424B4 1 d724324d424b4.htm FINAL PROSPECTUS Final Prospectus
Table of Contents

 

Filed pursuant to 424(b)(4)
Registration No. 333-201106

PROSPECTUS

20,000,000 Shares

 

LOGO

Common Stock

 

 

This is InfraREIT, Inc.’s initial public offering. We are selling 20,000,000 shares of our common stock.

Currently, no public market exists for the shares. We have been approved to list our common stock on the New York Stock Exchange under the symbol “HIFR.”

Immediately following the consummation of this offering, InfraREIT, L.L.C. will merge with and into InfraREIT, Inc., which we refer to as the Merger, with InfraREIT, Inc. as the surviving entity in the Merger. InfraREIT, L.L.C. owns electric transmission and distribution assets in Texas and leases them to Sharyland Utilities, L.P., which is a regulated utility, as described under “Business and Properties—Our Tenant—Our Leases.” Upon the consummation of this offering, we will be externally managed by Hunt Utility Services, LLC, or Hunt Manager. Hunt Manager is owned by an affiliate of Hunt Consolidated, Inc., a privately held company engaged in energy, real estate, investment and ranching businesses.

We will elect to be taxed as a real estate investment trust, or REIT, for U.S. federal income tax purposes commencing with the taxable year ending December 31, 2015. We believe that we have been organized and operate in a manner that allows us to qualify for taxation as a REIT for U.S. federal income tax purposes commencing with such taxable year, and we intend to continue to be organized and operate in this manner. Shares of our common stock are subject to limitations on ownership and transfer that are intended to assist us in maintaining our qualification as a REIT. Our charter contains certain restrictions relating to the ownership and transfer of our capital stock, including, subject to certain exceptions, an ownership limit of 9.8%, in value or in number of shares, whichever is more restrictive, on the ownership of outstanding shares of our common stock and an ownership limit of 9.8% in value of the aggregate of the outstanding shares of all classes or series of our capital stock. See “Description of Our Capital Stock—Restrictions on Ownership and Transfer” beginning on page 177 of this prospectus for a detailed description of the ownership and transfer restrictions applicable to our common stock.

We are an “emerging growth company” as defined under the federal securities laws and, as such, may elect to comply with certain reduced public company reporting requirements.

Investing in the common stock involves risks that are described in the “Risk Factors” section beginning on page 34 of this prospectus.

 

 

 

    

Per Share

      

Total

 

Public offering price

   $ 23.00         $ 460,000,000   

Underwriting discounts and commissions (1)

   $ 1.38         $ 27,600,000   

Proceeds, before expenses, to us

   $ 21.62         $ 432,400,000   

 

(1) Excludes an aggregate structuring fee payable to Merrill Lynch, Pierce, Fenner & Smith Incorporated, Citigroup Global Markets Inc. and RBC Capital Markets, LLC that is equal to 0.30% of the gross proceeds of this offering. Please see “Underwriting” for additional information regarding underwriting compensation.

The underwriters may also exercise their option to purchase up to an additional 3,000,000 shares from us, at the public offering price, less the underwriting discount, for 30 days after the date of this prospectus.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

The shares will be ready for delivery on or about February 4, 2015.

 

 

 

BofA Merrill Lynch   Citigroup

 

 

 

RBC Capital Markets   Morgan Stanley
UBS Investment Bank   Wells Fargo Securities
Scotiabank   SOCIETE GENERALE

 

 

The date of this prospectus is January 29, 2015.


Table of Contents

LOGO

 


Table of Contents

TABLE OF CONTENTS

 

    

Page

 

GLOSSARY OF TERMS

     ii   

PROSPECTUS SUMMARY

     1   

RISK FACTORS

     34   

FORWARD-LOOKING STATEMENTS

     68   

USE OF PROCEEDS

     70   

DISTRIBUTION POLICY

     71   

CAPITALIZATION

     78   

DILUTION

     79   

SELECTED FINANCIAL INFORMATION

     80   

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     83   

INDUSTRY OVERVIEW

     102   

REGULATION AND RATES

     103   

BUSINESS AND PROPERTIES

     106   

FINANCIAL INFORMATION RELATED TO OUR TENANT

     133   

MANAGEMENT

     135   

OUR MANAGER AND MANAGEMENT AGREEMENT

     149   

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     155   

INVESTMENT POLICIES AND POLICIES WITH RESPECT TO CERTAIN ACTIVITIES

     164   

PRINCIPAL STOCKHOLDERS

     166   

DESCRIPTION OF OUR CAPITAL STOCK

     171   

CERTAIN PROVISIONS OF MARYLAND LAW AND OUR CHARTER AND BYLAWS

     181   

THE OPERATING PARTNERSHIP AND THE PARTNERSHIP AGREEMENT

     189   

SDTS COMPANY AGREEMENT AND DELEGATION AGREEMENT

     197   

SHARES ELIGIBLE FOR FUTURE SALE

     200   

MATERIAL FEDERAL INCOME TAX CONSEQUENCES

     202   

ERISA CONSIDERATIONS

     224   

UNDERWRITING

     227   

LEGAL MATTERS

     234   

EXPERTS

     234   

WHERE YOU CAN FIND MORE INFORMATION

     234   

INDEX TO FINANCIAL STATEMENTS

     F-1   

Through and including February 23, 2015 (the 25th day after the date of this prospectus), all dealers effecting transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to a dealer’s obligation to deliver a prospectus when acting as an underwriter and with respect to an unsold allotment or subscription.

You should rely only on the information contained in this prospectus or in any free writing prospectus we may authorize to be delivered to you. We have not, and the underwriters have not, authorized anyone to provide you with different or additional information. If anyone provides you with different, additional or inconsistent information, you should not rely on it. We are not, and the underwriters are not, making an offer to sell these securities in any jurisdiction where an offer or sale is not permitted. You should assume that the information appearing in this prospectus is accurate as of the date set forth on the cover of this prospectus. Our business, financial condition, results of operations and prospects may have changed since that date.

The market data and certain other statistical information used throughout this prospectus are based on independent industry publications, government publications or other published independent sources. Some data is also based on our good faith estimates, which are derived from management’s knowledge of the industry and independent sources.

 

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GLOSSARY OF TERMS

This glossary highlights some of the industry terms that we use in this prospectus and is not a complete list of all of the defined terms used herein.

 

Abbreviation

  

Term

AFUDC

   allowance for funds used during construction

CREZ

   competitive renewable energy zones, as defined by a 2005 Texas law establishing the Texas renewable energy program

CWIP

   construction work in progress

DC Tie

   high-voltage direct current interconnection necessary to provide for electricity flow between asynchronous electric grids in North America

DCRF filing

   a distribution cost recovery factor filing with the Public Utility Commission of Texas that a distribution service provider is permitted to make to update its distribution tariffs to reflect recent capital expenditures, among other matters

distribution

   that portion of a power delivery network consisting of an interconnected group of electric distribution lines, towers, poles, substations, transformers and associated assets over which electric power is distributed from points within the transmission network to end use consumers

DSP

   a distribution service provider, i.e., a utility operating within the Electric Reliability Council of Texas territory that owns and operates electric distribution facilities, or other participants in the Electric Reliability Council of Texas territory that collect and remit payments on behalf of a distribution service provider

electric utilities

   DSPs, transmission service providers, transmission and distribution service providers, municipalities, cooperatives and others defined as Electric Utilities by the Public Utility Commission of Texas

ERCOT

   Electric Reliability Council of Texas

ERCOT 4CP

   the average of ERCOT coincident peak demand for the months of June, July, August and September, excluding the portion of coincident peak demand attributable to wholesale storage load (during 2013, ERCOT 4CP was approximately 65 gigawatts)

FERC

   Federal Energy Regulatory Commission

Footprint Projects

   transmission or distribution projects primarily situated within our distribution service territory, or that physically hang from our existing transmission assets, such as the addition of another circuit to our existing transmission lines, or that are physically located within one of our substations; Footprint Projects do not include the addition of a new substation on our existing transmission lines or generation interconnects to our existing transmission lines, unless the addition or interconnection occurred within our distribution service territory

kV

   kilovolt

kW

   kilowatt

kWh

   kilowatt-hour

MW

   megawatts

PUCT

   Public Utility Commission of Texas

 

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Abbreviation

  

Term

rate base

   calculated as our gross electric plant in service under generally accepted accounting principles, which is the aggregate amount of our total cash expenditures used to construct such assets plus AFUDC, less accumulated depreciation, and adjusted for accumulated deferred income taxes

REP

   retail electric provider, which are the companies that sell electricity to Texas customers

revenue requirement

   a transmission and distribution service provider’s revenue requirement is equal to its targeted total costs, including operating and maintenance costs, return on rate base and taxes

ROFO Projects

   identified projects that are being developed by Hunt Consolidated, Inc. and its affiliates with respect to which we will have a right of first offer

RTO

   regional transmission organization

service territory

   a designated area in which a utility is required or has the right to supply electric service to ultimate customers under a regulated utility structure

SPP

   Southwest Power Pool

TCOS filing

   an interim transmission cost of service filing with the PUCT that a transmission service provider is permitted to make up to twice per year to update its transmission cost of service, and therefore its transmission tariff, to reflect recent capital expenditures, among other matters. An interim TCOS filing establishes transmission cost of service until the next rate case or interim TCOS filing

T&D

   electric transmission and distribution

T&D assets

   rate-regulated electric transmission and distribution assets such as power lines, substations, transmission towers, distribution poles, transformers and related property and assets

TDSP

   transmission and distribution service provider, i.e. a utility operating within the ERCOT territory that owns and operates both electric transmission facilities and electric distribution facilities

transmission

   that portion of a power delivery network consisting of an interconnected group of electric transmission lines, towers, poles, switchyards, substations, transformers, and associated assets over which electric power is transmitted between points of supply or generation and distribution

TSP

   a transmission service provider, i.e., a utility operating within the ERCOT territory that owns and operates electric transmission facilities

TWh

   terawatt-hour

 

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EXPLANATORY NOTE

Our business is currently conducted through InfraREIT, L.L.C. (formerly known as Electric Infrastructure Alliance of America, L.L.C.), a Delaware limited liability company. On the date of, and immediately following, the consummation of this offering, InfraREIT, L.L.C. will be merged with and into InfraREIT, Inc., a Maryland corporation. We refer to this transaction as the “Merger.” As used in this prospectus, unless the context requires otherwise or except as otherwise noted, the words “Company,” “we,” “our” and “us” refer to InfraREIT, L.L.C. or InfraREIT, Inc. after giving effect to the Merger, as the context requires, together with its subsidiaries, including InfraREIT Partners, LP, a Delaware limited partnership, which we refer to as our “Operating Partnership.” “InfraREIT” when used in a historical context refers to InfraREIT, L.L.C. and when used in the present tense or prospectively refers to InfraREIT, Inc. References to our “existing investors” refer to the investors in InfraREIT, L.L.C. and/or our Operating Partnership, as the context requires, prior to the consummation of this offering and the reorganization transactions described under “Prospectus Summary—Our Structure and Reorganization Transactions—Reorganization Transactions” beginning on page 22 of this prospectus, which we refer to as the “Reorganization.” “Hunt” refers to Hunt Consolidated, Inc. and its subsidiaries, including Hunt Utility Services, LLC, which we refer to as “Hunt Manager,” and Hunt Transmission Services, L.L.C., which we refer to as “Hunt Developer.” “Sharyland” or “our tenant” refers to Sharyland Utilities, L.P. When we refer to “Hunt” in the context of our development agreement with Hunt Developer and Sharyland, we are referring to Hunt Developer, Sharyland and other affiliates of Hunt Consolidated, Inc. We refer in this prospectus to various Hunt entities, including Hunt, Hunt Manager, Hunt Developer and Hunt-InfraREIT, L.L.C., which we refer to as “Hunt-InfraREIT” and which holds Hunt’s equity in our Operating Partnership. Hunt has informed us that it intends to operate each such entity in a manner that respects its separate legal identity.

Unless otherwise indicated or the context requires, all information in this prospectus gives effect to a 1 for 0.938550 reverse split of the shares of InfraREIT, L.L.C. and a concurrent 1 for 0.938550 reverse split of the units representing limited partnership interests in our Operating Partnership, which we effected immediately prior to the effectiveness of the registration statement to which this prospectus relates. In addition, unless otherwise indicated, the information in this prospectus assumes the underwriters will not exercise their option to purchase up to an additional 3,000,000 shares of our common stock from us. Further, unless otherwise indicated or the context requires, all information in this prospectus relating to the number of shares of our common stock or the number of units in our Operating Partnership, as applicable, to be outstanding after the consummation of this offering gives effect to the Reorganization, including (1) the Merger, (2) the allocation of common units between Hunt-InfraREIT and InfraREIT, as the holders of units in our Operating Partnership, on the 32nd day following this offering (or, if later, the date on which the closing of the sale of additional shares of our common stock to the underwriters if they exercise their option to purchase additional shares) based on the assumption of an average weighted average daily price of our common stock during the 10 consecutive trading days prior to the end of the 30-day period following the completion of this offering equal to $23.00, which is the initial public offering price, and (3) the subsequent cancellation and conversion of our Class A common stock, redeemable Class A common stock and Class C common stock into shares of common stock based on such allocation of common units, as described under “Prospectus Summary—Our Structure and Reorganization Transactions—Reorganization Transactions” beginning on page 22 of this prospectus. Further, unless otherwise indicated or the context requires, the phrase “on a pro forma basis” means that the related financial information gives effect to the Pro Forma Adjustments described in the unaudited pro forma condensed consolidated financial statements for InfraREIT, Inc. included elsewhere in this prospectus.

 

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PROSPECTUS SUMMARY

This summary highlights certain significant aspects of our business and this offering. This is a summary of information contained elsewhere in this prospectus, is not complete and does not contain all of the information that you should consider before making your investment decision. You should carefully read the entire prospectus, including the information presented under the section entitled “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and the related notes thereto appearing elsewhere in this prospectus, before making an investment decision.

 

 

Company Overview

We are an externally-managed real estate investment trust (REIT) that owns rate-regulated electric transmission and distribution (T&D) assets, such as power lines, substations, transmission towers, distribution poles, transformers and related property and assets, in Texas. We are focused on paying a consistent and growing cash dividend that is sustainable on a long-term basis. We believe we are well positioned to take advantage of favorable trends in the T&D sector, including the replacement of aging assets and the construction of new assets to address growing energy demand. We believe our attractive REIT structure and focus on Texas and the southwestern United States, where we can leverage a proven track record of identifying, developing, constructing and acquiring critical infrastructure assets, provide us with a significant competitive advantage to execute our growth strategy.

We lease our T&D assets to Sharyland Utilities, L.P. (Sharyland), a Texas-based regulated electric utility, pursuant to leases that require Sharyland to make lease payments to us when our assets are placed in service. To support these lease payments, Sharyland delivers electric service and collects revenues directly from retail electric providers (REPs) and distribution service providers (DSPs), which pay rates approved by the Public Utility Commission of Texas (PUCT). REPs are the companies that sell electricity to Texas customers, and DSPs are primarily utilities operating within the Electric Reliability Council of Texas (ERCOT) territory that own and operate electric distribution facilities. Under the terms of our leases, Sharyland is responsible for the operation of our assets, all property related expenses associated with our assets, construction management and regulatory oversight and compliance related to our assets.

We have grown rapidly over the last several years, with our rate base increasing from approximately $60 million as of December 31, 2009 to approximately $1.1 billion as of September 30, 2014 and a projected $1.4 billion as of December 31, 2015. Our rate base amount is important because it is the key determinant of rent paid by our tenant to us. Rate base is calculated as our gross electric plant in service under generally accepted accounting principles (GAAP), which is the aggregate amount of our total cash expenditures used to construct our T&D assets plus an allowance for funds used during construction (AFUDC), less accumulated depreciation, and adjusted for accumulated deferred income taxes. Our projected rate base as of December 31, 2015 is based upon our projection for each component of rate base through the remainder of 2015. We expect to grow our rate base in the future through organic growth, as well as through acquisitions of T&D assets from Hunt Consolidated, Inc. (Hunt) and Sharyland, who originated and founded our business, and from third parties.

We intend to distribute substantially all of our cash available for distribution, less prudent reserves, through regular quarterly cash dividends. We expect our initial quarterly dividend rate to be $0.225 per share, or $0.90 per share on an annualized basis. We believe that as we grow our rate base we will also be able to increase our cash available for distribution and, as a result, increase our distribution per share. We intend to target a three year cumulative annual growth rate of our cash available for distribution per share of 10 to 15% through December 31, 2018. We intend to achieve the lower half of the range based solely on the expansion of T&D assets that are in the geographic footprint of our existing distribution assets or that are added to our existing transmission assets (Footprint Projects), with the ability to achieve the top half of the range coming from Hunt’s obligation under our development agreement to offer us identified T&D projects (ROFO Projects). See

 

 

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“—Agreements with Hunt—Development Agreement.” Our ability to grow our rate base, cash available for distribution and distributions per share is subject to a number of factors and other risks described under the caption “Risk Factors.”

Our business originated in the late 1990s when members of the Hunt family founded Sharyland, the first investor-owned utility created in the United States since the 1960s. In 2007, we obtained a private letter ruling from the Internal Revenue Service (IRS) confirming that our T&D assets could constitute real estate assets under applicable REIT rules. In 2008, the PUCT approved a restructuring that allowed us to utilize our REIT structure. In 2010, InfraREIT was formed as a REIT and, as part of that transaction, Hunt contributed assets into InfraREIT and obtained equity commitments from the following large institutional investors, which we refer to as our founding investors: Marubeni Corporation, John Hancock Life Insurance Company (U.S.A.), OpTrust Infrastructure N.A. Inc. and Teachers Insurance and Annuity Association of America.

Our T&D Assets

Our T&D assets are located throughout Texas and consist of over 50,000 electricity delivery points, approximately 620 miles of transmission lines, approximately 10,500 miles of distribution lines, 35 substations and a 300 megawatt (MW) high-voltage direct current interconnection (DC Tie) between Texas and Mexico, which we refer to as the Railroad DC Tie.

The following map shows the location and breakdown of our transmission assets and distribution assets:

 

LOGO

 

 

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Our Relationship with Hunt

Ownership

Hunt will own 3,176,878 shares of our common stock and 13,213,619 units in our Operating Partnership (OP Units) following the completion of this offering and the Reorganization, which will be subject to long-term lock-ups with us. This ownership would constitute 27.1% of our outstanding equity if all OP Units were exchanged for shares of our common stock. Hunt has informed us that it intends to continue to hold a substantial portion of its equity in us for the foreseeable future.

Leadership

Hunt Utility Services, LLC, which we refer to as Hunt Manager, serves as our external manager and is a subsidiary of Hunt. Additionally, members of the Hunt family own our tenant, Sharyland, which is controlled by Hunter L. Hunt, who is also a member of our board of directors. W. Kirk Baker, who is Chairman of our board of directors, previously served as president and chief executive officer of Hunt Manager and before that as Senior Vice President and General Counsel of Hunt Consolidated, Inc. Further, Hunt Transmission Services, L.L.C., which we refer to as Hunt Developer, has successfully developed transmission projects that are now in our rate base, and Hunt continues to develop transmission projects that we expect to have the opportunity to acquire in the future.

Hunt’s History of Success

Hunt was founded in 1934 when H.L. Hunt formed Hunt Oil Company and is actively engaged in energy, real estate, investment and ranching businesses in Texas and throughout the world. Mr. Hunt’s son, Ray L. Hunt, has been Hunt’s chairman since the mid-1970s. Hunt has a long history of entrepreneurial activity and a track record in developing and constructing large complex projects. In T&D acquisition and development, this history includes:

 

    Hunt and Sharyland commenced development of the Railroad DC Tie in 2003 to link the ERCOT grid with the Mexican national grid operated by the Comisión Federal de Electricidad (CFE). Construction was completed in 2007, and the Railroad DC Tie was placed in service as the first cross-border DC Tie of its kind to support both emergency power and commercial business activities between Texas and Mexico.

 

    Our Panhandle transmission assets were constructed pursuant to the competitive renewable energy zone (CREZ) initiative. Hunt and its affiliates, including Sharyland, were a driving force throughout the development of the CREZ initiative, which was originated at the direction of the Texas Legislature in 2005 and continued with the PUCT designating renewable energy zones and awarding rights to build transmission lines. In a manner representative of Hunt’s general approach, Sharyland has worked with elected officials, utility regulators, community leaders, landowners and various other stakeholders throughout the development and construction of our approximately 300 miles of transmission lines and four substations, and Sharyland continues to interact with these stakeholders as ongoing partners in the operation and expansion of these assets.

 

    In July 2010, Hunt and Sharyland acquired and integrated the T&D assets of Cap Rock Energy Corporation (Cap Rock) into our REIT structure. In connection with that acquisition, our subsidiary, Sharyland Distribution and Transmission Services, L.L.C. (SDTS), which at that time was a wholly-owned subsidiary of Hunt, acquired the T&D assets that qualify as real estate assets under our private letter ruling. Sharyland acquired all of the other assets and all Cap Rock employees became employees of Sharyland. Both the PUCT and the Federal Energy Regulatory Commission (FERC) approved the acquisition and integration into our REIT structure.

 

 

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Hunt’s Development Projects

Our development agreement with Hunt Developer and Sharyland provides us with a right of first offer to acquire the ROFO Projects described below, which consist solely of T&D projects that Hunt is developing or constructing. Although Hunt may develop other T&D projects that do not currently constitute ROFO Projects under the development agreement, Hunt has informed us that it intends for us to be the primary owner of all of Hunt’s T&D development projects as those projects are completed and placed in service. Under the terms of the development agreement, Hunt has the obligation to offer the ROFO Projects to us at least 90 days prior to the date on which such assets are expected to be placed in service. We expect the purchase price for the ROFO Projects or any other T&D projects Hunt develops will be negotiated by our Conflicts Committee and Hunt and will be based on a number of factors, such as the cash flow and rate base for the assets, market conditions, potential for incremental Footprint Projects, whether the assets are subject to a lease with Sharyland or another tenant, the terms of any such lease and the regulatory return we expect the assets will earn. Sharyland and Hunt Developer are each parties to our development agreement. However, the agreement, by its terms, applies to activities by all Hunt affiliates. As such, when discussing the development agreement, we use the term “Hunt” to refer to Hunt Developer, Sharyland and other affiliates of Hunt Consolidated, Inc.

Development Team

Our development agreement with Hunt Developer provides us with continued access to the Hunt Developer and Sharyland development teams and the development projects they source. Hunt Developer’s active and experienced T&D project development team includes Hunter Hunt and Pat Wood, a former FERC and PUCT chairman, and the eleven members of its team have 15 years of industry experience, on average. The Hunt Developer team has experience with ERCOT, the Southwest Power Pool (SPP), the California ISO (Cal-ISO), Western Electric Coordinating Council (WECC) and CFE, which enables it to identify and pursue T&D opportunities across the southwestern United States. This team has an extensive track record of successfully pursuing a variety of projects, including greenfield development (Sharyland and CREZ transmission), acquisitions (Cap Rock and transmission assets from Southwest Public Service Company), partnering with municipalities (Cross Valley transmission line) and cross border activity (transmission interconnection between ERCOT and CFE and a power marketing entity to facilitate commercial transactions with Mexico). Our access to the Hunt Developer and Sharyland development pipelines position us to capitalize on growth opportunities beyond our existing footprint and to potentially add to our current list of ROFO Projects offered by Hunt.

 

 

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ROFO Projects

Our development agreement with Hunt Developer and Sharyland provides us with a right of first offer to acquire ROFO Projects that Hunt is currently developing or constructing, including the following:

 

ROFO Project

  

Description

  

Status

Cross Valley transmission line

  

Approximately 50 mile transmission line in South Texas near the Mexican border. Total estimated construction cost (including financing costs) of $160 million to $185 million, of which $28 million has been spent though September 30, 2014.

   Under construction; expected completion in 2016

Golden Spread Electric Coop (GSEC) interconnection

   Approximately 55 mile transmission line connecting one of GSEC’s gas-fired generation facilities to our Panhandle transmission line. Total estimated construction cost (including financing costs) of $100 million to $120 million, of which $1 million has been spent through September 30, 2014.   

Under construction;

expected completion in 2016

Southline Transmission Project

   Approximately 240 miles of new transmission line and upgrades of approximately 120 miles of existing transmission lines in southern New Mexico and southern Arizona. Initially estimated construction cost (excluding financing costs) of $700 million to $800 million.    In active development; draft environmental impact statement published

Verde Transmission Project

   Approximately 30 mile transmission line in northern New Mexico. Initially estimated construction cost (excluding financing costs) of $60 million to $80 million.    In development

We have provided information about the Cross Valley and GSEC interconnection projects because of their size, their prominence in our core Texas markets and our belief that these ROFO Projects are the most likely ROFO Projects to be completed and offered to us. Although they are in the early stages of development and budgets for such projects, as well as potential arrangements that might result in developing the projects with partners, have not been finalized, we have also provided information about the Southline Transmission Project and Verde Transmission Project because they are the most prominent and advanced of Hunt’s non-Texas ROFO Projects. However, there can be no assurances that any of the ROFO Projects will be completed and offered to us or, if completed and offered to us, that the price and other terms of the acquisition of such projects can be negotiated on terms acceptable to us.

Other ROFO and Development Projects

In addition to the construction and development activity related to the projects above, Hunt and Sharyland are also evaluating and developing various projects in ERCOT and other regions of the United States. Such ROFO Projects include proposals to (i) reinforce the existing transmission grid in the Panhandle and South Plains region as

 

 

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new wind generators connect to the transmission grid, (ii) develop additional high-voltage DC ties along the Texas and desert Southwest border with Mexico, (iii) increase electric transmission between the PJM and MISO grids through projects in the Midwest and (iv) provide import capacity from New Mexico and Arizona into California.

Hunt and Sharyland are also developing a number of projects that are not included in the ROFO list. A typical example involves initiatives in South Texas to develop new transmission lines to enhance grid reliability and enable generation interconnections. Another example of Hunt’s innovative approach is Sharyland’s response to Lubbock Power & Light’s (LP&L) Request for Proposal (RFP) for generation services. In response to the RFP, Sharyland submitted a proposal to integrate LP&L’s system into ERCOT through multi-line alternatives ranging from approximately 67 to 92 miles, with an associated cost estimated to range from $166 million to $237 million. It is unknown at this time whether Sharyland will be successful in the RFP process. For any non-ROFO projects, Hunt has informed us that it intends for us to be the primary owner of Hunt’s T&D development projects as those projects are completed and placed in service. However, there can be no assurances that any of the non-ROFO Projects will be completed and offered to us or, if completed and offered to us, that the price and other terms of the acquisition of such projects can be negotiated on terms acceptable to us.

Transfer of ROFO Project Assets

Effective January 15, 2015, we transferred the assets related to the Cross Valley transmission line and GSEC interconnection projects, which are designated as ROFO Projects under our development agreement, to Hunt or one of its affiliates. Hunt Developer will continue to construct these projects and will offer such projects to us prior to completion pursuant to the terms of the development agreement. In exchange for these assets, we received $41.2 million, which equaled the rate base of the transferred assets plus reimbursement of out of pocket expenses associated with the formation of related special purpose entities and the Cross Valley project financing. The effect of this transfer is reflected in our unaudited pro forma condensed consolidated financial statements included elsewhere in this prospectus.

The Opportunity

The infrastructure necessary to transport and deliver electricity is vital to the continued economic advancement of the United States. At the national level, demand for T&D infrastructure is driven by several factors, including population growth, changes to a more environmentally-friendly generation mix and demand for a smarter grid. The Edison Electric Institute (EEI) estimates that its investor-owned utility members invested approximately $17.5 billion in the nation’s transmission grid in 2013, after investing $14.8 billion in 2012. This transmission investment cycle is expected to remain robust, with EEI estimating that over the next 10 years its members plan to invest over $60 billion, an approximate 18% increase from the prior year’s 10-year forecast. We believe we are well-positioned to capitalize on the opportunity created by the need for electric infrastructure spending in the United States and to execute our strategy.

T&D Infrastructure in the State of Texas

Texas, as one of the fastest-growing states, is expected to require significant T&D investments. Electricity demand has been increasing due to above-average economic growth, particularly as a result of oil and gas development and population growth. These two demand-side factors, as well as aging generation infrastructure, low natural gas prices and policy objectives to take advantage of the State’s attractive wind corridors, are driving significant T&D investments and support the $3.7 billion in transmission investment that ERCOT identifies in its five-year plan as of November 2014. Based on the location of our T&D assets and our service territory, we believe the opportunity to make investments in T&D assets that increase our rate base will be driven largely by extensive oil and gas production in West Texas, interconnections with renewable generation, particularly wind, in the Texas Panhandle and population growth in South Texas.

 

 

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The Permian Basin, where our Stanton service territory is located, covers an area 250 miles wide and 300 miles long and is one of America’s most prolific hydrocarbons fields, having produced more than 29 billion barrels of oil and 75 trillion cubic feet of natural gas since 1921. It also remains highly productive, with annual production in excess of 280 million barrels a year. According to the Texas Railroad Commission, which regulates oil and gas production in the State, issued drilling permits in the Permian Basin increased over 32% in five years, from 6,711 in 2008 to 8,872 in 2013 as new technologies in exploration have expanded recoverable resources. The U.S. Energy Information Administration expects this strong growth to continue, predicting that the region will see an increase in production from 1.3 million barrels per day in 2013 to 1.8 million barrels per day in 2015.

Power generation growth in Texas, particularly wind generation in which Texas leads the nation in operating MW, is a second driving factor for transmission infrastructure need. ERCOT expects total installed wind capacity to grow from 11,065 MW by the end of 2013 to 21,557 MW in 2017, an increase of approximately 95% based on signed interconnection agreements. Further, according to the ERCOT Regional Planning Group, as of August 1, 2014, there was 6,266 cumulative MW of wind generation capacity planned in the Panhandle region that has signed an interconnection agreement to connect to the ERCOT grid. The PUCT expects the completed CREZ system will ultimately transmit 18,500 MW of wind power from West Texas and the Panhandle to highly populated metropolitan areas of the State. In addition, ERCOT’s 2012 System Assessment forecasted that 16,500 MW of non-wind generation would be coming online in the next decade to help offset retiring coal units and other old assets. This demand from wind and other generators to connect to our Panhandle transmission facilities and other transmission systems should provide us with opportunities to construct or acquire interconnecting transmission lines, new substations and additional equipment and lines to support the increased electricity supply these developments will bring.

Finally, above-average population growth is driving electricity demand in the State and our service territories. According to the Texas State Data Center, the Texas population is projected to grow by 17.2% from 2013 to 2025. The Midland County population grew by 30.6% between 2000 and 2013 and is projected to grow by 16.4% between 2013 and 2023. In addition, the Texas State Data Center estimates that the population of the Lower Rio Grande Valley (LRGV), which includes the service area near McAllen as well as other border cities such as Edinburg, Harlingen and Brownsville, will grow more than 50% in the next 20 years from approximately 1.3 million in 2013 to nearly 2.0 million in 2033. We believe that substantial infrastructure investments will be required to ensure system reliability and serve growing demand in the LRGV.

T&D Infrastructure in the Southwestern United States

The southwestern United States, considered to be Arizona and New Mexico in addition to Texas, has seen significant investment in its electricity grid in response to new generation investment, particularly renewable generation, and a growing population.

Regional renewable energy generation is expected to double in the next ten years in Arizona and New Mexico to meet renewable portfolio standards (RPS), which we believe will provide transmission investment opportunities to connect new generation sources to local utility grids. Arizona’s renewable energy standard (RES) requires investor-owned utilities (IOUs) and cooperatives that have the majority of their customers in Arizona to meet 15% of their retail electric sales through eligible renewable technologies by 2025. According to the National Renewable Energy Laboratory (NREL), by 2025 this will require Arizona to purchase between 7.9 and 8.5 terawatt-hours (TWh) of renewable energy annually, compared to 3.2 TWh of annual production from existing or under-development assets as of 2012. This suggests that Arizona will need an additional 4.7 TWh to 5.3 TWh of annual renewable energy production by 2025, an approximate 150% increase. In New Mexico, the State’s RPS requires the IOUs to have 20% of annual sales from renewable energy by 2020. NREL suggests that the resulting demand for renewable energy related to the RES will be between 3.0 and 4.0 TWh in 2025, while the State’s existing facilities provide 2.0 TWh annually. This suggests an additional 1.0 to 2.0 TWh per year will be needed by 2025, a 50% to 100% increase.

 

 

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Growing populations in the southwest are also expected to drive investment opportunities. According to the Arizona Department of Administration, the population of Arizona is expected to increase by approximately 25% between 2013 and 2025, increasing from 6.6 million to 8.2 million individuals, while the New Mexico Bureau of Business and Economic Research expects the population of New Mexico to increase by approximately 20% by 2025, increasing from 2.1 million to 2.5 million individuals. The population increase of approximately 2 million in those states is expected to be concentrated in the cities of Phoenix, Tucson and Albuquerque and is expected to require additional grid transmission capability from the region’s generation sites.

Business Strategy

Focus on T&D assets. We intend to focus on owning T&D assets with long lives, low operating risks and stable cash flows consistent with the characteristics of our current portfolio. We believe that by focusing on this asset class and leveraging our industry knowledge we will maximize our strategic opportunities and overall financial performance.

Pursue sustainable dividend per share growth. We believe our platform will enable us to grow our rate base and, as a result, increase the amount of distributions we make to our stockholders. To achieve this growth, we will pursue the following:

 

    Grow Rate Base by Investing in Footprint Projects. We expect to make significant capital expenditures in Footprint Projects, driven primarily by investments to improve reliability, meet customer requirements and support oil and gas activities in our Stanton territory in the Permian Basin and interconnections to our Panhandle transmission assets. Based on current estimates, we expect our aggregate capital expenditures for Footprint Projects from 2015 to 2017 to be between $745 million and $775 million.

 

    Acquire ROFO Projects and other T&D projects from Hunt. Hunt Developer has agreed to offer ROFO Projects to us prior to their completion. We are not obligated to purchase, and Hunt is not obligated to sell, these projects if we do not agree upon the price and other terms of the purchase. See “—Agreements with Hunt—Development Agreement.” Hunt has informed us that it intends for us to be the primary owner of Hunt’s T&D development projects as those projects are completed and placed in service.

 

    Acquire other T&D assets from third parties. We intend to leverage relationships that we, Sharyland and Hunt maintain in the energy industry to source acquisition opportunities. We have a track record of acquiring T&D assets from third parties as a result of relationships maintained by Hunt and Sharyland’s business development teams. We believe that our structure, which relies on an ongoing relationship with operating lessees, combined with Sharyland’s operating track record and Hunt’s reputation as an innovative and credible developer of energy assets, will competitively position us to acquire other T&D assets.

Focus on Texas and southwestern United States initially. We are primarily focused on two main markets, Texas and the southwestern United States, where we believe the electric transmission sector will continue to grow significantly. This also allows us to leverage our existing relationships and a proven track record of identifying, developing, constructing and acquiring critical infrastructure assets. Substantially all of the ROFO Projects are located in Texas or the southwestern United States. Over time, we may expand our focus to other jurisdictions with favorable regulatory and growth characteristics.

Maintain a strong financial profile. We intend to maintain a balanced capital structure that enables us to increase our dividend over time and serve the long-term interests of our stockholders. Our financing policies will seek an optimal capital structure through various capital formation alternatives to minimize interest rate and refinancing risks and position us to pay stable and growing long-term dividends and maximize value.

 

 

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Competitive Strengths

Our assets generate stable cash flows. We generate revenue by leasing T&D assets to Sharyland. Sharyland’s lease payments to us are largely comprised of fixed base rent, with the remaining lease payments to us derived from a percentage of Sharyland’s gross revenue in excess of a specified threshold. Sharyland receives revenues from DSPs and REPs, which pay Sharyland PUCT-approved rates. The PUCT-approved rates are designed to allow the applicable utility to recover costs associated with maintaining and operating the assets and earn a return on invested capital. Through our leases, which include mechanisms for rent increases as we grow our rate base, we expect to benefit from the stability of Sharyland’s rate-regulated revenue stream. See “Business and Properties—Our TenantOur Leases.”

Our T&D assets are located in high-growth areas. Our Stanton territory assets serve a region atop the Permian Basin, which has experienced a rapid expansion in oil and gas investment. Our transmission assets in the Texas Panhandle are located in one of the most attractive wind corridors in the world and, we believe, will benefit from expanding wind power generation investment. Our McAllen territory is located in one of the most rapidly-growing population areas of the State and benefits from its border with Mexico, where we recently expanded power interconnection facilities through a long-standing relationship with CFE.

The ability to update transmission rates through interim TCOS filings, combined with Sharyland’s current distribution customer and load growth, reduces the necessity of filing frequent rate cases. The majority of Sharyland’s expected 2015-2017 capital expenditures are for transmission assets. Like other utilities in Texas, Sharyland is able to minimize regulatory lag through interim transmission cost of service (TCOS) filings. See “—Our Revenue Model—Regulatory Recovery.” With respect to capital expenditures for distribution assets, Sharyland’s revenues, and its lease payments to us, will grow as capital expenditures are made to support new customers and/or existing customers increase their electricity usage. We believe this growth will enable us to invest in our Footprint Projects and receive increased lease payments from Sharyland, without the need for Sharyland to frequently file rate cases to request increases in rates to cover such costs.

We benefit from our strong ties to and our alignment with Hunt. Hunt, and members of the Hunt family, own and control Hunt Manager, Sharyland and Hunt Developer. Hunt will own 3,176,878 shares of our common stock and 13,213,619 OP Units following this offering and the Reorganization, which will be subject to long-term lock-ups with us. See “Certain Relationships and Related Transactions—Arrangements with Hunt—Lock-Up Agreement with InfraREIT, Inc.” This ownership would constitute 27.1% of our outstanding equity if all OP Units were exchanged for shares of our common stock. In addition, the incentive payment under our management agreement with Hunt Manager is linked to our financial performance, requiring payment only if our quarterly distributions exceed $0.27 per share.

Sharyland has a proven development, construction and operating history and a strong reputation in Texas. Since Sharyland began operations in 1999, it has successfully developed, constructed and operated several T&D projects, including the CREZ project and the Railroad DC Tie, and successfully integrated and improved the operations of Cap Rock following our acquisition of it in 2010. Sharyland completed the CREZ project in November 2013, within the original timeframe outlined by the PUCT and under budget. Sharyland’s expertise and reputation helps Sharyland maintain positive customer and regulatory relationships, which we believe increases our ability to generate the returns we expect on our T&D assets.

We have rights to Hunt’s T&D pipeline. Our development agreement with Hunt Developer requires Hunt to offer all ROFO Projects to us prior to their completion. Hunt and Sharyland are responsible for Sharyland’s growth from a start-up operation to a utility that operates approximately $1.1 billion in rate base as of September 30, 2014.

 

 

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Hunt originated, and Hunt Manager and Hunt have expertise in applying, the REIT structure to regulated T&D assets. In 2005, Hunt and Sharyland employees, led by our Chairman, W. Kirk Baker, initiated the process of owning regulated T&D assets through a REIT structure. Over the last nine years, Hunt and Sharyland gained significant experience applying the REIT structure to a high-growth, regulated T&D business. Furthermore, in 2010, Hunt and Sharyland successfully acquired and integrated the Cap Rock T&D assets and operation directly into our REIT structure. Hunt’s team also successfully sourced, structured and negotiated on our behalf debt and equity financing arrangements to fund our organic growth, construction projects and the Cap Rock acquisition. We believe Hunt’s and Hunt Manager’s knowledge and experience gives us a competitive advantage in analyzing the complexities associated with our expected rate base growth, executing on development and acquisition opportunities within a REIT structure, obtaining regulatory approvals and structuring lease agreements with tenants.

Our REIT structure and balance sheet provide us with long-term cash distribution advantages. We believe our REIT structure positions us well to make enhanced cash distributions to our stockholders over the long term as compared with utilities and power oriented yield vehicles. Additionally, on a pro forma basis, we expect to be able to fund estimated capital expenditures from Footprint Projects through the end of 2017 without raising proceeds from additional equity offerings. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” for a description of our liquidity and target credit metrics.

