- Legacy Reserves unveiled its plans to become a C-corp.
- This move was preceded by significant buying of its common stock by a single party.
- There has been a history of instances where information appears to have been shared with a limited group of investors ahead of time.
- Recap of the last couple of years as a Legacy preferred investor.
On March 26th, 2018, Legacy Reserves (NASDAQ:LGCY) unveiled its plans to become a C-corp (link). There were certainly a number of legitimate reasons for moving away from the MLP structure which will not be covered in this article. What's more important to most investors here is how each part of the capital structure fared in this transformation, and how that aligned with previous announcements and SEC filings from the organization.
As some of you who have followed the partnership for some time know, I have written a number of articles on the stock and pored through countless pages of reports, filings, and completed some of my own projections and modeling on its expected cash flow. The last such article was on 6/20/16 where I recommended an exit from the preferred shares based on the fact that the board elected to award the leadership team with cash retention bonuses. This was a clear signal to me at the time that leadership was concerned about the future value of its units that were being awarded as part of the compensation.
With all the intrigue around the "merger" and the involvement of Baines Capital, I feel compelled to share my story from the start to help you make a better investing decision.
2016 and the Dividend Suspension
If you take a look at the chart, you'll see there was some pretty heavy selling volume around January 15th in LGCYO. The LGCYP chart looks similar, but selling was spread out between January 12th and January 19th. It was a pretty tough time to hold. Imagine my shock on January 21st when the announcement was made that distributions would be suspended for all units. The selling continued, but left many wondering whether some folks were aware of the announcement prior or whether it was just a coincidence. These things can be hard to prove and that was that, just another day on the markets.
The secret bond buybacks
On February 26th, Legacy filed its 10-K which contained this little nugget:
"During February 2016, Legacy purchased approximately $104 million of original principal amount of its Senior Notes on the open market."
This was all a little sneaky; it had not been mentioned on the conference call despite being very significant information. The preferred units traded down to $1.25, and with this knowledge in hand, I added 6,000 units to my portfolio. This information was public by virtue of being published on its website, but I'd say it was definitely not appropriately communicated to shareholders.
Fast forward to April-May of 2016, the bond repurchases continued a little more publicly, although I think my article was the first time this information had been broadly shared.
The wild price swings
In fairness to Legacy's management, this stock had become tossed around very easily. Case in point was the article I wrote on 6/20/2016 coincided with a pretty nasty sell-off in the preferred you can see in the chart above that stopped at about $4.30.
The penny stock traders
Another example was in April 2016, one of my Legacy articles was retweeted (among other tweets recommending to buy LGCY) by a penny stock account, and the incredible spike on the chart above happened. It was like something out of a movie, within 20 minutes of the tweet, the stock jumped and just kept from around $1.60 to a high of around $3.64.
Ok, all good stuff fun in the markets, right? Sure, management forgot to mention it purchased $104 million of its own bonds for $0.15 on the dollar (that was a fun year for common holders as they paid tax on those gains), neglected to mention it switched to cash incentives, but hey, this is business, the company tells you what it wants you to hear and you dig for the rest. It was all out there if you dug for it and even knew there was something you should be looking for.
Moving onto to 2017 and 2018
I stopped writing after that last article and moved my money out of the equity markets and onto other areas. However, I had a little cash set aside, and I decided to enter back into LGCYO in 2017. At this time, Daniel Jones was the SA author covering Legacy the most.
Daniel made a switch from his investment in the preferred to the common based on a call with investor relations sometime in late 2017. At the time, Daniel stated he'd been spooked by an implication from Dan Westcott on the phone that there could be an outcome for the preferred that would result in the Change Of Control (COC) ratios of 1.96 for LGCYP and 1.72 for LGCYO being forced on the preferred. Here is the exact text from his comment on the article"
Yeah, I did this actually right before the end of 2017. I read through the Preferred documents for when they were issued and spoke with investor relations and what they told me is that the Preferred could be converted at 1.962 times the common units but without the accrued distributions added in. It's really convoluted but I had probably 3 calls with investor relations involving this and that's what I took away from it. :(
As a precaution at the time, I actually sold my LGCYO position and bought into LGCYP. I immediately felt ridiculous as I'd paid a $0.20 premium for something that was later unanimously agreed among the community here was an unlikely if not implausible event. The COC ratio was a right for the preferred holder, not anything that could be forced upon them.
Enter Baines Creek Capital. Its filings caught the attention of the SA community, like this one on January 10th, 2018, where it announced to have purchased 7.8 million units. The stock at the time was trading around $2.20 after spending most of January in the low $1 range. It has amassed around 13.5 million common units and almost single-handedly drove the unit price to $5. This move left the SA community scratching the heads as to what its motivation could be. Some SA members even did background research on the firm that showed almost its entire firm's worth was invested in LGCY. What did it know that we didn't?
