The Reason Behind Legacy Reserves' Rapid Ascent

Summary

• Legacy Reserves has seen a real awakening this year, with investors piling back into the stocks.
• The move, while doubtlessly driven in part by a stronger oil and gas market, owes a great deal to Baines Creek Capital.
• The fund has rapidly acquired over 15% of Legacy's common units, as well as some preferred and call options.
• This catalyst provides shareholders with yet one more reason to consider a purchase in Legacy, but it's not without its risks.

One of the most fascinating ticker stories so far this year has to be that of Legacy Reserves (NASDAQ:LGCY). Since 2018 began, shares of the E&P company have soared, not only because of a better outlook regarding oil and gas, but because a small, obscure hedge fund has rapidly accumulated a significant portion of the business. This has led to a rise in optimism surrounding the company and has the potential to create a great deal of volatility (both up and down) for shareholders moving forward.

A big buyer

Baines Creek Capital's public story with Legacy began in 2016 when the firm reported the purchase of, on December 31st, 546,350 of the E&P firm's Class B Preferred units. Due to the size of the purchases leading up to that date, which brought the company's control over Legacy's Class B units to 7.6% of what all was outstanding, the firm filed a Form SC 13G/A. Any increase in stock ownership to 5% or greater must generally be disclosed to the public.

After the purchase in question, Baines went dark. It wasn't until October of last year that the firm began making more substantive moves. That month, the company reported its ownership, spread between Baines Creek Partners, Baines Creek Special Purpose Partners, and some of its managers/investors, of a total of 3.69 million common shares, or 5.01% of what was outstanding at that time. Again, silence crept over the picture. Investors could be excused for thinking that Baines was just buying a slice of Legacy to benefit from the upside with the intention of not diving in too much, but such a conclusion would prove to be wrong.

*Created by Author

In January of this year, Baines began to rapidly accumulate shares. Their January 9th filing, for instance, showed that management had increased its share count to 7.82 million. Due to reporting requirements, the company began letting the public know that it was acquiring units in Legacy on an almost daily basis. As you can see in the graph above, Baines acquired, through March 5th of this year, a total of 12.01 million shares.

*Created by Author

In the graph above, you can see how, using today's share count, the firm's ownership in Legacy has changed over time. In all, management has purchased a total of 15.6% of Legacy's units that are currently outstanding. In the graph below, you can see how the weighted-average purchase price (excluding the first 7.82 million shares worth) of Legacy in Baines' portfolio has changed over time relative to the moving average. In all, we know that they've paid $2.66 per share for the business on the whole for those bought after the 7.82 million share mark.

*Created by Author

This is worth noting because it tells us a few things. For starters, with a price today of $4.11 per share, up 155.3% from the $1.61 per share that the company closed 2017 at, it lets us know that Baines has benefited tremendously from the upside seen in Legacy. It also lets us arrive at an interesting observation: namely that Legacy makes up all, or nearly all, of Baines' portfolio.

In its latest Form ADV filing (dated March 1st of this year), the value of the Baines Creek Partners LP fund's portfolio stood at $24.05 million. Using Legacy's closing share price for that day, its common units alone that were in the portfolio would be valued at $23.95 million.

Another fund, Baines Creek Special Purpose Partners LP, had a gross asset value of nearly $4.90 million, but what's odd there is that the 4.54 million shares in Legacy that it owned should be worth $16.74 million. I can't figure out the reason for the divide there. The rest of the Legacy shares owned under Baines' filings are held under the names of some of the company's control persons.

What this allows us to conclude is that Baines is a highly concentrated firm with all or nearly all of its assets allocated between Legacy's common units, preferred units, and some call options. You would expect this kind of concentration to warrant an active stake in Legacy, but the mystery deepens here. Instead of taking on an active role, Baines filed under Rule 13D-1(C). In the image below, you can see some relevant language pertaining to this filing type.

*Taken from Morrison & Foerster

In essence, what we have here is a small fund (two really), plus some individuals associated with the funds, that elected to allocate pretty much all of their assets toward one company. What's more, although you would anticipate that such a large stake would entice the investors to take on an active role where they could effect change (even at the risk of Legacy's management enacting countermeasures like a poison pill in order to stave off activists), that did not come to pass.

To me, this indicates one likely scenario: it's not logical to expect anything nefarious because of the dollar amounts we are talking here (overall, Baines' ownership in Legacy is worth $49.37 million as of the time of this writing), so I can only conclude that there's some piece of information they have or some way of looking at the company that few others have. As part of my research, I reached out to Baines for comment, in particular to see if they would be able and willing to be interviewed regarding their purchase, but in the two days since reaching out, I have received no word back.

Takeaway

In the past, I have written about the attractiveness of Legacy as an investment prospect and I still feel the same way today. In fact, over the past two months, I have significantly increased my own stake in the business, raising it to the largest holding in my portfolio (with a weighted-average purchase price of $2.30). This significant move by Baines seems to support my stance, plus the acquisition of such a meaningful piece of the business has proven to be, in a way, a self-fulfilling prophecy since it has energized shareholders to pile in.

This does create a risk, however. Any sort of unraveling of Baines' stake in Legacy could spell issues for existing investors, so it would be fair to argue that what Baines does should be considered an integral part of any investors' research on the business moving forward.

Analyst’s Disclosure: I am/we are long LGCY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.