Our Revenue Model

We lease our T&D assets to our tenant, Sharyland, which makes lease payments to us consisting of fixed base rent and percentage rent. To support its lease payments to us, Sharyland delivers electric service and collects revenues directly from DSPs and REPs, which pay PUCT-approved rates. Under the terms of our leases, Sharyland is responsible for the operation of our assets, payment of all property related expenses associated with our assets, including repairs, maintenance, insurance and taxes (other than income taxes) and construction of Footprint Projects. As our rate base increases through Footprint Projects, ROFO Projects or other acquisitions, we generally expect our lease revenue to increase.

 

LOGO

Regulatory Recovery

General rate making

In Texas, an electric utility’s T&D rates are determined pursuant to rate case proceedings, which occur periodically, and are adjudicated by the PUCT to ensure that rates remain just and reasonable. Rates are determined after considering the utility’s annual operating cost of rendering service, adjusted for known and measurable changes, in addition to a reasonable return on invested capital. Sharyland makes all regulatory filings with the PUCT regarding our T&D assets. Per the terms of the leases, we have the right to request that Sharyland file a rate case proceeding.

 

 

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Updating Rates

Sharyland’s rates may be updated through three different mechanisms:

 

    A general rate case. A rate case is usually initiated by the utility or the PUCT, on its own motion or on complaint by an affected stakeholder. In general, a rate case is initiated when one party believes the amount of capital invested or the cost of service (operating or cost of capital) has changed significantly enough to warrant a review by the PUCT. In Texas, once a rate case is filed, it is generally concluded within one year.

 

    TCOS filing. For transmission assets, Sharyland is permitted to update its transmission tariff up to two times per year, outside of a general rate case, for certain changes such as additional capital expenditures, through interim TCOS filings. If there are no material deficiencies in the TCOS filing, or objections from intervenors, Sharyland’s transmission rates generally will be updated within 60 days of the TCOS filing.

 

    DCRF filing. For distribution assets, Sharyland is permitted to update its distribution tariff once a year, outside of a general rate case, for changes in the amount of invested capital for distribution and certain associated costs. Sharyland historically has not used distribution cost recovery factor (DCRF) filings to update its distribution tariffs.

Sharyland’s 2014 Rate Case

In January 2014, the PUCT approved a rate case filed by Sharyland applicable to all of our T&D assets other than our distribution assets in McAllen, Texas, providing for a capital structure consisting of 55% debt and 45% equity, a return on equity of 9.70% and a return on invested capital of 8.06% in calculating rates. The new rates became effective May 1, 2014. We expect Sharyland’s next rate case to be filed during the first half of 2016. For more information on how rates are determined, see “Regulation and Rates—Regulation of T&D Utilities.”

Rent Revenue

Rental Rates

All of our current revenue is comprised of rental payments from Sharyland under leases that were negotiated at various times between 2010 and 2014. Historically, we and Sharyland have negotiated rent payments intended to provide us with approximately 97% of the projected regulated return on rate base investment attributable to our assets that we and Sharyland would receive if we were a fully-integrated utility. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors Expected To Affect Our Operating Results and Financial Condition—Regulatory Recovery” and “Business and Properties—Our Tenant—Sharyland’s Regulatory Proceedings.” We and Sharyland have negotiated these rental rates based on the premise that we, as the owner of regulated T&D assets, should receive most of the regulated return on our invested capital, while leaving Sharyland with a portion of the return that gives it the opportunity to operate prudently and remain financially stable. Our leases require us to continue to negotiate rent payments in the future in a manner similar to this historical negotiation.

Sharyland makes lease payments to us that consist of fixed base rent and percentage rent (based on an agreed-to percentage of Sharyland’s gross revenues, as defined in our leases, in excess of a specified threshold). Because our existing rate base will decrease over time as our T&D assets are depreciated, revenue under our leases will decrease over time unless we add to our existing rate base by making additional capital expenditures to offset

 

 

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the decreases in the rent resulting from depreciation. The weighted average annual depreciation rate of our assets as of September 30, 2014 was 2.67%. We negotiated our current leases to provide for fixed base rent to comprise approximately 80-90% of the total expected rent (with the exception of the lease related to our Stanton transmission loop assets, which does not provide for percentage rent).

Lease Renewals

We expect to renew our leases with Sharyland prior to expiration. Our leases provide that we and Sharyland negotiate lease terms based on our historical negotiations and the return that utilities in the State of Texas are allowed to earn at the time of the negotiation. We generally expect that renewal terms will be at least five years. If either we or Sharyland do not wish to renew a lease, or we cannot agree to new lease terms, we expect that our rent negotiations with a new third-party tenant would be based on the rate base of the assets subject to the expired lease and the rate of return expected at the time a new lease is negotiated, among other factors. Our Stanton/Brady/Celeste lease, which relates to less than 25% of our existing assets, expires on December 31, 2015, and leases relating to our remaining assets expire at various times between December 31, 2019 and December 31, 2022. See “Business and Properties—Our Tenant—Our Leases.”

Lease Supplements

Our leases provide that as the completion of Footprint Projects increases our rate base, we and Sharyland will negotiate lease supplements so that Sharyland makes additional rent payments to us on this incremental rate base. Various factors could cause Sharyland’s expected lease payments on incremental rate base to be different than its lease payments to us on our existing rate base. For instance, if a rate case was finalized since the last lease or lease supplement, the new lease supplement would use regulatory assumptions from the most recent rate case. Also, our leases provide that either party can negotiate for economics that differ from our existing leases based on appropriate factors that our leases do not specifically list. However, the negotiation of lease supplements relates only to the revenue we expect to be generated from the incremental rate base subject to the negotiation, and in no circumstance will the negotiation change the rent payments negotiated with respect to prior leases and lease supplements.

Rate Base Growth

We will add to our rate base through capital expenditures for Footprint Projects, acquisitions of ROFO Projects or acquisitions of other T&D assets from Hunt or third parties.

For Footprint Projects, we generally fund all of the capital expenditures during the development or construction phase of a project, and these expenditures increase our rate base when they are placed in service. In advance of the time assets are placed in service, we will work with Sharyland to negotiate a supplement to our leases. Sharyland also may make a regulatory filing to update its rates to reflect the additional rate base.

When we acquire ROFO Projects or other T&D assets from Hunt, we would expect to assume any lease that is already negotiated with Sharyland or another tenant with respect to those T&D assets, and we will work with Sharyland or another tenant to update existing rates, as appropriate, for the addition to our rate base.

Prior to closing an acquisition from a third party, we will work with Sharyland, or another tenant, to pursue the addition of new leases and updating of existing rates, as appropriate, for the addition to our rate base.

 

 

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Described below are the key steps by which placing new assets into service increases our rate base and/or our expected lease payments, although the order and timing of each step will vary by asset:

 

LOGO

Agreements with Hunt

We have various agreements with Hunt, Hunt Developer, Hunt Manager and Sharyland. The following chart illustrates our relationships and alignment with each of these entities following the consummation of this offering and the Reorganization (based on the assumptions set forth in the “Explanatory Note” and as further described under “—Our Structure and Reorganization Transactions—Reorganization Transactions” below).

 

LOGO

Management Agreement

We and Hunt Manager have entered into a management agreement pursuant to which Hunt Manager will manage our day-to-day business, subject to oversight from our board of directors.

 

 

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Compensation

The following table summarizes the fees and expense reimbursements that we will pay to Hunt Manager pursuant to the management agreement:

 

Compensation

  

Description

Base Fee

   We will pay an annual base fee, or management fee, of $10 million through April 1, 2015. Effective as of April 1, 2015, the annual base fee will be adjusted to $13.1 million, which was intended to approximate 1.50% of our estimated total equity (including non-controlling interest) as of December 31, 2014, on a pro forma basis assuming this offering and the Reorganization transactions were completed on December 31, 2014. The base fee for each twelve month period beginning on each April 1 thereafter will equal 1.50% of our total equity as reflected on our consolidated balance sheet (including non-controlling interest) as of December 31 of the previous year. See “Capitalization” and our unaudited pro forma condensed consolidated balance sheet and related notes included elsewhere in this prospectus for information regarding the amount of our total equity as of September 30, 2014 after giving effect to this offering and the Reorganization transactions. The base fee will be subject to a $30 million cap, unless a greater amount is approved by a majority of our independent directors (or a committee comprised solely of independent directors).

Incentive Payment

   We will pay Hunt Manager an incentive payment, payable quarterly, equal to 20% of quarterly per OP Unit distributions (inclusive of the incentive payment) in excess of the Threshold Distribution Amount (as defined below); provided, however, that any distributions in excess of our cash available for distribution (as defined in the management agreement as an amount equal to (A) net income before noncontrolling interest, plus (B) depreciation, plus (C) amortization of deferred financing costs, if any, minus (D) AFUDC equity, minus (E) capital expenditures to maintain net assets (which equals depreciation expense), subject to adjustments to eliminate the impact of certain other non-cash items) will not be considered distributions for purposes of calculating the incentive fee. See “Our Manager and Management Agreement—Management Agreement—Management Fees” for the complete definition of cash available for distribution. Pursuant to the management agreement, the Threshold Distribution Amount will equal $0.27 per OP Unit, which is 120% of our initial projected annualized per OP Unit distribution for the year ending December 31, 2015, divided by four. See “Distribution Policy—Estimated Cash Available for Distribution for the Twelve Months Ending December 31, 2015.”

Reimbursement of Expenses

   We will reimburse Hunt Manager for all third-party expenses incurred on our behalf or otherwise in connection with the operation of our business, other than: compensation expenses related to Hunt Manager’s personnel (including our officers), occupancy costs incurred by Hunt Manager related to its place of business, time or project-based billing for work done by Hunt affiliates, travel and expenses for Hunt Manager’s employees, fees or costs associated with professional service organizations, publications, periodicals, professional development or related matters for Hunt Manager employees and income or franchise taxes payable by Hunt Manager, all of which will be the exclusive responsibility of Hunt Manager.

 

 

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Compensation

  

Description

Termination Fee

   If we exercise our right not to renew the management agreement at the end of the then-current term, we will be required to pay Hunt Manager a termination fee, in cash or equity, at our election, in an amount equal to three times the most recent annualized base management fee and incentive payment amount. If we elect to pay the termination fee in equity, the fee will be paid in OP Units, which will be issued five days after the effective date of termination, with the number of OP Units based on the volume weighted average price of our common stock during the 10 trading day period that precedes such effective date of termination.

Term

The term of the management agreement will expire December 31, 2019, except that it will automatically renew for successive five-year terms unless a majority of our independent directors decides to terminate the agreement. If our independent directors decide to terminate the agreement, we must give Hunt Manager notice of the termination at least one year in advance of the scheduled termination date and pay Hunt Manager the termination fee described above. We will also have the right to terminate the management agreement at any time for cause (as defined in the management agreement), and Hunt Manager may terminate the agreement at any time upon 365 days’ prior notice to us, provided that Hunt Manager may not terminate the agreement effective before December 31, 2019. In these circumstances, the termination fee would not be owed to Hunt Manager.

See “Our Manager and Management Agreement” for more information about the management agreement.

Structuring Fee Agreement

We have entered into a structuring fee agreement with Hunt-InfraREIT pursuant to which we issued 1,700,000 shares of common stock to Hunt-InfraREIT as a one-time reorganization advisory fee immediately prior to the effectiveness of the registration statement to which this prospectus relates in consideration for Hunt’s restructuring assistance in connection with the Reorganization and this offering.

Development Agreement

We have entered into a development agreement with Hunt Developer and Sharyland. Pursuant to the development agreement and our leases, we have the exclusive right to continue to fund the development and construction of Footprint Projects. Hunt will have the right to fund the development and construction of all ROFO Projects.

Hunt intends to fund the development and construction of the ROFO Projects through new development companies in which certain of our founding investors will have the opportunity to invest capital. We have a right of first offer with respect to these projects requiring Hunt to offer ROFO Projects to us at least 90 days prior to the date on which such assets are expected to be placed in service. Hunt’s offer will include price, form of consideration and other material terms of the proposed transaction, and delivery of the offer will commence a 75-day negotiation period. Following this period, if we are unable to reach an agreement on the terms of such purchase with Hunt and the investors in the project, they may, during the following 18 months, transfer the ROFO Project to a third party, but only on terms and conditions generally no more favorable to such third party than those offered by Hunt to us. Our governance policy will require that any acquisition of a ROFO Project by us be approved by our Conflicts Committee, which will be comprised solely of independent directors. Our Conflicts Committee will evaluate whether to seek to negotiate the acquisition of the ROFO Project based on

 

 

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whether it believes that the acquisition will be in our best interests taking into account the offered price and its analysis of the fair market value of the project. We expect the purchase price for any ROFO Projects will be negotiated by our Conflicts Committee and Hunt and will be based on a number of factors, such as the cash flow and rate base for the assets, market conditions, potential for incremental Footprint Projects, whether the assets are subject to a lease with Sharyland or another tenant, the terms of any such lease and the regulatory return we expect the assets will earn.

Hunt has informed us that the entities that hold certain of the ROFO Projects, including the Cross Valley transmission line project, will be owned by Hunt and certain of our founding investors. In all circumstances, an acquisition of a ROFO Project will require the approval of our Conflicts Committee following negotiations between that committee and Hunt. Hunt has informed us that it will have the unilateral authority to negotiate on behalf of these investors with our Conflicts Committee, and to negotiate and agree upon the terms of the sale of the ROFO Projects to us, as long as the consideration payable would result in the investors receiving at least 1.5 times the amount of equity capital they invested. We generally expect this threshold to translate into a purchase price equal to at least approximately 1.25 times the rate base for such assets, though the actual ratio will depend on the financing structure used on each development project. If the price does not meet this threshold, the sale of the ROFO Project will require the approval of Hunt and at least two of our founding investors in such project. In all circumstances, the acquisition of a ROFO Project from Hunt and these investors will require the approval of our Conflicts Committee. Although Hunt is required to offer all ROFO Projects prior to completion, there can be no assurances that the price and other terms of the acquisition of ROFO Projects can be negotiated on terms acceptable to us. The development agreement is coterminous with the management agreement, and our rights under the development agreement will expire effective upon the termination of the management agreement. See “Certain Relationships and Related Party Transactions—Arrangements with Hunt—Development Agreement.”

Lock-up Agreements

Hunt has agreed with the underwriters of this offering to a one-year lock-up that applies to all of its equity in us and our Operating Partnership. In addition, we have entered into a lock-up agreement with Hunt, pursuant to which Hunt has agreed with us that it will not transfer or sell 80% of its equity in us and our Operating Partnership that it will hold after the consummation of this offering and the Reorganization until the three-year anniversary of this offering. After the three-year anniversary, this lock-up will continue to apply to 50% of such equity through the five-year anniversary of this offering. Each of these lock-up agreements is subject to exceptions permitting Hunt to transfer equity to affiliates, employees and service providers, except that Hunt cannot transfer a number of shares of common stock or OP Units that exceeds 20% of the aggregate number of shares of our common stock and OP Units it will hold following the Reorganization transactions described under “—Our Structure and Reorganization Transactions—Reorganization Transactions.” Furthermore, in some circumstances, the transferee must assume the applicable lock-up restrictions. Hunt’s lock-up agreement with us will terminate upon the termination or non-renewal of the management agreement and development agreement. See “Certain Relationships and Related Party Transactions—Arrangements with Hunt—Lock-up Agreement with InfraREIT, Inc.” Hunt has informed us that it currently intends to hold a substantial portion of its equity in us for the foreseeable future.

 

 

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Conflicts of Interest

We are and intend to be party to several agreements and transactions in which Hunt, one or more of our major stockholders, members of our board of directors or our officers may have interests that differ from our stockholders, including the following:

 

    Each of our officers, including David Campbell, our President and Chief Executive Officer, is an employee of Hunt Manager. Hunt will control the compensation of our officers and the employees of Hunt Manager and has granted and in the future may grant compensation or awards that are based upon the performance of Hunt Manager, Hunt Developer, Sharyland or Hunt generally and from the profits that Hunt may generate from the sale of ROFO Projects to us. As a result, Mr. Campbell, as well as the other employees of Hunt Manager, may consider the interests of Hunt Manager, Hunt Developer, Sharyland and Hunt generally in any negotiation between us and one of those entities and may benefit from the consideration we pay Hunt Manager under the management agreement, from any economic benefit that Hunt or Sharyland receives from the sale of ROFO Projects to us pursuant to the development agreement and from the performance of Sharyland.

 

    W. Kirk Baker, who is the Chairman of our board of directors, was the President and Chief Executive Officer of Hunt Manager until August of 2014, was a senior officer in the Hunt Consolidated, Inc. organization until July of 2012, and received compensation and other benefits from Hunt and its affiliates during these time periods. Hunt and Mr. Baker have informed us that Mr. Baker continues to receive, and may in the future after completion of this offering continue to receive, various perquisites and incentive compensation from Hunt, including incentive compensation based on profits that Hunt may generate from the sale of ROFO Projects to us and payments that we make to Hunt Manager. Mr. Baker currently is Managing Partner of Captra Capital, an investment firm in which Mr. Baker and Hunt are currently the primary investors, and Hunt has funded and may continue to fund the operating overhead of Captra Capital’s manager, Captra Holdings, an entity that currently provides compensation and other benefits to Mr. Baker. As a result, Mr. Baker may consider the interests of Hunt Manager, Hunt Developer, Sharyland and Hunt generally in any negotiation between us and one of those entities and may benefit from the consideration we pay Hunt Manager under the management agreement, from any economic benefit that Hunt or Sharyland receives from the sale of ROFO Projects to us pursuant to the development agreement and from the performance of Sharyland.

 

    Hunter L. Hunt, who is a member of our board of directors, is also the senior officer and/or director of various Hunt-affiliated entities, including Sharyland and Hunt Manager. As a result, Mr. Hunt may consider the interests of Hunt Manager, Hunt Developer, Sharyland and Hunt generally in any negotiation between us and one of those entities and may benefit from the consideration we pay Hunt Manager under the management agreement, from any economic benefit that Hunt or Sharyland receives from the sale of ROFO Projects to us pursuant to the development agreement and from the performance of Sharyland. Mr. Hunt and members of his family also own and direct the operations of our tenant, Sharyland. As a result, Mr. Hunt’s interests in our leases with Sharyland may be different than the interests of our stockholders.

 

    Several of our significant equityholders, including Hunt and certain of our founding investors, may own interests in ROFO Projects that we may acquire pursuant to the development agreement and therefore may benefit from any consideration that we pay in connection with our acquisition of these projects.

 

 

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    Under the terms of the development agreement with Hunt Developer, we have the exclusive right to fund the construction of Footprint Projects. In addition, Hunt has granted us a right of first offer on the ROFO Projects. However, Hunt is free to pursue the development and construction of other T&D projects and may compete directly with us for the acquisition of other T&D assets and businesses.

 

    We depend on Hunt Manager for our day-to-day management, and we do not have any independent officers or employees. The officers and other personnel of Hunt Manager may possibly engage in other activities unrelated to our business, which may reduce the time that they spend on our matters.

 

    The base fee under our management agreement is determined by reference to our total equity, not our financial performance. In addition, the incentive payment payable to Hunt Manager under our management agreement is calculated as a percentage of the per OP Unit distributions in excess of the Threshold Distribution Amount made by our Operating Partnership to the holders of OP Units. As a result, Hunt Manager could recommend that we grow total equity or make Operating Partnership distributions in a manner that is different from the interests of our stockholders generally.

 

    Our charter and our agreements with Hunt permit our directors and officers and their affiliates (including individuals serving in such capacities who are also directors, officers or employees of Hunt and its affiliates) to, among other things, compete with us, own any investments or engage in any business activities (including investments and business activities that are similar to our current or proposed investments or business activities) and to refrain from presenting to us any business opportunities unless the opportunity is expressly offered to such person in his or her capacity as a director or officer of us.

We believe that Hunt’s shared alignment with our stockholders through Hunt’s ownership of equity in us and our Operating Partnership and the manner in which the incentive payment to Hunt Manager is calculated will help mitigate these conflicts of interests. In addition, consistent with New York Stock Exchange (NYSE) listing standards, a majority of our directors will be independent, and we intend to adopt a corporate governance policy designed to ensure that our Conflicts Committee, which will be comprised solely of independent directors, reviews and approves all material potential conflict transactions.

Risks Related to Our Business

Our business is subject to a number of risks, including risks that may prevent us from achieving our business objectives or may materially and adversely affect our business, financial condition, results of operations and cash flows. You should carefully consider these risks, including the risks discussed in the section entitled “Risk Factors,” before investing in our common stock. These risks include:

 

    Footprint Projects may not materialize for a variety of reasons, including as a result of reductions, relative to our current expectations, in oil and gas drilling and related activity in the Permian Basin due to lower oil and gas prices;

 

    our growth depends on Hunt Developer’s successful development and construction of ROFO Projects and other T&D projects and our ability to negotiate acquisitions of those projects on acceptable terms;

 

    it is difficult to forecast the magnitude and timing of capital needs, in part due to the recent rapid growth in the areas where our T&D assets are located, and, if our rate base and capital need forecasts prove to be inaccurate, we may not experience the revenue growth we anticipate or we may be forced to raise additional capital;

 

 

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    we currently rely on Sharyland for all of our revenues and, as a result, our business, financial condition, results of operations and cash flows depend on Sharyland’s solvency and financial and operating performance;

 

    we have not yet negotiated lease payments with respect to substantially all of the capital expenditures that we expect to fund during the next several years, our leases currently expire at various times between 2015 and 2022, and there is no assurance that new negotiations will result in lease payments that are higher than or comparable to the lease payments we expect under our current leases;

 

    the market for investing in energy infrastructure projects is competitive, which could adversely affect our ability to execute our growth strategy;

 

    we are externally managed and depend on Hunt Manager and its key personnel to provide services to us;

 

    there are various conflicts of interest in our relationship with Hunt and Sharyland, which could result in decisions that are not in the best interests of our stockholders;

 

    Sharyland has regulatory-required rights as managing member and as a minority owner of our subsidiary, SDTS, which affect our ability to control SDTS;

 

    Sharyland is required to conduct a rate case in 2016, which could adversely affect our expected lease revenue, primarily under lease supplements and new leases executed after the conclusion of the case;

 

    our T&D assets and Sharyland’s operations are subject to governmental regulation, and we rely on Sharyland to manage these regulatory matters;

 

    the character, location and utilization of our T&D assets could change as the result of technology driven changes such as significant adoption of onsite generation;

 

    PUCT approval is required to transfer Sharyland’s operating licenses to a new tenant, which makes it difficult to replace Sharyland as our tenant in the event of a material breach of the leases or to replace Sharyland with a new tenant at the end of the lease terms;

 

    our REIT structure presents challenges to future acquisitions;

 

    we rely on our tenant to construct our T&D assets, and, in some circumstances, our tenant relies on other third parties to complete construction projects;

 

    there are practical limits on our tenant’s ability to increase its rates that affect our ability to generate revenue from our capital expenditures;

 

    we expect that we will rely on the capital markets in order to meet our significant capital expenditure obligations in the future and to continue to distribute at least 90% of our taxable income to our stockholders; and

 

    our failure to qualify or maintain our qualification as a REIT would have significant adverse consequences to us and the per share trading price of our common stock.

 

 

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REIT Qualification

InfraREIT, L.L.C. elected to be treated as a REIT for U.S. federal income tax purposes commencing with the taxable year ended December 31, 2010 and, following the Merger, we will elect to be taxed as a REIT commencing with the taxable year ending December 31, 2015. We believe that we and InfraREIT, L.L.C. have been organized and operate in a manner that has allowed InfraREIT, L.L.C. to qualify for taxation as a REIT for U.S. federal income tax purposes commencing with its 2010 taxable year and through the consummation of the Merger, and will allow us to qualify for taxation as a REIT for U.S. federal income tax purposes commencing with the 2015 taxable year, and we intend to continue to be organized and operate in this manner. In order to qualify as a REIT for U.S. federal income tax purposes, we must continually satisfy a number of organizational and operational requirements, including requirements relating to the qualification of sources of our income as rents from real property and certain other specified types of income, the composition and values of our assets, the amounts we distribute to our stockholders and the diversity of ownership of our stock. To comply with the REIT requirements, we may need to forgo otherwise attractive opportunities and limit our expansion opportunities and the manner in which we conduct our operations. See “Risk Factors—Risks Related to REIT Qualification and Federal Income Tax Laws.” As a REIT, we are subject to U.S. federal income tax, but we generally will not owe U.S. federal income tax on our REIT taxable income, including any net capital gains, that we currently distribute to our stockholders. If we fail to qualify as a REIT in any taxable year, we will owe U.S. federal income tax at regular corporate rates. Even if we qualify for taxation as a REIT, we may also be subject to some federal, state and local taxes on our income or property. In addition, the income of any taxable REIT subsidiary that we own will be subject to taxation at regular corporate rates. See “Material Federal Income Tax Consequences.”

Distribution Policy

We intend to distribute substantially all of our cash available for distribution, less prudent reserves, through regular quarterly cash dividends.

The Internal Revenue Code of 1986, as amended, or the Code, generally requires that a REIT distribute annually at least 90% of its REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gains, and imposes tax on any taxable income retained by a REIT, including capital gains. To satisfy the requirements for qualification as a REIT, we intend to make regular quarterly distributions of all or substantially all of our REIT taxable income to holders of our common stock out of assets legally available for such purposes. We may also elect in the future to pay all or a portion of any distribution in the form of a taxable distribution of our stock or debt securities. Future distributions made by us, however, will be at the sole discretion of our board of directors.

We expect our cash available for distribution to be significantly more than taxable income for the foreseeable future. However, we may not be able to distribute 100% of our REIT taxable income for a variety of reasons, including because provisions of our financing arrangements limit our ability to make distributions in some circumstances. If we do not distribute 100% of our REIT taxable income, we will be subject to corporate income tax, and potentially excise tax, on the retained amounts. If our operations do not generate sufficient cash flow to allow us to satisfy the REIT distribution requirements, we may be required to fund distributions from working capital, borrow funds, sell assets or reduce such distributions. Our board of directors will review the alternative funding sources available to us from time to time.

Restrictions on Ownership and Transfer of Our Stock

Our charter will provide that, subject to certain exceptions, no person (other than John Hancock Life Insurance Company (U.S.A.), OpTrust N.A. Holdings Trust and Teachers Insurance and Annuity Association of America, each of which has been granted an exemption) may own more than 9.8% (in value or in number of shares, whichever is more restrictive) of the aggregate of the outstanding shares of our common stock or more

 

 

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than 9.8% (in value) of the aggregate of the outstanding shares of all classes or series of capital stock, which we refer to as the ownership limits, and will impose certain other restrictions on ownership and transfer of our stock. These restrictions are intended to assist with our REIT compliance under the Code, among other purposes. Our board of directors, in its sole discretion, may exempt a proposed transferee, prospectively or retroactively, from the ownership limits if certain conditions are satisfied and these restrictions will not apply if our board of directors determines that it is no longer in our best interests to continue to qualify as a REIT or that such restrictions are no longer necessary in order for us to continue to qualify as a REIT. The restrictions may delay or impede a transaction or a change of control that might be in your best interest. See “Description of Our Capital Stock—Restrictions on Ownership and Transfer” and “Risk Factors—Risks Related to Our Organization and Structure—Our charter contains restrictions on the ownership and transfer of our stock that may delay, defer or prevent a change of control transaction.”

JOBS Act

As a company with less than $1.0 billion in revenue during our last fiscal year, we qualify as an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012 (JOBS Act).

An emerging growth company may take advantage of reduced reporting requirements that are otherwise applicable to public companies. These provisions include not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, as amended (Sarbanes-Oxley Act). We may take advantage of this provision until the last day of our fiscal year following the fifth anniversary of the date of the first sale of our common equity securities pursuant to an effective registration statement under the Securities Act of 1933, as amended (Securities Act), which fifth anniversary will occur in 2020. However, if certain events occur prior to the end of such five-year period, including if we become a “large accelerated filer,” our annual gross revenues exceed $1.0 billion or we issue more than $1.0 billion of non-convertible debt in any three-year period, we will cease to be an emerging growth company prior to the end of such five-year period.

Furthermore, Section 107 of the JOBS Act provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. However, we are choosing to “opt out” of such extended transition period, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for companies that are not emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable.

To the extent that we utilize certain provisions available to us as an emerging growth company, the information that we provide to our stockholders may be different than you might receive from other public reporting companies in which you hold equity interests.

Our Structure and Reorganization Transactions

UPREIT Structure

We conduct our business through a traditional umbrella partnership REIT, or UPREIT, in which our properties are owned by our Operating Partnership, or direct and indirect subsidiaries of our Operating Partnership. Upon the consummation of this offering, InfraREIT will be the sole general partner of our Operating Partnership, and, following the Reorganization transactions described below, InfraREIT, Marubeni Corporation (together with its subsidiaries, Marubeni) and Hunt-InfraREIT, L.L.C. (Hunt-InfraREIT), an indirect subsidiary of Hunt and a limited partner of our Operating Partnership, will initially own substantially all of the OP Units. Following this offering, subject to the terms of the partnership agreement and applicable lock-up agreements, the

 

 

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OP Units held by MC Transmission Holdings, Inc., a wholly owned subsidiary of Marubeni, Hunt-InfraREIT and other limited partners may be redeemed for cash or, at our option, exchanged for shares of our common stock on a one-for-one basis, as described under “The Operating Partnership and the Partnership Agreement—Redemption Rights.”

Reorganization Transactions

Our business has historically been operated through InfraREIT, L.L.C., a Delaware limited liability company. In connection with this offering and the Reorganization, we will engage in a number of transactions, including the Merger, which will result in InfraREIT, Inc., a Maryland corporation, surviving as the public issuer and general partner of the Operating Partnership.

In 2011, the formation of an unrelated partnership between a Hunt affiliate and an affiliate of one of our founding investors resulted in the application of certain “excess share” provisions in InfraREIT, L.L.C.’s governing documents. As a result of these provisions, shares held by that founding investor in excess of 9.8% of the total number of outstanding shares of InfraREIT, L.L.C. were automatically transferred to Westwood Trust, as trustee of a trust for the benefit of a charitable beneficiary (Westwood Trust).

The Reorganization transactions are being undertaken for a number of reasons, including:

 

    to ensure that we qualify as a REIT going forward without regard to whether the application of the excess share provisions described above was effective to allow InfraREIT, L.L.C. to continue to be qualified as a REIT;

 

    to change from a Delaware limited liability company to a Maryland corporation; and

 

    so that the surviving public entity is the entity that currently holds the IRS private letter ruling confirming that our T&D assets qualify as real property under applicable REIT rules.

The bullet points below provide an overview of the steps of the Reorganization. For a more detailed description of the Reorganization, see “Description of Our Capital Stock—Reorganization.”

 

    Immediately prior to the effectiveness of the registration statement to which this prospectus relates, our Operating Partnership effected a reverse unit split whereby each holder of OP Units received 0.938550 OP Units of the same class in exchange for each such unit it held immediately prior to such time, which we refer to as the unit split.

 

    Immediately prior to the effectiveness of the registration statement to which this prospectus relates, we issued 1,700,000 shares of our common stock to Hunt-InfraREIT as a reorganization advisory fee. Hunt-InfraREIT immediately transferred 75,000 of the shares it received from us to OpTrust N.A. Holdings Trust (OpTrust) in settlement of potential claims related to the effect of the excess share provisions described above. The beneficiary of OpTrust N.A. Holdings Trust is OPTrust Infrastructure N.A. Inc., a wholly owned subsidiary of OPSEU Pension Plan Trust Fund. Equity Financial Trust Company, a corporate trustee, acts as the trustee of OPTrust N.A. Holdings Trust.

 

   

Immediately following the consummation of this offering and immediately before the Merger, our Operating Partnership will issue to Hunt-InfraREIT 1,167,287 OP Units as an accelerated payment of a portion of the carried interest anticipated to be owed to Hunt by our existing investors under the investment documents entered into by the parties in 2010. This portion of the carried interest is being accelerated as a result of negotiations with our founding investors in connection with the

 

 

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Reorganization transactions. To effect the shift in ownership from our existing investors to Hunt, an equal number of OP Units held by InfraREIT, L.L.C. in the Operating Partnership will be cancelled at the same time. This shift will not result in any dilution in the indirect ownership of our Operating Partnership by investors purchasing common stock in this offering.

 

    Immediately following the transactions described in the bullets above, InfraREIT, L.L.C. and InfraREIT, Inc. will engage in the Merger. As a result of the Merger, (1) holders of 5,000,000 common shares of InfraREIT, L.L.C. will receive cash consideration for each such common share equal to the public offering price (less the underwriting discounts and commissions and the underwriter structuring fee) received by us in this offering, (2) holders of the remaining 22,617,755 common shares of InfraREIT, L.L.C. (excluding those held by Westwood Trust, as discussed below) will receive 19,617,755 shares of our Class A common stock and 3,000,000 shares of our redeemable Class A common stock, and (3) holders of 25,145 Class C shares of InfraREIT, L.L.C. will receive 25,145 shares of our Class C common stock. The shares of redeemable Class A common stock will only be issued to the extent the underwriters have not exercised their option to purchase additional shares from us prior to the Merger and will be redeemable by us for consideration per share equal to the public offering price (less the underwriting discounts and commissions and the underwriter structuring fee) per share received by us if the underwriters’ option is exercised at any time after the Merger and prior to the end of the 30-day period following the date of this prospectus.

 

    Each founding investor will receive both cash and stock consideration in the Merger, and all other InfraREIT, L.L.C. shareholders will exclusively receive shares of Class A common stock or Class C common stock in the Merger. InfraREIT, L.L.C. gave each other holder of InfraREIT, L.L.C. common shares the opportunity to receive cash consideration in the Merger and each such holder elected to exclusively receive shares of Class A common stock under the merger agreement. All holders of InfraREIT, L.L.C. Class C common shares, as a separate class, will receive shares of Class C common stock pursuant to the merger agreement.

 

    Immediately following the consummation of this offering and simultaneously with the Merger, InfraREIT will contribute $323.2 million, which is the portion of the net proceeds from this offering not being paid as consideration in the Merger, to the Operating Partnership in exchange for OP Units.

 

    Immediately following the consummation of this offering and simultaneously with the Merger, we will issue 1,551,878 shares of our common stock to Hunt-InfraREIT in exchange for 1,551,878 OP Units tendered for redemption by Hunt-InfraREIT.

 

    Concurrently with the Merger, we will purchase 6,242,999 common shares that are currently held by Westwood Trust in consideration for the issuance of a promissory note to Westwood Trust in the principal amount of approximately $66.5 million.

 

   

Westwood Trust will immediately transfer the promissory note to Marubeni or its designated affiliate as required under InfraREIT, L.L.C.’s limited liability company agreement, and, immediately following receipt of the promissory note, MC Transmission Holdings, Inc., a wholly-owned subsidiary of Marubeni, will purchase 3,325,874 OP Units from the Operating Partnership in consideration for the assignment of the promissory note. The promissory note will then be transferred to us in exchange for the redemption of 3,325,874 OP Units held by us and the

 

 

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subsequent cancellation of such promissory note by us, resulting in no cash consideration having been paid or received by us pursuant to the purchase from Westwood Trust or the sale of OP Units to Marubeni.

 

    Approximately 32 days following the consummation of this offering, we will calculate the unaccelerated portion of the carried interest owed by our existing investors to Hunt to determine whether additional ownership should be shifted from our existing investors to Hunt or whether Hunt received too much ownership in the accelerated payment of a portion of the carried interest described above. The determination will be based upon the cash amounts received by the existing investors in the Merger and the redemption of redeemable Class A common stock if the underwriters’ option to purchase additional shares is exercised as well as the weighted average daily market price of a share of our common stock during the 10 consecutive trading days ending on the 30th day following the completion of this offering. If Hunt is owed additional carry, it will receive additional OP Units from the Operating Partnership and an equal number of shares of Class A common stock and Class C common stock held by our existing investors will be cancelled. If Hunt has received too much carry, it will pay cash to the existing investors in an amount equal to the weighted average market price described above for each OP Unit it received in the advance settlement of the carry to which it would not have otherwise been entitled.

 

    Immediately upon settlement of the unaccelerated portion of the carried interest owed by our existing investors to Hunt as described in the preceding bullet, all remaining shares of Class A common stock, redeemable Class A common stock and Class C common stock will be converted on a one-for-one basis into shares of common stock. No matter how our stock price performs during the 30-day period following this offering, the transactions related to Hunt’s carry will only result in a shift in the economic ownership of the Operating Partnership between Hunt and our existing investors and will not result in any dilution in the indirect ownership of our Operating Partnership by the investors in our common stock in this offering.

 

 

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The following chart shows our organizational structure after giving effect to this offering and the Reorganization (based on the assumptions set forth in the “Explanatory Note” and as further described under “—Reorganization Transactions” above).

 

LOGO

 

 

* Sharyland’s economic interest in SDTS is de minimis, and we do not expect it to result in distributions to Sharyland. Although Sharyland is the managing member of SDTS, we do have certain negative control rights, i.e., Sharyland is prohibited from causing SDTS to take certain actions, such as incurring indebtedness, unless Sharyland obtains our consent. Furthermore, Sharyland has delegated to us some of the related managing member authority and obligations pursuant to a delegation agreement. For a more detailed description of these matters, see “SDTS Company Agreement and Delegation Agreement.”
(1) Includes 28,000 profit interest partnership units in our Operating Partnership (LTIP Units) that will be issued upon the consummation of this offering to the InfraREIT directors, other than David Campbell and Hunter L. Hunt. See “Management—2015 Equity Incentive Plan” and “The Operating Partnership and the Partnership Agreement—Partnership Units.”

 

 

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Corporate Information

InfraREIT, Inc. was formed as a Delaware corporation in 2001 and converted into a Maryland corporation on September 29, 2014. Our Operating Partnership was formed as a Delaware limited partnership on December 16, 2009, and InfraREIT, L.L.C., which was formed as a Delaware limited liability company on October 4, 2010, acquired the general partner interest in our Operating Partnership on November 9, 2010 in connection with our formation transactions. For a detailed description of the Reorganization transactions to be effected in connection with this offering, see “—Our Structure and Reorganization Transactions—Reorganization Transactions.”

Our principal executive offices are located at 1807 Ross Avenue, 4th Floor, Dallas, Texas 75201, and our telephone number is (214) 855-6700. We maintain a website at www.infrareitinc.com. The information contained on our website or that can be accessed through our website neither constitutes part of this prospectus nor is incorporated by reference herein.

 

 

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The Offering

 

Common stock offered by us

20,000,000 shares (plus up to an additional 3,000,000 shares if the underwriters exercise their option to purchase additional shares of our common stock in full) (1)

 

Common stock to be outstanding after this offering

44,014,971 shares (2)

 

Common stock and OP Units to be outstanding after this offering

60,593,728 shares and OP Units (3)

 

Use of proceeds

The proceeds to us from this offering, after deducting underwriting discounts and commissions and the underwriter structuring fee, will be approximately $431.0 million. We will use $107.8 million of the proceeds from this offering to fund the cash portion of the consideration to be issued in the Merger described under “—Our Structure and Reorganization Transactions—Reorganization Transactions.” We will contribute the remaining $323.2 million of the proceeds we receive from this offering to our Operating Partnership in exchange for OP Units.

 

  We expect our Operating Partnership will use the proceeds from this offering that it receives from us (i) to repay an aggregate of approximately $1.0 million of indebtedness to Hunt Consolidated, Inc. pursuant to a promissory note, (ii) to repay indebtedness outstanding under our Operating Partnership’s revolving credit facility and under SDTS’s revolving credit facility, which, as of January 20, 2015, was approximately $72.0 million and $132.0 million, respectively, (iii) to pay offering expenses (other than the underwriting discounts and commissions and the underwriter structuring fee), estimated to be $5.6 million and (iv) for general corporate purposes.

 

Distribution policy

We intend to distribute substantially all of our cash available for distribution, less prudent reserves, through regular quarterly cash dividends. We expect to set our initial quarterly dividend rate at $0.225 per share of common stock, which amount may be changed in the future without advance notice. Our ability to pay the regular quarterly dividend is subject to various restrictions and other factors described in more detail under the caption “Distribution Policy.” We expect to pay a quarterly dividend in the last half of the first month of each fiscal quarter to holders of our common stock of record on or about the last day of the preceding fiscal quarter. We intend to pay a pro-rated dividend with respect to the period commencing from the date shares will be delivered to investors in this offering as set forth on the cover of this prospectus and ending on the last day of the then current fiscal quarter, based on $0.225 per share of common stock for a full quarter.