We all learned the answer on March 26th. As a result of the transformation which was technically a merger, the preferred units were going to be canceled and have the right to convert at the conversion ratios outlined in the prospectus. At the time this plan was likely formulated (January 2018 or before), the common units were trading at around $1.25 and the preferred averaged around $5 per unit. Given that the preferreds were owed around $4 in distributions and they had a $25 par value, a conversion of less than two common units for one preferred unit was certainly not a good thing for owners of the preferred.
Did Baines Creek have information the rest of us didn't, and should that information have been shared more publicly in its filings or press releases?
One of the interesting things about Legacy Reserves is that Dan Westcott, then CFO and now president, is the person that takes investor relations calls. Most financial folks are not suited to this role. It appears that Daniel Jones' call to Dan swayed his investment from the preferred to the common. Could it have been as simple as Baines making a few calls to investor relations to be tipped off to start looking for ways that the common might benefit?
The clues from the 10-K and the conference call
Legacy went as far as to say this in its latest 10-K filing:
Pursuant to repurchases we have made in the past, we own a face amount of $67.0 million of our 8% senior unsecured notes due 2020 (the "2020 Senior Notes" and together with the 2021 Senior Notes, the "Senior Notes") and $304.0 million of our 2021 Senior Notes, representing approximately 22% and 55% of the amounts outstanding, respectively. While we have treated these repurchases as extinguishments of debt for accounting purposes, we have not retired any of the Senior Notes that we have repurchased to date and, subject to certain restrictions, we retain voting rights under the corresponding indentures that govern the Senior Notes. In the future we may seek to exercise the voting rights we hold by virtue of our ownership of the Senior Notes pursuant to the indentures in order to vote in such a manner that is contrary to the interests of other holders of our Senior Notes.
After that document was published, I searched that document for any similar warnings about preferred exchanges, exchange ratios or anything similar. It seemed clear that some kind of debt for equity exchange was coming.
When asked about any change to a C-corp on the conference call, Legacy leadership had this to say:
Sure. Yes, that's a great question. I don't think we have a lot of latitude to talk about various ideas, particularly as we think about tax status, I guess, I'd remind everybody that such a move would require a unitholder vote. And so we don't plan on sneaking up on anybody. We can't make up those kind of changes unilaterally. So when we have formulated an idea and if we -- if upon that idea we gain board approval, we'll be back in front of the public to outline our plans. But until then, we're not really going to talk about ideas.
As we have found out, such a vote doesn't involve the preferred unitholders.
What about the bonds
The recent 8-K gives you some insight:
On March 23, 2018, the Partnership entered into an amendment to the Term Loan Agreement (the "Term Loan Amendment"). The Term Loan Amendment, subject to certain conditions, among which is the consummation of the Corporate Reorganization, amends certain provisions set forth in the Term Loan Agreement to, among other items:
• Permit the Corporate Reorganization and modify certain provisions to reflect the new corporate structure;
• provide that New Legacy and the General Partner will guarantee the debt outstanding under the Term Loan Agreement;
• provide that the Partnership may make unlimited restricted payments, subject to no default or event of default, pro forma availability under the Term Loan Agreement of at least 20%, and pro forma total leverage of not more than 3.00 to 1.00, as well as to pay taxes and ordinary course overhead expenses of New Legacy;
• waive any "Change in Control" (as defined in the Term Loan Agreement) triggered by the Corporate Reorganization;
• waive any requirement to prepay the Term Loans using the Partnership's Free Cash Flow or limit Capital Expenditures (each as defined in the Term Loan Agreement) prior to March 31, 2019; and
• permit redemptions of the 2020 Notes and the 2021 Notes with the cash proceeds of equity interests (or exchanges for equity interests) of New Legacy.
The next piece of the puzzle seems laid out pretty clearly, and I think the senior notes are in the cross-hairs. The Fir Tree deal previously executed that traded unsecured notes for a mixture of cash ($0.70 for each face value dollar) and common stock may be a template for a future move, although I would say that either a) that cash is sourced from selling units in new legacy or b) the bonds are traded directly for units of new legacy.
There is a lot more data here that could be shared, but one should be very wary of jumping into any part of the capital structure in this company. If you feel like you are in the know on what's going on here, go nuts and invest. The upsides have been covered in a couple of articles by SA author Daniel Jones.
There are two key risks to buying the common right here:
- Baines either stops buying or starts selling. The former is much more likely.
- Equity is raised at a significant discount. This money would be used to reduce debt, so it's not terrible dilution, but would be done at a discount to market most likely.
Best of luck in the markets.
This article was written by
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