inputs, all of which management teams should carefully consider in connection with capital structure reorganizations and transactions that involve equity instruments with similar features.