 

 

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Risk factors

See “Risk Factors” beginning on page 34 and other information included in this prospectus for a discussion of factors you should carefully consider before deciding to invest in our common stock.

 

NYSE ticker symbol

“HIFR.”

 

(1) As described under “—Our Structure and Reorganization Transactions—Reorganization Transactions,” 5,000,000 shares (plus up to an additional 3,000,000 shares if the underwriters exercise their option to purchase additional shares of our common stock in full) are intended to be attributable to sales by existing investors in InfraREIT, L.L.C. However, because those investors will not hold shares of our common stock until the Merger, which occurs immediately following the consummation of this offering, we will issue the shares intended to be attributed to these selling stockholders and the selling stockholders will receive the proceeds from the sale of those shares (less the underwriting discount) as merger consideration in the Merger. In addition, if the underwriters exercise their option to purchase additional shares from us, we will issue those additional shares and all of the proceeds from the sale of those additional shares (less the underwriting discount) will either be paid as additional merger consideration, if the exercise of the option occurs prior to the Merger, or used to redeem shares of our redeemable Class A common stock issued to InfraREIT, L.L.C.’s existing investors in the Merger.
(2) Gives effect to this offering and the Reorganization, including the Merger and the other transactions described under “—Our Structure and Reorganization Transactions—Reorganization Transactions,” based on the assumptions set forth in the “Explanatory Note.”
(3) Consists of (i) 44,014,971 shares of common stock and (ii) 16,578,757 OP Units held by Hunt-InfraREIT, our directors and MC Transmission Holdings, Inc., an affiliate of Marubeni, after giving effect to (x) this offering and the Reorganization, including the Merger and the other transactions described under “—Our Structure and Reorganization Transactions—Reorganization Transactions,” based on the assumptions set forth in the “Explanatory Note” and (y) the issuance of 28,000 LTIP Units to our directors, other than David Campbell and Hunter L. Hunt, upon the consummation of this offering as described under “Management—2015 Equity Incentive Plan.”

 

 

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Summary Pro Forma and Historical Selected Financial Data

The following tables show summary selected financial data on (1) a pro forma basis giving effect to the Pro Forma Adjustments described in the unaudited pro forma condensed consolidated financial statements included elsewhere in this prospectus for InfraREIT, Inc., and (2) a historical basis for InfraREIT, L.L.C. We have not presented summary selected financial data for InfraREIT, Inc. on a historical basis because InfraREIT, Inc. has had limited activity since its formation and because we believe that a discussion of the historical financial condition and results of operations of InfraREIT, Inc. would not be meaningful.

Historically, InfraREIT, L.L.C. followed the guidance included in SEC Staff Accounting Bulletin Topic 1.b. Accordingly, the InfraREIT, L.L.C. historical financial data as of and for the years ended December 31, 2013 and 2012 and for the nine months ended September 30, 2013 reflects all of the costs incurred on our behalf by our external manager for the periods presented. Beginning with the quarter ended June 30, 2014, the guidance in Staff Accounting Bulletin Topic 1.b. no longer applies. As a result, the historical financial data for InfraREIT, L.L.C., as well as the pro forma financial data, for the nine months ended September 30, 2014 does not include all costs incurred by our external manager during that period, but does include our management fees to Hunt Manager as well as the additional costs described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Significant Components of Our Results of Operations—Operating Expenses—General and Administrative.”

The summary pro forma financial data for the nine months ended September 30, 2014 and for the year ended December 31, 2013 has been derived from our unaudited pro forma consolidated financial statements included elsewhere in this prospectus. The InfraREIT, L.L.C. summary historical financial data as of and for the years ended December 31, 2013 and 2012 has been derived from the audited consolidated financial statements included elsewhere in this prospectus. The InfraREIT, L.L.C. summary historical financial data as of September 30, 2014 and for the nine months ended September 30, 2014 and 2013 was derived from the unaudited condensed consolidated financial statements included elsewhere in this prospectus, which include all adjustments, consisting of normal recurring adjustments, that our management considers necessary for a fair presentation of the financial position and the results of operations for such periods under GAAP. The results for the interim periods are not necessarily indicative of the results for the full year. The summary historical financial data is not necessarily indicative of results to be expected in future periods.

 

 

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The following tables should be read together with, and are qualified in their entirety by reference to, the pro forma and historical consolidated financial statements and the accompanying notes appearing elsewhere in this prospectus. Among other things, the pro forma and historical consolidated financial statements include more detailed information regarding the basis of presentation for the information in the following tables. The tables should also be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

   

InfraREIT, Inc.

Pro Forma

   

InfraREIT, L.L.C.
Historical

 
   

Nine Months
Ended
September 30,

2014

   

Year Ended
December 31,

2013

   

Nine Months
Ended
September 30,

   

Years Ended
December 31,

 
       

2014

   

2013

   

2013

   

2012

 
    (in thousands)  
    (Unaudited)     (Unaudited)              

Operating Information

         

Lease revenue

           

Base rent

  $ 76,399      $ 57,979      $ 76,399      $ 35,714      $ 57,979      $ 30,961   

Percentage rent

    12,972        15,214        12,972        7,654        15,214        11,821   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total lease revenue

    89,371        73,193        89,371        43,368        73,193        42,782   

Operating costs and expenses

           

General and administrative expense

    15,875        15,815        12,839        10,262        13,691        12,521   

Depreciation

    25,825        19,536        25,825        12,417        20,024        10,563   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating costs and expenses

    41,700        35,351        38,664        22,679        33,715        23,084   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

    47,671        37,842        50,707        20,689        39,478        19,698   

Other (expense) income

           

Interest expense, net

    (21,171     (17,330     (24,364     (10,764     (17,384     (17,314

Other income, net

    333        20,932        333        19,571        20,932        14,520   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other (expense) income

    (20,838     3,602        (24,031     8,807        3,548        (2,794

Income tax expense

    656        616        656        289        616        336   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

    26,177        40,828        26,020        29,207        42,410        16,568   

Less: Net income attributable to noncontrolling interest

    7,162        11,171        6,046        7,075        10,288        4,151   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income attributable to InfraREIT, Inc. (pro forma) or InfraREIT, L.L.C. (historical)

  $ 19,015      $ 29,657      $ 19,974      $ 22,132      $ 32,122      $ 12,417   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

 

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InfraREIT, Inc.

Pro Forma

   

InfraREIT, L.L.C.
Historical

 
   

Nine Months
Ended
September 30,

2014

   

Year Ended
December 31,

2013

   

Nine Months
Ended
September 30,

   

Years Ended
December 31,

 
       

2014

   

2013

   

2013

   

2012

 
    (in thousands)  
    (Unaudited)     (Unaudited)              

Other Information

         

Cash flows provided by operating activities

    N/A        N/A      $ 67,691      $ 17,943      $ 21,321      $ 15,349   

Cash flows used in investing activities

    N/A        N/A        (170,200     (286,284     (390,283     (361,340

Cash flows provided by financing activities

    N/A        N/A        119,418        287,622        360,266        336,672   

FFO before noncontrolling interest (1)(2)

  $ 52,002      $ 60,364        51,845        41,624        62,434        27,131   

EBITDA before noncontrolling interest (1)(2)

    73,829        78,310        76,865        52,677        80,434        44,781   

Adjusted EBITDA before noncontrolling interest (1)(2)

    73,507        57,496        76,543        33,121        59,620        30,261   

 

(1) Unaudited
(2) For a discussion of FFO, EBITDA and Adjusted EBITDA and a reconciliation to their nearest GAAP counterparts, see “—Non-GAAP Financial Measures.”

 

   

InfraREIT, Inc.

Pro Forma

   

InfraREIT, L.L.C.
Historical

 
   

As of
September 30,

2014

   

As of
September 30,

2014

   

As of
December 31,

 
       

2013

   

2012

 
    (in thousands)  
    (Unaudited)     (Unaudited)              

Balance Sheet

     

Gross property, plant and equipment

    $1,329,577      $ 1,329,577      $ 1,303,828      $ 900,444   

Cash and cash equivalents

    150,921        24,655        7,746        16,442   

Total assets

    1,546,492        1,448,503        1,326,363        928,976   

Short term borrowings and current portion of long-term debt

    19,139        212,639        79,777        11,303   

Long-term debt

    615,367        615,367        627,913        461,565   

Other liabilities

    14,626        24,730        54,480        107,330   

Total liabilities

    649,132        852,736        762,170        580,198   

Total InfraREIT, Inc. stockholders’ equity (pro forma) or InfraREIT, L.L.C. members’ capital (historical)

    645,173        448,293        427,709        257,332   

Noncontrolling interest

    252,187        147,474        136,484        91,446   

Total equity

    897,360        595,767        564,193        348,778   

Total equity and liabilities

    1,546,492        1,448,503        1,326,363        928,976   

 

 

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Non-GAAP Financial Measures

In this prospectus, we use financial measures that are derived on the basis of methodologies other than in accordance with U.S. GAAP. The “non-GAAP” financial measures used in this prospectus include FFO, EBITDA and adjusted EBITDA, all before noncontrolling interest. In this prospectus, when we use the phrase “before noncontrolling interest” to modify net income, FFO, EBITDA or Adjusted EBITDA, we are referring to the applicable amount of net income, FFO, EBITDA or Adjusted EBITDA, in each case before any reduction to such item as a result of the noncontrolling interest in our Operating Partnership. We derive these measures as follows:

 

    The National Association of Real Estate Investment Trusts, or NAREIT, defines FFO as net income (computed in accordance with GAAP), excluding gains and losses from sales of property (net) and impairments of depreciated real estate, plus real estate depreciation and amortization (excluding amortization of deferred financing costs) and after adjustments for unconsolidated partnerships and joint ventures. Applying the NAREIT definition to our financial statements results in FFO representing net income before net income attributable to noncontrolling interest, depreciation, impairment of assets and gain (loss) on sale of assets. FFO does not represent cash generated from operations as defined by GAAP and it is not indicative of cash available to fund all cash needs, including distributions.

 

    We define EBITDA as net income before net income attributable to noncontrolling interest, interest expense (net), income tax expense, depreciation and amortization.

 

    We define adjusted EBITDA as EBITDA adjusted to eliminate the impact of certain items that we do not consider indicative of our core operating performance, including: (a) the financial impact of contingent consideration, (b) AFUDC—equity and (c) change in fair value of derivatives.

Our management uses FFO, EBITDA and adjusted EBITDA all before noncontrolling interest as important supplemental measures of our operating performance. We use these metrics before noncontrolling interest as we feel it is important to evaluate our entire consolidated business. These performance measures provide perspectives not immediately apparent from net income. We consider FFO to be an important supplemental disclosure of operating performance for an equity REIT due to their widespread acceptance and use among REITs. In addition, we believe that FFO, EBITDA and adjusted EBITDA are frequently used by securities analysts, investors and other interested parties in the evaluation of REITs.

We offer these measures to assist the users of our financial statements in assessing our operating performance under GAAP, but these measures are non-GAAP measures and should not be considered measures of liquidity, alternatives to net income or indicators of any other performance measure determined in accordance with GAAP, nor are they indicative of funds available to fund our cash needs, including capital expenditures, make payments on our indebtedness or make distributions. However, our method of calculating these measures may be different from methods used by other companies and, accordingly, may not be comparable to similar measures as calculated by other companies that do not use the same definition or implementation guidelines or interpret the standards differently from us. Investors should not rely on these measures as a substitute for any GAAP measure, including net income, cash flows provided by operating activities or revenues.

 

 

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FFO

The following table sets forth a reconciliation of net income attributable to InfraREIT to FFO before noncontrolling interest for the periods presented:

 

   

InfraREIT, Inc.

Pro Forma

   

InfraREIT, L.L.C.

Historical

 
   

Nine Months Ended

September 30,

2014

   

Year Ended

December 31,

2013

   

Nine Months Ended
September 30,

   

Years Ended
December 31,

 
       

2014

   

2013

   

2013

   

2012

 
    (Dollars in thousands)  

Net income attributable to InfraREIT, Inc. (pro forma) and InfraREIT, L.L.C. (historical) (1)

  $ 19,015      $ 29,657      $ 19,974      $ 22,132      $ 32,122      $ 12,417   

Net income attributable to noncontrolling interest

    7,162        11,171        6,046        7,075        10,288        4,151   

Depreciation

    25,825        19,536        25,825        12,417        20,024        10,563   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

FFO before noncontrolling interest

  $ 52,002      $ 60,364      $ 51,845      $ 41,624      $ 62,434      $ 27,131   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Net income of InfraREIT, Inc. (pro forma) reflects the impact of straight-line rents as follows: $(4.9) million for the nine months ended September 30, 2014 and $1.4 million for the year ended December 31, 2013. Net income of InfraREIT, L.L.C. (historical) reflects the impact of straight-line rents as follows: $(4.9) million for the nine months ended September 30, 2014, $4.0 million for the nine months ended September 30, 2013, $1.4 million for the year ended December 31, 2013 and $0.4 million for the year ended December 31, 2012.

EBITDA and Adjusted EBITDA

The following table sets forth a reconciliation of net income attributable to InfraREIT to EBITDA before noncontrolling interest and Adjusted EBITDA before noncontrolling interest for the periods presented:

 

   

InfraREIT, Inc.

Pro Forma

   

InfraREIT, L.L.C.

Historical

 
   

Nine Months Ended

September 30,

2014

   

Year Ended

December 31,

2013

   

Nine Months Ended
September 30,

   

Years Ended
December 31,

 
       

2014

   

2013

   

2013

   

2012

 
    (Dollars in thousands)  

Net income attributable to InfraREIT, Inc. (pro forma) and InfraREIT, L.L.C. (historical) (1)

  $ 19,015      $ 29,657      $ 19,974      $ 22,132      $ 32,122      $ 12,417   

Net income attributable to noncontrolling interest

    7,162        11,171        6,046        7,075        10,288        4,151   

Interest expense, net

    21,171        17,330        24,364        10,764        17,384        17,314   

Income tax expense

    656        616        656        289        616        336   

Depreciation

    25,825        19,536        25,825        12,417        20,024        10,563   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

EBITDA before noncontrolling interest

    73,829        78,310        76,865        52,677        80,434        44,781   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Change in fair market value of contingent consideration

    1,110        841        1,110        —          841        753   

Allowance for funds used during construction—equity

    (1,432     (21,655     (1,432     (19,556     (21,655     (15,273
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted EBITDA before noncontrolling interest

  $ 73,507      $ 57,496      $ 76,543      $ 33,121      $ 59,620      $ 30,261   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Net income of InfraREIT, Inc. (pro forma) reflects the impact of straight-line rents as follows: $(4.9) million for the nine months ended September 30, 2014 and $1.4 million for the year ended December 31, 2013. Net income of InfraREIT, L.L.C. (historical) reflects the impact of straight-line rents as follows: $(4.9) million for the nine months ended September 30, 2014, $4.0 million for the nine months ended September 30, 2013, $1.4 million for the year ended December 31, 2013 and $0.4 million for the year ended December 31, 2012.

 

 

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RISK FACTORS

An investment in shares of our common stock involves a high degree of risk. Before making an investment decision, you should carefully consider the following risk factors, together with the other information contained in this prospectus. If any of the risks discussed in this prospectus occurs, our business, financial condition, liquidity and results of operations could be materially and adversely affected. If this were to happen, the price of our common stock could decline significantly and you could lose a part or all of your investment.

Risks Related to Our Business

Our business model and growth strategy depends on our ability to grow our rate base and lease revenue.

We will not be able to increase our lease revenue significantly unless the rate base of our T&D assets grows. We expect to increase our rate base by funding Footprint Projects, acquiring ROFO Projects and other T&D assets from Hunt and acquiring T&D assets from third parties. Our development agreement with Hunt Developer distinguishes between Footprint Projects, which under the agreement are T&D assets that are in the geographic footprint of our existing distribution assets or that are added to our existing transmission assets and that we own and fund, and ROFO Projects, which are certain specified T&D projects being developed by Hunt. Our ability to grow our rate base and revenues in the manner we expect depends on Footprint Projects meeting or exceeding our capital expenditure budgets, Hunt’s ability to develop and construct ROFO Projects and our ability to acquire ROFO Projects or other T&D assets from Hunt or third parties on acceptable terms. The amount of available investment in Footprint Projects and ROFO Projects depends on a number of factors. For instance:

 

    Our 2015 and forward capital expenditure projections incorporate our estimates of the potential impact of the recent oil price decline on demand in our service territories and our T&D investment in Footprint Projects. If the oil price declines continue, or if oil and gas producers, pipeline and processing companies and other service providers in West Texas respond with more significant reductions in their ongoing investments than we currently estimate, the load growth in our service territory in and around Stanton, Texas would be negatively impacted and our T&D investment in Footprint Projects in this territory would be less than we expect, particularly in 2017 and beyond. Furthermore, in a low oil price environment in which overall economic growth in Texas is reduced, Hunt’s ability to develop and construct additional ROFO Projects in Texas (other than the Cross Valley transmission line and the GSEC interconnection, which are under construction) may be adversely impacted, as there may be less need for new transmission investment.

 

    Both Footprint Projects and ROFO Projects will be adversely affected if electricity generators, particularly wind generators, in and near the Texas Panhandle do not request connection to our Panhandle transmission facilities or do not follow through on existing interconnection requests, or if ERCOT or the PUCT determines that generators, and not transmission service providers, should fund the construction of generation interconnects. The number and amount of these requests depends in large part on the viability and success of wind generators in the Texas Panhandle, which in turn depends on a number of factors that are outside of our control, including the economics of wind generation generally and in the ERCOT market in particular, the availability of the production tax credit for wind generators, which currently applies only to projects that began substantial construction before December 31, 2013, customer demand for generation, the availability of wind generation from other geographical regions and the price of natural gas.

 

   

Although our right of first offer with Hunt applies to certain ROFO Projects that are in earlier stages of development, there are ROFO Projects currently under development or construction that are relatively important to our rate base growth plans. We refer to these projects as the Cross Valley transmission line and the GSEC interconnection, and they are described in more detail in “Business and Properties—Project Development—ROFO Projects.” Both projects are permitted and the Cross

 

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Valley transmission line is currently under construction, but there is no assurance that either project will be completed. Even if these projects are completed and become operational, there is no assurance that we will be able to negotiate for their acquisition on acceptable terms.

 

    Additional T&D project development opportunities, including some of the ROFO Projects, will likely be adversely affected if population and cross-border trade in South Texas, including in our territory in and around McAllen, Texas, do not grow at the rates we anticipate.

If our forecasts regarding Footprint Project and ROFO Project capital needs prove to be inaccurate, it could have a material adverse effect on our financial condition and results of operations.

Demand for electricity in our territories, in particular our territory in and around Stanton, Texas, has been growing rapidly, which makes forecasting capital expenditures more difficult than it would be in a utility with more consistent growth. Because we expect oil and gas drilling activities, along with related investments in processing facilities, pipelines and other supporting services and activities, to drive a substantial portion of the demand growth in this territory, recent oil price decreases and volatility compound these forecasting challenges. In many circumstances, the accuracy of forecasting our capital needs depends on whether or not existing and potential customers follow through on their planned facilities. We expect these forecasting challenges will continue, not only in our Stanton, Texas territory but also with respect to capital needs related to requests from generators to connect to our Panhandle transmission assets and with respect to other aspects of our capital expenditures plan. These difficulties affect both our ability to project capital expenditures for our Footprint Projects and Hunt’s ability to project its capital expenditures for ROFO Projects. Our forecasting difficulties are compounded by uncertainty regarding the acquisition cost of a ROFO Project, which we will not know with any level of certainty until we negotiate the terms of any such acquisition or whether we will be able to negotiate an acquisition. If, for these or other reasons, we are unable to forecast our capital needs accurately, our financial condition and stock price could be adversely affected. For instance, if our capital needs are significantly more than budgeted, we may need to raise debt or equity capital to meet our obligations, which we may not be able to do on favorable terms or at all. If we are unable to obtain the debt or equity financing to satisfy our capital expenditure demands, we may not be able to meet our capital expenditure obligations under our leases. If our forecasts prove to be inaccurate and capital needs are less than budgeted, we will likely have an inefficient capital structure or excess cash, and our growth would be less than we expect, which would adversely affect our financial condition, results of operations and our ability to make distributions to our stockholders.

We may not be able to make cash distributions to holders of our common stock comparable to our anticipated initial annual distribution rate or achieve our target growth rate of cash available for distributions to holders of our common stock.

We intend to make regular quarterly cash distributions to holders of our common stock. The amount of our cash available for distribution principally depends upon the amount of cash we generate from our operations, which may fluctuate from quarter to quarter based on, among other things:

 

    the level and timing of capital expenditures we make;

 

    Hunt’s development and construction of ROFO Projects and other T&D projects and our ability to acquire those T&D assets;

 

    the amount of any cash management fees we pay Hunt Manager under the management agreement, as well as any third party expenses for which we are directly responsible;

 

    our debt service requirements and other liabilities;

 

    fluctuations in our working capital needs;

 

    our ability to borrow funds and access capital markets;

 

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Table of Contents
    restrictions contained in the agreements governing our indebtedness;

 

    lease payments actually received; and

 

    other business risks affecting our cash levels.

As a result of all these factors, we cannot guarantee that we will have sufficient cash generated from operations to pay a specific level of cash distributions to holders of our common stock.

Because all of our lease revenues are currently generated by lease payments from Sharyland, our business, financial condition, results of operations and cash flows are dependent on Sharyland’s financial and operating performance.

Our tenant’s ability to make lease payments to us under our leases is subject to its ability to generate cash flows or raise additional capital sufficient to support its obligations. Our tenant’s financial and operating performance is subject to the following risks, as well as other risks identified in this prospectus and those that we are not currently aware of, that could adversely affect its financial and operating performance and, as a result, its ability to make lease payments to us:

 

    Although Sharyland reported net income during the nine months ended September 30, 2014, both on a GAAP basis and on a management-reported basis, Sharyland has historically incurred both GAAP and management-reported losses. For a discussion of our tenant’s management-reported net loss and a reconciliation to net income (loss), its nearest GAAP counterpart, see “Financial Information Related to Our Tenant.” These losses were largely due to its lease payment obligations to us, the rapid growth of demand in its service territory and the development of new systems and system upgrades from the business acquired in the Cap Rock acquisition in 2010. If our tenant were to operate at a loss in future years, and if it is unable to obtain debt or equity capital to fund its cash needs, its financial condition and liquidity may suffer.

 

    Our tenant’s rates are regulated by the PUCT. It must file a full rate proceeding with the PUCT in order to increase its rates to reflect higher operation and maintenance expense. Therefore, if its expenses increase rapidly, including for reasons outside of its control, our tenant’s revenues may not be sufficient to cover its expenses. Our anticipated growth in rate base during the next few years will exacerbate this risk, making it more likely that our tenant’s expenses will increase before it may increase its rates through a rate proceeding.

 

    If the PUCT determines that capital expenditures were not reasonable and necessary, recovery of such expenditures would not be included in our tenant’s tariff rates. Further, if our tenant is found to have imprudently incurred capital expenditures that were subject to a prior interim TCOS or DCRF filing, it could be required to refund the return it had received on those capital expenditures. Although such determinations would adversely impact our tenant’s results of operations and liquidity and would decrease the amount of percentage rent owed, they would not affect its obligations to make base rent payments to us.

 

   

The amount of percentage rent that we generate is based on Sharyland’s revenues. If Sharyland’s revenue growth rate is lower than we expect, we will not generate the percentage rent we expect. Sharyland’s revenue growth depends on a number of factors, including the frequency and results of rate case filings and customer, load and kWh growth in Sharyland’s service territories, including in our Stanton service territory, which are in turn impacted by a number of factors, including the pace of oil and gas activity in the Permian Basin. Furthermore, if Sharyland’s load growth in its distribution service territories is lower than we expect, Sharyland may be required to file rate cases more frequently than we expect in order to generate revenue sufficient to pay its lease payments and

 

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Table of Contents
 

other expenses, which would increase the regulatory risk associated with our revenue, profitability and financial condition forecasts.

 

    When we negotiate our lease terms with our tenant, we make assumptions about the amount of tariff revenue the related assets will generate. Those assumptions may be incorrect, and, even if they are correct when made, the facts that informed those assumptions may change over time. Such changes could impose lease payment obligations on our tenant that are not matched to its revenue.

 

    Compliance with U.S. federal, state and local laws and regulations may cause our tenant to incur additional operating costs. In addition, failure to comply with these requirements could result in the imposition of liens, fines, civil or criminal liability and/or indemnification obligations that would significantly increase our tenant’s operating expenses.

If our tenant experiences declines in its financial and operating performance, it may request discounts or deferrals on its lease payments to us or seek to terminate its leases with us, which would decrease the amount of lease revenue we receive from it. Decreases in the amount of lease revenue received from our tenant would adversely affect our business, financial condition, results of operations and cash flows.

The occurrence of a bankruptcy or insolvency by Sharyland could diminish the lease revenue we receive from our lease agreements with Sharyland, increase our financial obligations and cause acceleration of our debt.

Our leases include a provision permitting us to terminate the leases in the event of a bankruptcy by our tenant. However, should our tenant become a bankruptcy debtor, the bankruptcy court could declare that provision unenforceable or, if we do not terminate the lease, may permit our tenant to assume or reject any or all of our lease agreements, which Sharyland may be permitted to select at its option. If assumed, any past due amounts owing to us would be cured. If rejected, the rejection will be a breach of the particular lease or leases so rejected, and we would attempt to either renegotiate the lease with our tenant or identify an alternate tenant. Any new lease with an alternate tenant would require PUCT approval, including PUCT approval of the transfer of our tenant’s operating licenses to a new tenant. Pending our tenant’s decision, the bankruptcy laws require it to pay its post-bankruptcy rental obligations to us in full when due. Depending upon the sufficiency of assets available to pay claims, a rejection of the leases in bankruptcy or an insolvency of Sharyland could ultimately preclude full collection of sums due us under our lease agreements with our tenant. Furthermore, the agreements governing our indebtedness consider it a default if our tenant becomes bankrupt, which would automatically accelerate our indebtedness, or if our tenant is not the lessee of our assets, which could result in the acceleration of such indebtedness.

In addition, our leases are net leases and as such require that our tenant pay for repairs, maintenance, ad valorem or property taxes and other assessments levied on our T&D assets. See “Business and Properties—Our Tenant—Our Leases.” Many of these costs are both significant and payable in arrears. If not previously paid by our tenant, the default or bankruptcy of our tenant would likely place the financial burden for these accrued costs on us without any corresponding ability on our part to either transfer the obligation for these costs to a new tenant, recoup these costs from third parties or otherwise avoid paying these costs. To the extent any such events occur, our financial condition and results of operations may likely be adversely affected.

We have not yet negotiated lease payments with respect to substantially all of the capital expenditures that we expect to fund during the next several years, and our leases expire at various times between 2015 and 2022. There is no assurance that new negotiations will result in lease payments that are higher than or comparable to the lease payments we expect under our current leases.

From time to time, we negotiate rent supplements under our leases related to capital expenditures we fund to provide us with a return on such capital expenditures over time. Additionally, under the terms of our development agreement, we are required to give Sharyland a right of first offer to lease any assets we acquire or develop, subject

 

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to limited exceptions. If we and Sharyland are unable to agree on lease terms, we will only be able to lease the assets to other tenants on terms that are more favorable to us than Sharyland’s best offer. Historically, we and Sharyland have negotiated rent payments intended to provide us with approximately 97% of the projected regulated return on rate base investment attributable to our assets. The amount of the rent increase related to a supplement is subject to negotiation each time a supplement is agreed to, but our existing leases provide that our historical agreements with our tenant will serve as the basis for the rental rate increase or new rent payments, subject to limited factors that can affect the negotiation, including the rate of return that utilities in the State of Texas are generally earning at the time of the relevant negotiation. See “Business and Properties—Our Tenant—Our Leases—Supplements” for a description of the manner in which this supplement process operates and “Business and Properties—Our Revenue Model” for an explanation of how these rents are derived. Because we expect significant capital expenditures during the next several years, the results of these negotiations will affect a significant portion of the lease revenue we expect during the next several years. There is no assurance that the results of these negotiations will result in returns on these capital expenditures that are higher than or comparable to the returns we expect as a result of our tenant’s current lease obligations.

Furthermore, the lease relating to less than 25% of our existing assets expires on December 31, 2015, and leases relating to our remaining assets expire at various times between December 31, 2019 and December 31, 2022. There is no assurance that the lease payments in any renewals of these leases, or in any new lease with a different tenant, will be higher than or comparable to the payments we expect under our current leases. If we are unable to negotiate lease payments that are higher than or comparable to the lease payments we expect under our current leases, our financial condition, results of operations and cash flows will be negatively impacted.

Our structure and the terms of our leases with our tenant limit our control over SDTS and our T&D assets.

Sharyland, as the managing member of our subsidiary, SDTS, has the exclusive power and authority on behalf of SDTS to manage, control, administer and operate the properties, business and affairs of SDTS in accordance with the limited liability company agreement governing SDTS, subject to a variety of negative control rights in favor of our wholly-owned subsidiary Transmission and Distribution Company, L.L.C., or TDC, and a delegation agreement with us. See “SDTS Company Agreement and Delegation Agreement—Delegation Agreement.” TDC owns substantially all of the economic interest in SDTS. Nevertheless, our management and board of directors is limited in their ability to exert control over SDTS and our T&D assets. This arrangement also complicates any decision by our board of directors not to renew or terminate our leases with our tenant.

In addition, under the terms of our leases, our tenant is responsible for, and fulfills, substantially all of the operational functions that, in an integrated utility, would be controlled and directed by the owner of the T&D assets. These functions include repairing and maintaining the T&D assets leased from us, planning new T&D projects, forecasting capital expenditures, handling customer billing and complaints, handling community relations matters, accounting for substantially all of the utility’s operations and maintenance costs, cybersecurity, construction management, handling environmental and regulatory matters (including maintaining various regulatory certifications) and all other matters related to the operation of the utility. While we have influence over the manner in which our tenant provides these functions pursuant to the terms of our leases and through Hunt Manager’s working relationship with Sharyland, we do not control our tenant and, as a result, do not have the same level of control as a similarly situated owner of T&D assets in an integrated utility. As a result, even if we believe that our T&D assets are not being operated efficiently or effectively, we may not be able to require our tenant to change the way it operates them and our financial condition and results of operations may be adversely affected.

Further, due to the interrelated nature of our relationships with Sharyland, Hunt, Hunt Manager and Hunt Developer, conflicts of interests may arise between us and Sharyland when negotiating our leases or in Sharyland’s operation of the assets under our leases. In addition, any negative change in our relationships with Sharyland, Hunt, Hunt Manager or Hunt Developer could negatively impact the other relationships. Accordingly, the negotiations and agreements between us and these entities and their affiliates and the development of our assets under our leases may not reflect the best interests of our stockholders.

 

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Changes in technology may reduce the value of our T&D assets and could adversely affect our business.

Research and development activities are ongoing to improve existing and alternative technologies to produce electricity, including advancements related to self-generation and distributed energy technologies such as gas turbines, fuel cells, microturbines, photovoltaic (solar) cells and concentrated solar thermal devices. It is possible that advances in these or other technologies will reduce the costs of electricity production from these technologies to a level that will enable these technologies to compete effectively with traditional generation plants. Self-generation itself may exacerbate these trends by reducing the pool of customers, subject to certain regulatory limits, from whom fixed costs are recovered, while potentially increasing costs of system modifications that may be needed to integrate the systemic effects of self-generation. To the extent self-generation facilities become a more cost-effective option for certain customers, T&D investment opportunities generally may decrease, adversely affecting our growth plans, and our tenant’s financial and operating performance may be adversely impacted, which in turn would decrease the amount of percentage rent our tenant owes us and may lead it to request discounts or deferrals on its lease payments to us or seek to terminate its leases with us. Decreases in the amount of lease revenue received from our tenant would adversely affect our business, financial condition, results of operations and cash flows.

Failure to renew a lease with Sharyland upon its expiration, or any decision to terminate a lease as a result of a material breach thereof by Sharyland, would be complicated and costly and could adversely affect our operating results, financial condition and relationship with regulators and ratepayers.

The lease relating to less than 25% of our existing assets, which we refer to as the S/B/C Lease, expires on December 31, 2015, and leases relating to our remaining assets expire at various times between December 31, 2019 and December 31, 2022. We have the right to terminate our leases if Sharyland breaches those leases by, for example, failing to pay us rent when that rent is due, after applicable grace periods. However, for a variety of reasons, terminating the leases, or entering into a new lease with a different tenant following expiration of our leases with Sharyland, would be complex and costly. Under our leases, Sharyland may not cease to be the operator of the T&D assets at any time, including upon termination or expiration of the leases, without first acquiring any necessary regulatory approvals from the PUCT and other regulatory bodies, including PUCT approval of the transfer of Sharyland’s operating licenses to a new tenant. As a result, Sharyland will continue to operate the T&D assets subject to the lease while we, Sharyland and the new tenant are obtaining these regulatory approvals. If we are terminating a lease because we believe that Sharyland has materially breached the lease, and Sharyland is contesting our right to terminate the lease, it would be difficult to obtain the necessary regulatory approvals to substitute a new tenant unless we can demonstrate that Sharyland was no longer capable of providing adequate service. We also must obtain approval under our debt agreements if we desire to terminate a lease, and if we terminate a lease with Sharyland without such approval, we would be in default under our debt agreements, which could result in the acceleration of any outstanding indebtedness thereunder. In addition, transfer of operational control of the related T&D assets from Sharyland to a new tenant could also be complicated, and problems associated with this transfer could adversely affect our results of operations and financial condition. For instance, if our tenant is in the process of constructing a Footprint Project, we would either have to transition responsibility for constructing that Footprint Project to the new tenant or negotiate for Sharyland to complete its construction of such project which could be costly. Any decision to not renew or terminate our leases with our tenant is also complicated by Sharyland’s position as the managing member of SDTS. See “SDTS Company Agreement and Delegation Agreement.” In addition, at the time a lease terminates, Sharyland may be a tenant under another lease with us that has not terminated, and we may be parties to a management agreement with Hunt Manager and a development agreement with Hunt Developer. We may choose not to terminate a lease, or not to enforce or to enforce less vigorously any rights we may have against Sharyland under a lease, because of our desire to maintain these other relationships with Sharyland or Hunt. The complexities associated with terminating a lease with Sharyland, or entering into a lease with a different tenant upon expiration of a Sharyland lease, could make us less likely to choose to do so, even if we would prefer a new tenant, which could adversely affect our operating results, financial condition and relationships with regulators and ratepayers.

 

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If we decided to replace Sharyland as the tenant under our leases, we may have trouble identifying a new tenant that will agree to acceptable lease terms.

If we determine that a renewal of a lease with Sharyland is not in the best interests of our stockholders, if Sharyland determines it no longer wishes to be the tenant under a lease upon its expiration or if we desire to terminate a lease as a result of a breach of that lease by Sharyland, in each circumstance we would need to identify a new tenant for the lease. Any new tenant would need to be a qualified and reputable operator of T&D assets with the wherewithal and capability of acting as our tenant. Furthermore, in many such circumstances any new tenant of a significant portion of our assets would need to be willing and able to make their financial statements public and agree to timely provide us with those financial statements in order for us comply with our obligation to include our tenant’s financial statements in the periodic reports we file under the Securities Exchange Act of 1934, as amended (Exchange Act). There is no assurance that we would be able to identify a tenant that meets these criteria, or that if we are able to identify any such tenant, we would receive lease terms from a new tenant that are as favorable as the existing lease terms with Sharyland.

Our growth plan will continue to subject us to risks involved in single tenant leases.

We intend to focus our development and acquisition activities on real properties that are net leased to single tenants. If we are able to successfully implement our growth plan and develop and acquire infrastructure assets outside of Texas, we may enter into leases with counterparties other than Sharyland. Furthermore, we may develop and acquire assets in Texas that we lease to tenants other than Sharyland. However, even if this growth plan is implemented, it is likely that we will continue to rely on a small number of third-party tenants for all or substantially all of our revenue. Therefore, we expect that our business, financial condition and results of operations will continue to be subject to the concentration risks associated with a small number of tenants.

Our T&D assets and our tenant’s operations are subject to governmental regulation and oversight that could adversely impact our expected returns and operating results, and we rely upon our tenant to manage these matters.

Under the terms of our leases, our tenant is responsible for all of the regulatory matters associated with our T&D assets, including determining whether the capital expenditures we fund are reasonable and necessary, complying with regulatory, environmental and safety matters and interfacing with various regulatory bodies.

Our tenant’s rates are regulated by the PUCT and are subject to cost-of-service regulation and annual earnings oversight. Although rate regulation is premised on the timely recovery of prudently incurred costs and the opportunity to earn a reasonable rate of return on invested capital, there is no assurance that the PUCT will determine that all of our rate base can be recovered through our tenant’s rates, or that the PUCT will not otherwise make regulatory determinations that adversely affect our T&D assets or our tenant. The PUCT could determine that capital expenditures were not reasonable and necessary, and that recovery of such expenditures should not be included in our tenant’s rates, or the PUCT could challenge other regulatory judgments that our tenant makes, such as those related to affiliate charges, operations and maintenance expenses, tax elections, rate case expenses, regulatory assets and other matters. While these determinations would not affect our tenant’s previously negotiated rent obligations to us, they could adversely affect our tenant’s ability to meet its obligations generally, including its obligations to pay us rent pursuant to the leases. Furthermore, if the PUCT made a determination that adversely affected our rate base, and as a result our tenant were unable to meet its rent obligations to us and we terminated the related lease, it is unlikely that the replacement tenant would be willing to pay us rent for anything other than the PUCT-approved rate base amount. Also, if the PUCT makes a determination that adversely affects the amount of our rate base, we may need to take accounting charges that impair our assets, which could further adversely affect our results of operations and financial condition.

 

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We and our tenant are subject to periodic rate cases. In connection with the 2014 rate case settlement, Sharyland agreed to bring another rate case during 2016 based on a 2015 test year. The outcome of the 2016 rate case is unknown, but if Sharyland’s rates are reduced or if existing regulatory parameters are reduced, our lease revenue, and the fair market value of our T&D assets, will be adversely affected.

In addition, our T&D assets and our tenant’s operations are subject to U.S. federal, state and local laws and regulation, including laws and regulations related to regulatory, environmental and human health and safety matters. We generally rely on our tenant to ensure compliance with these laws and rules, and, generally, our tenant is required under our leases to remedy the effect of any non-compliance during the term of the applicable lease. Compliance with the requirements under these various regulatory regimes may cause us or our tenant to incur significant additional costs, and failure to comply with these requirements could result in the shutdown of the non-complying assets, the imposition of liens, fines and/or civil or criminal liability. Utility operations may also be affected by legislative and regulatory changes, as well as changes to market design, market rules, tariffs and cost allocation by ERCOT, the PUCT or FERC. Further, for regulatory reasons, we may be forced to sell certain of our assets or to swap assets with another utility in order to improve service performance. We cannot predict what effect any such changes in the regulatory environment will have on us or on Sharyland’s operations. Furthermore, under some of our leases, we indemnify our tenant for environmental liabilities that materialized prior to the date we acquired the property. Although in some instances we are indemnified by the prior owner of such property, any material expenditures, fines or damages that we must pay, including pursuant to the indemnity given to our tenant, would adversely affect our results of operations and financial condition.

Our growth depends in part on Hunt’s ability to develop and construct ROFO Projects and other T&D assets and our acquisition of all or a significant interest in such assets at a price that is accretive to our stockholders.

We have a right of first offer with respect to ROFO Projects during the term of the development agreement with Hunt Developer. We also expect that Hunt will continue to pursue additional development opportunities for T&D projects and that we will have an opportunity to acquire those in the future. However, we do not have the right to require Hunt Developer to pursue the development and construction of any such projects, and Hunt Developer’s development team may not be successful in identifying additional projects that are attractive investments. Furthermore, we may not be able to reach agreement on the purchase price and other terms of the acquisition of ROFO Projects or any other T&D projects. If we are unable to reach agreement on the terms of the acquisition of a ROFO Project, we will not have the right to prohibit Hunt or Sharyland from operating the T&D assets for its own benefit or from selling the assets to another third party on terms no less favorable than those offered by us. If Hunt does not develop ROFO Projects that are attractive to us, or if we are unable to agree upon the terms of the acquisition of ROFO Projects, we will not experience the rate base and lease revenue growth we expect.

