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Henry's Law of Deal Promotes

© Copyright 2010 James D. Henry

Calculating the Promote

In years gone by, the standard carried interest was the famous "third-for-a-quarter" deal in which the investor paid a third of the working interest costs in exchange for a quarter of the working interest revenues. The operator/promoter was "carried" for the resulting 8.33 percent interest (33.33% - 25%). If the operator succeeded in selling all three thirds of his deal, he ended up being "carried" for a quarter of the entire well (8.33% x 3). But when the oil and gas business falls upon hard times, as it periodically does, third-for-a-quarter deals are hard to sell, and knowledgeable investors can usually expect to pay a less rigorous promote. "Carried for an eighth" is often the deal for sophisticated investors. Please note that this is not exactly the same promote as "cost plus an eighth." Most of the common promotes can be stated in two or three different ways, and the investor should not be confused by the terminology. Below are some easy algebraic expressions that will allow you to quantify the severity of a promote factor (P) based upon how it is represented to you by the operator. Bear in mind that a promote factor of P = 1.0 means no promote at all. Let us remind you that the following numbers do not take into consideration the net revenue percentage of the lease(s) involved. For the Total Promote, read on below the following table.

 If the Operator Says the Deal Is: Calculate The Promote Factor (P) Using:
Pay a/b for c/d P = ad/bc
Cost + x% P = 1 + x/100
Carried ("Back in") for x/y P = 1 + x/(y - x)
Carried ("Back in") for x% P = 1 + 1/([100/x] - 1)

Using these formulae, some of the more common carried interest promotes that the investor is likely to encounter are:

The Deal: Promote Factor (P): Equivalent Deals:
1/3 for 1/4 1.3333 Carried for 1/4 or Cost + 33.33%
Cost + 25% 1.2500 Carried for 1/5 or 1/4 for 1/5
Carried for 15% 1.1765 Cost + 17.65%
Cost + 15% 1.1500 NA
Carried for 1/8 1.1429 1/7 for 1/8
Cost + 1/8 1.1250 Carried for 1/9 or 1/8 for 1/9
Cost + 10% 1.1000 Carried for 1/11 or 1/10 for 1/11
Heads up 1.0000 No promote

The better prospects will often command a higher price (i. e., a greater promote) in the market place, although price/promote is not a reliable indicator of any given prospect's likelihood of geological or financial success. Prudent investors will rarely pay more than a 20 percent carry (P = 1.2500) for most prospects—perhaps only cost plus an eighth (P = 1.1250) if the operator is also keeping a substantial override and/or delivering his investors less than an 80 percent revenue interest. The table above is only accurate if a)  the operator is giving the investor the net revenue interest (NRI) that was obtained from the mineral owner in the original base lease(s), or b) the well is a dry hole.

TOTAL PROMOTE FOR A PRODUCING WELL

The total promote—let's call it "T"—for a well that goes on production can not be less than P, but it can be, and often is, greater. That depends on how much of the operator's revenue interest is passed on to the investors. If the promoter gives his investor the same NRI that he originally acquired from the mineral owner, then there is no additional promote and T is exactly equal to P. The promoter's desire to scrape off an overriding royalty interest (ORRI), especially if the NRI of the base lease was relatively high to begin with, is very often irresistble. Overrides do not affect the mineral owner's royalty; they are carved out of the working interest exclusively, hence they affect the investor. If there are any ORRIs involved, the total promote can be calculated by multiplying P by the ratio of: the operator's revenue interest divided by the investor's revenue interest. Or put another way:

T = P x (promoter's NRI/investor's NRI)

For example, let's say it's a cost plus 25% deal; the operator originally got the lease with a 13/16ths NRI (0.8125), and he keeps a very generous 1/6th ORRI and promotes it to his investors who get a 75% (0.75) NRI. Reading P from the table above the calculation of T would be:

T = 1.25 x (.8125/.75) = 1.354

That's a slightly greater promote than a third-for-a-quarter deal (P = 1.3333) with no ORRI scraped off. Be aware that the promoter will rarely be anxious to reveal his original NRI and/or his ORRI, if any, unless it is relatively small and modest. There is nothing unethical about that, although it makes the calculation of T impossible.

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