Crosstex leverages partnership structure, aims to create value, raise equity for growth

The management of Crosstex Energy, a midstream energy company, has leveraged the master limited partnership business structure to establish two publicly traded entities. Our aggressive pursuit of a business strategy focused on growth and our unique market position have enabled us to create significant value and raise considerable equity in the marketplace.

Crosstex management launches company, sets stage for growth

In 1996, key management members of an independent exploration and production company led a buyout of the firm’s gas-marketing business and founded Crosstex, which now provides a variety of services to transport natural gas from field production areas to end users.

Management believed that the best way to build this midstream energy business was as an independent company. At the time of the buyout, Crosstex had 9 employees. Today - some 10 years later - the company employs more than 600 people.

During the first years of its independent operation, Crosstex was capital constrained, which limited the company’s ability to grow. This changed in May 2000 when Yorktown Energy Partners, a New York-based equity fund, made a significant investment, capitalizing Crosstex with an enterprise value of about $28 million.

Today, there are two Crosstex companies with an aggregate enterprise value of $4 billion. Crosstex Energy LP, or CELP, is a master limited partnership (MLP) that entered the public arena in December 2002. Today CELP’s enterprise value is approximately $2.5 billion. Crosstex Energy Inc., or CEI, owns the general partner of CELP and went public in January 2004. CEI has a current enterprise value of approximately $1.5 billion.

The MLP structure has proven to be an extremely beneficial foundation for the ownership of midstream assets during the last 12 years. As a publicly traded entity, partnerships pay no income taxes and pass on taxable earnings and losses to their partners, or owners. The equity security that represents ownership interests in publicly held partnerships is the common unit, which trades similarly in the marketplace to a public corporation’s share of common stock. Unitholders are allocated their share of earnings and losses on a Schedule K-1 at the end of the fiscal year.

The partnerships that have excelled in the marketplace generally have grown accretively through acquisition and internal development. Consequently, they have steadily increased per-unit distribution payments, which the market has recognized with higher unit prices and lower yields over time. Partnerships generally finance growth as Crosstex has - through a combination of new debt and equity issuances.

A general partner controls the partnership and generally owns a two percent interest. A separate partnership interest called Incentive Distribution Rights (IDRs) provides the general partner with an incentive to increase the distributions to limited partners and ensures that the general partner pursues accretive acquisitions and projects. The IDRs automatically increase the general partner’s share of cash distributions as per-unit distributions rise.

In Crosstex’s case, the general partner receives two percent of the total distributions until each of the limited partners receives $1.00 per unit annually (the rate the partnership paid when it went public). If CELP pays distributions that total more than $1.00 per unit annually, the general partner receives 15% of the amount between $1.00 and $1.25 per year; 25% of the amount paid between $1.25 and $1.50 per year; and 50% of the amount paid in excess of $1.50 per unit.

Crosstex’s most recent distribution was at an annual rate of $2.24 per unit, an increase of 224% since its IPO in December 2002. As a result, distributions to CEI’s interest, including IDRs, have increased from $4.4 million in the first quarter after its IPO to over $11.5 million in the first quarter of 2007. The distribution increase, and the expectation of continued distribution growth, has caused the unit price of CELP’s common units to rise from an IPO price of $10 per unit to over $35.

Trendsetting move: Crosstex takes its general partner public

At the time of the CELP IPO, Crosstex management and Yorktown Energy owned 100% of CEI, the owner of CELP’s general partner. Because CEI remained a private entity, management and Yorktown had no means to access liquidity in the market.

Yorktown had invested in Crosstex through limited-life funds, and the time was approaching when Yorktown would need to distribute the proceeds from those investments to its partners. Yorktown and Crosstex management did not want to liquidate their interest by selling CEI because they saw a tremendous growth opportunity. They decided that bringing the general partner into the public marketplace would develop a liquid security that Yorktown could distribute to its partners. It also would give Crosstex management access to the market so members could diversify their investments, as their holdings in CEI represented substantially all their net worth.

Substantially all CEI’s assets consist of CELP partnership interests, including the IDRs. At the time, two other MLPs had general partners that were contained within publicly traded corporations, but they owned additional, significant assets that made the general partner assets difficult to value. Because no other MLPs had completed an IPO of their general partner interest, there was no real precedent to value a general partner. At the time of the CELP IPO, CELP was valued with a 10% yield, i.e., its initial distribution rate of $1.00 per year resulted in a $10 unit price. The yield had fallen below 7% over time, and it was thought that the valuation of the owner of the general partner might reflect a similar yield.

In addition to the valuation question, Crosstex management had to decide if it was preferable to bring the owner of the general partner public as an MLP, a Limited Liability Corporation (LLC), or a typical C-corporation. We determined to do the latter because we believed it would allow the general partner to appeal to a broader institutional base. Many traditional institutions have difficulty dealing with certain tax issues related to MLP ownership, including tax reporting, but want a means to participate in the growth of MLPs. Our C-corporation structure provides that.