Also, Hunt may not be able to sell to us a ROFO Project even if we agree with Hunt on the price and other terms of the sale. Hunt intends to finance the development of ROFO Projects through development companies in which certain of our founding investors will have the opportunity to invest capital. Hunt may require those investors to sell their interests in the ROFO Projects only if the consideration payable would result in the investors receiving at least 1.5 times the amount of equity capital they invested; we generally expect this threshold to translate into a purchase price equal to at least approximately 1.25 times the rate base for the related assets, though the actual ratio will depend on the financing structure used on each development project. If the price does not meet this threshold, the sale of the ROFO Project will require the approval of Hunt and at least two of our founding investors in such project. There can be no assurance that the price for which we are willing to purchase a ROFO Project will satisfy that return threshold and, if we fail to satisfy such threshold, that the investors will otherwise agree to sell their interests in the ROFO Project.

The development agreement is coterminous with the management agreement and will expire effective upon the termination of the management agreement. Accordingly, if either we or Hunt Manager decide not to renew or to terminate the management agreement pursuant to its terms, we will no longer have rights to the ROFO Projects.

 

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Our growth, financial condition and results of operations would be negatively impacted if the PUCT, the FERC or other utility commissions outside of the State of Texas determine that a utility that leases its regulated assets from a REIT should not benefit from an income tax allowance.

In determining an electric utility’s tariff, part of the cost of service is an income tax allowance, or ITA. Either the FERC or a state utility commission first determines the appropriate investment return for the utility and then grosses up the return to cover the taxes imposed on the utility’s income. An ITA for a C corporation is well established.

The FERC’s current policy on ITAs for pass-through entities is set forth in its 2005 Policy Statement on Income Tax Allowances, which provides that a partnership, which is a pass-through entity for tax purposes, that owns regulated utility assets can receive an ITA in its rates so long as the partnership can demonstrate that its partners (or owners of the partners) have actual or a potential income tax liability for the income generated by the regulated utility. If the partners in the partnership do not pay taxes (i.e., municipalities) then no ITA will be granted. The ITA of a pass-through entity will be determined in a rate case proceeding by the weighted marginal tax rate of the owning partners. Pass-through entities that the FERC has considered include master limited partnerships, limited liability companies and Subchapter S corporations. So long as InfraREIT qualifies as a REIT, it may claim a deduction for dividends it pays its stockholders in calculating its taxable income. Otherwise, InfraREIT pays tax as a C corporation. InfraREIT does not own utility property directly, but instead invests in utility assets indirectly through its Operating Partnership. The Operating Partnership is a limited partnership and is therefore a pass-through entity. We believe that each of its partners (InfraREIT, Hunt-InfraREIT and other limited partners) has actual or potential income tax liability, and that, as such, an ITA is appropriate under current FERC policy. However, while the FERC approved our acquisition of Cap Rock in 2010 with an ownership structure in which the FERC-regulated assets were held through a lease, the approval did not explicitly address whether an ITA would be allowed in our structure. Although we believe that the same question is now a matter of settled law in Texas, there can be no assurance that the law will not change. In addition, we are also targeting regulated infrastructure assets in jurisdictions outside of Texas, some of which have addressed pass-through entities, but none have explicitly addressed how an ITA would apply to our structure. If these jurisdictions determine that a utility that leases its regulated assets from a REIT should not benefit from an ITA, the regulated rates will be lower and our growth plan related to developing or acquiring assets in these jurisdictions may be adversely affected.

Our REIT structure may pose challenges to our ability to acquire infrastructure assets, and our inability to successfully acquire infrastructure assets would adversely affect growth in our asset base.

Because we intend to continue to qualify as a REIT, a limited amount of our revenues can be generated from non-qualifying sources. See “Material Federal Income Tax Consequences—Taxation of the Company—Requirements for Qualification as a REIT—Gross Income Tests.” As a result, a component of our growth strategy is to acquire qualifying REIT assets and lease them to third parties with the personnel and expertise to operate these assets, which we refer to as the lessor/lessee structure. The lessor/lessee structure poses a number of challenges to our ability to acquire additional T&D assets, including:

 

    regulatory agencies in many jurisdictions are unfamiliar with our lessor/lessee structure, which could result in greater regulatory scrutiny or longer regulatory approval processes in connection with any proposed acquisition of REIT qualifying assets and, in some circumstances, may cause the regulatory agency to withhold approval for any such acquisition;

 

    the acquisition of a business by us would require us either to acquire only the REIT qualifying assets or to separate the assets of the business between us and a third party tenant;

 

    if a target business owns both REIT qualifying assets, such as T&D assets, and non-qualifying assets, such as generation assets, we may need to dispose of the non-qualifying assets or hold those assets in a taxable REIT subsidiary, which could complicate and delay the acquisition or lower our expected returns from such acquisition;

 

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    transaction structures would require us to either lease the acquired assets back to the seller of the assets, which the seller may not prefer, or to identify a third party lessee that is willing to operate the assets as a tenant and assume the related risks and rewards, which may be difficult;

 

    we may not be able to negotiate favorable rent and other terms with third-party lessees;

 

    publicly traded utilities who are potential sellers of T&D assets to us may be hesitant to lease those assets back from us because of the potential failed sale-leaseback accounting repercussions of such transactions and the potential related negative credit impacts; and

 

    the complexity involved in separating the REIT-qualifying assets from the assets associated with the operation of the business may take additional management time and resources, challenge our ability to successfully integrate the acquisition and cost more than an acquisition by a conventional utility would in most circumstances; in addition, selling the operating assets may result in gain on sale and an associated tax cost of separating the assets.

As a result of these and other challenges, some sellers may prefer other potential buyers even in situations where we have agreed to pay comparable consideration. Our inability to acquire additional REIT-qualifying assets would limit our ability to execute on our growth strategy and would adversely affect our results of operations.

Acquisitions of T&D assets, including ROFO Projects, could divert time and resources and may not result in the benefits anticipated, which would adversely affect our financial condition and results of operations.

Future acquisitions could divert time and focus from operating our business. Integrating acquired assets may also result in unforeseen operating difficulties and expenditures. We may not accurately assess the value or prospects of acquisition candidates, and the anticipated benefits from our future acquisitions may not materialize. We expect the purchase price for any ROFO Projects will be negotiated by our Conflicts Committee and Hunt based on a number of factors. Such purchase price may include a premium to rate base, however, we expect that any lease with respect to such assets with Sharyland or another tenant would be negotiated with the intent to provide us with a return on and of the rate base associated with the assets over time, without regard to the acquisition premium, if any. In addition, future acquisitions or dispositions could result in potentially dilutive issuances of our equity securities, including our common stock, the incurrence of debt, the assumption of contingent liabilities and the future impairment of goodwill, any of which could harm our financial condition and results of operations.

We rely on third parties to support our growth, and our inability to find qualified third-party providers or the failure of third parties to provide timely and quality services would have an adverse impact on our ability to grow.

We do not have internal operational or construction management expertise. As a result, we rely on third parties to manage aspects of our growth, including the construction of our T&D assets. To date, our tenant has managed the planning and construction of our projects, but, in some circumstances, our tenant also relies on third-party contractors to complete these projects. For instance, our tenant managed the recent expansion of the Railroad DC Tie at the Mexican border and is currently managing the construction of various interconnects to generators from our Panhandle transmission assets, among other projects. Furthermore, we expect that Sharyland or another third party will manage the construction of a number of ROFO Projects. In some geographic areas where we expect growth, particularly in the Permian Basin, there is a shortage of qualified personnel to provide all of the services we need. If we are unable to find qualified personnel and third-party service providers to support the planning and construction of our projects, we may not be able to grow our rate base in the manner that we expect or at all. In addition, there is no assurance that these third parties will comply with their contractual obligations and complete construction projects efficiently, timely, cost-effectively or prudently,

which could cause regulatory agencies to rule adversely on the revenue from related rate base investments.

 

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Construction problems could adversely affect the timing of expected revenues from those projects, since we do not begin to recognize revenues under our leases with respect to Footprint Projects until the related assets are placed in service, and also could subject Sharyland or us to fines and penalties for failure to complete projects on the agreed-upon schedule.

The rapid growth that we expect increases the risk that construction project difficulties will adversely affect our financial condition and results of operations.

A substantial portion of the growth that we expect in our asset base is comprised of construction projects in the State of Texas. This growth profile makes us particularly susceptible to risks that construction projects generally are subject to, including:

 

    the ability to obtain labor or materials on favorable terms or at all;

 

    ability to obtain right-of-way on a timely basis;

 

    equipment, engineering and design failure;

 

    labor strikes;

 

    adverse weather conditions;

 

    the ability to obtain necessary operating permits in a timely manner;

 

    legal challenges;

 

    delays due to funding that is yet to be secured by third parties;

 

    changes in applicable law or regulations;

 

    adverse interpretation or enforcement of permit conditions, laws and regulations by courts or the permitting agencies;

 

    other governmental actions; and

 

    events in the global economy.

Many of these risks, if they materialize, could result in substantial delays in construction projects. For instance, many projects require environmental and other permits and approvals. Obtaining these permits can be time consuming and unpredictable. If these or other issues result in delays, the timing and amount of capital expenditures and lease revenues from these projects may be different than we anticipated, which could adversely affect our results of operations and cash flow.

The lag time between the time we fund capital expenditures and the time we begin receiving rent payments related to those capital expenditures can be lengthy.

Our tenant’s obligation to pay rent in respect of capital expenditures we fund does not begin until the assets related to such capital expenditures are placed in service. The lag time between the time that we fund capital expenditures with respect to a project and when the assets related to such project are placed in service and begin generating revenue can be lengthy. Although we will earn AFUDC on the amounts we have expended on capital expenditures that have not yet been placed in service, this accrual does not represent cash earnings. Because a significant portion of the growth we expect over the next several years relates to multi-year Footprint Projects, this lag will apply to a significant portion of our capital expenditures. Additionally, we may in some

 

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cases agree to rent holidays in connection with the negotiation of rent supplements. Such rent holidays are designed to delay our tenant’s rent obligations to us until the cost of such assets are reflected in our tenant’s revenue. These rent holidays typically last between one and eight months, during which we will not receive lease payments related to the increase in rate base or recognize AFUDC. See “Business and Properties—Our Tenant—Our Leases—Supplements.” Failure to timely receive rent payments related to the capital expenditures we fund could inhibit our ability to make cash distributions to our stockholders and could force us to fund our business from other sources, including the issuance of equity securities or the incurrence of additional indebtedness. Those funding sources may not be available on favorable terms or at all, which would adversely affect our business, results of operations, cash flow and financial condition.

There are limitations on our tenant’s ability to increase its rates, which could adversely affect our tenant’s ability to meet its rent obligations to us.

Our tenant’s rates are established through rate proceedings and may be updated through interim TCOS and DCRF filings. These interim filings allow our tenant to adjust its rates to reflect capital expenditures that have been made since the prior filing but not to reflect increased operation and maintenance expense. In order to increase its rates to reflect higher operation and maintenance expense, our tenant must file a full rate proceeding with the PUCT.

Various limitations apply to our tenant’s ability to make interim TCOS and DCRF filings. For example, our tenant may only make interim TCOS filings twice per year and may only make a DCRF filing once per year during a one-week window each April. Additionally, even if our capital expenditures or our tenant’s increased costs justify an increase to its distribution tariff rates, it may be difficult in certain circumstances for our tenant to implement the rate adjustments without engendering significant public opposition, which could adversely affect its ability to meet its rent obligations to us. If our tenant is unable to meet its rent obligations to us, our cash flows, results of operations and financial condition will be adversely affected.

The relative illiquidity of our infrastructure assets may hinder our ability to sell our assets when we desire and may discourage third parties from seeking to acquire the Company or our business.

Investments in infrastructure assets are relatively illiquid compared to other investments. Thus, we may not be able to sell our T&D assets when we desire or at prices acceptable to us in response to changes in economic or other conditions. Additionally, the relative illiquidity of our assets may make us less desirable to third parties seeking to acquire our business, which may prevent a change in control of our company that would be in the best interests of our stockholders.

We expect to rely on the capital markets in order to meet the significant capital expenditures and acquisition costs we expect in the future and to continue to distribute at least 90% of our taxable income to our stockholders.

To qualify as a REIT, we generally must distribute annually to our stockholders at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction and excluding any net capital gains, and we will be subject to regular corporate income taxes to the extent that we distribute less than 100% of our REIT taxable income each year, determined without regard to the dividends paid deduction and including any net capital gains. We expect to raise equity and debt capital in the future to support our growth and the distributions we will be required to make to our stockholders. As a result, our financial condition and liquidity will be adversely affected if market conditions prevent us from obtaining financing on favorable terms or at all. Adverse business developments or market disruptions could increase the cost of financing or prevent us from accessing the capital markets. Events that could cause or contribute to a disruption of the capital markets include, but are not limited to:

 

    a recession or an economic slowdown;

 

    the bankruptcy of one or more energy companies or financial institutions;

 

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    a significant change in energy prices;

 

    a terrorist or cyber attack or threatened attack;

 

    a material change in the U.S. federal income tax code;

 

    the outbreak of a pandemic or other similar event; or

 

    a significant electricity or natural gas transmission disruption.

Our ability to access the capital markets may be severely restricted at a time when we would like, or need, to access those markets, which could impact our flexibility to react to changing economic and business conditions. In some scenarios, if debt or equity capital were unavailable on any terms, we would be unable to comply with the REIT distribution rules or our obligations to fund capital expenditures for Footprint Projects under the leases, or both.

Covenants under the agreements governing our indebtedness may limit our operational flexibility and may restrict our ability to make distributions to our stockholders.

The agreements governing our indebtedness contain covenants that place restrictions that, among other things, limit our ability to:

 

    incur indebtedness;

 

    make restricted payments (distributions) from the borrowing entity;

 

    merge, consolidate or transfer all or substantially all of our or our subsidiaries’ assets;

 

    enter into transactions with affiliates;

 

    create liens on our or our subsidiaries’ assets;

 

    make certain investments or acquisitions;

 

    change the nature of our business;

 

    sell or lease assets; and

 

    terminate or modify certain terms of our leases.

The agreements also require us to maintain specified financial ratios and satisfy financial condition tests.

For example, the Operating Partnership must maintain at all times, on a consolidated basis, a total debt to capitalization ratio of not more than 0.75 to 1.00 and, for each period of four consecutive fiscal quarters, a consolidated debt service coverage ratio of at least 1.20 to 1.00. Debt service coverage ratio means cash available for debt service divided by debt service payments, and is measured on a 12-month trailing basis. Cash available for debt service means lease revenue less general and administrative expenses. TDC, a member of SDTS and a wholly owned subsidiary of the Operating Partnership, must maintain at all times a total debt to capitalization ratio of not more than 0.75 to 1.00 on a consolidated basis and must maintain, for each four consecutive fiscal quarter period, a consolidated debt service coverage ratio of at least 1.20 to 1.00 and a balance in a debt service reserve account equal to two quarterly principal plus interest payments payable on TDC’s senior secured notes. In addition, SDTS must maintain at all times, on a consolidated basis, a total debt to capitalization ratio of not more than 0.65 to 1.00 and, for each period of four consecutive fiscal quarters, a consolidated debt service coverage ratio (as defined above) of at least 1.40 to 1.00. Furthermore, under the CREZ term loan, Sharyland Projects, L.L.C., or SPLLC, the entity that owns substantially all of our Panhandle assets, must maintain a debt to total capitalization ratio not to exceed 0.70 to 1.00 at the end of any fiscal quarter. A dividend stopper is also in place prohibiting distributions unless the debt service coverage ratio is at least 1.20 to 1.00.

 

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Our ability to continue to borrow and make restricted payments is subject to compliance with our covenants, and a failure to comply with our covenants could cause a default under the applicable debt instrument or limit our ability to make restricted payments to fund distributions to stockholders we are required to make in accordance with the REIT rules unless we are able to take other mitigating steps or are eligible for certain statutory relief provisions, which could require us to seek an amendment or waiver or cause us to no longer maintain our status as a REIT, or ultimately repay the related debt with capital from other sources. See “Material Federal Income Tax Consequences—Taxation of the Company—Annual Distribution Requirements” and “—Failure To Continue To Qualify.” Under those circumstances, other sources of capital may not be available to us or may be available only on unattractive terms. In addition, our T&D assets are collateral under our secured financings. If we are unable to make our debt payments, or otherwise default under the agreements governing our indebtedness, the property could be foreclosed upon or transferred to the collateral agent with a consequent loss of income and asset value. A foreclosure of any of our properties would adversely affect our financial condition, results of operations, liquidity and our ability to service debt and make distributions to our stockholders.

We rely on our tenant to comply with some of the covenants under our credit arrangements.

Our credit facilities and other indebtedness require our tenant to deliver certain financial statements and reports, maintain its licenses and permits, deliver certain required notices, operate and maintain our T&D assets and maintain proper books of records and account in conformity with GAAP and include events of default triggered by (i) a bankruptcy by our tenant, (ii) any judgment being entered against our tenant for payment of money in excess of $2 million, (iii) a default by our tenant with respect to any of its indebtedness in excess of $2 million or any other default by our tenant with respect to any of its indebtedness that could lead to a material adverse effect (as defined in the applicable debt agreements) and (iv) in some cases, a default by our tenant under our leases that could lead to a material adverse effect (as defined in the applicable debt agreements). Our debt agreements also limit our tenant’s ability to incur indebtedness, subject to some exceptions. We have reflected these covenants in our leases. Our ability to continue to borrow is subject to our tenant’s continued compliance with these and other covenants, and our tenant’s failure to comply with these covenants could cause a default under our credit facilities, which could require us to repay the related debt with capital from other sources, all of which would adversely affect our financial condition and results of operations.

We have a significant amount of indebtedness, and we expect to incur significant additional indebtedness. Our indebtedness limits our financial flexibility, and, if we are unable to borrow on favorable terms, our financial condition and results of operations would be adversely affected.

As of September 30, 2014, on a pro forma basis, we had total consolidated indebtedness of $634.5 million, of which $400.9 million (or approximately 63.2%) was variable rate debt. We expect substantial capital expenditures related to Footprint Projects and acquisition costs related to ROFO Projects during the next several years. To fund these capital expenditures and acquisition costs, we expect to incur significant additional indebtedness. There can be no assurance that these funds will be available to us on favorable terms or at all. Furthermore, significant debt levels can reduce our flexibility to react to changing business and economic conditions, increasing the risk of investing in our common stock. A material portion of our lease revenue will be dedicated to the payment of interest on our indebtedness, thereby reducing the funds available for working capital, capital expenditures and distributions to our stockholders. When our credit facilities mature, we will need to be able to repay the debt, most likely by incurring additional indebtedness or issuing common stock or other equity. Our ability to secure additional financing, if needed, prior to or after our existing debt instruments mature may be substantially restricted by the existing level of our indebtedness and the restrictions contained in our debt instruments. We may not be able to refinance some or all of our indebtedness on favorable terms or at all, which could inhibit our ability to fulfill our obligations to fund capital expenditures for Footprint Projects under the leases, execute our growth strategies, complete future acquisitions or take advantage of other business opportunities and could have a material adverse effect on our financial condition and results of operations.

 

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Our T&D assets and our tenant’s operations may be affected by hazards associated with electricity transmission and distribution and other events for which our tenant’s and/or our property insurance may not provide adequate coverage.

Our T&D assets and our tenant’s operations are subject to hazards associated with electricity transmission and distribution, including explosions, fires, inclement weather, natural disasters, mechanical failure, unscheduled downtime, equipment interruptions, remediation, discharges or releases of toxic or hazardous substances and other environmental risks. These hazards can cause severe damage to or destruction of property and equipment and may result in suspension of operations and the imposition of civil or criminal penalties. However, there may not be adequate property insurance to cover the associated costs of repair or reconstruction, or insurance may not be available at commercially reasonable rates, or, for some events, at all. For instance, property insurance coverage for a portion of our T&D assets has not been available on commercially reasonable terms for several years, and, as a result, we have waived or amended the requirements under our leases that Sharyland obtain such insurance. In this respect, we and Sharyland are self insured for a substantial portion of our T&D assets. In the event remediating any damage or loss is considered a repair under the applicable lease, our tenant is responsible for the cost of repairing or replacing such damage or loss whether or not covered by insurance. On the other hand, in the event remediating any damage or loss is considered a Footprint Project under the lease, we will be responsible for payment of any insurance deductible, as well as for any such damage or loss not covered by insurance.

Although it is possible that our capital expenditures to fund these remediations could be recoverable pursuant to an interim TCOS or DCRF filing or a rate case, in some circumstances recovery of the related expenditures could be delayed, in which case our tenant may likely request a rent holiday with respect to the related capital expenditures until they are generating revenue. If we agreed to this rent holiday, our financial condition and results of operations would be adversely affected. If we do not agree, the financial burden of paying us rent on these remediation costs would adversely affect our tenant’s financial condition, cash flows and revenues.

In addition, any damage or destruction to our T&D assets could interrupt our tenant’s operations, reducing the amount of tariff revenue it collects, which would lower the amount of percentage rent payments that our tenant owes us. Furthermore, any such revenue reduction would make it more difficult for our tenant to meet its obligations generally, including its rent obligations to us. We carry no business interruption insurance independent of what our tenant carries, and it carries only a minimal amount of business interruption insurance.

Sharyland has the right to cause our subsidiary, SDTS, to raise equity capital without our consent, which could dilute our interests in our T&D assets.

Generally, our consent is required before our subsidiary, SDTS, engages in any material action. The exception is that if improvements to our T&D assets that constitute Footprint Projects are required by a regulatory authority or are reasonably necessary in order to serve Sharyland’s customers or to maintain the safety or reliability of our T&D assets, and if the SDTS working capital reserve is insufficient for such Footprint Projects, Sharyland may, without our consent, cause SDTS to raise capital to fund these Footprint Projects through the admission of additional members of SDTS. We can prevent Sharyland from doing so, at any time, by contributing the necessary capital to SDTS. Furthermore, Sharyland’s rights to dilute our interest in SDTS are subject at all times to its obligation as the tenant under our leases to negotiate and pay us rent on the related capital expenditures when they are placed in service. However, subject to these limitations, Sharyland may exercise its right in a manner that may dilute our economic interest in our T&D assets, which could adversely affect our financial condition and results of operations. See “SDTS Company Agreement and Delegation Agreement.”

 

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Because of the lessor/lessee structure, if our tenant’s revenue increases in the future, our lease revenue will not increase as quickly as it would if we were operating as an integrated utility.

All of our revenues come from lease payments from our tenant. The lease payments for the assets we owned at our inception in 2010 were negotiated in 2010, the lease payments for our Panhandle and Stanton transmission loop assets were negotiated in 2014 and the lease payments for our other capital expenditures have been, or will be, negotiated at or around the time the applicable assets are placed in service. If market conditions change, e.g., there is inflation or an increase in authorized returns on equity or other changes that could increase our tenant’s rate of return, and our tenant completes a rate case that allows it to realize a greater rate of return than what was originally anticipated, we would not be able to force our tenant to renegotiate the leases to reflect the effect of the higher rate of return. Because percentage rent is based on our tenant’s revenues, we would share some of the benefit of the increase in our tenant’s rates, but our revenue may not increase to the same extent as our peers’ revenue increases in those circumstances or if we were operating as an integrated utility.

Our industry is highly competitive, and increased competitive pressure could adversely affect our business and our ability to execute our growth strategy.

The market for investing in energy infrastructure assets is highly competitive and fragmented, and recently the number and variety of investors for energy infrastructure assets has been increasing, specifically in our core Texas market. Some of our competitors are large companies that have greater financial, managerial and other resources than we do. In addition, some of our competitors have established relationships with other utilities and other stakeholders that may better position them to take advantage of certain opportunities. Furthermore, in small portions of our service territories, existing and potential customers have a choice between Sharyland and other utilities that may have lower distribution tariffs than Sharyland, which could result in those customers choosing the other utility over Sharyland. Our ability to execute our growth strategy could be adversely affected by the activities of our competitors and other stakeholders. These competitive pressures could have a material adverse effect on our business, expected capital expenditures, results of operations, financial condition and our distributions to our stockholders.

We have a limited history, and our business strategy may not succeed in the long term.

We began generating revenues from lease payments from T&D assets in 2010, and a significant portion of our total assets were placed in service and began generating revenues in 2013. If our assets are unable to generate the lease revenues we predict, or if our business model does not generate the benefits and growth opportunities that we are seeking to achieve, we may be forced to change our business model and our financial condition and results of operations may suffer.

We may be subject to increased finance expenses if we do not effectively manage our exposure to interest rate risks.

We are exposed to various types of market risk in the normal course of business, including the impact of interest rate changes. Some of our indebtedness bears interest at variable rates, generally linked to market benchmarks such as LIBOR. The credit markets have recently experienced historical lows in interest rates. As the overall economy strengthens, it is possible that monetary policy will continue to tighten further, resulting in higher interest rates to counter possible inflation. Interest rates on floating rate credit facilities and future debt offerings could be higher than current levels, causing our financing costs to increase accordingly. If we are not successful in limiting our exposure to changes in interest rates, our business, financial condition and results of operations could be materially and adversely affected.

If we are unable to protect our rights to the land under our towers, lines and substations, it could adversely affect our business and operating results.

Our T&D real property interests include fee interests, easements, licenses and rights-of-way. A loss of these interests at a particular tower site may interfere with our tenant’s operations and ability to generate lease

 

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revenues from our T&D assets. In addition, any such loss could result in a default under our credit facilities, which could distract our management team, damage our relationship with our lenders and result in the acceleration of our indebtedness. Although our tenant generally has condemnation authority, use of condemnation can be expensive, resulting in costs to our tenant or us that may not be recoverable in rates, and the exercise of condemnation authority can be time consuming, sometimes taking several months or even years before the related real property assets are acquired. We generally rely on our tenant for title work related to our real property acquisitions. For various reasons, our tenant may not always have the ability to access, analyze and verify all information regarding titles and other issues prior to our acquisition of T&D assets. If we and our tenant are unable to protect our real property rights related to our T&D assets, our results of operation and financial condition may be adversely affected.

Utilities, including our tenant, are subject to adverse publicity and reputational risks, which make them vulnerable to negative customer perception and could lead to increased regulatory oversight or other sanctions.

Utility companies, including our tenant, are important to transmitting and distributing electricity that is critical to end-use customers and as a result have been the subject of public criticism focused on the reliability of their distribution services and the speed with which they are able to respond to outages caused by storm damage or other events. Adverse publicity of this nature may render legislatures, public service commissions and other regulatory authorities and government officials less likely to view utilities such as our tenant in a favorable light and may cause it to be susceptible to less favorable legislative and regulatory outcomes or increased regulatory oversight. Unfavorable regulatory outcomes can include more stringent laws and regulations governing our tenant’s operations, such as reliability and customer service quality standards or vegetation management requirements, as well as fines, penalties or other sanctions or requirements. The imposition of any of the foregoing could have a material negative impact on our tenant’s business, results of operations, cash flow and financial condition, which in turn could negatively impact its ability to make lease payments to us.

A portion of our net income relates to AFUDC, which is a non-cash income accrual and not representative of cash earnings.

A significant portion of the capital expenditures we expect during the next several years relates to multi-year projects. As a result of this and other construction projects, we expect a portion of our net income during the next several years to relate to AFUDC. This is a non-cash accounting accrual that increases the rate base balance of previously incurred capital expenditures when the related assets are placed in service but does not represent cash generated from operations. As a result, our net income is a less reliable indicator of the cash our business is generating than it would be if we were funding less capital expenditures or if our capital expenditures related to shorter term projects.

The preparation of our financial statements involves the use of estimates, judgments and assumptions, and our financial statements may be materially affected if our estimates prove to be inaccurate.

Financial statements prepared in accordance with U.S. GAAP require the use of estimates, judgments and assumptions that affect the reported amounts. Different estimates, judgments and assumptions reasonably could be used, which could materially affect our financial statements. Further, changes in these estimates, judgments and assumptions are likely to occur from period to period in the future. Significant areas of accounting requiring the application of management’s judgment include determining the fair value of our assets. These estimates, judgments and assumptions are inherently uncertain and, if they prove to be wrong, we face the risk that charges to income will be required. In addition, because we have a limited operating history, in some of these areas we have limited experience in making these estimates, judgments and assumptions that could cause the risk of future charges to income to be greater than if we had more experience in these areas. Any such charges could significantly harm our business, financial condition, results of operations and the price of our securities. See “Management’s Discussion and Analysis of Financial Condition and Results of

 

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Operations—Summary of Significant Accounting Policies” for a discussion of the accounting estimates, judgments and assumptions that we believe are the most critical to an understanding of our business, financial condition and results of operations.

We will incur increased costs as a result of being a publicly traded company.

As a public company, we will incur additional legal, accounting and other expenses that we did not incur as a private company. In addition, rules implemented by the Securities and Exchange Commission (SEC) and NYSE have imposed various requirements on public companies, including establishment and maintenance of effective disclosure and financial controls and changes in corporate governance practices. Our management will need to devote a substantial amount of time to these compliance initiatives. Moreover, these rules and regulations will increase our legal and financial compliance costs and will make some activities more time-consuming and costly. For example, we expect these rules and regulations to make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. As a result, it may be more difficult for us to attract and retain qualified people to serve on our board of directors, our board committees or as executive officers.

We have a significant goodwill balance related to the acquisition of Cap Rock and our formation transactions, both of which occurred in 2010. A determination that goodwill is impaired could result in a significant non-cash charge to earnings.

We had a goodwill balance at September 30, 2014 of approximately $138.4 million, of which $83.4 million is attributable to our acquisition of Cap Rock and $55 million is attributable to our formation transactions in 2010. An impairment charge must be recorded under GAAP to the extent that the implied fair value of goodwill is less than the carrying value of goodwill, as shown on the consolidated balance sheet. We are required to test goodwill for impairment at least annually and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors that may result in an interim impairment test include a decline in our stock price causing market capitalization to fall below book value, an adverse change in business conditions or an adverse regulatory action. If we were to determine that our goodwill is impaired, we would be required to reduce our goodwill balance by the amount of the impairment and record a corresponding non-cash charge to earnings. Depending on the amount of the impairment, an impairment determination could have a material adverse effect on our financial condition and results of operations but would not have an impact on our cash flow.

As a holding company with no operations of our own, we will depend on distributions from our subsidiaries to meet our payment obligations and make distributions to our stockholders.

We derive all of our operating income from, and hold all of our assets through, our subsidiaries. As a result, we depend on distributions from our subsidiaries in order to meet our payment obligations and make distributions to our stockholders, but our subsidiaries generally have no obligation to distribute cash to us. Provisions of applicable law, contractual restrictions or covenants or claims of a subsidiary’s creditors may limit our subsidiaries’ ability to make payments or other distributions to us.

We expect to become subject to financial reporting and other requirements for which our accounting, internal audit and other management systems and resources may not be adequately prepared.

Following this offering, we will become subject to reporting and other obligations under the Exchange Act, including the requirements of Section 404 of the Sarbanes-Oxley Act. Section 404 requires management to annually assess the effectiveness of our internal controls over financial reporting and, after we are no longer an “emerging growth company” (as described below), requires our independent registered public accounting firm to express an opinion on the effectiveness of our internal controls over financial reporting. This assessment will

 

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need to include disclosure of any material weaknesses identified by our management in our internal control over financial reporting, as well as a statement that our independent registered public accounting firm has issued an opinion on our internal control over financial reporting. To the extent applicable to us, these reporting and other obligations place or will place significant demands on our management, administrative, operational, internal audit and accounting resources and will cause us to incur significant expenses. To comply with these obligations, we may need to upgrade our systems or create new systems, implement additional financial and management controls, reporting systems and procedures, expand or outsource our internal audit function, and hire additional accounting, internal audit and finance staff. Design of our internal control environment is particularly challenging given our business model of owning regulated T&D assets and leasing them to a third party.

In addition, we will be required to include Sharyland’s financial statements in the periodic reports we file under the Exchange Act. However, our management does not prepare Sharyland’s financial statements, and neither our board of directors nor our management has any oversight over the preparation of those financial statements or over Sharyland’s internal control over financial reporting. Sharyland’s auditors identified a material weakness in Sharyland’s review process related to failed sale-leaseback accounting during its review of Sharyland’s financial statements for the quarter ended September 30, 2013. Although the material weakness was remediated by the fourth quarter of 2013 and Sharyland’s auditors did not identify a material weakness in connection with the 2013 year-end audit of Sharyland’s financial statements, there can be no assurance that Sharyland will not have additional material weaknesses or significant deficiencies in the future that may result in material misstatements in Sharyland’s financial statements or in Sharyland’s inability to timely provide us its financial statements. If Sharyland is unable to timely provide us with its financial statements, we may be unable to file our periodic reports within the timeframe required by the Exchange Act, which could result in certain penalties imposed by the SEC and could negatively impact our ability to access the capital markets or to comply with our obligations under our registration rights agreement.

The JOBS Act will allow us to postpone the date by which we must comply with certain laws and regulations intended to protect investors and to reduce the amount of information we provide in our reports filed with the SEC.

The JOBS Act is intended to reduce the regulatory burden on “emerging growth companies.” As defined in the JOBS Act, a public company whose initial public offering of common equity securities occurred after December 8, 2011 and whose annual gross revenues are less than $1.0 billion will, in general, qualify as an “emerging growth company” until the earliest of:

 

    the last day of its fiscal year following the fifth anniversary of the date of its initial public offering of common equity securities;

 

    the last day of its fiscal year in which it has annual gross revenue of $1.0 billion or more;

 

    the date on which it has, during the previous three-year period, issued more than $1.0 billion in non-convertible debt; and

 

    the date on which it is deemed to be a “large accelerated filer,” which will occur at such time as the Company (1) has an aggregate worldwide market value of common equity securities held by non-affiliates of $700 million or more as of the last business day of its most recently completed second fiscal quarter, (2) has been required to file annual and quarterly reports under the Exchange Act for a period of at least 12 months and (3) has filed at least one annual report pursuant to the Exchange Act.

Under this definition, we will be an “emerging growth company” upon the completion of this offering and could remain an “emerging growth company” until as late as December 31, 2020.

 

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The JOBS Act provides that, so long as a company qualifies as an “emerging growth company,” it will, among other things, be exempt from the provisions of Section 404(b) of the Sarbanes-Oxley Act requiring that its independent registered public accounting firm provide an attestation report on the effectiveness of its internal control over financial reporting and from any rules that may be adopted by the Public Company Accounting Oversight Board requiring mandatory audit firm rotation or a supplement to the auditor’s report on the financial statements.

Although we are still evaluating the JOBS Act, we may take advantage of some or all of the reduced regulatory and reporting requirements that will be available to us so long as we qualify as an “emerging growth company.” Among other things, this means that our independent registered public accounting firm will not be required to provide an attestation report on the effectiveness of our internal control over financial reporting so long as we qualify as an “emerging growth company,” which may increase the risk that weaknesses or deficiencies in our internal control over financial reporting go undetected. Likewise, so long as we qualify as an “emerging growth company,” we may elect not to provide you with certain information that we would otherwise have been required to provide in filings we make with the SEC, which may make it more difficult for investors and securities analysts to evaluate our company. As a result, investor confidence in the Company and the market price of our common stock may be adversely affected.

Risks Related to Related Party Transactions and Conflicts of Interest

Hunt’s ownership and control of Hunt Manager and its current and prior relationships with our Chief Executive Officer and other officers and with three members of our board of directors give rise to conflicts of interest.

Our business originated in the Hunt organization, and Hunt Manager, our external manager, is a subsidiary of Hunt. All of our officers, including our President and Chief Executive Officer, David Campbell, are employees of Hunt Manager. Hunt controls, and will continue to control after the completion of this offering, the compensation of all our officers, including Mr. Campbell, and Hunt Manager’s employees will continue to enjoy various employee perquisites and access associated with being a Hunt employee. Hunt Manager has granted, and may in the future grant, compensation or awards that are based upon the performance of Hunt Manager, Hunt Developer, Sharyland and Hunt generally to our officers, including Mr. Campbell. As a result, Mr. Campbell and our other officers and other employees of Hunt Manager may benefit from the consideration paid by us under the management agreement, from any economic benefit that Hunt or Sharyland receives from the sale of ROFO Projects to us pursuant to the development agreement or from the performance of Sharyland. As a result, Mr. Campbell, our other officers and the other employees of Hunt Manager may consider the interests of these Hunt affiliates in any negotiations and may be incentivized to focus on ROFO Projects and divert attention from Footprint Projects. The duties owed to us by our officers, including Mr. Campbell, and Mr. Campbell’s duties to us as a director, may conflict with duties to, and pecuniary interest in, Hunt Manager, Hunt Developer, Sharyland and Hunt generally. Therefore, the negotiations and agreements between us, our subsidiaries or our Operating Partnership and these entities and their affiliates may not solely reflect the interests of our stockholders.

W. Kirk Baker, who is the Chairman of our board of directors, was the President and Chief Executive Officer of Hunt Manager until August of 2014, was a senior officer in the Hunt Consolidated, Inc. organization until July of 2012, and received compensation and other benefits from Hunt and its affiliates during these time periods. Hunt and Mr. Baker have informed us that Mr. Baker continues to receive, and may in the future after completion of this offering continue to receive, various perquisites and incentive compensation from Hunt, including incentive compensation based on profits that Hunt may generate from the sale of ROFO Projects to us and payments that we make to Hunt Manager. Mr. Baker currently is Managing Partner of Captra Capital, an investment firm in which Mr. Baker and Hunt are currently the primary investors, and Hunt has funded and may continue to fund the operating overhead of Captra Capital’s manager, Captra Holdings, an entity that currently provides compensation and other benefits to Mr. Baker. Mr. Baker’s duties to us as a director may conflict with his duties to, and pecuniary interest in, Captra Capital, Captra Holdings, Hunt Manager, Hunt Developer and

 

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Sharyland. As a result, Mr. Baker may consider the interests of Hunt Manager, Hunt Developer, Sharyland and Hunt generally in any negotiation between us and one of those entities and may benefit from the consideration we pay Hunt Manager under the management agreement, from any economic benefit that Hunt or Sharyland receives from the sale of ROFO Projects to us pursuant to the development agreement and from the performance of Sharyland. Therefore, the negotiations and agreements between us, our subsidiaries or our Operating Partnership and these entities and their affiliates may not solely reflect the interests of our stockholders.

Hunter L. Hunt, who is a member of our board of directors, directly or indirectly has a significant economic interest in, and controls, Hunt Manager, Hunt Developer and Sharyland. Accordingly, Mr. Hunt will benefit from the consideration paid to Hunt Manager under the management agreement, from any economic benefit that Hunt or Sharyland receives from the sale of ROFO Projects to us pursuant to the development agreement and from the performance of Sharyland under the leases. Mr. Hunt’s duties to us as a director may conflict with his duties to, and pecuniary interest in, Hunt Manager, Hunt Developer, Sharyland and Hunt generally. As a result, Mr. Hunt may consider the interests of Hunt Manager, Hunt Developer, Sharyland and Hunt generally in any negotiation between us and one of those entities and may benefit from the consideration we pay Hunt Manager under the management agreement, from any economic benefit that Hunt or Sharyland receives from the sale of ROFO Projects to us pursuant to the development agreement and from the performance of Sharyland.

Although we intend to operate and manage our business for the benefit of our stockholders, there is a risk that actual or perceived conflicts of interests could affect the manner in which we treat Hunt as a limited partner in the Operating Partnership or how we manage our relationships with Hunt Manager, Hunt Developer and Sharyland under the management agreement, the development agreement and our leases. If we were to terminate any of our leases with Sharyland, we would lose the benefit of the relationship that we have cultivated with Sharyland and could damage our relationship with Hunt. Further, if we were to terminate the management agreement with Hunt Manager, we would no longer have the benefits associated with our development agreement with Hunt Developer, since the development agreement automatically expires upon the termination of the management agreement. These complications and costs could adversely affect our results of operations, financial condition and relationship with regulators and ratepayers.

Other than our right to own and construct Footprint Projects and an obligation to offer us ROFO Projects, Hunt and Sharyland are not contractually prohibited from competing against us for T&D assets or businesses, including within the State of Texas, and our charter contains provisions waiving any liability to us or our stockholders as a result of the participation of directors and officers and their affiliates in any such competitive activity.

