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Royalty Lending

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SUMMARY
There is an alternative lending to Peer to Peer lending; a process I call Royalty Based Lending (RBL).
It is an investment vehicle that doesnt risk large amount of cash, it has no correlation with the stock
market, is non-correlated with most alternative investments and it is easy to understand.
RBL loans are made to owners of oil and gas mineral rights who are currently receiving monthly royalty
payments from oil and gas companies. RBL is akin to buying lottery winnings at a discount; in this case
RBL loans high interest cash and is repaid from oil and gas monthly cash royalty payments.
The investment instrument is a Limited Partnership consisting of a General Partner, Royalty Lending
Financial Services (RLFS) and Limited Partners (LP). LPs make investment in the Partnership/Fund;
RLFS finds borrowers, does due diligence, prepares paperwork and manages the cash repayment from the
operator until the loan is satisfied.
The few companies doing RBL are generally small specialty loan companies or family funds. The loan
pool is financed from personal or close family investors and when the loan pool is fully exhausted, the
operation goes into a suspense mode till principal can be replenished. None of these operations offer
opportunities for outside investors.
RLFS does invite investors at large, and has a target return of 12% annually; cash distribution of interest
is paid each quarter and principal is reinvested. Although 12% is not a guarantee, (a) the typical RBL
business model and (b) results from 2 quarters of the 1
st
series definitely supports it.
BACKGROUND
Mineral Rights Ownership What Is It?
The most fundamental level of mineral ownership (MRO) is a "fee mineral interest." This is an absolute
and perpetual ownership of the minerals beneath the surface of a tract of land. In virtually all countries
around the world, the owner of the surface estate be it a house or farmland has absolutely no rights
with regards to the mineral estate. Generally, it is the central governments or monarchs who own such
rights.
Not so in the USA; private citizens can own both a mineral estate and a surface estate. In a large
number of instances, these two estates have been separated ("severed") from each other; if so, they may
be bought and sold separately. Where the estates have been severed, the MROs right to drill and explore
for minerals overrides land owners surface rights which means the MRO has almost an unfettered right
to explore and seek his mineral rights revenues.
Mineral Rights into Royalties
To bring oil and gas reserves to market, the mineral rights are leased to oil companies through a lease
contract with MRO. The MRO and the oil company agree to certain terms regarding the rights, privileges
and obligations of the respective parties during the exploration and possible production stages.
Usually, in exchange for providing the oil company a right to drill for a period of time, the MRO gets an
up-front lease bonus payment plus a royalty percentage of the value of any production. If no drilling
occurs, the lease simply expires.
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The duration of the lease may be extended when drilling or production starts. This enters into the period
of time known as the secondary term, which applies for as long as oil and gas is produced in paying
quantities or commercial quantity.
Oil and gas royalties and the underlying minerals rights are valuable property in addition to being an
excellent source of consistent and reliable income. In fact, these properties are commonly bought and sold
through the Internet at specialty auctions for oil and gas properties. These auctions provide a lively
secondary market to further promote the liquidity of these mineral properties. Not uncommon for mineral
properties to sell for 50X to 80X an average monthly cash royalty payment.
THE INVESTMENT OPPORTUNITY
RBL Is a Narrowly Defined Boutique Market
RLFS services a boutique market made up of MROs who have urgent cash flow needs for medical issues,
vacations, large purchase, home remodel, school debt, etc. They dont want to sell their royalties (will sell
in a pinch), but are willing to pay a high interest rate for a short term loan. In Texas alone there are
300,000 individual MROs who hold and receive royalty payments from 6,000,000 producing properties.
Just as a matter of size, if only1% of the Texas 300,000 MROs borrowed an average loan amount of
$25,000, the portfolio base would be $75 million and at 12%, investors receive about $9 million in
interest payments. Our expectation is 5-10% of the MROs will look to borrow sometime during their
productive royalty years.
RLFS Simple RBL Model
LPs invest in a loan pool; RLFS makes loans from the pool to MRO who assign their mineral rights and
monthly royalty payments to the Limited Partnership; RLFS uses this monthly cash payment to pay down
the loan balance until the loan is satisfied; then the mineral right and cash payment is reassigned back to
the MRO.
Making the loan decision is easy because credit reports and tax return & personal finance data is not
required; so scores and judgments are obviated.
RLFS requires just documented history of:
verification of the monthly royalty payments,
well history and longevity estimates
proof of multiple royalty sources for repayment
validation of a clean title to the mineral rights
documented audit trail of ownership and
assignment of cash royalty payments to RLFS.
Typical terms and specifications:
Royalty collateral is valued up to 25 times the average monthly cash flow; loan to value (LTV) is
50%; the maximum term is 36 months, although a 4 year amortization with a balloon payment at
the end of the loan is possible
Since the loans are investor financed, the interest rate is 18%; with compounding daily interest
the effective interest rate is 19.72%.
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A 3% loan origination fee is charged to cover the costs of legal expenses associated with the loan,
document recordation, delivery services and other due diligence costs. The origination fee does
not cover the cost of county and state transfer taxes if they apply.
The first two months re-payments are withhold from the loan proceeds, as it frequently takes this long to
get royalties redirected to RLFS from the oil and gas operator.
Once the loan is approved and the borrower agrees to the terms, the borrower will execute the following
documents:
Promissory note
Deed of Trust which will be recorded in the county where the minerals are located. If the state
does not recognize deeds of trust a Special Warranty Deed conveying the Mineral interest to the
lender will be recorded in the county where the minerals are located. In this case, a letter
agreement specifying that the minerals will be returned when the loan is satisfied will be
provided.
A letter to the operators, informing them of the loan and directing them to send borrowers
royalties from the oil and gas company to RLFS until the loan is satisfied.
As soon as the loan is paid-off, RLFS will release the Deed of Trust (or convey the property back
to borrower, if previously deeded it to RLFS) and inform the royalty payor that the loan has been
satisfied and instruct them to make payment back - directly to the borrower.
COMPETITION
If making a loan is simple and no credit check is necessary why dont the banks do these loans?
Historically, banks do not recognize the collateral value of royalties earned from producing oil and gas
properties. For most banks, there is a substantial amount of paperwork involved with a royalty loan that
also requires an appraisal or valuation of the royalty. Such valuations are specialized and require
resources outside of the banks normal reach. Consequently, it usually is not a cost effective loan product
and is not offered by the majority of banks.
DEFAULTS
RLFS also anticipates some loan defaults - and with default - the Partnership ends up owning the property
at a potentially below-market cost. With defaults, the investors will normally have the option of selling
their interest in the foreclosed property or having their share of the royalties and minerals deeded directly
to them.
RISKS
The largest risk in the RBL model is the loss of cash flow to repay the loan. The could occur from (a)
drop in oil and gas prices or (b) loss of oil and gas production that generates the cash flow. What is the
likelihood of them occurring?
Highly likely the price of oil will fluctuate. However; according to oil-price.net and others
(http://www.oil-price.net/en/articles/lower-bound-of-oil-prices.php), it is unlikely that the price of oil will
drop below $80