In January 2004, we completed the CEI IPO at $6.50 a share and an initial annual dividend of $0.40 per share (split adjusted) for a yield a little higher than 6%. Currently, CEI’s dividend rate is $0.88 per share, and its stock price is approximately $30.00 per share, yielding less than 3%.

We always knew that the market placed a premium on CELP’s ability to increase partnerships’ distributions. The IDRs command an additional premium from the market in the form of a significantly lower yield because they give the general partner’s owner substantial leverage to that growth.

Since the success of CEI’s initial public offering - the first IPO for the general partner of an MLP - several midstream energy companies have taken the general partners of their MLPs public. However, they have used an MLP or LLC structure instead of the C-corporation structure Crosstex used.

Barnett Shale play is linchpin of Crosstex’s growth strategy

The Barnett Shale natural-gas formation, the most active drilling province in the United States, covers a large area encompassing many counties in and around Fort Worth, Texas. Natural-gas production in the Barnett Shale play has climbed to about two billion cubic feet of gas per day (bcf/d) from approximately one-half a bcf/d 5 years ago. Industry projections call for Barnett production to climb to more than 6 bcf/d by 2011.

Crosstex management made a company-making decision to participate in the growth surrounding the Barnett Shale. We established and pursued a strategy to provide gas producers in the play with the means to transport their product to market by building the necessary infrastructure. Initially, we developed a small gas-gathering system in Denton County, Texas, that gave Crosstex immediate, but limited, exposure to the play’s development.

We expanded our reach by working with a privately owned independent oil and gas exploration and production company, Chief Holdings LLC, the third largest producer in the Barnett Shale at the time. Chief’s executives were concerned that transportation capacity out of the play to end-user markets would become constrained by rapidly increasing production volumes.

As a result, Crosstex designed and constructed the $130 million North Texas Pipeline (NTPL), using volume commitments from Chief to underwrite the project. The NTPL was Crosstex’s first significant investment in the Barnett Shale area and signified that we were serious about our investment in the play and the important role it would play in building our platform for growth.

During the construction of the NTPL, Crosstex secured additional dedications from Chief for the development of processing plants in the area. Currently, Crosstex has in place or is developing processing capacity of 285 million cubic feet of gas per day at an expected cost of about $143 million.

While Crosstex was developing these assets, Chief’s owners and management determined that conditions were ideal for them to explore the sale of their company. Crosstex was interested in purchasing the Chief’s midstream gathering business, which would be an ideal addition to the assets we were constructing. We forged an agreement with Devon Energy Corp., the largest and most active gas producer in the Barnett Shale, who was pursuing the acquisition of Chief’s oil and gas production and undeveloped acreage.

In 2002, Devon had acquired Mitchell Energy & Development Corp., the company that pioneered the Barnett Shale’s development, drilling its first well in the play in 1981. Subsequently, Mitchell - and then Devon - was instrumental in devising and improving the drilling and completion techniques that enabled this formidable natural-gas deposit to be commercially developed.

As we worked with Devon on our joint bid for Chief’s assets, they provided great insight into their development plans for the play. Our solid business relationship with Devon and the dedication of their production from the Chief acreage to Crosstex reassured us about the value of the acquisition.

We bid aggressively, paying $480 million for an asset that had a current cash flow of only $10 million because we could clearly see a rapid ramp-up in cash flows from the assets. We knew that we would need to quickly invest another $200 million to complete the development of our midstream infrastructure so we could efficiently and effectively gather gas from Devon and other producers in the Barnett Shale area.

Crosstex capitalizes on general partner’s market appeal to raise equity

It was imperative that Crosstex find an equity structure to finance the acquisition that allowed it to be cash-flow accretive during the first 18 months of our ownership while cash flows began to develop. We also had to do this quickly and privately as the negotiations with Chief were under way. During the previous year, we had worked with some of our investors to create a subordinated partnership unit structure to finance the equity for our North Texas Pipeline. The holders of these subordinated units did not share in our MLP’s cash distributions for a period of time.

We believed a similar subordinated unit structure was the ideal tool to finance our portion of the Chief acquisition due to the steep cash flow growth profile we expected from the assets. We were seeking a total of $360 million of equity to finance the acquisition and other development projects under way. At the time, accessing this amount of subordinated equity in a private transaction was unprecedented in the MLP market.

Crosstex management turned to the general partner to take down half the equity we needed through a private issuance of its equity. CEI’s stock had been performing so well that institutions were anxious for an opportunity to buy large blocks of CEI stock, which weren’t available in the marketplace. We offered CEI’s stock to them and used the proceeds to buy $180 million of the new subordinated units. We quickly priced and placed the remaining $180 million of subordinated equity with institutions.

The success of the placement was reflected in the performance of CEI equity after the announcement of the Chief transaction. CEI’s stock price increased from just under $24 to over $30 between our announcement of the Chief acquisition and the closing of the transaction less than two months later.

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