Under the terms of the development agreement with Hunt Developer and Sharyland, we have the exclusive right to fund the construction of Footprint Projects. In addition, Hunt has granted us a right of first offer on ROFO Projects. However, Hunt is free to pursue the development and construction of other T&D projects and may compete directly with us for the acquisition of other T&D assets and businesses, including within the State of Texas. If Hunt were to acquire another utility that owns T&D assets, it may direct future development and acquisition opportunities to the other utility. Moreover, Hunt Manager may also serve as manager for any other T&D business that Hunt may acquire, which could divert the time and focus of our management team away from our business, which could materially harm our business and our results of operations. Additionally, as permitted by the Maryland General Corporation Law (MGCL), our charter contains provisions that permit our directors and officers and their affiliates (including individuals serving in such capacities who are also directors, officers and/or employees of Hunt and its affiliates) to compete with us, own any investments or engage in any business activities, including investments and business activities that are similar to our current or proposed investments or business activities, without any obligation to present any such business opportunity to us unless the opportunity is expressly offered to such person in his or her capacity as a director or officer of us.

 

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We are dependent on Hunt Manager and its executive officers and key personnel, who provide services to us through the management agreement. We may not find a suitable replacement for Hunt Manager if the management agreement is terminated or for these executive officers and key personnel if any of them leaves Hunt Manager or otherwise becomes unavailable to us.

We are externally advised and managed by Hunt Manager, and all members of our senior management are employees of Hunt Manager. Pursuant to our management agreement, Hunt Manager is obligated to supply us with all of our senior management team. Subject to guidelines or policies adopted by our board of directors, Hunt Manager has significant discretion regarding the implementation of our investment and operating policies and strategies. Accordingly, our success depends significantly upon the experience, skill, resources, relationships and contacts of the executive officers and key personnel of Hunt Manager. The executive officers and key personnel of Hunt Manager have extensive knowledge of the Company and our industry. If any executive officer or key person of Hunt Manager leaves Hunt Manager or otherwise becomes unavailable to manage our business, our performance could be adversely impacted.

Our management agreement with Hunt Manager expires on December 31, 2019, and termination of the management agreement would eliminate our rights to Hunt Developer’s development pipeline and could harm our relationship with our tenant. Additionally, Hunt Manager’s interests and incentives relating to our business may differ from our long-term best interests.

The initial term of the management agreement will expire on December 31, 2019. The management agreement will automatically extend for additional five-year terms, unless we decide to terminate it pursuant to its terms. We will also have the right to terminate the management agreement at any time for cause, and Hunt Manager may terminate the agreement at any time upon 365 days’ prior notice to us, provided that Hunt Manager may not exercise this right in a manner that results in the management agreement terminating before December 31, 2019. Any termination of the management agreement would end Hunt Manager’s obligation to provide us with the executive officers and key personnel upon whom we rely for the operation of our business and, unless we terminate for cause, would also terminate our rights to ROFO Projects under the development agreement. In addition, we are required to pay Hunt a termination fee equal to three times the most recent annualized base management and incentive payment if we terminate the agreement for any reason other than cause. Further, any termination of our relationships with Hunt Manager and Hunt Developer may negatively impact our relationship with Sharyland, including Sharyland’s willingness to renew our leases or to negotiate supplements on terms that are favorable to us. Termination or failure to renew our leases could result in a default under our indebtedness. Additionally, because the base fee payable to Hunt Manager under the management agreement is calculated by reference to our total equity and the incentive payment payable to Hunt Manager is calculated as a percentage of the per OP Unit distributions to the Operating Partnership’s unitholders in excess of the Threshold Distribution Amount, Hunt Manager may be motivated to grow total equity or make Operating Partnership distributions in a manner that is not in our long-term best interests or in the best interests of our other stockholders.

Hunt Manager’s liability is limited under the management agreement, and we have agreed to indemnify Hunt Manager against certain liabilities. As a result, we could experience poor performance or losses for which Hunt Manager would not be liable.

Pursuant to the management agreement, Hunt Manager will not assume any responsibility other than to render the services called for thereunder and will not be responsible for any action of our board of directors in following or declining to follow its advice or recommendations. Hunt Manager maintains a contractual as opposed to a fiduciary relationship with us. Under the terms of the management agreement, Hunt Manager, its officers, members and personnel, any person controlling or controlled by Hunt Manager and any person providing sub-advisory services to Hunt Manager will not be liable to us, any subsidiary of ours, our directors, our stockholders or any subsidiary’s stockholders or partners for acts or omissions performed in accordance with and pursuant to the management agreement, except those resulting from acts constituting gross negligence, willful misconduct, bad faith or reckless disregard of Hunt Manager’s duties under the management agreement.

 

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In addition, we have agreed to indemnify Hunt Manager and each of its officers, directors, members, managers and employees from and against any claims or liabilities, including reasonable legal fees and other expenses reasonably incurred, arising out of or in connection with our business and operations or any action taken or omitted on our behalf pursuant to authority granted by the management agreement, except where attributable to gross negligence, willful misconduct, bad faith or reckless disregard of such person’s duties under the management agreement. As a result, we could experience poor performance or losses for which Hunt Manager would not be liable.

The management agreement, the development agreement and our leases were not negotiated on an arm’s-length basis and may not be as favorable to us as if they had been negotiated with unaffiliated third parties.

The management agreement with Hunt Manager, the development agreement with Hunt Developer and our leases with Sharyland were negotiated between related parties and before our independent directors were elected, and their terms, including the consideration payable to Hunt Manager and lease payments to us, may not be as favorable to us as if they had been negotiated with unaffiliated third parties.

The terms of these agreements and leases may not solely reflect your best interest and may be overly favorable to the other party to such agreements and leases, including in terms of the substantial compensation to be paid to these parties under these agreements. Further, we may choose not to enforce, or to enforce less vigorously, our rights under the management agreement, the development agreement or our leases, as applicable, because of our desire to maintain our ongoing relationships with Hunt, Sharyland and our founding investors.

Risks Related to REIT Qualification and Federal Income Tax Laws

Qualifying as a REIT involves highly technical and complex provisions of the Code, and our failure to qualify or remain qualified as a REIT would cause us to owe U.S. federal income tax, which would negatively impact our results of operations and reduce the amount of cash available for distribution to our stockholders.

InfraREIT, L.L.C. elected to be taxed as a REIT under the Code commencing with the taxable year ended December 31, 2010 and, following the Merger described under “Prospectus Summary—Our Structure and Reorganization Transactions—Reorganization Transactions,” we will elect to be taxed as a REIT commencing with the taxable year ending December 31, 2015. We believe that InfraREIT, L.L.C. was organized and operated in a manner that allowed it to qualify for taxation as a REIT for U.S. federal income tax purposes commencing with its taxable year ended December 31, 2010. We further believe that InfraREIT, Inc. has been organized and will operate in a manner that will enable it to qualify as a REIT for U.S. federal income tax purposes commencing with its taxable year ending December 31, 2015. The U.S. federal income tax laws governing REITs are complex and require us to meet, on an ongoing basis, various tests regarding the nature and diversification of our assets and our income, the ownership of our outstanding shares, and the amount of our distributions. Even a technical or inadvertent violation could jeopardize our REIT qualification.

We are one of only a few REITs to be engaged in owning and leasing T&D assets or similar assets. There is little or no guidance in the tax law regarding the qualification of T&D assets as real estate assets for purposes of qualifying as a REIT and the rent therefrom as qualifying rental income under the REIT asset and income tests. We hold a private letter ruling from the IRS that provides that T&D systems qualify as real estate assets and the rent therefrom generally constitutes qualifying rental income. We are entitled to rely upon that ruling for those assets that fit within the scope of the rulings only to the extent that (i) we have the legal and contractual rights described therein and are considered to be the same taxpayer as, or are treated for tax purposes as the successor to, the taxpayer that obtained the ruling, (ii) we did not misstate or omit in the ruling request a relevant fact and (iii) we continue to operate in the future in accordance with the relevant facts described in such request. No assurance can be given that we will always be able to operate in the future in accordance with the relevant facts described in such request. If we were not able to treat the T&D assets as real estate assets and/or the rent therefrom as qualifying rental income for purposes of applying the REIT asset or income tests, we may fail to qualify as a REIT.

 

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In addition, our compliance with the REIT income and quarterly asset requirements depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis in accordance with existing REIT regulations and rules and interpretations thereof. Furthermore, judicial and administrative interpretations of the U.S. federal income tax laws governing REIT qualification are limited, and new IRS guidance, legislation, court decisions or other administrative guidance, in each case possibly with retroactive effect, may make it more difficult or impossible for us to qualify as a REIT or adversely change the tax treatment of a REIT. Thus, given the highly complex nature of the rules governing REITs, the ongoing importance of factual determinations and the possibility of future changes in our circumstances or the rules applicable to REITs, no assurance can be given that we will so qualify for any particular year, and we could be adversely affected by any such change in, or any new, U.S. federal income tax law, regulation or administrative interpretation.

If we fail to qualify as a REIT in any taxable year, unless we were eligible for certain statutory relief provisions:

 

    we would not be allowed a deduction for distributions to our stockholders in computing our taxable income and would be required to pay U.S. federal income tax on our taxable income at corporate income tax rates;

 

    we also could be liable for alternative minimum tax and increased state and local taxes;

 

    we would be liable for interest and possible penalties for failure to make any required estimated tax payments in a year in which the failure occurred;

 

    we no longer would be required to distribute substantially all of our taxable income to our stockholders; and

 

    we could not re-elect to be taxed as a REIT for four taxable years following the year in which we failed to qualify as a REIT.

In such a case, any such corporate tax liability could be substantial and would reduce our net income and cash available for, among other things, our operations and distributions to stockholders. In addition, we might need to borrow money or sell assets in order to pay any corporate tax liability. As a result of all these factors, our failure to qualify as a REIT also could impair our ability to expand our business and raise capital, and could materially and adversely affect our results of operations and financial condition and the trading price of our common stock.

Even if we qualify as a REIT, we may face tax liabilities that reduce our cash flow.

Even if we qualify for taxation as a REIT, we may be liable for certain U.S. federal, state and local taxes on our income and assets, including taxes on any undistributed income, a 100% penalty tax on gain if we sell property as a dealer, alternative minimum tax, tax on income from some activities conducted as a result of a foreclosure, and state or local income, franchise, property and transfer taxes, including mortgage recording taxes. See “Material Federal Income Tax Consequences—Taxation of the Company—General.” In addition, although we do not currently own any taxable REIT subsidiaries, if we were to acquire or form a taxable REIT subsidiary, it would be subject to U.S. federal, state and local corporate income or franchise taxes. In order to meet the REIT qualification requirements, or to avoid the imposition of the 100% tax penalty that applies to certain gains if we sell property as a dealer to customers in the ordinary course of business, we may hold some of our assets through taxable REIT subsidiaries. Any taxes paid by such taxable REIT subsidiary would decrease the cash available for distribution to our stockholders.

 

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If our Operating Partnership fails to qualify as a partnership for federal income tax purposes, we would cease to qualify as a REIT and suffer other adverse consequences.

We believe that our Operating Partnership is treated as a partnership for federal income tax purposes. As a partnership, our Operating Partnership is not subject to federal income tax on its income. Instead, for federal income tax purposes, each of its partners, including us, are allocated, and may be required to pay tax with respect to, such partner’s share of the Operating Partnership’s income. We cannot guarantee that the IRS will not challenge the status of our Operating Partnership or any other subsidiary partnership in which we own an interest as a partnership or disregarded entity for federal income tax purposes, or that a court would not sustain such a challenge. If the IRS were successful in treating our Operating Partnership or certain subsidiary partnerships as an entity taxable as a corporation for federal income tax purposes, we would fail to meet the applicable REIT gross income tests and certain of the asset tests applicable to REITs and, accordingly, we would likely cease to qualify as a REIT. Also, the failure of our Operating Partnership or certain subsidiary partnerships to qualify as a partnership or disregarded entity could cause the applicable entity to become subject to federal corporate income tax, which would adversely affect our results of operations and reduce significantly the amount of cash the Operating Partnership has available for distribution to its partners, including us.

Our ownership of taxable REIT subsidiaries is subject to certain restrictions, and we will be required to pay a 100% penalty tax on certain income or deductions if our transactions with our taxable REIT subsidiaries are not conducted on arm’s length terms.

We may acquire securities in taxable REIT subsidiaries in the future. A taxable REIT subsidiary is a corporation, other than a REIT, in which a REIT directly or indirectly holds stock, and that has made a joint election with such REIT to be treated as a taxable REIT subsidiary. If a taxable REIT subsidiary owns more than 35% of the total voting power or value of the outstanding securities of another corporation, such other corporation will also be treated as a taxable REIT subsidiary. Other than some activities relating to lodging and health care facilities, a taxable REIT subsidiary may generally engage in any business, including the provision of customary or non-customary services to tenants of its parent REIT. A taxable REIT subsidiary is subject to federal income tax as a regular C corporation. In addition, a 100% excise tax will be imposed on certain transactions between a taxable REIT subsidiary and its parent REIT that are not conducted on an arm’s length basis.

A REIT’s ownership of securities of a taxable REIT subsidiary is not subject to the 5% or 10% asset tests applicable to REITs. Not more than 25% of the value of our total assets may be represented by securities (including securities of taxable REIT subsidiaries), other than those securities includable in the 75% asset test. We anticipate that the aggregate value of the stock and securities of any taxable REIT subsidiaries and other nonqualifying assets that we own will be less than 25% of the value of our total assets, and we will monitor the value of these investments to ensure compliance with applicable ownership limitations. In addition, we intend to structure our transactions with any taxable REIT subsidiaries that we own to ensure that they are entered into on arm’s length terms to avoid incurring the 100% excise tax described above. There can be no assurance, however, that we will be able to comply with the 25% limitation or to avoid application of the 100% excise tax discussed above.

To maintain our REIT status, we may be forced to borrow funds during unfavorable market conditions, and the unavailability of such capital on favorable terms at the desired times, or at all, may cause us to curtail our investment activities and/or to dispose of assets at inopportune times, which could materially and adversely affect us and the per share trading price of our common stock.

To qualify as a REIT, we generally must distribute annually to our stockholders at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction and excluding any net capital gains, and we will be liable for regular corporate income taxes to the extent that we distribute less than 100% of our REIT taxable income, determined without regard to the dividends paid deduction and including any net

 

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capital gains, each year. In addition, we will be subject to a 4% nondeductible excise tax on the amount, if any, by which distributions paid by us in any calendar year are less than the sum of 85% of our ordinary income, 95% of our capital gain net income and 100% of our undistributed income from prior years. In order to maintain our REIT status and continue to receive a deduction from income for dividends paid to our stockholders, we may need to borrow funds to meet the REIT distribution requirements even if the then prevailing market conditions are not favorable for these borrowings. See “Material Federal Income Tax Consequences—Taxation of the Company—Annual Distribution Requirements.” These borrowing needs could result from, among other things, differences in timing between the actual receipt of cash and recognition of income for federal income tax purposes, or the effect of non-deductible capital expenditures, the creation of reserves or required debt or amortization payments. These sources, however, may not be available on favorable terms or at all. Our access to third-party sources of capital depends on a number of factors, including the market’s perception of our growth potential, our current debt levels, the market price of our common stock, and our current and potential future earnings. We cannot guarantee that we will have access to such capital on favorable terms at the desired times, or at all, which may cause us to curtail our investment activities and/or to dispose of assets at inopportune times, and could materially and adversely affect us and the per share trading price of our common stock.

If InfraREIT, L.L.C. is determined to have failed to qualify as a REIT for any reason or if we acquire C corporations in the future, we may inherit material tax liabilities and other tax attributes from InfraREIT, L.L.C. or such acquired corporations, and we may be required to distribute earnings and profits.

The formation of a partnership unrelated to InfraREIT in 2011 between a Hunt affiliate and an affiliate of Marubeni triggered certain provisions in InfraREIT, L.L.C.’s limited liability company agreement designed to protect against rent received from Sharyland being deemed to be rent from a related party which could have caused InfraREIT, L.L.C. to fail to qualify as a REIT. As a result of the application of these provisions, shares held by Marubeni that would have resulted in Marubeni holding in excess of 9.8% of the total number of outstanding shares of InfraREIT, L.L.C. were automatically transferred to Westwood Trust. If these provisions were deemed to be ineffective, InfraREIT, L.L.C. would not have met the REIT requirements and, as a result, would have been taxed as a C corporation. If InfraREIT, L.L.C. is deemed to have failed to meet the REIT requirements as a result of the 2011 transaction or otherwise, we would be liable for the taxes InfraREIT, L.L.C. would have been required to pay, which could have an adverse effect on our financial condition and results of operations.

In addition, we have previously acquired, and from time to time we may acquire, C corporations or assets of C corporations in transactions in which the basis of the corporations’ assets in our hands is determined by reference to the basis of the assets in the hands of the acquired corporations, or carry-over basis transactions. In this regard, in 2010, we acquired Cap Rock Holdings Corporation in a transaction that was treated as a carry-over basis transaction.

In the case of assets we acquire from a C corporation in a carry-over basis transaction, including the assets of InfraREIT, L.L.C. if it failed to meet the REIT requirements and, thus, it is deemed to have been taxed as a C corporation prior to the Merger, if we dispose of any such asset in a taxable transaction (including by deed in lieu of foreclosure) during the ten-year period beginning on the date of the carry-over basis transaction, then we will be required to pay tax at the highest regular corporate tax rate on the gain recognized to the extent of the excess of (1) the fair market value of the asset over (2) our adjusted tax basis in the asset, in each case determined as of the date of the carry-over basis transaction. Any taxes we pay as a result of such gain would reduce the amount available for distribution to our stockholders. The imposition of such tax may require us to forgo an otherwise attractive disposition of any assets we acquire from a C corporation in a carry-over basis transaction, and as a result may reduce the liquidity of our portfolio of investments. In addition, in such a carry-over basis transaction, we will succeed to any tax liabilities and earnings and profits of the acquired C corporation. To qualify as a REIT, we must distribute any non-REIT earnings and profits by the close of the taxable year in which such transaction occurs. If the IRS were to determine that we acquired non-REIT earnings and profits from a corporation that we failed to distribute prior to the end of the taxable year in which the carry-

 

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over basis transaction occurred, we could avoid disqualification as a REIT by paying a “deficiency dividend.” Under these procedures, we generally would be required to distribute any such non-REIT earnings and profits to our stockholders within 90 days of the determination and pay a statutory interest charge at a specified rate to the IRS. Such a distribution would be in addition to the distribution of REIT taxable income necessary to satisfy the REIT distribution requirement and may require that we borrow funds to make the distribution even if the then-prevailing market conditions are not favorable for borrowings. In addition, payment of the statutory interest charge could materially and adversely affect us.

If InfraREIT, L.L.C. failed to qualify as a REIT and we are considered a “successor” to InfraREIT, L.L.C. under applicable Treasury Regulations, we may be ineligible to elect REIT status for the four taxable years following the year in which InfraREIT, L.L.C. ceased to qualify as a REIT. We believe that we would not be a considered a “successor” to InfraREIT, L.L.C. for purposes of such provisions. See “Material Federal Income Tax Consequences—Certain Tax Considerations Related to the Reorganization.”

The IRS may treat sale-leaseback transactions as loans, which could jeopardize our REIT status or require us to make an unexpected distribution.

The IRS may take the position that specific sale-leaseback transactions that we treat as leases are not true leases for federal income tax purposes but are, instead, financing arrangements or loans. If a sale-leaseback transaction were so re-characterized, we might fail to satisfy the REIT asset tests, the income tests or distribution requirements and consequently lose our REIT status effective with the year of re-characterization. The primary risk relates to our loss of previously incurred depreciation expenses, which could affect the calculation of our REIT taxable income and could (unless we were able to take other mitigating steps or were eligible for certain statutory relief provisions) cause us to fail the REIT distribution test that requires a REIT to distribute at least 90% of its REIT taxable income, determined without regard to the dividends paid deduction and excluding any net capital gain. In this circumstance, we may elect to distribute an additional dividend of the increased taxable income so as not to fail the REIT distribution test. This distribution would be paid to all stockholders at the time of declaration rather than the stockholders existing in the taxable year affected by the re-characterization. See “Material Federal Income Tax Consequences—Taxation of the Company—Annual Distribution Requirements” and “—Failure To Continue To Qualify.”

Dividends payable by REITs do not qualify for the reduced tax rates available for some dividends.

The current maximum U.S. federal income tax rate for certain qualified dividends payable to U.S. stockholders that are individuals, trusts and estates is 20%, or 23.8% including investment taxes on investment income applicable to certain stockholders under the Patient Protection and Affordable Care Act, or PPACA. Dividends payable by REITs are generally not eligible for the reduced rates and therefore may be subject to a 39.6%, or 43.4% including PPACA investment taxes, maximum U.S. federal income tax rate on ordinary income. Although the reduced U.S. federal income tax rate applicable to dividend income from regular corporate dividends does not adversely affect the taxation of REITs or dividends paid by REITs, the more favorable rates applicable to regular corporate dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the shares of REITs, including the per share trading price of our common stock. States may also choose to tax investment and dividend income at higher rates than ordinary income, and to the extent more states do so, then such taxes may further reduce the attractiveness of REITs from an investment standpoint. Any future changes in the federal, state or local income tax laws regarding the taxation of dividends payable to stockholders could also impact the attractiveness of REITs from an investment standpoint.

 

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Complying with REIT requirements may affect our profitability and may force us to liquidate or forgo otherwise attractive investments.

To qualify as a REIT, we must continually satisfy tests concerning, among other things, the nature and diversification of our assets, the sources of our income and the amounts we distribute to our stockholders. We may be required to liquidate or forgo otherwise attractive investments in order to satisfy the asset and income tests or to qualify under certain statutory relief provisions. We also may be required to make distributions to stockholders at disadvantageous times or when we do not have funds readily available for distribution. As a result, having to comply with the distribution requirement could cause us to sell assets in adverse market conditions, borrow on unfavorable terms or distribute amounts that would otherwise be invested in future acquisitions, capital expenditures or repayment of debt. Accordingly, satisfying the REIT requirements could materially and adversely affect us.

Legislative or other actions affecting REITs could have a negative effect on us.

The rules dealing with federal, state and local income taxation are constantly under review by persons involved in the legislative process and by the IRS and the U.S. Department of the Treasury. Changes to the tax laws, with or without retroactive application, could materially and adversely affect our investors or us. We cannot predict how changes in the tax laws might affect our investors or us. New legislation, Treasury Regulations, administrative interpretations or court decisions could significantly and negatively affect our ability to qualify as a REIT or the income tax consequences of such qualification.

Complying with REIT requirements may limit our ability to hedge effectively.

The REIT provisions of the Code may limit our ability to hedge our assets and operations. Under these provisions, any income that we generate from transactions intended to hedge our interest rate exposure will be excluded from gross income for purposes of the gross income tests if the instrument hedges interest rate risk on liabilities used to carry or acquire real estate assets, or certain other specified types of risk, and such instrument is properly identified under applicable Treasury Regulations. Income from hedging transactions that do not meet these requirements will generally constitute nonqualifying income. As a result of these rules, we may have to limit our use of hedging techniques that might otherwise be advantageous or implement those hedges through a taxable REIT subsidiary, which would be liable for tax on gains and for which we would not receive any tax benefit for losses, except to the extent they were carried forward to offset future taxable income of the taxable REIT subsidiary.

Liquidation of our assets may jeopardize our REIT qualification.

If we are compelled to liquidate our assets to repay obligations to our lenders, we may be unable to comply with the requirements relating to our assets and our sources of income, thereby jeopardizing our qualification as a REIT, or we may be subject to a 100% tax on any resultant gain if we sell assets that are treated as inventory or property held primarily for sale to customers in the ordinary course of business.

Risks Related to the Offering and Ownership of Our Common Stock

The OP Units in our Operating Partnership held by the limited partners, including Hunt-InfraREIT and MC Transmission Holdings, Inc., may be redeemed by the limited partners, which could result in the issuance of a large number of new shares of our common stock and/or force us to expend significant cash which may not be available to us on favorable terms or at all.

Assuming our stock trades at $23.00, which is the initial public offering price, for the 30-day period following the closing of this offering, Hunt-InfraREIT will own approximately 13,213,619 OP Units in our Operating Partnership. In addition, Marubeni will own 3,325,874 OP Units in our Operating Partnership. Subject

 

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to any contractual lock-up provisions, including the one year lock-up agreement with the underwriters in this offering (or six months with respect to MC Transmission Holdings, Inc.), and a one year holding period (or six months with respect to MC Transmission Holdings, Inc.) required by our Operating Partnership’s partnership agreement, a limited partner of our Operating Partnership may at any time require us to redeem the OP Units it holds for cash at a per-OP Unit value equal to the 10 day trailing trading average of a share of our common stock at the time of the requested redemption. At our election, we may satisfy the redemption through the issuance of shares of our common stock on a one share of common stock for one OP Unit basis. However, the limited partners’ redemption right may not be exercised if and to the extent that the delivery of the shares upon such exercise would result in any person violating the ownership and transfer restrictions set forth in our charter. See “The Operating Partnership and the Partnership Agreement—Redemption Rights.”

This offering will be dilutive to the net tangible book value per share of our common stock purchased in this offering, and there may be future dilution related to subsequent issuances of shares of our common stock.

The initial public offering price of our common stock will be substantially higher than the book value per share of our outstanding common stock immediately after this offering and completion of the Merger. If you purchase common stock in this offering, you will incur immediate dilution of approximately $12.37 in the net tangible book value per share of common stock from the price you pay for our common stock in this offering. See “Dilution” for further discussion of how your ownership interest in us will be immediately diluted.

There is currently no public market for our common stock, and an active trading market for our common stock may not develop following this offering.

There is no established trading market for our common stock. We have been approved to list our common stock on the NYSE. We cannot guarantee, however, that an active trading market for our common stock will develop after this offering or, if one develops, that it will be sustained. In the absence of a public market, you may be unable to liquidate an investment in our common stock. The initial public offering price for shares of our common stock was determined by negotiations between us and the representatives of the underwriters, and the price at which shares of our common stock trade after the completion of this offering may be lower than the price at which the underwriters sell them in this offering.

The market price and trading volume of shares of our common stock may fluctuate significantly following this offering.

Even if an active trading market develops after this offering, the market price of our common stock may be highly volatile and subject to wide fluctuations. Our financial performance, governmental regulatory action, tax laws, interest rates and market conditions in general could have a significant impact on the future market price of our common stock. In addition, the trading volume in our common stock may fluctuate and cause significant price variations to occur. If the market price of our common stock declines significantly, you may be unable to resell your shares at or above the public offering price or at all.

Some of the factors that could negatively affect our share price or result in fluctuations in the price of our stock include:

 

    our quarterly distributions;

 

    our operating performance and the performance of other similar companies;

 

    changes in the rates our tenant can charge its customers;

 

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    deviations from funds from operations, adjusted funds from operations, capital needs or earnings estimates;

 

    adverse market reaction to any increased indebtedness we incur in the future;

 

    the termination of or failure to renew a lease with Sharyland;

 

    announcements by us or our competitors of significant contracts or acquisitions;

 

    additions or departures of key personnel;

 

    general market, economic and political conditions;

 

    changes in accounting standards, policies, guidance, interpretations or principles;

 

    changes in the tax laws applicable to REITs;

 

    passage of legislation or other regulatory developments that adversely affect us or our industry; and

 

    other factors described in these “Risk Factors.”

Future sales of shares of our common stock, or the perception that such sales might occur, may depress the price of our shares.

Future issuances of shares of our common stock, the availability of shares for resale in the open market and the perception that these issuances or resales may occur could decrease the market price per share of our common stock. Any sales by us or our existing investors of a substantial number of shares of our common stock in the public market, or the perception that such sales might occur, may cause the market price of our shares to decline. Upon the consummation of this offering, all shares of common stock sold in this offering will be freely tradable without restriction (other than the ownership limit and the other restrictions on ownership and transfer of our stock as set forth in our charter), unless the shares are owned by one of our affiliates or subject to the lock-up agreements described below. See “Shares Eligible for Future Sale.”

We, each of our directors and executive officers and certain of our other existing investors have agreed, with limited exceptions, that we and they will not, without the prior written consent of Merrill Lynch, Pierce, Fenner & Smith Incorporated and Citigroup Global Markets Inc., on behalf of the underwriters, during the period ending one year (for directors, executive officers and Hunt) or 180 days (for certain of our other existing investors) after the date of this prospectus, directly or indirectly, offer to sell or otherwise dispose of any shares of our common stock or file a registration statement with the SEC relating to the offering of any shares of our common stock.

Certain of our existing investors and Hunt-InfraREIT, as a limited partner of our Operating Partnership, are party to a registration rights agreement with us. Pursuant to this agreement, and after the lock-up agreements with the underwriters pertaining to this offering and the additional lock-ups with us agreed to by Hunt and Hunt-InfraREIT expire, we have agreed to register under the Securities Act for resale all or a portion of the approximately 40,536,113 shares of our common stock, including 16,543,493 OP Units that upon redemption may, at our option, be exchanged for shares of our common stock on a one-for-one basis, held by the parties to that agreement. Registration of the sale of these shares of our common stock would facilitate their sale into the public market. If any or all of these holders cause a large number of their shares to be sold in the public market, such sales could reduce the trading price of our common stock and could impede our ability to raise future capital.

 

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Future offerings of debt, which would be senior to our common stock upon liquidation, and/or preferred equity securities, which may be senior to our common stock for purposes of distributions or upon liquidation, may adversely affect the market price of our stock.

In the future, we may attempt to increase our capital resources and fund capital needs by making additional offerings of debt or preferred equity securities. Upon liquidation, holders of our debt securities and shares of preferred stock and lenders with respect to other borrowings will receive distributions of our available assets prior to the holders of our common stock. Additional equity offerings may dilute the holdings of our existing stockholders or reduce the market price of our common stock, or both. Holders of our common stock are not entitled to preemptive rights or other protections against dilution. Our preferred stock, if issued, could have a preference on liquidating distributions or a preference on distribution payments that could limit our ability to make a distribution to the holders of our common stock. Since our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Thus, our stockholders bear the risk of our future offerings reducing the market price of our common stock and diluting their stock holdings in us.

Market interest rates may affect the value of our common stock.

One of the factors that investors may consider in deciding whether to buy or sell our common stock is our distribution rate as a percentage of our stock price, relative to market interest rates. If market interest rates increase, prospective investors may desire a higher distribution rate on our common stock, implying a lower stock price all other things being equal, or seek securities paying higher dividends or interest. Higher interest rates would likely increase our borrowing costs and potentially decrease the cash available for distribution. As a result, interest rate fluctuations and capital market conditions can affect the market value of our common stock.

Risks Related to Our Organization and Structure

Certain provisions of Maryland law and of our charter and bylaws could inhibit changes in control, preventing our stockholders from realizing a potential premium over the market price of our stock in a proposed acquisition.

Certain provisions of the MGCL may have the effect of inhibiting or deterring a third party from making a proposal to acquire us or of impeding a change of control under circumstances that otherwise could provide the holders of shares of our common stock with the opportunity to realize a premium over the then-prevailing market price of such shares, including:

 

    “Business Combination” provisions that, subject to limitations, prohibit certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of our outstanding voting stock or an affiliate or associate of ours who, at any time within the two-year period immediately prior to the date in question, was the beneficial owner, directly or indirectly, of 10% or more of our then outstanding voting stock) or an affiliate of an interested stockholder for five years after the most recent date on which the stockholder becomes an interested stockholder, and thereafter impose special stockholder voting requirements and special appraisal rights on these combinations; and

 

    “Control Share” provisions that provide that holders of “control shares” of our Company (defined as shares which, when aggregated with other shares controlled by the stockholder, entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of issued and outstanding “control shares”) have no voting rights with respect to such shares except to the extent approved by our stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares.

 

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As permitted by the MGCL, we have elected, by resolution of our board of directors, to exempt from the business combination provisions of the MGCL any business combination between us and any other person that is first approved by our board of directors (including a majority of our directors who are not affiliates or associates of such person), and our bylaws contain a provision exempting any and all acquisitions of our stock from the control share provisions of the MGCL. However, our board of directors may by resolution elect to repeal the exemption from the business combination provisions of the MGCL and may by amendment to our bylaws opt in to the control share provisions of the MGCL at any time in the future.

Certain provisions of the MGCL permit our board of directors, without stockholder approval and regardless of what is currently provided in our charter or bylaws, to implement certain corporate governance provisions. Our charter contains a provision whereby we elect, at such time as we become eligible to do so (which we expect to be upon the completion of this offering), to be subject to the provisions of Title 3, Subtitle 8 of the MGCL relating to the filling of vacancies on our board of directors. In addition, through provisions in our charter and bylaws unrelated to Subtitle 8, we already (1) have a board of directors that is classified in three classes serving staggered three-year terms, (2) require a two-thirds vote for the removal of any director from the board, which removal must be for cause, (3) vest in the board the exclusive power to fix the number of directorships, subject to limitations set forth in our charter and bylaws, and (4) require, unless called by the chairman of our board of directors, our lead director, if any, our chief executive officer, our president or our board of directors, the request of stockholders entitled to cast not less than a majority of all votes entitled to be cast on a matter at such meeting to call a special meeting to consider and vote on any matter that may properly be considered at a meeting of stockholders. These provisions may have the effect of limiting or precluding a third party from making an unsolicited acquisition proposal for us or of delaying, deferring or preventing a change in control of us under circumstances that otherwise could provide the holders of shares of our common stock with the opportunity to realize a premium over the then current market price.

In addition, the advance notice provisions of our bylaws could delay, defer or prevent a transaction or a change of control of our company that might involve a premium price for holders of our common stock or otherwise be in their best interest. See “Certain Provisions of Maryland Law and Our Charter and Bylaws.”

Our external management structure and our relationships with and dependence on Hunt and its affiliates could prevent a change in control.

Our relationships with Hunt Manager, Hunt Developer and Sharyland are interrelated. The development agreement with Hunt Developer expires automatically upon termination of the management agreement, regardless of whether the management agreement is terminated by us or by Hunt Manager (unless we terminate for cause). Accordingly, the termination of our relationship with Hunt Manager as our external manager would terminate our right of first offer with respect to ROFO Projects. Further, any negative change in our relationships with Hunt Manager, Hunt Developer or Sharyland could negatively impact the other relationships. The existence of and our dependence on these relationships, and the perceived impact that a change in control may have on them, may have the effect of limiting or precluding a third party from making an unsolicited acquisition proposal for us, even if such a transaction would otherwise be in the best interests of our stockholders.

In addition, we are required to pay Hunt a termination fee equal to three times the most recent annualized base management and incentive payment if we terminate the agreement for any reason other than cause. Except in cases of for-cause termination, we are only allowed to exercise this termination right on or before December 31, 2018, to be effective December 31, 2019. The payment of a termination fee, and the limited time period in which the termination right may be exercised, may discourage the acquisition of us by any third party that does not want to continue the relationship with Hunt Manager.

 

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Our charter contains restrictions on the ownership and transfer of our stock that may delay, defer or prevent a change of control transaction.

Our charter, subject to certain exceptions, authorizes our board of directors to take such actions as it determines are advisable to preserve our qualification as a REIT. Our charter also prohibits, among other things, the beneficial or constructive ownership by any person (which includes any “group” as defined by Section 13(d)(3) of the Exchange Act) of more than 9.8% in value or number of shares, whichever is more restrictive, of the aggregate of the outstanding shares of our common stock or more than 9.8% in value of the aggregate of the outstanding shares of all classes or series of our capital stock, in each case excluding any shares that are not treated as outstanding for federal income tax purposes. Our board of directors, in its sole and absolute discretion, may exempt a person, prospectively or retroactively, from these ownership limits if certain conditions are satisfied. The restrictions on ownership and transfer of our stock may:

 

    discourage a tender offer or other transactions or a change in management or of control that might involve a premium price for our common stock or that our stockholders otherwise believe to be in their best interests; or

 

    result in the transfer of shares acquired in excess of the restrictions to a trust for the benefit of a charitable beneficiary and, as a result, the forfeiture by the acquirer of the benefits of owning the additional shares.

See “Description of Our Capital Stock—Restrictions on Ownership and Transfer.”

Our structure as an UPREIT may give rise to conflicts of interest.

Our directors and officers have duties under Maryland law to us. At the same time, we have fiduciary duties, as general partner, to our Operating Partnership and to its limited partners under Delaware law. Our duties as the general partner of the Operating Partnership may come into conflict with the duties of our directors and officers to us. Although our Operating Partnership’s partnership agreement generally limits our liability for our acts or omissions in our capacity as the general partner of the Partnership, provided we acted in good faith, Delaware law is not settled on these types of modifications to fiduciary duties and we have not obtained an opinion of counsel as to the validity or enforceability of such provisions.

We may structure acquisitions of assets in exchange for OP Units on terms that could limit our liquidity or our flexibility.

We may acquire assets by issuing OP Units in exchange for an asset owner contributing assets to our Operating Partnership. If we enter into such transactions, in order to induce the contributors of such assets to accept OP Units, rather than cash, in exchange for their assets, it may be necessary for us to provide them additional incentives. For instance, our Operating Partnership’s partnership agreement provides that any holder of OP Units may exchange such units for cash equal to the value of an equivalent number of shares of our common stock or, at our option, for shares of our common stock on a one-for-one basis. Finally, in order to allow a contributor of assets to defer taxable gain on the contribution of assets to our Operating Partnership, we might agree not to sell a contributed asset for a defined period of time or until the contributor exchanged the contributor’s units for cash or shares. Such an agreement would prevent us from selling those assets, even if market conditions made such a sale favorable to us.

Our authorized but unissued shares of common and preferred stock may prevent a change in our control.

Our charter authorizes our board of directors to issue additional authorized but unissued shares of common or preferred stock. In addition, our board of directors may, without stockholder approval, amend our charter to increase the aggregate number of our authorized shares of stock or the number of shares of stock of any

 

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class or series that we have authority to issue and classify or reclassify any unissued shares of common or preferred stock and set the preferences, rights and other terms of the classified or reclassified shares. As a result, our board of directors may establish a class or series of shares of common or preferred stock that could delay or prevent a transaction or a change in control that might involve a premium price for our shares of common stock or otherwise be in the best interests of our stockholders.

Our charter contains provisions that make removal of our directors difficult, which could make it difficult for our stockholders to effect changes to our board of directors.

Our board of directors is classified into three classes, and our charter provides that, subject to the rights of holders of any class or series of preferred stock, a director may be removed only for cause (as defined in our charter) and then only by the affirmative vote of holders of shares entitled to cast at least two-thirds of all the votes entitled to be cast generally in the election of directors. Further, our charter and bylaws provide that, at such time as we become eligible to make an election under Title 3, Subtitle 8 of the MGCL (which we expect to be upon the completion of this offering), except as may be provided by our board of directors in setting the terms of any class or series of stock, any and all vacancies on our board of directors shall be filled only by the affirmative vote of a majority of the remaining directors in office, even if less than a quorum, for the full term of the class of directors in which the vacancy occurred. These requirements prevent stockholders from removing directors except for cause and with a substantial affirmative vote and from replacing directors with their own nominees and may prevent a change in control of our company that is in the best interests of our stockholders.

 

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FORWARD-LOOKING STATEMENTS

Some of the information in this prospectus may contain forward-looking statements. Forward-looking statements give our current expectations, contain projections of results of operations or of financial condition, or forecasts of future events. Words such as “could,” “will,” “may,” “assume,” “forecast,” “position,” “predict,” “strategy,” “expect,” “intend,” “plan,” “estimate,” “anticipate,” “believe,” “project,” “budget,” “potential” or “continue” and similar expressions are used to identify forward-looking statements. Without limiting the generality of the foregoing, forward-looking statements contained in this prospectus include our expectations regarding our strategies, objectives, growth and anticipated financial and operational performance, including guidance regarding our capital expenditures and rate base, expected lease payments, our infrastructure programs, estimated cash flow projections, estimated distributions to our stockholders and our tax position. Forward-looking statements can be affected by assumptions used or by known or unknown risks or uncertainties. Consequently, no forward-looking statements can be guaranteed.