per barrel since that is the price necessary for the leader of OPEC, Saudia
Arabia, to maintain social stability within its population; and
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Price of natural gas also can fluctuate. During 2014, natural gas had a low of about $3.50 and a
high of $6.00. Based on aggressive marketing of natural gas as alternative to coal and gas
guzzling cars it is likely natural gas at a price in the range of $3 - $6 per 1000 cubic ft. or so will
be a continuing reality.
Loss of production can occur when the well is forced to shut-in (stop for repairs, etc).
o Most shut-ins are planned and have no ultimate revenue effect
o Occasionally an unexpected shut-in will occur and can lead to full stoppage of that wells
operations (closure). Not a common event.
Risk mitigation requires (a) multiple sources of monthly cash from prospective borrowers to guard against
production loss, (b) valuation of the collateral so that monthly installment repayment is not affected by
drop in prices and (c) verification of the collateral cash flow and (d) clean title to the collateral.
MANAGEMENT
Donald Skotty Our managing partner with over thirty years experience in oil and gas accounting and
personally owns significant oil and gas royalties in multiple states.
Joe Christina Our legal partner with over twenty years experience as an oil and gas attorney.
Howard Klemmer - Our marketing & customer relations partner who has many years of lending
experience, plus he is an avid oil and gas investor.
Consequently, we understand lending and we understand oil and gas, and more importantly, we
understand the value of producing royalties as collateral for short term loans. We do not require credit
reports or tax returns to approve a royalty loan. We do need to know that the royalties have sufficient
value in order to protect the lenders should you default and that your minerals are free of any
encumbrances.
THE BOTTOM LINE
Oil and gas investing will be around for many more years. RBL is a boutique business that takes
advantage of and lends against the oil and gas revenue streams. RBL is simply making a loan with lower
risks and higher premiums.



