Rex Energy (NASDAQ:REXX) announced July 25, 2016 that it had privately negotiated an exchange agreement for the exchange of $43.5 million in aggregate principal of its 1.00%/8.00% Senior Secured Second Lien Notes due 2020 (referred to as its "2L") for 16.8 million shares of common stock. This particular exchange, apparently, was with "a fund managed by a certain holder" - a meaningful anecdote provided by Rex management in the press release accompanying the transaction announce. To my knowledge, this is the third and largest exchange of any kind for the 2L tranche of the Rex cap structure; the 2L is Rex's second most senior tranche of its cap structure (thus the nickname "2L"). The size of the most recent swap (shown below via Rex Energy SEC filings) and the pricing at which equity was issued to satisfy the swap is a meaningful development in what has been a fast moving, ever more-stressed story. I'll explain:
First, I'll concede that ultimately - if Rex is to survive this downturn - these toxic swaps [punitively dilutive swaps entered into from the swap-side (the swapping, non-company party) for liquidity and liquidity alone] are the highest visibility strategy available to management for execution. Rex can't exactly open up the CAPEX spend or magically create cash flows by any other means at this point. Liquidity constraints, capital constraints, lien-tethered asset management constraints (i.e. Rex can't create liquidity, manage liabilities, and/or optimize production by divesting assets because the assets are spoken for by lien holder classes - the assets are literally securing the "worth" of the underlying lien-based paper), and general balance sheet credibility constraints are limiting of the destressing optionality of the enterprise. I've expressed this dynamic in bullet point fashion in prior research. This constraint driven dynamic is also the reason Rex equity fails to react to "good news" when announced - the market realizing that efforts are simply too little too late. But, in engaging in increasingly punitive toxic swaps Rex management is only doing what it has always done - work in a best effort to save the enterprise.
That said these swaps are still incredibly, well, punitive to equity holders. What's "best" for the company is not always what's best for the equity class. In this instance, that certainly rings true. This becomes especially true if ultimately Rex isn't to survive - which is my prognostication at this point. If Rex ultimately doesn't survive, the equity class (into the final days of existence at least) will have simply been a monetization vehicle, a value-recovery vehicle for more senior classes. And this would be perfectly legal and justifiable in bankruptcy court, by the way.
Since April 11, 2016 - which was the date Rex hosted its annual shareholder meeting and updated that it had 66,048,227 shares outstanding - toxic swaps have diluted common equity holders 44%. The expanded float has diluted existing equity ownership, sure; but ultimately what this has done is create a massive share overhang that's sold into each and every time there's been anything of a share price (technical) breakout. Put another way, if you've held Rex equity into the massive and punitive dilution that's taken place since April 11th there's been a larger and larger float that has needed to be "moved" in order for you to realize anything of value recovery (i.e. higher share pricing). This too, in addition to the market's realization that Rex's efforts are "too little, too late", is the reason why the equity class has "failed to react to good news" when released. It isn't that the market is failing entirely to react, it's that the "market" has been asked to lift an increasingly heavy load (the expanding share float):
All of this should be troubling if you're still holding Rex equity. But what should be far more troubling is the nature of the toxic swap engagements AND how obvious the most recent transaction made the "liquidity premium" from the swap side. Again, I'll explain.
If we take a look at the composition of the most recently announced swap transaction, we can identify that the "fund" engaging in the swap did so entirely for liquidity. The "fund" was swapping an illiquid vehicle (the 2L paper it was holding) for a liquid vehicle (common equity). How do I know this?
Well for starters this is the only logical reason I can come to that a sophisticated investor, especially one presumably tasked with being a fiduciary, would move down the cap structure in an extremely stressed enterprise; that's just "Risk Management 101". This becomes an especially reliable starting point, in my opinion, based on the "visibility" of the stress at Rex (i.e. Rex isn't even an arguable case of "stressed or not" - it's quite clearly "stressed"). But in addition to this, the economics of the underlying swap itself.
I can reasonably price the 2L paper at the time the swap was agreed to at $.30 (or thirty cents on the dollar). To be clear, this doesn't mean that the 2L swap-party owned the 2L paper being swapped at this price - this was just the price I presume the paper was trading at the time of the swap agreement (you can see the paper is extremely illiquid):
Rex equity traded the day prior to the day the swap was to be executed (July 21, 2016) between $0.67 and $0.74 (shares were issued the next day - on July 22, 2016). If we use a mid-price on the equity trading, we come to ~$.70 on the day. Now, to be perfectly clear, in all the swap transactions I've ever participated in/consulted on there's always been an equity price "calculation" used to determine the "pin" price at which equity is exchanged (from the company side); the equity has never been used in the exchange at "spot pricing". Usually this is an immediate-term trading indication - for example, average equity price T3D. However, for simplicities sake we'll use the mid-price calculation of $.70 for this particular swap economics calculation.
If we use a $.30/$.70 swap agreement pricing schedule - and to be clear every swap transaction I've ever participated in/consulted on has had an equity "premium associated" [the party swapping the senior paper for the junior equity is given the "pin" pricing "plus" (e.g. a 10%/20%/etc. discount to that "pin" pricing which incents the swap-party to actually execute the swap)] - we come to a calculation that the swap-party exchanged $13.05 million in "market value" 2L paper for $11.76 million in equity value (this calculation excludes assumed payment of interest accrued and owed). Again, there could be variance from any of the above listed moving pieces - the equity "pin" pricing used, the premium given to the swap-party at exchange (or put another way the "discount" to "pin" pricing applied), the pricing at which the 2L paper was assumed (I've participated in transactions before where I was able to negotiate a higher 2L price in an exchange than was actually trading), etc. - but if we use this set of assumptions the swap-party took a loss on the transaction to market pricing of the 2L paper being swapped. That's right, on a market to market basis - the swap-party took a slight loss on the transaction.
Why would the swap-party allow this to happen? Liquidity. The swap-party wanted out [or was forced out of the 2L paper "by prospectus" (we know the swap party was a "fund")] and it clearly wasn't going to be able to move out of $43.5 million in "face value" 2L paper via "on-exchange" transactions (i.e. by selling the 2L paper using an exchange auction mechanism). This is the logic behind my statement that equity holders should be absolutely disturbed by this transaction. While on the surface this might seem like a win for Rex, and with that the most junior cap structure tranche at Rex (the equity class), it just isn't.
If "funds" are calling down to Rex (Rex by law can't solicit these types of transactions) to take "losses" on swaps (for liquidity) that means: the "fund" wants out of Rex entirely (not good), the "fund" wants liquidity because the "fund" has determined Rex will ultimately fail and it can't hold paper (regardless of how senior) into a bankruptcy (not good), the "fund" doesn't believe the current market pricing of the 2L reflects actual, eventual recovery value (not good), etc. But quite obviously, none of these scenarios are a "good thing" - especially for the equity class. Even given potential variance of swap terms, I don't think my logic is terribly flawed.
I've long championed Rex management for execution and for being able to draw out the timeline to any in-court restructuring (for Rex investors). Management has done a good job here into this seemingly never ending commodity crisis. I just think thinks have gone on too long and that things are unsalvageable at this point. I think the recently announced 2L swap transaction speaks to this with great clarity.
I continue to believe there to be nothing of recovery value for equity class investors here. I continue recommend an immediate selling down of all equity exposure. Good luck, everybody.
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