A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. We believe that we have chosen these assumptions or bases in good faith and that they are reasonable. However, when considering these forward-looking statements, you should keep in mind the risk factors and other cautionary statements in this prospectus. Actual results may vary materially. You are cautioned not to place undue reliance on any forward-looking statements. You should also understand that it is not possible to predict or identify all such factors and should not consider the following list to be a complete statement of all potential risks and uncertainties. Factors that could cause our actual results to differ materially from the results contemplated by such forward-looking statements include:

 

    risks that the Footprint Projects will not materialize for a variety of reasons, including as a result of reductions in oil and gas drilling and related activity in the Permian Basin due to lower oil and gas prices relative to our current expectations;

 

    our ability to acquire ROFO Projects or other T&D assets from Hunt on terms that are accretive to our stockholders;

 

    our current reliance on our tenant for all of our revenues and, as a result, our dependency on our tenant’s solvency and financial and operating performance;

 

    defaults on or non-renewal or early termination of leases by our tenant;

 

    risks related to future lease negotiations;

 

    changes in the regulated rates the tenants of our assets may charge their customers;

 

    the completion of our capital expenditure projects on time and on budget;

 

    competitive conditions for the development and acquisition of T&D assets;

 

    insufficient cash available to meet distribution requirements;

 

    the price and availability of debt and equity financing;

 

    increased interest rates;

 

    changes in the availability and cost of capital;

 

    our level of indebtedness or debt service obligations;

 

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    changes in governmental policies or regulations with respect to our permitted capital structure, acquisitions and dispositions of assets, recovery of investments and our authorized rate of return;

 

    weather conditions and other natural phenomena;

 

    the effects of existing and future tax and other laws and governmental regulations;

 

    our failure to qualify or maintain our status as a REIT;

 

    availability of qualified personnel;

 

    the termination of our management agreement or development agreement or the loss of the services of Hunt Manager or the loss of access to the development function of Hunt Developer;

 

    the effects of future litigation;

 

    changes in the tax laws applicable to REITs;

 

    adverse economic developments in the electric power industry;

 

    changes in general business and economic conditions, particularly in Texas; and

 

    certain factors discussed elsewhere in this prospectus.

Forward-looking statements speak only as of the date on which they are made. While we may update these statements from time to time, we are not required to do so other than pursuant to applicable laws. For a further discussion of these and other factors that could impact our future results and performance, see “Risk Factors.”

 

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USE OF PROCEEDS

We expect to receive proceeds from this offering of approximately $431.0 million, after deducting the underwriting discounts and commissions and the underwriter structuring fee. We will use $107.8 million of the proceeds from this offering to fund the cash portion of the consideration to be issued in the Merger described under “Prospectus Summary—Our Structure and Reorganization Transactions—Reorganization Transactions.” We will contribute the remaining $323.2 million of the proceeds we receive from this offering to our Operating Partnership in exchange for common units. We expect our Operating Partnership will use the proceeds from this offering that it receives from us (i) to repay an aggregate of $1.0 million of indebtedness to Hunt Consolidated, Inc. pursuant to a promissory note, (ii) to repay indebtedness outstanding under our Operating Partnership’s revolving credit facility and under SDTS’s revolving credit facility, which, as of January 20, 2015, was approximately $72.0 million and $132.0 million, respectively, (iii) to pay offering expenses (other than the underwriting discounts and commissions and the underwriter structuring fee), estimated to be $5.6 million and (iv) for general corporate purposes.

On November 20, 2014, Hunt Consolidated, Inc. loaned $1.0 million to InfraREIT, Inc. The promissory note bears interest at 2.5%, compounded annually and is due on the earlier of November 1, 2015 and the completion of this offering. The proceeds from this promissory note were used to purchase stock in other publicly traded REITs prior to this offering. We do not expect to invest in other publicly traded securities in the future.

As of September 30, 2014, the Operating Partnership had $118.5 million of indebtedness outstanding under its prior credit facility at a 2.66% interest rate. On December 10, 2014, the Operating Partnership entered into a new $75.0 million revolving credit facility that will mature on December 10, 2019 and terminated its prior credit facility after repaying the prior facility with proceeds of its new revolving credit facility and proceeds of SDTS’s amended and restated revolving credit facility described below. Borrowings under the new credit facility bear interest, at the Operating Partnership’s election, at a rate equal to (1) the one, two, three or six-month LIBOR plus 2.5%, or (2) a base rate (equal to the highest of (A) the Federal Funds Rate plus 1/2 of 1%, (B) the Bank of America prime rate and (C) one-month LIBOR plus 1%) plus 1.5%. Borrowings made under the Operating Partnership’s prior credit facility within the last twelve months were used primarily to fund capital expenditures.

As of September 30, 2014, SDTS had $75.0 million of indebtedness outstanding under its revolving credit facility at a 2.15% interest rate. On December 10, 2014, the SDTS credit agreement was amended and restated in order to, among other things, increase the amount of the revolving credit facility to a total of $250.0 million. The revolving credit facility matures on December 10, 2019, and borrowings bear interest, at SDTS’s option, at a rate per annum equal to either (1) a base rate, determined as the greatest of (A) the administrative agent’s prime rate, (B) the federal funds effective rate plus 1/2 of 1% and (C) LIBOR plus 1.00% per annum, plus a margin of 1.00% per annum or (2) LIBOR plus a margin of 2.00% per annum. Borrowings made under SDTS’s revolving credit facility within the last twelve months were used primarily to fund capital expenditures.

Affiliates of the underwriters are lenders under the Operating Partnership’s revolving credit facility and SDTS’s revolving credit facility and will, in that respect, receive a portion of the proceeds from this offering through the repayment of such indebtedness. Please read “Underwriting.”

 

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DISTRIBUTION POLICY

You should read the following discussion of our distribution policy in conjunction with “—Assumptions and Considerations” below, which includes the factors and assumptions upon which we base our cash distribution policy. In addition, this discussion contains forward-looking statements that involve numerous risks and uncertainties. The forward-looking statements are subject to a number of important factors, including those factors discussed under “Risk Factors” and “Forward-Looking Statements,” that could cause our actual results to differ materially from the results contemplated by such forward-looking statements.

For information regarding our historical consolidated results of operations, you should refer to our historical consolidated financial statements included elsewhere in this prospectus.

We intend to distribute substantially all of our cash available for distribution, less prudent reserves, through regular quarterly cash dividends. To qualify as a REIT, we must distribute annually to our stockholders an amount equal to at least 90% of our REIT taxable income, determined without regard to the deduction for dividends paid and excluding any net capital gain. We will be liable for income tax on our taxable income that is not distributed and for an excise tax to the extent that certain percentages of our taxable income are not distributed by specified dates. We expect our cash available for distribution to be significantly more than taxable income for the foreseeable future. Therefore, we expect to distribute an amount in excess of our REIT taxable income. Furthermore, we anticipate that, at least during our initial taxable years, our distributions will exceed our then current and then accumulated earnings and profits, as determined for U.S. federal income tax purposes, due to non-cash expenses, primarily depreciation and amortization charges that we expect to incur. Therefore, all or a portion of these distributions may represent a non-taxable return of capital for U.S. federal income tax purposes. The extent to which our distributions exceed our current and accumulated earnings and profits may vary substantially from year to year. To the extent that a distribution is treated as a return of capital for U.S. federal income tax purposes, it will reduce a holder’s adjusted tax basis in the holder’s shares, and to the extent that it exceeds the holder’s adjusted tax basis will be treated as gain resulting from a sale or exchange of such shares. As a result, the gain (or loss) recognized on the sale of that common stock or upon our liquidation will be decreased (or increased) accordingly. For a more complete discussion of the tax treatment of distributions to holders of our common stock, see “Material Federal Income Tax Consequences.” Income as computed for purposes of the foregoing tax rules will not necessarily correspond to our income as determined for financial reporting purposes pursuant to generally accepted accounting principles.

Any distributions we make will be authorized by and at the discretion of our board of directors based upon a variety of factors deemed relevant by our directors, which may include:

 

    actual cash available for distribution;

 

    our financial condition;

 

    our level of retained cash flows;

 

    our capital requirements;

 

    any debt service requirements;

 

    our taxable income;

 

    the annual distribution requirements under the REIT provisions of the Code;

 

    applicable provisions of Maryland law; and

 

    other factors that our board of directors may deem relevant.

 

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Our ability to make distributions to our stockholders will depend upon the performance of our business. To the extent that our cash available for distribution is less than the amount required to be distributed under the REIT provisions of the Code, we may consider various funding sources to cover any shortfall, including borrowing funds, using a portion of the net proceeds we receive in this offering or future offerings or selling certain of our assets. We do not currently intend to pay future distributions from the proceeds of this offering. We also may elect in the future to pay all or a portion of any distribution in the form of a taxable distribution of our stock or debt securities. In addition, our board of directors may change our distribution policy in the future. Our debt arrangements include covenants that may restrict our ability to make distributions to our equityholders. We currently have no intention to issue any preferred stock, but, if we do, the distribution preference on the preferred stock could limit our ability to make distributions to the holders of our common stock. See “Risk Factors” and “Material Federal Income Tax Consequences—Taxation of the Company—Annual Distribution Requirements.”

Estimated Cash Available for Distribution for the Twelve Months Ending December 31, 2015

We intend to pay a regular quarterly dividend initially set at a rate of $0.225 per share, but which may be changed in the future without advance notice. See “—Assumptions and Considerations” for further information as to the assumptions we have made for the forecast. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Summary of Significant Accounting Policies” for information regarding the accounting policies we have followed for the forecast.

We have included below our estimated cash available for distribution for the 12-month period ending December 31, 2015. We expect our quarterly dividend rate to be $0.225 per share, or $0.90 per share on an annualized basis. The actual dividends paid to stockholders with respect to the first quarter of 2015 will be pro-rated, calculated from the date shares will be delivered to investors in this offering as set forth on the cover of this prospectus through March 31, 2015. We have presented estimated cash available for distribution for 2015 because we intend to report this data on a calendar year basis after the conclusion of the offering to which this prospectus relates. Our forecast is a forward-looking statement and reflects our judgment as of the date of this prospectus of the conditions we expect to exist and the course of action we expect to take during the twelve months ending December 31, 2015. It should be read together with the historical consolidated financial statements and the accompanying notes thereto included elsewhere in this prospectus and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” We believe that we have a reasonable basis for these assumptions and that our actual results of operations will approximate those reflected in our forecast, but we can give no assurance that our forecasted results will be achieved. The assumptions and estimates underlying the forecast, as described below under “—Assumptions and Considerations,” are inherently uncertain and, although we consider them reasonable as of the date of this prospectus, they are subject to a wide variety of significant business, economic and competitive risks and uncertainties that could cause actual results to differ materially from forecasted results, including, among others, the risks and uncertainties described in “Risk Factors.” Any of the risks discussed in this prospectus, to the extent they occur, could cause actual results of operations to vary significantly from those presented below. Accordingly, there can be no assurance that the forecast will be indicative of our future performance or that actual results will not differ materially from those presented in the forecast. If our forecasted results are not achieved, we may not be able to pay a regular quarterly dividend at our initial annual distribution rate or at all. Inclusion of the forecast in this prospectus should not be regarded as a representation by us, the underwriters or any other person that the results contained in the forecast will be achieved. Therefore, you are cautioned not to put undue reliance on this information.

The accompanying forecast was not prepared with a view toward complying with the guidelines established by the American Institute of Certified Public Accountants with respect to prospective financial information. Neither our independent auditors, nor any other independent accountants, have compiled, examined or performed any procedures with respect to our forecast, nor have they expressed any opinion or any other form of assurance on our forecast or its achievability, and our independent auditors assume no responsibility for, and disclaim any association with, our forecast.

 

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We do not undertake any obligation to release publicly any revisions or updates that we may make to the forecast or the assumptions used to prepare the forecast to reflect events or circumstances after the date of this prospectus other than as required by law.

 

     Twelve Months Ending
December 31, 2015
 
     (in thousands)  

Lease revenue

   $ 149,095   

Operating costs and expenses

  

General and administrative expenses (1)

     (58,675

Depreciation

     (39,986
  

 

 

 

Total operating costs and expenses

$ (98,662
  

 

 

 

Income from operations

$ 50,433   

Other income (expense)

Interest expense, net

$ (35,930

Other income (expense), net (2)

  (7,788
  

 

 

 

Total other income (expense)

$ (43,718

Income tax expense

  (1,051
  

 

 

 

Net income before noncontrolling interest

$ 5,664   

Add: Depreciation

  39,986   
  

 

 

 

Funds From Operations before noncontrolling interest

$ 45,651   

Add: Amortization of deferred financing cost (3)

  3,108   

Add: Non-cash consideration paid in Class A OP Units (2)

  9,118   

Add: Non-cash equity compensation (1)

  644   

Less: Allowance for funds used during construction—equity

  (1,330

Add (Less): Effect of percentage rent calculation method

  —     

Add (Less): Effect of straight-line rents (4)

  7,876   

Less: Capital expenditures to maintain net assets (5)

  (39,986

Add: Reorganization expenses (1)

  39,602   

Estimated Cash Available for Distribution

  64,683   
  

 

 

 

Less: Growth capital expenditures (6)

  (208,340

Add: Net debt borrowed to fund growth capital expenditures and principal amortization (7)

  208,340   

Estimated Cash Available for Distribution after investing and financing activities

  64,683   
  

 

 

 

Annualized Dividend per Share (8)

  0.90   
  

 

 

 

Total estimated initial annual distributions to limited partners and stockholders (9)

  54,534   

Excess (10)

  10,149   

Payout ratio (11)

  0.843   

 

(1) Our estimated general and administrative expenses for 2015 include (i) recurring expenses of $19.1 million (including non-cash equity compensation of $0.6 million) and (ii) expenses associated with the Reorganization, consisting of a non-cash expense of $39.1 million related to the issuance of 1.7 million shares of our common stock to Hunt-InfraREIT as a reorganization advisory fee and cash expenses of $0.5 million for professional services, primarily related to legal, audit and tax services.

 

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(2) Includes a non-cash expense of $9.1 million related to the issuance of 983,418 Class A OP Units to Hunt-InfraREIT upon consummation of this offering. We intend to issue these Class A OP Units to settle our contingent obligation related to the CREZ construction project owed to Hunt-InfraREIT pursuant to the InfraREIT, L.L.C. constituent documents. We have calculated the amount of this non-cash expense based on the initial public offering price of $23.00 per share.
(3) Represents non-cash amortization of deferred financing costs associated with debt issuances.
(4) Represents an adjustment related to the difference between the timing of cash based rent payments made under our lease and when we recognize base rent revenue under GAAP. We recognize base rent on a straight-line basis over the applicable term of the lease commencing when the related assets are placed in service, which is frequently different than the period in which the cash rent becomes due.
(5) Our definition of cash available for distribution includes a deduction of the portion of capital expenditures needed to maintain our net assets. This amount is equal to the depreciation expense within the applicable period. The portion of capital expenditures in excess of depreciation, which we refer to as growth capital expenditures, will increase our net assets and is expected to be funded in the near term with cash on hand and debt financing. The amounts of growth capital expenditures and related funding sources are excluded from the definition of cash available for distribution. The amount of capital expenditures we expect during the near term is higher than depreciation, as described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Capital Expenditures.”
(6) Represents estimated total capital expenditures less the portion of capital expenditures needed to maintain our net assets.
(7) Represents estimated amortization of debt in the amount of $19.2 million, offset by debt that we intend to raise in the same amount and debt that we intend to issue to fund our growth capital expenditures.
(8) Based upon the expected initial quarterly dividend rate of $0.225 per share. As we pay per-share dividends, we expect that our Operating Partnership will make distributions to its limited partners. We expect the per-unit distributions that our Operating Partnership makes to equal the per-share distributions that we make to our stockholders.
(9) Based upon a total of 60,593,728 OP Units outstanding after this offering and the Reorganization.
(10) Calculated as estimated cash available for distribution for the 12 months ending December 31, 2015 minus the total estimated initial annual distributions to limited partners and stockholders.
(11) Calculated as the total estimated initial annual distributions to limited partners and stockholders divided by estimated cash available for distribution for the 12 months ending December 31, 2015.

Assumptions and Considerations

Set forth below are the material assumptions that we have made to demonstrate our ability to generate our estimated funds from operations before noncontrolling interest and estimated cash available for distribution for the twelve months ending December 31, 2015. The forecast has been prepared by and is the responsibility of our management. Our forecast reflects our judgment of the conditions we expect to exist and the course of action we expect to take during the forecast periods. The assumptions we disclose are those we believe are material to our forecasted results of operations. We believe we have a reasonable basis for these assumptions. However, we can give no assurance that our forecasted results will be achieved. There will likely be differences between our forecasted and our actual results, and those differences may be material. If our forecast is not achieved, we may not be able to pay cash dividends on our common stock at the initial quarterly dividend level or at all.

The forecast assumes that in February 2015 we will raise proceeds of $431.0 million in this offering (after deducting underwriting discounts and commissions and the underwriter structuring fee) through the issuance of 20,000,000 shares of our common stock at a price of $23.00 per share. The forecast also assumes that the proceeds of this offering will be used as described in “Use of Proceeds” elsewhere in this prospectus, including the payment of $107.8 million to existing investors as merger consideration in the Merger immediately following the consummation of this offering.

 

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Lease Revenue

 

     Twelve Months Ending
December 31, 2015
 
     (in thousands)  

Signed base rent(1)(2)

   $ 119,648   

Unsigned base rent(3)

   $ 2,705   

Signed percentage rent(2)(4)(5)

   $ 25,946   

Unsigned percentage rent(5)(6)

   $ 796   
  

 

 

 

Total

$ 149,095   

 

(1) Represents the amount of base rent lease revenue we expect under lease supplements that are signed and in effect as of the date of this prospectus, with base rent straight-lined over the term of the lease in accordance with GAAP.

 

(2) In late 2014, we signed lease supplements with Sharyland related to expected 2015 placed-in-service capital expenditures of $330.7 million. A portion of our 2015 base rent and percentage rent is attributable to the capital expenditures to which these supplements relate. If the actual placed-in-service amounts and/or weighted-average placed-in-service date of the related T&D assets is different than the assumptions we made in late 2014, then either we or Sharyland can request a validation. Pursuant to a validation, base rent amounts and percentage rent percentages may be amended, and a true-up payment may be required. See “Business and Properties—Our Tenant—Our Leases” for a description of this validation process. In no event will we use the validation process to account for differences between the expected and actual return on capital expenditures, rather only to account for the difference in estimated and actual capital expenditures and related matters such as the actual placed in service date of T&D assets funded by our capital expenditures.

 

(3) Represents the amount of base rent lease revenue we expect, straight-lined over the term of the lease in accordance with GAAP, related to a validation of our 2014 placed-in-service capital expenditures under our leases. We have signed lease supplements with Sharyland that estimated the amount of expected 2014 placed-in-service capital expenditures. We expect that the actual amount of 2014 placed-in-service capital expenditures will be higher under our S/B/C Lease than we expected when we signed these lease supplements. As a result, we have the right to, and expect to request, a validation under our S/B/C Lease in the first quarter of 2015 at which point we expect to enter into an amended and restated S/B/C Lease supplement with Sharyland. We expect to commence this validation process shortly after completion of this offering. Our estimate of 2015 base rent under our S/B/C Lease is based on our initial estimate of the amount of actual 2014 placed-in-service capital expenditures under our S/B/C Lease, which is higher than the amount we estimated at the time we and Sharyland signed the amended S/B/C Lease supplement. Under the existing provisions of our S/B/C Lease, if a validation process is initiated, we and Sharyland are required to derive revised base rent using the same inputs and assumptions that we used when the lease supplements were originally signed in 2014, other than using the actual amount of 2014 placed-in-service capital expenditures rather than the estimated amount. As a result, we believe we have a reasonable basis to estimate the amount of incremental base rent lease revenue that will result from the validation process.

 

(4) Represents the amount of percentage rent lease revenue we expect under lease supplements that are signed and in effect as of the date of this prospectus.

 

(5)

Because Sharyland owes us percentage rent based on percentages of Sharyland’s gross revenue, our percentage rent estimates for both signed lease supplements and unsigned lease supplements are based in part on projections of Sharyland’s gross revenue during 2015. Gross revenue is a defined term under our leases that generally means the revenue Sharyland generates from our T&D assets, subject to a number of adjustments described in “Business and Properties—Our Tenant—Our Leases.” We have assumed that Sharyland’s distribution gross revenue grew 23.5% in 2014 compared to 2013 and will grow 2.1% in 2015 compared to 2014. These assumptions are based in part on Sharyland’s and our projections regarding

 

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  customer, load and kWh growth in Sharyland’s service territories during 2014 and throughout 2015, which in turn are based on estimates of the level of oil and gas activity in our Stanton territory in the Permian Basin. Our assumptions regarding Sharyland’s transmission gross revenue assume that there will be additional TCOS filings effective in April and November of 2015. We have based our assumptions regarding the timing of these TCOS filings, and the amounts of transmission capital expenditures that will be placed in service throughout 2015, on Sharyland’s transmission project capital expenditure budgets and completion schedules, which are in turn based in part on a variety of factors, including reliability and growth-driven needs in Sharyland’s service territory and on requests from wind and other generators to connect to our Panhandle transmission assets.

 

(6) Represents the amount of percentage rent lease revenue we expect to recognize in 2015 related to a validation of our 2014 placed-in-service capital expenditures under our leases. We have signed lease supplements with Sharyland that estimated the amount of expected 2014 placed-in-service capital expenditures. We expect that the actual amount of 2014 placed-in-service capital expenditures will be higher under our S/B/C Lease than we expected when we signed these lease supplements. As a result, we have the right to, and expect to request, a validation under our S/B/C Lease in the first quarter of 2015 at which point we expect to enter into an amended and restated S/B/C Lease supplement with Sharyland. We expect to commence this validation process shortly after completion of this offering. We are able to estimate the effect this expected validation will have on 2015 percentage rent under our S/B/C Lease for two reasons. First, we have initial estimates of the amount of 2014 placed-in-service capital expenditures under our S/B/C Lease, and we are able to compare it to the amounts we and Sharyland estimated when we signed the amended S/B/C Lease supplement to incorporate this estimate in 2014. Second, our S/B/C Lease requires Sharyland and InfraREIT to derive revised percentage rent terms using the same inputs and assumptions that we used when the lease supplements were originally signed in 2014, other than using the actual amount of 2014 placed-in-service capital expenditures rather than the estimated amount. Based on the increased placed-in-service capital expenditure amounts, we are able to derive the expected percentage rent terms that we expect our S/B/C Lease supplement for 2015 to include following completion of the validations. As a result, we believe we have a reasonable basis to estimate the amount of incremental percentage rent lease revenue that will result from the validation process.

General and Administration Expenses

We have assumed that the total general and administration expenses in 2015 will be $58.7 million. Our assumptions include:

 

    Base management fees of $12.3 million, assuming $2.5 million for the first quarter and $9.8 million for the last three quarters.

 

    A non-cash expense of $39.1 million related to the issuance of 1.7 million shares of our common stock to Hunt-InfraREIT as a reorganization advisory fee.

 

    Cash expenses incurred in 2015 related to the Reorganization of $0.5 million.

 

    No incentive payments in 2015 based on the projected dividend (and our expectation that the Operating Partnership will make per-unit distributions in the same amount).

 

    Other third-party expenses of $6.8 million in 2015, including director compensation and other costs of being a public company.

 

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Depreciation Expense

We estimate that we will incur depreciation and amortization expense of $40.0 million in 2015. We have assumed gross electric plant of $1.7 billion as of December 31, 2015 and a weighted average depreciation rate of 2.70% for 2015. Forecasted depreciation and amortization expense reflects management’s estimates, which are based on consistent average depreciable asset lives and depreciation methodologies under GAAP.

Interest Expense

Our interest expense forecast assumes:

 

    $204.0 million of debt will be repaid immediately following the consummation of this offering using the proceeds of this offering, resulting in estimated funded indebtedness of $629.4 million as of January 20, 2015. We have also estimated a year-end debt balance of $742.8 million. We have assumed that debt at SDTS will not exceed 55% of total capital, which is the percentage of debt allowed for setting Sharyland’s rates.

 

    A weighted average interest rate of 4.78% for 2015.

 

    AFUDC debt of $0.6 million in 2015 based on an AFUDC debt rate of 3.62% applied to construction work in progress (CWIP).

 

    An amortization rate for deferred financing costs of 11.6% in 2015, resulting in debt amortization costs of $3.1 million in 2015.

Other Income, Net

Our other income, net forecast assumes:

 

    The forecast for other income, net assumes AFUDC equity will be $1.3 million in 2015 based on an AFUDC equity rate of 9.7% applied to CWIP.

 

    A non-cash expense of $9.1 million as a result of a change in the fair market value of our contingent consideration owed to Hunt-InfraREIT, which we have calculated based on the initial public offering price of $23.00 per share.

Income Tax Expense

Income tax expense is the Texas state margin tax, and we have assumed that this tax will equal approximately 0.7% of our revenue.

 

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CAPITALIZATION

The following table sets forth our cash and cash equivalents and capitalization as of September 30, 2014:

 

    On an actual basis for InfraREIT, L.L.C.; and

 

    On a pro forma basis for InfraREIT, Inc.

We derived this table from, and it should be read in conjunction with and is qualified in its entirety by reference to, our historical and pro forma consolidated financial statements and the accompanying notes included elsewhere in this prospectus. You should also read this table in conjunction with “Use of Proceeds,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Description of Our Capital Stock—Reorganization.”

 

   

As of September 30, 2014

 
    Actual     Pro Forma (1)  
    (in thousands)  

Cash and cash equivalents

  $ 24,655      $ 150,921   
 

 

 

   

 

 

 

Total debt:

Short-term borrowings

$ 193,500    $ —     

Current portion of long-term debt

  19,139      19,139   

Long-term debt

  615,367      615,367   
 

 

 

   

 

 

 

Total debt

  828,006      634,506   
 

 

 

   

 

 

 

Equity:

Total InfraREIT, L.L.C. members’ capital

  448,293      —     
 

 

 

   

 

 

 

Preferred stock, $0.01 par value per share; 50,000,000 shares authorized, none issued and outstanding, pro forma

  —     

Common stock, $0.01 par value per share; 450,000,000 shares authorized and 44,014,971 shares issued and outstanding, pro forma

  440   

Additional paid in capital

  673,603   

Accumulated deficit

  —        (28,870
 

 

 

   

 

 

 

Members’ capital

  448,293      —     
 

 

 

   

 

 

 

Total stockholders’ equity

  645,173   

Noncontrolling interests

  147,474      252,187   
 

 

 

   

 

 

 

Total equity

  595,767      897,360   
 

 

 

   

 

 

 

Total capitalization

$ 1,423,773    $ 1,531,866   
 

 

 

   

 

 

 

 

(1) The information presented on a pro forma basis above is illustrative only and may change based on the average weighted average daily price of our common stock during the 10 consecutive trading days prior to the end of the 30-day period following the completion of this offering.

 

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DILUTION

Purchasers of our common stock in this offering will experience an immediate and substantial dilution in the net tangible book value of our common stock from the initial public offering price. At September 30, 2014, we had a net tangible book value of approximately $274.4 million, or $7.83 per share held by existing investors before this offering. After giving effect to the sale by us of the shares of our common stock in this offering, including the use of proceeds as described under “Use of Proceeds,” the deduction of underwriting discounts and commissions and the underwriter structuring fee and the Reorganization, the pro forma net tangible book value at September 30, 2014 attributable to common stockholders would have been $468.0 million, or $10.63 per share of our common stock. This amount represents an immediate increase in net tangible book value of $2.80 per share to existing investors in InfraREIT and an immediate dilution in pro forma net tangible book value of $12.37 per share from the initial public offering price of $23.00 per share of our common stock to new public investors in this offering. The following table illustrates the per share dilution:

 

Initial public offering price per share

$ 23.00   

Net tangible book value per share before this offering (1)

$ 7.83   

Net increase in net tangible book value per share attributable to this offering

$ 2.80   
  

 

 

    

Pro forma net tangible book value per share after this offering (2)

$ 10.63   
     

 

 

 

Dilution in net tangible book value per share to new investors in this offering (3)

$ 12.37   
     

 

 

 

 

(1) Based on net tangible book value of approximately $274.4 million as of September 30, 2014 divided by the number of shares outstanding before this offering, which is 35,054,186 shares. Net tangible book value as of September 30, 2014 consists of total assets of $1,448.5 million less intangible assets, which are comprised of goodwill of $138.4 million and deferred financing costs and other regulatory assets of $35.5 million net of total liabilities of $852.7 million and non-controlling interest of $147.5 million.

 

(2) Based on pro forma net tangible book value of approximately $468.0 million as of September 30, 2014 divided by the number of shares of our common stock outstanding after this offering, which will be 44,014,971 shares. Pro forma net tangible book value consists of total assets of $1,546.5 million less intangible assets, which are comprised of goodwill of $138.4 million and deferred assets and other regulatory assets of $38.8 million net of total liabilities of $649.1 million and noncontrolling interest of $252.2 million.

 

(3) Dilution is determined by subtracting pro forma net tangible book value per share of our common stock after giving effect to this offering from the initial public offering price paid by a new investor for a share of our common stock.

Net Tangible Book Value Attributable to New and Existing Investors

The table below summarizes, as of September 30, 2014, on a pro forma basis, total net tangible book value attributable to investments by our existing investors and total net tangible book value attributable to cash paid by the new investors purchasing shares in this offering. In calculating the net tangible book value attributable to new investors in this offering, we used the initial public offering price of $23.00 per share and deducted underwriting discounts and commissions and other offering costs.

 

    

Shares Issued

   

Total

Net Tangible Book
Value

   

Average
Amount
Per
Share

 
    

Number

    

Percent

   

Amount

    

Percent

   

Existing investors

     24,015         54.6   $ 42,613         9.1   $ 1.77   

New investors

     20,000         45.4     425,400         90.9     21.27   
  

 

 

    

 

 

   

 

 

    

 

 

   

Total

  44,015      100.0 $ 468,013      100.0 $ 10.63   

 

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SELECTED FINANCIAL INFORMATION

The following tables set forth selected financial data on (1) a pro forma basis giving effect to the Pro Forma Adjustments described in the unaudited pro forma condensed consolidated financial statements included elsewhere in this prospectus for InfraREIT, Inc., and (2) a historical basis for InfraREIT, L.L.C. We have not presented selected financial data for InfraREIT, Inc. on a historical basis because InfraREIT, Inc. has had limited activity since its formation and because we believe that a discussion of the historical financial condition and results of operations of InfraREIT, Inc. would not be meaningful.

Historically, InfraREIT, L.L.C. followed the guidance included in SEC Staff Accounting Bulletin Topic 1.b. Accordingly, the InfraREIT, L.L.C. historical financial data as of and for the years ended December 31, 2013 and 2012 and for the nine months ended September 30, 2013 reflects all of the costs incurred on our behalf by our external manager for the periods presented. Beginning with the quarter ended June 30, 2014, the guidance in Staff Accounting Bulletin Topic 1.b. no longer applies. As a result, the historical financial data for InfraREIT, L.L.C., as well as the pro forma financial data, for the nine months ended September 30, 2014 does not include all costs incurred by our external manager during that period, but does include our management fees to Hunt Manager as well as the additional costs described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Significant Components of Our Results of Operations—Operating Expenses—General and Administrative.” You should read the following selected pro forma and historical consolidated data in connection with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the pro forma and historical consolidated financial statements and related notes thereto appearing elsewhere in this prospectus.

The selected pro forma financial data for the nine months ended September 30, 2014 and for the year ended December 31, 2013 has been derived from our unaudited pro forma consolidated financial statements included elsewhere in this prospectus. The InfraREIT, L.L.C. selected historical consolidated financial data as of and for the years ended December 31, 2013 and 2012 have been derived from the audited historical consolidated financial statements appearing elsewhere in this prospectus. The InfraREIT, L.L.C. selected historical financial data as of September 30, 2014 and for the nine months ended September 30, 2014 and 2013 was derived from the unaudited condensed consolidated financial statements included elsewhere in this prospectus, which include all adjustments, consisting of normal recurring adjustments, that our management considers necessary for a fair presentation of the financial position and the results of operations for such periods under GAAP. The results for the interim periods are not necessarily indicative of the results for the full year. The historical results are not indicative of the results we expect in the future. For a discussion of FFO, EBITDA and Adjusted EBITDA, including their limits as financial measures, see “Prospectus Summary—Non-GAAP Financial Measures.”

 

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InfraREIT, Inc.

Pro Forma

   

InfraREIT, L.L.C.
Historical

 
   

Nine Months
Ended
September 30,

2014

   

Year Ended
December 31,

2013

   

Nine Months
Ended
September 30,

   

Years Ended
December 31,

 
       

2014

   

2013

   

2013

   

2012

 
   

(in thousands)

 
    (Unaudited)     (Unaudited)              

Operating Information

         

Lease revenue

           

Base rent

  $ 76,399      $ 57,979      $ 76,399      $ 35,714      $ 57,979      $ 30,961   

Percentage rent

    12,972        15,214        12,972        7,654        15,214        11,821   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total lease revenue

  89,371      73,193      89,371      43,368      73,193      42,782   

Operating costs and expenses

General and administrative expense

  15,875      15,815      12,839      10,262      13,691      12,521   

Depreciation

  25,825      19,536      25,825      12,417      20,024      10,563   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating costs and expenses

  41,700      35,351      38,664      22,679      33,715      23,084   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

  47,671      37,842      50,707      20,689      39,478      19,698   

Other (expense) income

Interest expense, net

  (21,171   (17,330   (24,364   (10,764   (17,384   (17,314

Other income, net

  333      20,932      333      19,571      20,932      14,520   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other (expense) income

  (20,838   3,602      (24,031   8,807      3,548      (2,794

Income tax expense

  656      616      656      289      616      336   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

  26,177      40,828      26,020      29,207      42,410      16,568   

Less: Net income attributable to noncontrolling interest

  7,162      11,171      6,046      7,075      10,288      4,151   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss) attributable to InfraREIT, Inc. (pro forma) or InfraREIT, L.L.C. (historical)

$ 19,015    $ 29,657    $ 19,974    $ 22,132    $ 32,122    $ 12,417   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other Information

         

Cash flows provided by operating activities

    N/A        N/A      $ 67,691      $ 17,943      $ 21,321      $ 15,349   

Cash flows used in investing activities

    N/A        N/A        (170,200     (286,284     (390,283     (361,340

Cash flows provided by (used in) financing activities

    N/A        N/A        119,418        287,622        360,266        336,672   

FFO before noncontrolling interest (1)(2)

  $ 52,002      $ 60,364        51,845        41,624        62,434        27,131   

EBITDA before noncontrolling interest (1)(2)

    73,829        78,310        76,865        52,677        80,434        44,781   

Adjusted EBITDA before noncontrolling interest (1)(2)

    73,507        57,496        76,543        33,121        59,620        30,261   

 

(1) Unaudited.

 

(2) For a discussion of FFO, EBITDA and Adjusted EBITDA and a reconciliation to their nearest GAAP counterparts, see “Prospectus Summary—Non-GAAP Financial Measures.”

 

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InfraREIT, Inc.

Pro Forma

   

InfraREIT, L.L.C.
Historical

 
   

As of
September 30,

2014

   

As of
September 30,

2014

   

As of
December 31,

 
       

2013

   

2012

 
    (in thousands)  
    (Unaudited)     (Unaudited)              

Balance Sheet

     

Gross property, plant and equipment

    $1,329,577      $ 1,329,577      $ 1,303,828      $ 900,444   

Cash and cash equivalents

    150,921        24,655        7,746        16,442   

Total assets

    1,546,492        1,448,503        1,326,363        928,976   

Short term borrowings and current portion of long-term debt

    19,139        212,639        79,777        11,303   

Long-term debt

    615,367        615,367        627,913        461,565   

Other liabilities

    14,626        24,730        54,480        107,330   

Total liabilities

    649,132        852,736        762,170        580,198   

Total InfraREIT, Inc. stockholders’ equity (pro forma) or InfraREIT, L.L.C. members’ capital (historical)

    645,173        448,293        427,709        257,332   

Noncontrolling interest

    252,187        147,474        136,484        91,446   

Total equity

    897,360        595,767        564,193        348,778   

Total equity and liabilities

    1,546,492        1,448,503        1,326,363        928,976   

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with “Selected Financial Information,” “Business and Properties” and our historical consolidated financial statements and the related notes included elsewhere in this prospectus. This discussion contains forward-looking statements that involve numerous risks and uncertainties. The forward-looking statements are subject to a number of important factors, including those factors discussed under “Risk Factors” and “Forward-Looking Statements,” that could cause our actual results to differ materially from the results described herein or implied by such forward-looking statements.

InfraREIT, L.L.C., InfraREIT, Inc. and InfraREIT Partners, LP (Operating Partnership) intend to enter in to a merger and transaction agreement to be dated on or around the date of effectiveness of the registration statement to which this prospectus relates. Pursuant to that merger agreement, InfraREIT, L.L.C. will merge with and into InfraREIT, Inc. immediately following completion of this offering, with InfraREIT, Inc. surviving (the Merger). Because InfraREIT, L.L.C. owned and conducted substantially all of our historical assets and operations before this Merger, the following discusses and analyzes the financial condition and results of operation of InfraREIT, L.L.C. Where material, the following discusses and analyzes the pro forma financial condition and results of operations of InfraREIT, Inc. described in the unaudited pro forma condensed consolidated financial statements included elsewhere in this prospectus. For more information regarding InfraREIT, Inc.’s historical financial condition and results of operations, as well as the pro forma information, you should read the consolidated financial statements and related notes included elsewhere in this prospectus.

Overview

We own rate-regulated electric transmission and distribution (T&D) assets in Texas as part of a dividend growth oriented real estate investment trust (REIT). We currently own T&D assets throughout Texas, including the Texas Panhandle near Amarillo, the Permian Basin in and around Stanton, Central Texas around Brady, Northeast Texas in and around Celeste and South Texas near McAllen. We have grown rapidly over the last several years, with our rate base increasing from approximately $60 million as of December 31, 2009 to approximately $1.1 billion as of September 30, 2014. We expect that organic growth as well as acquisitions of T&D assets from Hunt Consolidated, Inc. (Hunt) and Sharyland Utilities (Sharyland) and from third parties will allow us to achieve continued growth in our rate base, which is calculated as our gross electric plant in service under generally accepted accounting principles (GAAP) less accumulated depreciation and adjusted for deferred taxes. For additional information on our assets, see “Business and PropertiesOur T&D Assets.”

We are externally managed by Hunt Utility Services, which we refer to as Hunt Manager. All of our officers are employees of Hunt Manager, and we do not expect to have any employees upon completion of this offering. We expect to benefit from the experience, skill, resources, relationships and contacts of the executive officers and key personnel of Hunt Manager. Pursuant to our management agreement with Hunt Manager, Hunt Manager provides for the day-to-day management of the Company, subject to the oversight of our board of directors. In exchange for these management services, we pay a management fee to Hunt Manager. See “Our Manager and Management Agreement—Management Agreement.”

Our Revenue Model

We lease our T&D assets to our tenant, Sharyland, a Texas-based utility regulated by the Public Utility Commission of Texas (PUCT). To support its lease payments to us, Sharyland delivers electric service and collects revenues directly from distribution service providers and retail electric providers, which pay PUCT-approved rates. Under the terms of our leases, Sharyland is responsible for the operation of our assets, all property related expenses associated with our assets, including repairs, maintenance, insurance and taxes (other than income and REIT excise taxes), construction management and regulatory oversight and compliance. Our

 

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development agreement with Hunt Transmission Services, L.L.C., which we refer to as Hunt Developer, and our leases provide that we will own and fund the development and construction of T&D assets that are in our distribution service territory or that are added to one of our transmission substations or that hang from one of our existing transmission lines (Footprint Projects). For Footprint Projects, we generally fund all of the capital expenditures during the construction or development phase of a project, and these expenditures increase our rate base when the related assets are placed in service. During this period, we also accrue an allowance for funds used during construction (AFUDC), which represents the approximate cost of the debt and equity used to fund these cash expenditures. AFUDC that accrues during this period increases our rate base when the assets are placed in service. Once our T&D assets are placed in service, we stop accruing AFUDC and begin depreciating those assets. Hunt Developer has agreed to give us a right of first offer on certain specified transmission development projects (ROFO Projects). We do not fund capital expenditures associated with ROFO Projects. Instead, Hunt is obligated to offer ROFO Projects to us at least 90 days before they are energized, giving us an opportunity to acquire ROFO Projects at a purchase price that will be negotiated by our Conflicts Committee, which will be comprised solely of independent directors. We expect that the negotiated price will be based on a number of factors, including the rate base for the assets, market conditions, potential for incremental Footprint Projects, whether the lease terms have been negotiated with Sharyland or another tenant, and the regulatory return we expect the assets will earn.