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EXAMPLE: Amortization and Cash Flow Spreadsheet
Lets take a look at a typical 36 month loan and repayment transaction. Attached is a spread sheet
example of this investing strategy; more information is available from Howard Klemmer at
hklemmer@fairwindcapital.com
The spreadsheet has two sections; the borrower section and the investor section. On the left of the
spreadsheet is the funding and repayment section (Part 1) and on the right is the investor earnings section
(Part 2).

Major Sections:

Part 1: Loan Repayment Schedule The loan amortization and repayment calculations.
Principal (amount borrowed) = 21,000
Quoted Interest Rate (nominal rate) = 18%
Daily Interest (nominal rate divided by 365) =.000493151
Monthly Payments (use pmt function in excel ) pmt (0.18/12,36 months, -21000) =759.20
Loan Origination = 3.0%
Loan Origination Fee = .03 x 21000=630.00
Prepaid Payment = 2 months of payments to compensate for delay in receiving royalty = 1518.40
Disbursed Amount = ($ borrowed origination prepayment); 21000 - 630 1518.40=18,851.60
Term = 36 months
Total Repayment: expected 759.20 x 36 = 27,331.20 calculated in schedule = 27,256.42
Interest Paid = repayment principal; 27,256.42 21,000 = 6,256
Principal Repaid = 21,000
Return on Investment = 6,256/21,000 = 29.79% (see note below)
Effective Interest = (1+ .18/365)
365
-1; (1+.000493)
365
-1= (1.1972 ) 1= 19.72%


XIRR (excel) = dispersed amount + payments: ( -18,851.60) 36 payments of 759.20 = 19.56%

Part 2: Estimate of Cash Flow What investor gets
Limited Partners = 12%/18% = 66.7%
General Partners = 100-66.7 = 33.3% Amount to pay expenses and GP fee
LP Total Interest Cash Flow = sum of col LP Interest Flow = 4,170.95
LP Return Year 1 = { 1
st
yr interest /[(start bal + finish bal) / 2] } =
2,181.66/(19,481.60 + 15162.08)/2 = 2,181.66 / 17321.84 = 12.59%
LP Return Year 2 = { 2
nd
yr interest /[(start bal + finish bal) / 2] }
1,445.80 / (14,612.24 + 8,220.38) / 2 =1,445.80 / 11,416.31 = 12.66%
LP Return Year 3 = { 3
rd
yr interest /[(start bal + finish bal) / 2] }
543 / (7,578.74 + 0 ) / 2 = 543 / 3,789.37 = 14.33%

Note: The difference between the ROI in Part 1 and the ROI in Part 2; yrs 1, 2, 3 is the amount of
principal being used. In Part 2, the actual principal being used is paired with the actual interest. In Part 1,
the total interest is being measured against the total amount borrowed (without considering reduced
remaining balance due to principal repayment) over the three years.