Significant Components of Our Results of Operations

Lease Revenue

All of our revenue is comprised of rental payments from Sharyland under our leases with Sharyland. Sharyland makes scheduled lease payments to us that generally consist of base rent, which is a fixed amount, and percentage rent, which is based on an agreed-to percentage of Sharyland’s gross revenue, as defined in the leases, earned through the PUCT-approved rates charged to its customers in excess of an annual specified threshold. We recognize base rent under these leases on a straight-line basis over the applicable term. We recognize percentage rent under these leases once the revenue earned by Sharyland on the leased assets exceeds the annual specified threshold. Because the annual threshold must be met before we can recognize any percentage revenue, we anticipate our revenue during the first and second quarters each year will be lower than the third and fourth quarters. For information regarding how we calculate Sharyland’s gross revenue, see “Business and Properties—Our Tenant—Our Leases—Rent.”

Operating Expenses

General and Administrative

Our historical general and administrative expenses during the nine-month period ended September 30, 2014 included management fees to Hunt Manager as well costs we incurred directly, such as professional services costs. In preparing our financial statements for the years ended December 31, 2013 and 2012 and the nine-month period ended September 30, 2013, we followed the guidance included in SEC Staff Accounting Bulletin Topic 1.b. Pursuant to this guidance, our general and administrative expenses included all costs incurred on our behalf by Hunt Manager, including compensation expenses, overhead costs related to the lease of our office space and software license fees during the nine-month period ended September 30, 2013 and the years ended December 31, 2013 and 2012. Our historical general and administrative expenses during these periods also included costs we incurred directly, such as professional services costs. On June 24, 2014, our board of directors agreed to increase the annual management fee from $2.5 million to $10.0 million effective January 1, 2014. Accordingly, beginning with the six-month period ended June 30, 2014, the guidance in Staff Accounting Bulletin Topic 1.b. no longer applies. As a result, our general and administrative expenses for the nine-month period ended September 30, 2014 does not include all costs incurred by our external manager during that period but does include management fees paid to Hunt Manager as well as additional costs we incur directly, such as professional services costs and direct reimbursement of third-party costs paid to outside service providers. We expect the general and administrative expenses we incur directly to increase significantly during 2015 compared

 

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to 2014, primarily as a result of an expected non-cash expense of $39.1 million related to the issuance of 1.7 million shares of our common stock to Hunt-InfraREIT as a reorganization advisory fee. We expect that general and administrative expense will also increase after the completion of this offering because we will be a public company and because our management fee will increase, effective April 1, 2015, with these increases partially offset by an expected decrease in expenses we incur to prepare for this offering in 2015 compared to 2014. After this offering, we will begin paying stock exchange listing fees, transfer agent costs and other expenses, such as legal and audit costs related to filings with the Securities and Exchange Commission, that we did not incur as a private company. Effective April 1, 2015, our management fee will increase from $10 million annually to $13.1 million annually through March 31, 2016. The base fee for each twelve month period beginning on each April 1 thereafter will equal 1.50% of our total equity (including non-controlling interest) as of December 31 of the immediately preceding year, subject to a $30 million cap, unless a greater amount is approved by a majority of our independent directors (or a committee comprised solely of independent directors).

Depreciation

Depreciation expenses consist primarily of depreciation of electric plant using the straight-line method of accounting based on rates established in our tenant’s most recent rate case. We begin to recognize depreciation on our assets when they are placed in service, which reduces our rate base in those assets.

Other Items of Income or Expense

AFUDC, which represents the approximate cost of debt and equity used to finance plant under construction, is a non-cash accounting accrual that increases our construction work in progress (CWIP) balance. AFUDC rates are determined based on electric plant instructions found in the Federal Energy Regulatory Commission (FERC) regulations; AFUDC does not represent cash generated from operations. Once our T&D assets are placed in service, we stop accruing AFUDC on those assets.

Interest Expense, net

Interest expense, net is comprised of interest expense associated with our outstanding borrowings, increased or decreased by realized gains or losses on our cash flow hedging instruments, increased by amortization of deferred financing costs and decreased by the portion of AFUDC that relates to our cost of borrowed funds (AFUDC on borrowed funds).

Other Income, net

Other income, net is comprised primarily of AFUDC that relates to the cost of our equity (AFUDC on other funds), offset by any expenses we incurred related to certain changes in the assessed value of the contingent consideration our Operating Partnership owes to Hunt-InfraREIT, L.L.C. (Hunt-InfraREIT), which is a limited partner of our Operating Partnership. As a result of the consummation of this offering, we expect to incur a non-cash expense of $9.1 million related to the issuance of 983,418 Class A units representing partnership interests in our Operating Partnership (Class A OP Units) to Hunt-InfraREIT upon consummation of this offering. We intend to issue these Class A OP Units to settle our contingent obligation related to the CREZ construction project owed to Hunt-InfraREIT pursuant to the InfraREIT, L.L.C. constituent documents. We have estimated the amount of this non-cash expense based on the initial public offering price of $23.00 per share. Following the consummation of this offering, other than the expense described above, we do not expect to incur any additional expenses related to contingent consideration. See “Contingent Consideration and Deemed Capital Contributions” for additional disclosure regarding this contingent consideration.

 

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Factors Expected To Affect Our Operating Results and Financial Condition

Our results of operations and financial condition will be affected by numerous factors, many of which are beyond our control. The key factors we expect to impact our results of operations and financial condition include our lease revenues, the amount of additional capital expenditures we make to fund Footprint Projects and the acquisition cost of any ROFO Projects we acquire.

Lease Revenues

Our revenue is derived from rent from Sharyland, which is comprised of base rent, which is a fixed amount, and percentage rent, which is based on an agreed-to percentage of Sharyland’s gross revenue, as defined in the leases, earned through the PUCT-approved rates charged to its customers in excess of a specified threshold. See “—Regulatory Recovery.” Our negotiations of both base and percentage rent with Sharyland depend on the amount of rate base that is up for renewal or subject to a new lease. Because our existing rate base will decrease over time as our T&D assets are depreciated, the base rent under our leases with respect to a significant portion of our assets will also decrease over time as our assets are depreciated. As a result, rent under our leases will decrease over time unless we add to our existing rate base by making additional capital expenditures and supplementing our leases to increase the rent owed to us in an amount sufficient to offset the decreases in the base rent resulting from depreciation. Additionally, as a result of the percentage rent component of our leases, our revenue will vary based on Sharyland’s revenue. However, because the percentage rent under our leases currently ranges from 23% to 37% of Sharyland’s annual gross revenue in excess of specified thresholds, our revenue does not vary as significantly as it would if we were an integrated utility.

We expect to report an increase in lease revenue for 2014 compared to 2013, primarily due to having a full year of lease revenue relating to our Panhandle assets under our competitive renewable energy zone (CREZ) lease as well as the effect of other lease supplements. Also, we expect to report an increase in base rent as a percentage of total rent for 2014 compared to 2013 because CREZ lease base rent, as a percentage of total rent, is higher than under our other existing leases. We also expect lease revenue to increase during the first nine months of 2015 compared to the first nine months of 2014 as a result of lease revenue generated from the assets we placed in service during 2014 and the assets we expect to place in service during 2015. As required by our leases, Sharyland’s January 2014 rate case settlement, described below, as well as any future Sharyland rate case results, will impact our negotiations with Sharyland regarding rental rates included in lease renewals and lease supplements related to future capital expenditures.

Regulatory Recovery

Sharyland charges rates for its T&D services that are approved by the PUCT. With respect to transmission services, Sharyland charges all distribution service providers (DSPs) for its cost of service, or revenue requirement, as set in its most recent rate case. DSPs pay Sharyland a monthly amount based on each DSP’s pro rata share, during the prior year, of the average of ERCOT coincident peak demand for the months of June, July, August and September (ERCOT 4CP). With respect to distribution services, Sharyland charges retail electric providers (REPs) rates that are based upon tariffs approved in its most recent rate case. The tariff typically includes a per-kilowatt hour (kWh) charge and a flat customer charge for residential customers, and may include a per-kWh, a per kilowatt (kW) and a flat customer charge for other customer classes. See “Regulation and Rates” and “Business and Properties—Our Tenant—Sharyland’s Regulatory Proceedings.” Sharyland may update its rates through a full rate proceeding with the PUCT. Additionally, Sharyland may update its transmission rates up to two times per year through interim transmission cost of service (TCOS) filings and its distribution rates no more than once a year through a distribution cost recovery factor filing. Sharyland settled a rate case that relates to substantially all of our assets other than our distribution assets in McAllen, Texas that was approved by the PUCT on January 23, 2014. As a result of the rate case, Sharyland is entitled to earn a return on equity of 9.70% and a return on invested capital of 8.06% in calculating rates, assuming a capital

 

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structure consisting of 55% debt and 45% equity. The new rates became effective on May 1, 2014. Sharyland agreed in that settlement to file its next rate proceeding in 2016, based upon the test year ending December 31, 2015. Sharyland updated its transmission tariff through an interim TCOS filing in January 2014, a filing effective May 1, 2014 (the reconciliation filing) that gave effect to the rate case results and a subsequent interim TCOS filing in August of 2014. The following outlines, by way of example, the manner in which Sharyland’s TCOS filing on August 15, 2014 (the August 2014 interim TCOS filing) updated Sharyland’s transmission rates:

 

    The August 2014 interim TCOS filing compared Sharyland’s revenue requirement as of July 31, 2014 (approximately $136.6 million) to Sharyland’s revenue requirement established in Sharyland’s reconciliation filing in March 2014 (approximately $128.5 million). The August 2014 revenue requirement updated rate base, taking into account changes in the original cost of plant in service and accumulated depreciation. The August 2014 revenue requirement also updated for changes in depreciation expense, taxes other than income tax and federal income tax.

 

    The difference in the revenue requirement for the August 2014 interim TCOS filing and the reconciliation filing in March 2014 was approximately $8.1 million. Sharyland’s interim annual transmission rate was then calculated by dividing its updated annual transmission revenue requirement of approximately $136.6 million by 2013 ERCOT 4CP of approximately 65 gigawatts, deriving a transmission rate of $2.094/kW.

The PUCT approved the August 2014 interim TCOS filing on October 3, 2014, giving Sharyland the right to begin billing DSPs at the updated transmission rate of $2.094/kW, instead of the rate established in connection with the reconciliation filing that applied through October 3, 2014. Effective October 3, 2014, each DSP paid Sharyland, monthly, an amount that on an annualized basis equals $2.094/kW multiplied by the DSP’s ERCOT 4CP usage during 2013. In other words, the amount the DSP paid Sharyland after the effectiveness of the August 2014 interim TCOS filing has depended on the DSP’s 2013 usage, and not the DSP’s 2014 usage. This tariff has been and will be subsequently updated for any subsequent interim TCOS filings, rate cases and other filings. We have amended our lease supplements with Sharyland to reflect the increased rent that Sharyland owes with respect to the additional transmission assets added in the August 2014 interim TCOS filing.

As a result of the amount of capital expenditures we expect to fund over the next several years, we expect that Sharyland will continue to use the twice-yearly interim TCOS mechanism to update its revenue requirement and wholesale transmission tariff. See “Business and Properties—Our Tenant—Sharyland’s Regulatory Proceedings—Transmission Tariff.”

Capital Expenditures

Generally, we expect to enter into lease supplements related to capital expenditures in advance of the year in which the related assets are placed in service. For instance, in late 2014, we entered into revised lease supplements that memorialized Sharyland’s obligation to pay us rent on the capital expenditures we expect for 2015. As 2015 progresses, if the amount of expected placed-in-service capital expenditures, or the related placed-in-service dates, differ from expectations, either Sharyland or we may request a rent validation in order to adjust rent obligations to true-up the difference between actual and expected capital expenditure amounts and placed-in-service dates. Our leases do not require that we follow this exact timeline and process, and we may determine, together with Sharyland, that an alternate process is more efficient.

Historically, the capital expenditures during the construction or development phase of a project have been reflected in our electric plant, net as CWIP. However, due to the development agreement, the capital expenditures for ROFO Projects prior to acquisition by us will be funded by third parties, and therefore will not be included in the CWIP reflected on our balance sheet. Partially as a result, our AFUDC income will be lower in future years than it has been historically.

 

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InfraREIT, L.L.C. Results of Operations

 

    

Nine Months Ended

September 30,

   

Years Ended

December 31,

 
    

2014

   

2013

   

2013

   

2012

 
     (in thousands)  
     (Unaudited)              

Operating Information

        

Lease revenue

        

Base rent

   $ 76,399      $ 35,714      $ 57,979      $ 30,961   

Percentage rent

     12,972        7,654        15,214        11,821   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total lease revenue

  89,371      43,368      73,193      42,782   

Operating costs and expenses

General and administrative expense

  12,839      10,262      13,691      12,521   

Depreciation

  25,825      12,417      20,024      10,563   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating costs and expenses

  38,664      22,679      33,715      23,084   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

  50,707      20,689      39,478      19,698   

Other (expense) income

Interest expense, net

  (24,364   (10,764   (17,384   (17,314

Other income, net

  333      19,571      20,932      14,520   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other (expense) income

  (24,031   8,807      3,548      (2,794

Income tax expense

  656      289      616      336   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

  26,020      29,207      42,410      16,568   

Less: Net income attributable to noncontrolling interest

  6,046      7,075      10,288      4,151   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income attributable to InfraREIT, L.L.C.

$ 19,974    $ 22,132    $ 32,122    $ 12,417   
  

 

 

   

 

 

   

 

 

   

 

 

 

Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013

Lease revenue—Lease revenue was $89.4 million for the nine months ended September 30, 2014 compared to $43.4 million for the nine months ended September 30, 2013, an increase of $46.0 million, or 106.1%. Base rent contributed $76.4 million and $35.7 million during the nine months ended September 30, 2014 and 2013, or 85.5% and 82.4%, of the total revenue, respectively. Percentage rent was $13.0 million, or 14.5%, of our total revenue for the nine months ended September 30, 2014, compared to $7.7 million, or 17.6%, of our total revenue during the nine months ended September 30, 2013. We recognize percentage rent on our leases once Sharyland’s revenue exceeds the annual specified thresholds.

The increase in base rent was primarily driven by the additional lease revenue associated with the Panhandle transmission assets being placed in service, which resulted in revenue recognition of $46.6 million under our CREZ lease during the nine-month period ended September 30, 2014 compared to $10.3 million for the same period in 2013. Additionally, other distribution and transmission assets placed in service generated additional base rent of $4.4 million during the nine months ended September 30, 2014 as compared to the same period in 2013. The increase in percentage rent of $5.3 million was primarily driven by an increase of percentage rent related to our CREZ lease that resulted in $3.8 million of percentage rent being recognized during the nine months ended September 30, 2014, compared to no percentage rent recognized during the comparable period in the prior year on the same lease. We also experienced an increase in our other leases that generated an additional $1.5 million of percentage rent during the nine months ended September 30, 2014 compared to the same period in the prior year. The increase in our percentage rent is due to the additional assets we have placed in service coupled with an increase in revenue at Sharyland through the nine months ended September 30, 2014 as compared to the previous year. See Note 2 of the Notes to the condensed consolidated financial statements for additional information regarding our leases.

 

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General and administrative expense—General and administrative expenses were $12.8 million and $10.3 million for the nine months ended September 30, 2014 and 2013, respectively, an increase of $2.6 million, or 25.1%. The increase in general and administrative expense has been driven by an increase in professional services of $3.4 million, primarily related to legal, audit and tax services. These costs have been the results of our efforts to prepare the company for an initial public offering. The increase in professional services has been partially offset by the management fee paid to our manager being lower than the allocated manager costs reflected in the prior period. Historically, we followed the guidance included in SEC Staff Accounting Bulletin Topic 1.b. Pursuant to this guidance, our general and administrative expenses included all costs incurred on our behalf by Hunt Manager, including compensation expenses, overhead costs related to the lease of our office space and software license fees. On June 24, 2014, our board of directors agreed to increase the annual management fee from $2.5 million to $10.0 million effective January 1, 2014. Beginning with the quarter ended June 30, 2014, the guidance in Staff Accounting Bulletin Topic 1.b. no longer applies. As a result, our general and administrative expenses for the nine-month period ended September 30, 2014 does not include all costs incurred by our external manager during that period but does include management fees paid to Hunt Manager as well as additional costs we incur directly, such as professional services costs and direct reimbursement of third-party costs paid to outside service providers. As a result of the increased management fee, we, through our Operating Partnership, incurred costs associated with management fees of $7.5 million during the nine months ended September 30, 2014.

Depreciation—Depreciation expense was $25.8 million for the nine months ended September 30, 2014 compared to $12.4 million for the nine months ended September 30, 2013, an increase of $13.4 million, or 108.0%. The increase in depreciation expense is due to additional assets being placed in service, primarily driven by our Panhandle transmission assets being placed in service throughout 2013.

Interest expense, net—Interest expense, net was $24.4 million during the nine months ended September 30, 2014 compared to $10.8 million for the nine months ended September 30, 2013, an increase of $13.6 million, or 126.3%. The increase in interest expense, net is due to lower AFUDC on borrowed funds of $10.2 million during the nine months ended September 30, 2014 compared to the same period in 2013, resulting from our lower CWIP balances after our Panhandle transmission assets were placed in service throughout 2013. Additionally, the remaining increase in interest expense of $3.4 million during the nine months ended September 30, 2014, compared to the same period in 2013, was primarily a result of higher debt balances. See Notes 9 and 10 of the Notes to the condensed consolidated financial statements for additional information.

Other income, net—Other income, net was $333,000 during the nine-month period ended September 30, 2014 compared to $19.6 million for the nine-month period ended September 30, 2013, a decrease of $19.2 million, or 98.3%. The decrease in other income, net was driven by a decline in AFUDC on other funds by $18.1 million to $1.5 million for the nine-month period ended September 30, 2014 compared to $19.6 million the prior period. The decrease of AFUDC on other funds resulted from our lower CWIP balances after our Panhandle transmission assets were placed in service throughout 2013. Other income, net also included $1.1 million of expense related to a change in fair value of the Operating Partnership’s contingent consideration owed to Hunt-InfraREIT pursuant to the provisions of the Operating Partnership’s partnership agreement during the nine months ended September 30, 2014. There was no such charge in the same period in 2013. See Note 15 of the Notes to the condensed consolidated financial statements for additional information regarding contingent consideration.

Year Ended December 31, 2013 Compared to Year Ended December 31, 2012

Lease revenue—Lease revenue was $73.2 million for the year ended December 31, 2013 compared to $42.8 million for the year ended December 31, 2012, an increase of $30.4 million, or 71.1%. Base rent contributed $58.0 million and $31.0 million during the years ended December 31, 2013 and 2012, or 79.2% and 72.4%, of the total revenue, respectively. Percentage rent was $15.2 million, or 20.8%, of our total revenue for the year ended December 31, 2013, compared to $11.8 million, or 27.6%, of our total revenue during the year ended December 31, 2012.

 

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The increase in base rent was significantly driven by the additional lease revenue associated with the Panhandle transmission assets being placed in service, which resulted in revenue recognition of $23.3 million under our CREZ lease during the twelve month period ended December 31, 2013 compared to none for the same period in 2012. Additionally, other distribution and transmission assets placed in service generated an additional base revenue of $3.7 million during the twelve months ended December 31, 2013 as compared to the same period in 2012. The increase in percentage rent of $3.4 million during the year ended December 31, 2013 as compared to the same period in 2012 was primarily driven by a $67.3 million increase in Sharyland’s gross revenue. Our percentage rent is driven by the revenue earned by Sharyland for the usage of our total leased assets. Our increase in percentage rent of $3.4 million during the twelve month period ended December 31, 2013 as compared with the twelve month period ended December 31, 2012 was driven by additional lease revenue associated with the Panhandle transmission assets of $1.6 million, an increase in usage of $1.4 million across the leased system and an increase of $0.4 million due to a change in percentage rent rates used in 2013 as compared to 2012. There was no revenue associated with the Panhandle transmission assets during the twelve month period ended December 31, 2012. See Note 3 of the Notes to the consolidated financial statements for additional information regarding our leases.

General and administrative expense—General and administrative expenses were $13.7 million and $12.5 million for the years ended December 31, 2013 and 2012, respectively, an increase of $1.2 million, or 9.3%. We have reflected the costs incurred on the Company’s behalf by Hunt Manager during these periods. These costs include compensation, rent expense and other costs totaling $11.6 million and $10.7 million for the years ended December 31, 2013 and 2012, respectively. General and administrative expenses also included professional services such as audit, tax and legal of $2.1 million and $1.8 million during the years ended December 31, 2013 and 2012, respectively.

Depreciation—Depreciation expense was $20.0 million for the year ended December 31, 2013 compared to $10.6 million for the year ended December 31, 2012, an increase of $9.5 million, or 89.6%. The increase in depreciation expense is due to additional assets being placed in service, primarily driven by our Panhandle transmission assets being placed in service during the 2013 twelve month period.

Interest expense, net—Interest expense, net was $17.4 million during the year ended December 31, 2013 compared to $17.3 million for the year ended December 31, 2012, an increase of $70,000, or 0.4%. The increase in interest expense, net is due to higher interest expense of $30.0 million during the 2013 twelve month period, compared to $26.5 million during the 2012 twelve month period, as a result of higher debt balances, partially offset by higher AFUDC on borrowed funds of $12.6 million during the 2013 twelve month period compared to $9.2 million during the 2012 twelve month period. See Notes 10 and 11 of the Notes to the consolidated financial statements for additional information.

Other income, net—Other income, net was $20.9 million during the twelve month period ended December 31, 2013 compared to $14.5 million for the twelve month period ended December 31, 2012, an increase of $6.4 million, or 44.2%. Other income, net was driven primarily by AFUDC on other funds of $21.7 million and $15.3 million during the twelve month periods ended December 31, 2013 and 2012, respectively. The increase of AFUDC on other funds resulted from our higher CWIP balances during the 2013 period compared to the 2012 period, partially offset by a higher debt to equity structure used to calculate the AFUDC on other funds during the 2013 twelve month period compared to the 2012 twelve month period. Other income, net included $841,000 and $753,000 of expense related to a change in fair value of the Operating Partnership’s contingent consideration owed to Hunt-InfraREIT pursuant to the provisions of the Operating Partnership’s partnership agreement during the twelve month periods ended December 31, 2013 and 2012, respectively. See Note 16 of the Notes to the consolidated financial statements for additional information regarding contingent consideration.

 

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Liquidity and Capital Resources

As of September 30, 2014, we had $24.7 million of unrestricted cash and cash equivalents, or $150.9 million on a pro forma basis. We use our cash on hand primarily for the payment of capital expenditures, operating expenses, debt service payments and our dividend payments. As of September 30, 2014, we also had $1.7 million of restricted cash and $11.5 million of unused capacity under our revolving credit facilities, or $1.7 million and $325.0 million, respectively, on a pro forma basis. Before the completion of this offering, our principal sources of liquidity were members’ contributions, proceeds from borrowings under our credit facilities and cash flows from operations. Following completion of this offering, our members will no longer periodically contribute cash to InfraREIT, as they have historically. We expect the proceeds from this offering, cash flows from operations and borrowings under our credit facilities to be sufficient to fund current obligations, projected working capital requirements, maturities of long-term debt, budgeted capital spending and the payment of dividends in accordance with REIT requirements of the U.S. federal income tax laws and our distribution policy for at least the next twelve months. We expect that we will be able to fund estimated capital expenditures associated with Footprint Projects through the end of 2017 without raising proceeds from additional equity offerings. However, if (i) debt capital is unavailable on favorable terms or at all at a time when we would choose to access debt capital markets, (ii) the capital expenditure requirements of our business are different than expectations, (iii) we have the need for equity capital in connection with the purchase of ROFO Projects or other non-Footprint Projects, (iv) our credit metrics are weaker than our expectations and/or (v) the cash flows from operations do not meet our current estimates or any other unexpected factors impact our liquidity and cash position, we may seek to raise proceeds from the equity markets at an earlier time.

Under the terms of our leases, Sharyland provides a capital expenditure forecast on a rolling three-year basis that sets forth anticipated capital expenditures related to our T&D assets. We fund Footprint Projects related to our T&D assets as we and Sharyland determine such Footprint Projects are required pursuant to the terms of our leases. To the extent we fund such Footprint Projects, Sharyland is required to lease the assets related to such Footprint Projects.

Although we expect to have sufficient funds to address our capital needs for at least the next twelve months, in the future we expect to rely on the capital markets in order to meet our capital expenditure obligations and to continue to distribute at least 90% of our taxable income to our stockholders. If our ability to access the capital markets is restricted or if debt or equity capital were unavailable on favorable terms or at all at a time when we would like, or need, to access those markets, our ability to fund capital expenditures under our leases or to comply with the REIT distribution rules could be adversely affected.

Capital Expenditures

Our total capital expenditures for the nine months ended September 30, 2014 and for the years ended December 31, 2013 and 2012 were $170.2 million, $390.3 million and $361.3 million, respectively. Although our development agreement will not be effective until the consummation of this offering and we have not historically categorized projects as Footprint Projects, our capital expenditures for the nine months ended September 30, 2014 include expenditures of $24.3 million on projects that were transferred on January 15, 2015 to Hunt or one of its affiliates and designated as ROFO Projects under our development agreement. See “Prospectus Summary—Our Relationship with Hunt—Hunt’s Development Projects—Transfer of ROFO Project Assets.”

We expect to have significant future capital expenditures as a result of the customer growth in Sharyland’s service territory. The table below shows the estimated aggregate capital expenditures for 2014 through 2017 for Footprint Projects. We intend to fund these projects with a mix of debt, contributions from members (prior to the completion of this offering), proceeds from this offering and cash flows from operations. Our expected capital expenditures are primarily related to the expansion of our existing transmission grid, such as adding a second circuit to our Panhandle transmission assets due to increased wind generation capacity, and growth in our distribution service territories, such as customer interconnects driven by oil and gas activity in the Permian Basin.

 

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The estimated capital expenditure amounts listed below relate solely to Footprint Projects that we expect to own from project inception and not to the acquisition price of any ROFO Projects pursuant to our development agreement or the acquisition of any other T&D assets from Hunt or any other third party. The aggregate estimated amounts listed below are based upon a variety of assumptions, including load growth, Sharyland’s and our past experience, reliability needs and historical precedent.

 

    

(in millions)

 
    

2014

    

2015

    

2016

    

2017

 

Transmission

   $ 100       $ 135       $ 165       $ 160   

Distribution

     60         110         105         85   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

$ 155-165    $ 240-250    $ 265-275    $ 240-250   

Our anticipated capital expenditures are based on a three-year rolling forecast and judgments of the conditions we expect to exist and the capital expenditures we expect to be able to make in the future to meet the reliability needs, customer growth and load growth on our system. Our 2015 and 2016 capital expenditures forecast is driven primarily by the need to improve the reliability of the existing system and meet the identified requirements of customers. The longer-term drivers of our capital expenditure forecast are the expansion of wind and other generation assets in the Panhandle and South Plains, ongoing growth in the oil and gas sector in West Texas and population growth and economic expansion in South Texas. The assumptions and estimates underlying the forecast and these judgments are believed by us to be reasonable as of the date of this prospectus but are inherently uncertain and subject to a wide variety of significant business, economic and competitive risks and uncertainties that could cause the amount and timing of our capital expenditures to differ materially from our current expectations. For example, if the recent oil price declines continue, or if oil and gas producers, pipeline and processing companies and other service providers in West Texas respond with more significant reductions in their ongoing investments than we currently estimate, the load growth in our service territory in and around Stanton, Texas would be negatively impacted and our capital expenditures related to Footprint Projects in this territory would be less than we expect, particularly in 2017 and beyond.

Credit Arrangements

Prior Operating Partnership Revolving Credit Facility

On January 3, 2014, the Operating Partnership established a revolving credit facility led by Bank of America, N.A., as administrative agent, which includes a letter of credit facility. The prior credit facility was guaranteed by Transmission and Distribution Company, L.L.C. (TDC), a subsidiary of the Company. The maximum amount of borrowings and other extensions of credit under the prior credit facility was limited to $130.0 million. The borrowings and other extensions of credit under the revolving credit facility were secured by the assets of, and the Operating Partnership’s equity interests in, TDC on the same basis as the senior secured notes issued by TDC, as described below.

Under the prior credit facility, the Operating Partnership was required to maintain at all times, on a consolidated basis, a total debt to capitalization ratio (as defined in the Operating Partnership’s prior credit agreement) of not more than 0.75 to 1.00, and maintain for each period of four consecutive fiscal quarters a debt service coverage ratio (as defined in the Operating Partnership’s credit agreement) of at least 1.20 to 1.00.

At September 30, 2014, the Operating Partnership was in compliance with all covenants under this agreement.

Borrowings and other extensions of credit under the prior credit facility bore interest, at the Operating Partnership’s election, at a rate equal to (i) the one, two, three or six-month London Interbank Offered Rate (LIBOR) plus 2.5%, or (ii) a base rate (equal to the highest of (A) the Federal Funds Rate plus  12 of 1%, (B) the Bank of America prime rate and (C) LIBOR plus 1%) plus 1.5%. The agreement required maintenance of certain financial ratios and imposes certain restrictive covenants.

 

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At September 30, 2014, the Operating Partnership had $118.5 million outstanding related to the prior credit facility. The Operating Partnership had $11.5 million of remaining capacity and no letters of credit outstanding under the prior credit facility as of September 30, 2014. On November 13, 2014, we amended the credit facility to extend the maturity date to March 31, 2015, and on December 10, 2014, we terminated the prior credit facility in connection with the Operating Partnership’s entry into the new revolving credit facility described below.

New Operating Partnership Revolving Credit Facility

On December 10, 2014, the Operating Partnership entered into a new $75.0 million five-year revolving credit facility to be led by Bank of America, N.A. Up to $15.0 million of the new revolving credit facility is available for issuance of letters of credit. The new revolving credit facility is guaranteed by TDC and is secured by the assets of, and the Operating Partnership’s equity interests in, TDC on the same basis as the senior secured notes issued by TDC, as described below. Additionally, upon the consummation of this offering and the Merger, InfraREIT, Inc. will also become a guarantor under the new revolving credit facility.

The credit agreement governing the new revolving credit facility imposes certain restrictive covenants on the Operating Partnership, including, but not limited to, restrictions on the ability of the Operating Partnership to incur additional indebtedness, create liens or other encumbrances, make investments, enter into mergers or consolidations, sell or otherwise transfer assets, enter into any line of business other than the business of the transmission and distribution of electric power and the provision of ancillary services and certain restrictions on the payment of dividends. The credit agreement requires the Operating Partnership to maintain, at all times, on a consolidated basis, a total debt to capitalization ratio of not more than 0.75 to 1.00 and to maintain, for each period of four consecutive fiscal quarters, a debt service coverage ratio of at least 1.20 to 1.00. The credit agreement also contains restrictions on the amount of Sharyland’s indebtedness and other restrictions on, and covenants applicable to, Sharyland.

Borrowings and other extensions of credit under the revolving credit facility bear interest, at the Operating Partnership’s election, at a rate equal to (i) the one, two, three or six-month London Interbank Offered Rate (LIBOR) plus 2.5%, or (ii) a base rate (equal to the highest of (A) the Federal Funds Rate plus  12 of 1%, (B) the Bank of America prime rate and (C) LIBOR plus 1%) plus 1.5%. Letters of credit are subject to a letter of credit fee equal to the daily amount available to be drawn times 2.5%. The Operating Partnership also is required to pay a commitment fee and other customary fees under the new revolving credit facility.

The credit agreement contains customary events of default. If an event of default occurs and is continuing, the lenders may accelerate amounts due under the new revolving credit facility (except in the case of a bankruptcy event of default, in which case such amounts will automatically become due and payable).

The new revolving credit facility commitment will terminate on December 10, 2016; provided that the maturity date will automatically be extended to December 10, 2019 upon the completion of this offering. The Operating Partnership may prepay amounts outstanding under the new revolving credit facility in whole or in part without premium or penalty.

SDTS Revolving Credit Facility

On June 28, 2013, our subsidiary, Sharyland Distribution and Transmission Services, L.L.C. (SDTS), entered into a credit agreement, which we refer to as the SDTS credit agreement, providing for a five-year revolving credit facility in the amount of $75.0 million led by Royal Bank of Canada, as administrative agent. On December 10, 2014, the SDTS credit agreement was amended and restated in order to, among other things, increase the amount of the revolving credit facility to a total of $250.0 million. Up to $25.0 million of the revolving credit facility is available for issuance of letters of credit, and up to $5.0 million of the revolving credit

 

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facility is available for swingline loans. The revolving credit facility is secured by substantially all of the assets of, and TDC’s equity interests in, SDTS on the same basis as the senior secured notes issued by SDTS, as described below.

The SDTS credit agreement contains customary covenants including, but not limited to, restrictions on the ability of SDTS to incur additional indebtedness, create liens or other encumbrances, make investments, enter into mergers, consolidations, liquidations or dissolutions, sell or otherwise transfer assets, enter into any line of business other than the business of the transmission and distribution of electric power and the provision of ancillary services and certain restrictions on the payment of dividends. We are not able to use proceeds of the revolving credit facility to fund projects that are separately owned and financed by Sharyland Projects, L.L.C. (SPLLC), our project finance subsidiary and a wholly-owned subsidiary of SDTS, such as our Panhandle transmission assets or any other future project finance subsidiary of SDTS.

The facility also contains restrictions on the amount of Sharyland’s indebtedness and other restrictions on, and covenants applicable to, Sharyland. SDTS must maintain at all times, on a consolidated basis, a total debt to capitalization ratio of not more than 0.65 to 1.00, and maintain for each period of four consecutive fiscal quarters a debt service coverage ratio (as defined in the SDTS credit agreement) of at least 1.40 to 1.00.

As of September 30, 2014, SDTS was in compliance with all covenants of its credit agreement.

Loans outstanding under the revolving credit facility bear interest, at SDTS’s option, at a rate per annum equal to either (i) a base rate (determined as the greatest of (A) the administrative agent’s prime rate, (B) the federal funds effective rate plus 1/2 of 1% and (C) LIBOR plus 1.00% per annum), plus a margin of either 0.75% or 1.00% per annum, depending on the total debt to capitalization ratio of SDTS on a consolidated basis, or (ii) LIBOR plus a margin of either 1.75% or 2.00% per annum, depending on the total debt to capitalization ratio of SDTS on a consolidated basis. Letters of credit are subject to a letter of credit fee equal to the daily amount available to be drawn times either 1.75% or 2.00% per annum, depending on the total debt to capitalization ratio of SDTS on a consolidated basis. SDTS is also required to pay a commitment fee and other customary fees under its revolving credit facility.

The revolving credit facility is subject to customary events of default. If an event of default occurs and is continuing, the required lenders (as defined in the SDTS credit agreement) may accelerate amounts due under the credit facility (except in the case of a bankruptcy event of default, in which case such amounts will automatically become due and payable).

SDTS is entitled to prepay amounts outstanding under the facility with no prepayment penalty.

The outstanding borrowings under the revolving credit facility at September 30, 2014 were $75.0 million, a portion of which was used to repay a term loan facility that SDTS had previously established. The revolving credit facility commitment terminates on December 10, 2019.

CREZ Construction Loan

On June 20, 2011, our project finance subsidiary, SPLLC, which owns our Panhandle transmission assets constructed as part of the CREZ project, entered into a construction-term loan agreement consisting of a $667.0 million construction-term loan syndicated broadly to a group of 14 international banks, with Société Generale as administrative agent. At that time, SPLLC also issued $60.0 million in 5.04% fixed rate notes due June 2018. The construction-term loan agreement was reduced to $447.0 million on March 8, 2013 as a result of a reduction in the expected CREZ construction budget. The outstanding amount of $407.0 million under the construction-term loan converted to a term loan on May 16, 2014 in connection with our Panhandle transmission assets being placed in service, execution of a related lease supplement and related matters. The outstanding borrowings under the term loan at September 30, 2014 were $400.9 million. SPLLC is entitled to prepay amounts

 

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outstanding under the loan agreement, subject to payment of any swap or breakage costs incurred by a lender in connection with such prepayment. The CREZ term loan accrues interest at LIBOR plus 2.25% for a period of three years, at which point the interest rate will increase to LIBOR plus 2.50%. Currently, interest on the term loan is payable the last day of the selected interest period for interest periods of three months or less, and every three months for interest periods that are greater than three months. Interest on the fixed rate note is payable at the end of each quarter. Amortized principal amounts on the term loan are payable quarterly; the fixed rate note does not provide for any current principal amortization. SPLLC is entitled to prepay amounts outstanding under the fixed rate notes, subject to payment of a prepayment penalty equal to the excess of the discounted value of the remaining scheduled payments with respect to such notes over the amount of the prepaid notes. The CREZ term loan contains customary covenants that include restrictions on the ability of SPLLC to incur additional indebtedness, create liens or other encumbrances, make investments, enter into mergers, consolidations, liquidations or dissolution (provided that SPLLC may merge into or consolidate with SDTS), sell or otherwise transfer its assets and enter into any activities other than the ownership and development of the CREZ project, and the loan includes certain restrictions on the payment of dividends. Under the CREZ term loan, SPLLC must maintain a debt to total capitalization ratio not to exceed 0.70 to 1.00 at the end of any fiscal quarter. We are currently in compliance with all covenants under these loans. The loan matures on June 20, 2018.

Senior Secured Notes

On December 31, 2009, our subsidiary, SDTS, issued $53.5 million aggregate principal amount of 7.25% per annum senior secured notes, which mature on December 30, 2029 with principal and interest payable quarterly. As of September 30, 2014, $46.7 million of principal was outstanding under this loan. In connection with our $221.5 million acquisition of Cap Rock Holdings Corporation in 2010, our subsidiaries entered into several different debt arrangements. SDTS issued $110.0 million aggregate principal amount of 6.47% per annum senior secured notes, which mature on September 30, 2030, with principal and interest payable quarterly. The SDTS notes are secured by the assets of, and TDC’s equity interests in, SDTS. As of September 30, 2014, $106.6 million of principal was outstanding under this loan.

Another subsidiary, TDC, issued $25.0 million aggregate principal amount of 8.5% per annum senior notes, which mature on December 30, 2020, with principal and interest payable quarterly. The TDC notes are secured by the assets of, and the Operating Partnership’s equity interests in, TDC. As of September 30, 2014, $20.3 million of principal was outstanding under this loan.

SDTS and TDC are entitled to prepay amounts outstanding under the notes, subject to payment of a prepayment penalty equal to the excess of the discounted value of the remaining scheduled payments with respect to such notes over the amount of the prepaid notes.

These facilities contain customary covenants that include restrictions on the ability to incur additional indebtedness, create liens or other encumbrances, make investments, enter into mergers, consolidations, liquidations or dissolution, sell or otherwise transfer assets, enter into any line of business other than the business of the transmission and distribution of electric power and the provision of ancillary service, and certain restrictions on the payment of dividends. The facilities also contain restrictions on the amount of Sharyland’s indebtedness and other restrictions on, and covenants applicable to, Sharyland. TDC must maintain at all times, on a consolidated basis, a total debt to capitalization ratio of not more than 0.75 to 1.00, and must maintain, for each four consecutive fiscal quarter period, a consolidated debt service coverage ratio of at least 1.20 to 1.00 and a balance in a debt service reserve account equal to two quarterly principal plus interest payments payable on the notes. SDTS must maintain at all times, on a consolidated basis, a total debt to capitalization ratio of not more than 0.65 to 1.00 and, for each period of four consecutive fiscal quarters, a consolidated debt service coverage ratio of at least 1.40 to 1.00. Debt service coverage ratio means cash available for debt service divided by debt service payments, and is measured quarterly on a 12-month trailing basis. Cash available for debt service means lease revenue less general and administrative expenses. We are currently in compliance with all covenants under these loans.

 

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The following chart illustrates our various debt obligations as of January 20, 2015 after giving effect to the use of proceeds from this offering:

 

LOGO

The foregoing descriptions of our credit arrangements are only summaries. For complete descriptions, we refer you to the credit documents which are filed as exhibits to the registration statement of which this prospectus is a part. See “Where You Can Find More Information.”

Cash Flows

Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013

Cash flows from operating activities—Net cash provided by operating activities was $67.7 million and $17.9 million during the nine months ended September 30, 2014 and 2013, respectively. In addition to working capital changes during the periods presented, our increase in cash rent payments was the primary driver in the change in cash flows from operating activities.

Cash flows from investing activities—Net cash used in investing activities was $170.2 million and $286.3 million during the nine months ended September 30, 2014 and 2013, respectively. The net cash used in investing activities was driven by our capital expenditures related to construction of our T&D assets, including payments associated with our Panhandle transmission assets pursuant to the CREZ Project, which decreased during the nine months ended September 30, 2014.

Cash flows from financing activities—Net cash provided by financing activities was $119.4 million and $287.6 million during the nine months ended September 30, 2014 and 2013, respectively. Cash provided by financing activities was driven by borrowings of $134.5 million and $231.5 million during the nine months ended September 30, 2014 and 2013, respectively. Additionally, cash provided by financing activities included members’ contributions of $90.9 million during the nine months ended September 30, 2013. Cash provided by financing activities was partially offset by cash used in financing activities, including dividends paid and

 

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distributions to noncontrolling interest of $12.2 million during the nine months ended September 30, 2013. Cash provided by financing activities also included repayments of borrowings of $14.2 million and $22.2 million during the nine months ended September 30, 2014 and 2013, respectively.

Year Ended December 31, 2013 Compared to Year Ended December 31, 2012

Cash flows from operating activities—Net cash provided by operating activities was $21.3 million and $15.3 million during the years ended December 31, 2013 and 2012, respectively. In addition to working capital changes during the periods presented, our increase in cash rent payments was the primary driver in the change in cash flows from operating activities.

Cash flows from investing activities—Net cash used in investing activities was $390.3 million and $361.3 million during the years ended December 31, 2013 and 2012, respectively. The net cash used in investing activities was driven by our capital expenditures related to construction of our T&D assets including the construction of our Panhandle transmission assets pursuant to the CREZ project.

Cash flows from financing activities—Net cash provided by financing activities was $360.3 million and $336.7 million during the years ended December 31, 2013 and 2012, respectively. Cash provided by financing activities was driven by borrowings of $258.0 million and $213.0 million during the years ended December 31, 2013 and 2012, respectively. Additionally, cash provided by financing activities included members’ contributions of $136.9 million and $130.4 million during the years ended December 31, 2013 and 2012, respectively. Cash provided by financing activities was partially offset by cash used in financing activities, including dividends paid and distributions to noncontrolling interest of $12.2 million during the year ended December 31, 2013. Cash used in financing activities also included repayments of borrowings of $23.2 million and $9.0 million during the years ended December 31, 2013 and 2012, respectively.

Off-Balance Sheet Arrangements

We had no off-balance sheet arrangements as of December 31, 2013 and 2012.

Contingent Consideration and Deemed Capital Contributions

Contingent Consideration

We conduct our business as a traditional umbrella partnership REIT, or UPREIT. InfraREIT, the corporate parent in our structure and the entity that is selling shares of common stock in this offering, is the general partner of our Operating Partnership. In connection with our organization in November 2010, the Operating Partnership agreed to issue up to $82.5 million of capital account credit to Hunt-InfraREIT, the limited partner of the Operating Partnership, pro rata as we funded the first $737.0 million of cash expenditures on our CREZ project. In accordance with Accounting Standards Codification (ASC) 805 and 480, we determined that the obligation to issue these future deemed capital credits was contingent consideration, and we assessed the fair value of our obligation at $78.6 million as of the date of acquisition in November 2010. We have included the related obligation as a long-term liability in our consolidated balance sheet. The fair value of the contingent consideration is evaluated at each reporting period based on, among other things, expected capital expenditures, and any change in its current fair value is recognized by us as an expense in the current period. As a result of these evaluations, we recognized $1.1 million of expense during the nine months ended September 30, 2014 and no expense during the nine months ended September 30, 2013. We also recognized approximately $841,000 and $753,000 of expense during the years ended December 31, 2013 and 2012, respectively. These expenses resulted from our evaluation that the value of this contingent consideration liability had changed during these periods primarily due to changes in the amount and timing of expected capital expenditures.

As of September 30, 2014 and December 31, 2013, the Operating Partnership had issued approximately $71.4 million and $67.9 million, respectively, of capital account credits to Hunt-InfraREIT in partial settlement of

 

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this contingent consideration obligation. As of September 30, 2014 and December 31, 2013, approximately $10.2 million and $12.6 million, respectively, was recorded as contingent consideration in our consolidated balance sheets.

Upon completion of this offering, the Operating Partnership will issue Hunt-InfraREIT an additional 983,418 Class A OP Units, which will settle our contingent obligation to Hunt-InfraREIT pursuant to our constituent documents.

Deemed Capital Credits

At the inception of the Operating Partnership, we agreed that the Operating Partnership would issue deemed capital credits to Hunt-InfraREIT with respect to certain development projects. The amount of capital account credit issued equals 5% of our capital expenditures on these projects, including AFUDC. As of September 30, 2014, the Operating Partnership had issued Hunt-InfraREIT $2.1 million in capital account credits with respect to this obligation. As of September 30, 2014, $19,560 of capital account credits had been earned with respect to this obligation, which we issued on October 1, 2014. We record these capital account credits as asset acquisition costs included as part of the capital project in our CWIP balance.

On January 1, 2015, the Operating Partnership issued Hunt-InfraREIT 17,595 Class A OP Units, which represents 5% of an estimated $3.7 million of capital expenditures and AFUDC related to the expansion of our Railroad DC Tie incurred in the fourth quarter of 2014. Once the actual capital expenditure and AFUDC amounts are finally determined, if it is determined that Hunt-InfraREIT received too many Class A OP Units, Hunt-InfraREIT will be required to pay the Operating Partnership an amount in cash equal to the value of the additional Class A OP Units it received. If it is determined that Hunt-InfraREIT received too few Class A OP Units, the Operating Partnership will pay Hunt-InfraREIT an amount in cash not to exceed $50,000 equal to the value of the Class A OP Units it should have received.

After the completion of this offering, we will no longer have the obligation to issue deemed capital credits.

Contractual Obligations

The table below summarizes our contractual obligations and other commitments as of December 31, 2013:

 

Contractual Obligations

  

Total

    

Less than
1 year

    

1-3 years

    

3-5 years

    

More than
5 years

 
     (in thousands)  

Long-term debt—principal

   $ 632,690       $ 4,777       $ 14,447       $ 472,154       $ 141,312   

Long-term debt—interest *

     166,495         23,741         46,144         38,066         58,544   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

$ 799,185    $ 28,518    $ 60,591    $ 510,220    $ 199,856   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

* Interest for floating rate based on LIBOR as of December 31, 2013 plus an applicable margin.

There have been no material changes, outside the ordinary course of business, to our contractual obligations and other commitments set forth in the table above since December 31, 2013.

Quantitative and Qualitative Disclosure About Market Risk

We have floating rate debt under our CREZ term loan and our revolving credit facilities and are exposed to changes in interest rates on this indebtedness. The credit markets have recently experienced historical lows in interest rates. As the overall economy strengthens, it is possible that monetary policy will continue to tighten further, resulting in higher interest rates to counter possible inflation. Interest rates on our floating rate debt and future debt offerings could be higher than current levels, causing our financing costs to increase accordingly.

 

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To mitigate the risk associated with the CREZ loan, in 2010 we entered into an interest rate swap contract that effectively capped our LIBOR based interest rate exposure on up to $261.0 million of our outstanding principal through June 2014. This swap terminated effective June 30, 2014. As of September 30, 2014, the outstanding balance on that loan was $400.9 million.

A hypothetical increase or decrease in interest rates by 1.0% would have changed our interest expense by $3.2 million for the nine months ended September 30, 2014. If our CREZ loan hedge had not been in effect, a hypothetical increase or decrease in interest rates by 1.0% would have changed interest expense by $4.5 million for the nine months ended September 30, 2014.

Summary of Significant Accounting Policies

The selection and application of accounting policies is an important process that has developed as our business activities have evolved and as the accounting rules have developed. Accounting rules generally do not involve a selection among alternatives, but involve an implementation and interpretation of existing rules, and the use of judgment to the specific set of circumstances existing in our business. Compliance with the rules necessarily involves reducing a number of very subjective judgments to a quantifiable accounting entry or valuation. We endeavor to properly comply with all applicable rules on or before their adoption, and we believe the proper implementation and consistent application of the accounting rules are critical. Our most significant accounting policies are discussed below. See Note 1 of the Notes to the Consolidated Financial Statements included elsewhere in this prospectus for further details on our accounting policies.

Regulatory

For regulatory purposes, including regulatory reporting, our T&D assets and the operations of our tenant, Sharyland, are viewed on a combined basis. As a result, regulatory principles applicable to the utility industry also apply to us. Accordingly, we capitalize AFUDC during the construction period of our T&D assets, and our lease agreements with Sharyland rely on FERC definitions and policies regarding capitalization of expenses to define the term Footprint Projects, which are the amounts we are obligated to fund pursuant to the leases. The amounts we fund for these Footprint Projects include allocations of Sharyland employees’ time, including overhead allocations consistent with FERC policies and GAAP.

Electric Plant, net

Electric plant is stated at the original cost of acquisition or construction, which includes the cost of contracted services, direct labor, materials, acquisition adjustments and overhead items. In accordance with the FERC uniform system of accounts guidance, we capitalize AFUDC, which represents the approximate cost of debt and equity to finance plant under construction. AFUDC on borrowed funds is classified on our income statement as a reduction of our interest expense, while AFUDC on other funds is classified as other income. AFUDC rates are determined based on electric plant instructions found in the FERC regulations.

Gains or losses resulting from retirement or other disposition of utility property in the normal course of business are credited or charged to accumulated depreciation.

Under the leases, we are responsible for funding Footprint Projects, and Sharyland is responsible for funding all repairs. Footprint Projects are funded by expenditures that are capitalized under GAAP, and repairs are replacements or remedial activity on our T&D assets that are expensed, and not capitalized, under GAAP.

Goodwill

Goodwill represents the excess of costs of an acquired business over the fair value of the assets acquired, less the amount of liabilities assumed. Goodwill is not amortized and is tested for impairment annually

 

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or more frequently if events or changes in circumstances arise. As of September 30, 2014 and December 31, 2013, we had $138.4 million in goodwill recorded on our consolidated balance sheets, of which $83.4 million related to the acquisition of Cap Rock Holdings Corporation and $55.0 million related to InfraREIT, L.L.C.’s formation transactions, each of which occurred in 2010. These amounts are not reflected as goodwill for federal income tax purposes.

Business Combinations

We account for business combinations under ASC 805, “Business Combinations,” which requires the acquirer of a business to recognize and measure in its financial statements the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree, measured at their fair values as of the acquisition date. Under ASC 805, we recognize contingent consideration arrangements at their acquisition-date fair values with subsequent changes in fair value reflected in earnings. Significant estimates and management assumptions are used to determine the fair value of business combinations and the accounting for contingent consideration.

Income Taxes

InfraREIT, L.L.C. elected to be treated as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the Code), commencing with the taxable year ended December 31, 2010 and, following the Merger, InfraREIT, Inc. will elect to be taxed as a REIT commencing with the taxable year ending December 31, 2015. We believe that we and InfraREIT, L.L.C. have been organized and operate in a manner that has allowed InfraREIT, L.L.C. to qualify for taxation as a REIT for U.S. federal income tax purposes commencing with its 2010 taxable year and through the consummation of the Merger, and will allow us to qualify as a REIT for federal income tax purposes commencing with the 2015 taxable year, and we intend to continue operating in such a manner. To maintain our qualification as a REIT, we are required to annually distribute to our stockholders at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction and excluding any net capital gain, and meet the various other requirements imposed by the Code relating to such matters as operating results, asset holdings, distribution levels and diversity of stock ownership. Provided that we qualify for taxation as a REIT, we generally will receive a deduction for dividends paid to our stockholders for U.S. federal income tax purposes which will reduce our taxable income. We are still liable for state and local income and franchise taxes and to federal income and excise tax on our undistributed income. If we fail to qualify as a REIT in any taxable year and are unable to avail ourselves of certain savings provisions set forth in the Code, all of our taxable income would be subject to federal income tax at regular corporate rates, including any applicable alternative minimum tax. Unless entitled to relief under specific statutory provisions, we would be ineligible to elect to be treated as a REIT for the four taxable years following the year for which we lose our qualification. It is not possible to state whether in all circumstances we would be entitled to this statutory relief.

Revenue Recognition

Our lease revenue consists of annual base rent and percentage rent based upon a percentage of the revenue Sharyland generates on our leased T&D assets in excess of a specified amount. Applicable guidance provides that we recognize lease revenue over the term of lease agreements with Sharyland. Applying this principle, we recognize the base rent amounts that were in effect at the time the original leases were executed over the term of the applicable lease on a straight-line basis. Our leases require that we and Sharyland supplement the base rent amounts, and the percentages that are used to calculate percentage rent, if the amount of capital expenditures we have funded that are placed in service exceeds base amounts set forth in the lease. We recognize the increases to base rent related to these incremental capital expenditures on a straight-line basis over the lease term. We recognize percentage rent under the leases at such time as the revenue earned by Sharyland on the leased assets exceeds the annual specified threshold for the applicable lease.

 

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Deferred Financing Costs and Other Regulatory Assets

Amortization of deferred financing costs associated with TDC’s debt issuance is computed using the straight-line method over the life of the loan, which approximates the effective interest method. Amortization of deferred financing costs associated with the debt of SDTS and SPLLC is computed using the straight-line method over the life of the loan in accordance with the applicable regulatory guidance.

Deferred costs recoverable in future years of $23.8 million at September 30, 2014 and December 31, 2013 represent operating costs incurred from inception of Sharyland through December 31, 2007. We have determined that these costs are probable of recovery through future rates based on orders of the PUCT in Sharyland’s prior rate cases and regulatory precedent.

Derivative Instruments

We use derivatives to hedge against changes in cash flows related to interest rate risk (cash flow hedging instrument). ASC Topic 815, “Derivatives and Hedging,” requires all derivatives be recorded on the consolidated balance sheet at fair value. We determine the fair value of the cash flow hedging instrument based on the difference between the cash flow hedging instrument’s fixed contract price and the underlying market price at the determination date. The asset or liability related to the cash flow hedging instrument is recorded on the consolidated balance sheet at its fair value.

We record unrealized gains and losses on the effective cash flow hedging instrument as components of accumulated other comprehensive income. We record realized gains and losses on the cash flow hedging instrument as adjustments to interest expense, net. Settlements of derivatives are included within operating activities on the consolidated cash flow statement. Any ineffectiveness in the cash flow hedging instrument would be recorded as an adjustment to interest expense in the current period.

 

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INDUSTRY OVERVIEW

The electric power industry is composed of power plants that generate electricity, transmission networks that move power at high-voltage from generation stations to areas where electricity is needed and distribution systems that deliver power at lower voltages from substations and transformers to customers. Electric transmission systems generally consist of transmission towers, power lines, substations and associated facilities, typically operated at 60 kilovolts (kV) or above, that are used to reliably serve their loads and to transmit electricity to another transmission service customer. Electric distribution systems generally consist of facilities, including power lines, poles, meters and associated support systems, typically operated below 60 kV, that are used for the distribution of electricity to end users. According to the Edison Electric Institute (EEI), an industry association, the U.S. electric transmission grid consists of more than 200,000 miles of high-voltage (230 kV and greater) transmission lines. Since 2000, EEI’s members have significantly increased their development of the United States transmission infrastructure, investing approximately $17.5 billion in 2013 alone, and are projected to spend an additional $60.6 billion through 2024.

In the contiguous United States, the network of transmission and distribution (T&D) lines is not unified into a single power grid. Instead, there are three main grids that are distinct and have only limited points of interconnection. These grids are the Western Interconnected System, the Eastern Interconnected System and the Texas Interconnected System. As of June 18, 2007, the Federal Energy Regulatory Commission (FERC) granted the North American Electric Reliability Corporation (NERC) the legal authority to enforce reliability standards with all users, owners and operators of the bulk power system in the United States, and made compliance with those standards mandatory and enforceable. In many regions of the United States, in coordination with the FERC and the NERC, regional transmission organizations (RTOs) or independent system operators (ISOs) manage the flow of electric power and help administer the bulk power market in their respective geographic regions. ISOs and RTOs have similar responsibilities. Each is generally responsible for the administration and control of the electric transmission grid in its respective area or region, although RTOs have greater flexibility in their organizational structure.

There are several RTOs or ISOs operating within the United States. The Electric Reliability Council of Texas (ERCOT) is the ISO that manages the Texas Interconnected System. It coordinates the flow of electric power to 23 million Texans and schedules power on a grid that connects 40,500 miles of transmission lines and more than 550 generation units. ERCOT also performs financial settlement for the competitive wholesale bulk-power market and administers retail switching for 6.7 million premises in competitive choice areas of Texas. ERCOT is a non-profit corporation governed by a board of directors and subject to oversight by the Public Utility Commission of Texas (PUCT) and the Texas Legislature.

Texas is the only state in the contiguous United States with its own power grid, making it largely independent from other networks in the United States. In 1995, the Texas Legislature began the process of deregulation in the electricity market, requiring utilities to provide independent generators with non-discriminatory, open access to transmission to support wholesale competition. In 1999, the Texas Legislature continued the transition, requiring the retail electric market to be opened to competition by 2002 and requiring incumbents to unbundle business functions into separate wholesale generation, transmission and distribution service providers (TDSPs) or “wires companies,” and retail electric providers (REPs) (which are the companies that sell electricity to Texas customers). Owners of wholesale generation, which consist, in Texas, primarily of owners of gas or coal-fired generation plants, nuclear plants and wind farms, generate electricity and sell it to REPs. REPs in turn enter into agreements with end-users to provide electricity, and the electricity is delivered through T&D systems owned by TDSPs. TDSPs maintain the poles, wires and meters that deliver and measure the electricity consumed, restore power following outages, read customer meters, and provide the amount of electricity consumed to the customers’ designated REP for billing and customer service.

 

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REGULATION AND RATES

Overview

In the United States, electric infrastructure assets are generally owned by utilities that are subject to regulation by various federal, state and local agencies. State regulatory commissions generally establish utility rates based on a traditional cost of service basis, providing for the timely recovery of prudently incurred costs and the opportunity to earn a reasonable rate of return on invested capital, subject to review and approval through periodic regulatory proceedings.

Regulation of T&D Utilities

Federal Regulation

The FERC regulates transmission and wholesale sales of electricity in interstate commerce, reviews mergers and acquisitions, direct and indirect transfers of jurisdictional assets, issuance of debt or securities and corporate transactions by electricity companies, and reviews siting applications for electric transmission projects under limited circumstances. The FERC also protects the reliability of the high voltage interstate transmission system through mandatory reliability standards. Pursuant to the Federal Power Act, the FERC is responsible for ensuring that the rates, terms and conditions of electric transmission service and the wholesale sale of electric energy are “just and reasonable” and “not unduly discriminatory or preferential.” The Energy Policy Act of 2005 directed the FERC to develop incentive-based rate treatments for transmission of electric energy in interstate commerce, including incentive rates of return on equity for new investment by public utilities and full recovery of prudently incurred costs. Although currently none of our T&D assets are regulated by the FERC, we were subject to FERC regulation with respect to some of our T&D assets in the past and the FERC has agreed to our structure of leasing T&D assets to Sharyland.

Regulation in Our Territories

T&D services provided wholly within ERCOT are not subject to traditional rate regulation by the FERC. All of our T&D assets are located in ERCOT within the State of Texas.

The PUCT regulates “electric utilities” and TDSPs under the Public Utility Regulatory Act, including approving rates for T&D service, setting reliability and safety standards, and ensuring that the TDSP does not discriminate in its treatment of customers, REPs and generators in the delivery of electricity. TDSPs are comprised of distribution service providers (DSPs), which generally own and operate electric distribution systems, and transmission service providers (TSPs), which generally own and operate electric transmission systems. Both our subsidiary, Sharyland Distribution & Transmission Services, L.L.C. (SDTS), and our tenant, Sharyland Utilities (Sharyland), are “electric utilities” subject to regulation by the PUCT. Sharyland is also subject to regulation by the PUCT as both a TSP and a DSP, as is the case with other investor-owned utilities that own T&D assets in Texas. Rates are established through rate case proceedings, which occur periodically and are typically initiated by the utility or the PUCT, on its own motion or on complaint by an affected stakeholder, to ensure that rates remain just and reasonable. In this prospectus, when we refer to a “rate case” or a “rate proceeding,” we are referring to these formal proceedings before the PUCT, and not to interim transmission cost of service filings (interim TCOS filings) or distribution cost recovery factor filings (DCRF filings), which are described below. Rates are determined by the electric utility’s cost of rendering service to the public during a historical test year, adjusted for known and measurable changes, in addition to a reasonable return on invested capital.

We own our T&D assets and lease them to Sharyland, which is an operating utility. We cannot remove Sharyland as the tenant under our leases without prior approval of the PUCT. The T&D rates for Sharyland are based on the combined financial statements of Sharyland and SDTS. In other words, the lease obligations that

 

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Sharyland owes us are disregarded in the PUCT’s evaluation of matters related to the utility, and the audited books and records of Sharyland and SDTS are used to prepare a combined rate filing. As our tenant and the operator of the electric system, Sharyland holds the Certificate of Convenience and Necessity (CCN) for all of our T&D assets.

TSP Rates

In ERCOT, TSPs generate revenue primarily by charging all DSPs within ERCOT for the TSP’s cost of service, or revenue requirement. ERCOT DSPs pay TSPs annual amounts, typically billed to the DSP monthly, based on the DSP’s pro rata share, during the prior year, of the average of ERCOT coincident peak demand for the months of June, July, August and September (ERCOT 4CP), excluding the portion of coincident peak demand attributable to wholesale storage load. Each TSP files a tariff for transmission service to establish its rates, calculated as the TSP’s commission-approved transmission cost of service, or revenue requirement, divided by the aggregate ERCOT 4CP during the prior year. Therefore, the monthly transmission service charge to be paid by each DSP is the product of each TSP’s monthly rate as specified in its tariff and the DSP’s previous year’s share of the aggregate ERCOT 4CP. An example of how this calculation works in Sharyland’s transmission tariff is described below under “Business and Properties—Our Tenant—Sharyland’s Regulatory Proceedings—Transmission Tariff.”

The transmission revenue that ERCOT TSPs generate has not varied significantly within any given year, except when the TSP has updated its revenue requirement through an interim TCOS filing, described in the next paragraph, or a rate proceeding. Transmission revenue can vary from year to year if ERCOT 4CP increases or decreases. In addition, revenue is subject to theoretical variability based on the credit-worthiness of DSPs in Texas, but generally this has not significantly affected transmission revenue for TSPs, as no DSP has become subject to a bankruptcy or insolvency proceeding since deregulation in 2002.

A TSP can update its transmission rates up to two times per year through interim TCOS filings. In an interim TCOS filing, the TSP updates its revenue requirement to reflect changes in in-service net transmission assets, the effect of depreciation and any update to ERCOT 4CP and property taxes, among other matters. The TSP is not permitted in these filings to update its revenue requirement to reflect any changes in its operations and maintenance charges, which can be updated only through a full rate proceeding with the PUCT. If a TSP’s application is materially sufficient and there are no intervenors that challenge the update, generally the TSP’s transmission rates will be updated within 60 days of the date of the interim TCOS filing. After this update, the TSP will be permitted to update the monthly invoices that the TSP sends to ERCOT DSPs to reflect the adjusted transmission rates. The updates of the rates pursuant to an interim TCOS filing will be subject to review in the next rate case filing for the TSP.

DSP Rates

DSP revenue is subject to more variability than TSP revenue. Distribution rates, or tariffs, are determined in the DSP’s most recent rate proceeding. Typically, tariffs are assigned to different classes of retail customers in a rate case, which classes generally include residential, commercial and industrial customers. The tariff typically includes a per-kilowatt hour (kWh) charge and a flat customer charge for residential customers, and may include a per-kWh, a per kilowatt (kW) and a flat customer charge for other customer classes. Because of the per kWh charge, generally there is more variability in a DSP’s revenue than there is in a TSP’s revenue. DSPs collect revenue by charging REPs, which are the entities that interface with and bill the end users. The REPs are permitted to pass on to end users the distribution charges REPs pay to the DSPs.

A DSP can update its distribution rates no more than once a year through a DCRF filing. A TDSP such as Sharyland may only make a DCRF filing between April 1 and April 8 in any given year. Additionally, a DSP can only change its rates pursuant to a DCRF filing no more than four times between rate proceedings and may not make a DCRF filing while a rate proceeding is pending. In a DCRF filing, the DSP updates its amount of

 

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invested capital for its distribution facilities and certain associated costs. The DSP is not permitted in a DCRF filing to update changes in its operations and maintenance expenses. If a DSP’s application is not materially deficient and there are not intervenors that challenge the filing, generally the DSPs distribution rates will be updated on September 1 of the year in which the DCRF filing was made (unless the DSP can show good cause for the rates to be updated as of another date). Sharyland has not historically used DCRF filings to update its distribution rates.

 

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BUSINESS AND PROPERTIES

We are an externally-managed REIT that owns T&D assets in Texas. We are focused on paying a consistent and growing cash dividend that is sustainable on a long-term basis. We believe we are well positioned to take advantage of favorable trends in the T&D sector, including the replacement of aging assets and the construction of new assets to address growing energy demand. We believe our attractive REIT structure and focus on Texas and the southwestern United States, where we can leverage a proven track record of identifying, developing, constructing and acquiring critical infrastructure assets, provide us with a significant competitive advantage to execute our growth strategy.

We lease our T&D assets to Sharyland, a Texas-based regulated electric utility, pursuant to leases that require Sharyland to make lease payments to us when our assets are placed in service. To support these lease payments, Sharyland delivers electric service and collects revenues directly from DSPs and REPs, which pay rates approved by the PUCT.

We have grown rapidly over the last several years, with our rate base increasing from approximately $60 million as of December 31, 2009 to approximately $1.1 billion as of September 30, 2014 and a projected $1.4 billion as of December 31, 2015. We expect to grow our rate base in the future through organic growth, as well as through acquisitions of T&D assets, including ROFO Projects, from Hunt Consolidated, Inc. (Hunt) and Sharyland, who originated and founded our business, and from third parties.

We intend to distribute substantially all of our cash available for distribution, less prudent reserves, through regular quarterly cash dividends. We expect our initial quarterly dividend rate to be $0.225 per share, or $0.90 per share on an annualized basis. We believe that as we grow our rate base we will also be able to increase our cash available for distribution and, as a result, increase our distribution per share. We intend to target a three year cumulative annual growth rate of our cash available for distribution per share of 10 to 15% through December 31, 2018. We intend to achieve the lower half of the range based solely on the expansion of T&D assets that are in the geographic footprint of our existing distribution assets or that are added to our existing transmission assets (Footprint Projects), with the ability to achieve the top half of the range coming from Hunt’s obligation under our development agreement to offer us identified T&D projects (ROFO Projects). See “Certain Relationships and Related Transactions—Arrangements with Hunt—Development Agreement.” We believe acquisitions of the Cross Valley transmission line and Golden Spread Electric Coop (GSEC) interconnection, two ROFO Projects currently under construction, could allow us to exceed the midpoint of the range. The additional successful development and acquisition of the Southline transmission project, other significant third party acquisitions, or capital expenditures in excess of our current estimates to fund Footprint Projects could position us to meet the high end of the range. Our ability to grow our rate base, cash available for distribution and distributions per share is subject to a number of factors and other risks described under the caption “Risk Factors.”

Our business originated in the late 1990s when members of the Hunt family founded Sharyland, the first investor-owned utility created in the United States since the 1960s. In 2007, we obtained a private letter ruling from the Internal Revenue Service (IRS) confirming that our T&D assets could constitute real estate assets under applicable REIT rules. In 2008, the PUCT approved a restructuring that allowed us to utilize our REIT structure. In 2010, InfraREIT was formed as a REIT and, as part of that transaction, Hunt contributed assets into InfraREIT and obtained equity commitments from the following large institutional investors, which we refer to as our founding investors: Marubeni Corporation, John Hancock Life Insurance Company (U.S.A.), OpTrust Infrastructure N.A. Inc. and Teachers Insurance and Annuity Association of America.

 

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Our T&D Assets

Our T&D assets are located throughout Texas, including the Texas Panhandle near Amarillo, the Permian Basin in and around Stanton, Central Texas around Brady, Northeast Texas in and around Celeste and South Texas near McAllen. Our T&D assets consist of over 50,000 electricity delivery points, approximately 620 miles of transmission lines, approximately 10,500 miles of distribution lines, 35 substations and a 300 megawatt (MW) high-voltage direct current interconnection (DC Tie) between Texas and Mexico, which we refer to as the Railroad DC Tie.

The following map shows the location and breakdown of our transmission assets and distribution assets:

 

LOGO

Our T&D assets are owned by our subsidiary SDTS and its wholly-owned subsidiaries, Sharyland Projects, L.L.C. (SPLLC) and SDTS FERC, L.L.C. (SDTS FERC). Substantially all of our T&D assets are security under our SDTS revolving credit facility and SDTS senior secured notes. Our Panhandle transmission assets constructed pursuant to the CREZ project are security under a separate CREZ project finance loan we have with a consortium of banks. For more information on our revolving credit facility, senior secured notes and CREZ project finance loan, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Credit Arrangements.”

 

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The following table is a summary description of our T&D assets:

 

Asset Name

 

Owner/Landlord

 

Location of Assets

 

Description of Assets

 

Encumbrances

Panhandle Assets   SPLLC   Texas Panhandle   Approximately 300 miles of 345 kV transmission lines and 4 designated collection stations   Security under CREZ term loan and senior secured notes
Stanton/Brady/Celeste Assets   SDTS   In and around Stanton, Brady and Celeste, Texas   Approximately 9,500 miles of overhead distribution lines; underground distribution lines; transmission lines and substations   Security under SDTS revolving credit facility and SDTS senior secured notes
McAllen Assets   SDTS   Primarily South Texas   DC Tie; transmission operations center; approximately 15 miles of 138 kV transmission lines; distribution lines and 3 substations   Security under STDS revolving credit facility and SDTS senior secured notes
Stanton Transmission Loop Assets   SDTS FERC   Near Stanton, Texas   Approximately 305 miles of 138 kV transmission lines and connected substations   The equity in SDTS FERC is security under SDTS revolving credit facility and SDTS senior secured notes
ERCOT Transmission Assets   SDTS   Texas Panhandle   A substation in the Panhandle; additional ERCOT transmission assets may be added in the future   Security under SDTS revolving credit facility and SDTS senior secured notes

Our T&D assets are subject to regulation as an electric utility by the PUCT. For additional information on regulation by the PUCT, see “Regulation and Rates.”

 

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Our Relationship with Hunt

Ownership

Hunt will own 3,176,878 shares of our common stock and 13,213,619 units in our Operating Partnership (OP Units) following the completion of this offering and the Reorganization, which will be subject to long-term lock-ups with us. This ownership would constitute 27.1% of our outstanding equity if all OP Units were exchanged for shares of our common stock. Hunt has informed us that it intends to continue to hold a substantial portion of its equity in us for the foreseeable future.

Leadership

Hunt Utility Services, LLC, which we refer to as Hunt Manager, serves as our external manager and is a subsidiary of Hunt. Additionally, members of the Hunt family own our tenant, Sharyland, which is controlled by Hunter L. Hunt, who is also a member of our board of directors. W. Kirk Baker, who is Chairman of our board of directors, previously served as president and chief executive officer of Hunt Manager and before that as Senior Vice President and General Counsel of Hunt Consolidated, Inc. Further, Hunt Transmission Services, L.L.C., which we refer to as Hunt Developer, has successfully developed transmission projects that are now in our rate base, and Hunt continues to develop transmission projects that we expect to have the opportunity to acquire in the future.

The following chart illustrates our relationships and alignment with Hunt and its affiliates following the consummation of this offering and the Reorganization (based on the assumptions set forth in the “Explanatory Note” and as further described under “Description of Our Capital Stock—Reorganization”).

 

LOGO

Hunt’s History of Success

Hunt was founded in 1934 when H.L. Hunt formed Hunt Oil Company and is actively engaged in energy, real estate, investment and ranching businesses in Texas and throughout the world. Mr. Hunt’s son, Ray L. Hunt, has been Hunt’s chairman since the mid-1970s. Hunt has a long history of entrepreneurial activity and a track record in developing and constructing large complex projects. In T&D acquisition and development, this history includes:

 

    In 1984, at a time when Hunt was the only active oil company in Yemen, Hunt discovered a major oil field that helped Yemen reach production levels in excess of 150,000 barrels of oil per day.

 

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    Hunt and Sharyland commenced development of the Railroad DC Tie in 2003 to link the ERCOT grid with the Mexican national grid operated by the Comisión Federal de Electricidad (CFE). Construction was completed in 2007, and the Railroad DC Tie was placed in service as the first cross-border DC Tie of its kind to support both emergency power and commercial business activities between Texas and Mexico.

 

    In 2010, Hunt and its partners launched PERU LNG, which is the first natural gas liquefaction plant in South America and represents the largest investment in one single project ever made in Peru. Delivering gas to the PERU LNG facility from the Camisea gas fields also required Hunt to manage the construction of a 250-mile pipeline over the Andes that holds the record for the highest pipeline in the world at over 16,000 feet.

 

    Our Panhandle transmission assets were constructed pursuant to the competitive renewable energy zone (CREZ) initiative. Hunt and its affiliates, including Sharyland, were a driving force throughout the development of the CREZ initiative, which was originated at the direction of the Texas Legislature in 2005 and continued with the PUCT designating renewable energy zones and awarding rights to build transmission lines. In a manner representative of Hunt’s general approach, Sharyland has worked with elected officials, utility regulators, community leaders, landowners and various other stakeholders throughout the development and construction of our approximately 300 miles of transmission lines and four substations, and Sharyland continues to interact with these stakeholders as ongoing partners in the operation and expansion of these assets.

 

    In July 2010, Hunt and Sharyland acquired and integrated the T&D assets of Cap Rock Energy Corporation (Cap Rock) into our REIT structure. In connection with that acquisition, our subsidiary, SDTS, which at that time was a wholly-owned subsidiary of Hunt, acquired the T&D assets that qualify as real estate assets under our private letter ruling. Sharyland acquired all of the other assets and all Cap Rock employees became employees of Sharyland. Both the PUCT and the FERC approved the acquisition and integration into our REIT structure.

Hunt’s Development Projects

Our development agreement with Hunt Developer and Sharyland provides us with a right of first offer to acquire the ROFO Projects described below, which consist solely of T&D projects that Hunt is developing or constructing. Although Hunt may develop other T&D projects that do not currently constitute ROFO Projects under the development agreement, Hunt has informed us that it intends for us to be the primary owner of all of Hunt’s T&D development projects as those projects are completed and placed in service. Under the terms of the development agreement, Hunt has the obligation to offer the ROFO Projects to us at least 90 days prior to the date on which such assets are expected to be placed in service. We expect the purchase price for the ROFO Projects or any other T&D projects Hunt develops will be negotiated by our Conflicts Committee and Hunt and will be based on a number of factors, such as the cash flow and rate base for the assets, market conditions, potential for incremental Footprint Projects, whether the assets are subject to a lease with Sharyland or another tenant, the terms of any such lease and the regulatory return we expect the assets will earn. Sharyland and Hunt Developer are each parties to our development agreement. However, the agreement, by its terms, applies to activities by all Hunt affiliates. As such, when discussing the development agreement, we use the term “Hunt” to refer to Hunt Developer, Sharyland and other affiliates of Hunt Consolidated, Inc.

Development Team

Our development agreement with Hunt Developer provides us with continued access to the Hunt Developer and Sharyland development teams and the development projects they source. Hunt Developer’s active and experienced T&D project development team includes Hunter Hunt, co-President of Hunt Consolidated, and

 

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Pat Wood, a former FERC and PUCT chairman, and the eleven members of its team have 15 years of industry experience, on average. Additionally, the Hunt Developer team has experience with ERCOT, the Southwest Power Pool (SPP), California ISO (Cal-ISO), Western Electric Coordinating Council (WECC) and CFE, which enables them to identify and pursue T&D opportunities across the southwestern United States. This team has an extensive track record of successfully pursuing a variety of projects including greenfield development (Sharyland and CREZ transmission), acquisitions (Cap Rock and transmission assets from Southwest Public Service Company), partnering with municipalities (Cross Valley transmission line) and cross border activity (transmission interconnection between ERCOT and CFE and a power marketing entity to facilitate commercial transactions with Mexico). Our access to the Hunt Developer and Sharyland development pipelines position us to capitalize on growth opportunities beyond our existing footprint and to potentially add to our current list of ROFO Projects offered by Hunt.

ROFO Projects

Our development agreement with Hunt Developer and Sharyland provides us with a right of first offer to acquire ROFO Projects that Hunt is currently developing or constructing, including the following:

ROFO Project

  

Description

  

Status

Cross Valley transmission line

  

Approximately 50 mile transmission line in South Texas near the Mexican border. Total estimated construction cost (including financing costs) of $160 million to $185 million, of which $28 million has been spent though September 30, 2014.

   Under construction; expected completion in 2016

GSEC interconnection

   Approximately 55 mile transmission line connecting one of GSEC’s gas-fired generation facilities to our Panhandle transmission line. Total estimated construction cost (including financing costs) of $100 million to $120 million, of which $1 million has been spent through September 30, 2014.   

Under construction;

expected completion in 2016

Southline Transmission Project

   Approximately 240 miles of new transmission line and upgrades of approximately 120 miles of existing transmission lines in southern New Mexico and southern Arizona with an initially estimated construction cost (excluding financing costs) of $700 million to $800 million.    In active development; draft environmental impact statement published

Verde Transmission Project

   Approximately 30 mile transmission line in northern New Mexico with an initially estimated construction cost (excluding financing costs) of $60 million to $80 million.    In development

 

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We have provided information about the Cross Valley and GSEC interconnection projects because of their size, their prominence in our core Texas markets and our belief that these ROFO Projects are the most likely ROFO Projects to be completed and offered to us. Although they are in the early stages of development and budgets for such projects, as well as potential arrangements that might result in developing the projects with partners, have not been finalized, we have also provided information about the Southline Transmission Project and Verde Transmission Project because they are the most prominent and advanced of Hunt’s non-Texas ROFO Projects. However, there can be no assurances that any of the ROFO Projects will be completed and offered to us or, if completed and offered to us, that the price and other terms of the acquisition of such projects can be negotiated on terms acceptable to us.

Other ROFO and Development Projects

In addition to the construction and development activity related to the projects above, Hunt and Sharyland are also evaluating and developing various projects in ERCOT and other regions of the United States. Such ROFO Projects include proposals to (i) reinforce the existing transmission grid in the Panhandle and South Plains region as new wind generators connect to the transmission grid, (ii) develop additional high-voltage DC ties along the Texas and desert Southwest border with Mexico, (iii) increase electric transmission between the PJM and MISO grids through projects in the Midwest and (iv) provide import capacity from New Mexico and Arizona into California.

Hunt and Sharyland are also developing a number of projects that are not included in the ROFO list. A typical example involves initiatives in South Texas to develop new transmission lines to enhance grid reliability and enable generation interconnections. Another example of Hunt’s innovative approach is Sharyland’s response to Lubbock Power & Light’s (LP&L) Request for Proposal (RFP) for generation services. In response to the RFP, Sharyland submitted a proposal to integrate LP&L’s system into ERCOT through multi-line alternatives ranging from approximately 67 to 92 miles, with an associated cost estimated to range from $166 million to $237 million. It is unknown at this time whether Sharyland will be successful in the RFP process. For any non-ROFO projects, Hunt has informed us that it intends for us to be the primary owner of Hunt’s T&D development projects as those projects are completed and placed in service. However, there can be no assurances that any of the non-ROFO Projects will be completed and offered to us or, if completed and offered to us, that the price and other terms of the acquisition of such projects can be negotiated on terms acceptable to us.

Transfer of ROFO Project Assets

Effective January 15, 2015, we transferred the assets related to the Cross Valley transmission line and GSEC interconnection projects, which are designated as ROFO Projects under our development agreement, to Hunt or one of its affiliates. Hunt Developer will continue to construct these projects and will offer such projects to us prior to completion pursuant to the terms of the development agreement. In exchange for these assets, we received $41.2 million, which equaled the rate base of the transferred assets plus reimbursement of out of pocket expenses associated with the formation of related special purpose entities and the Cross Valley project financing. The effect of this transfer is reflected in our unaudited pro forma condensed consolidated financial statements included elsewhere in this prospectus.

The Opportunity

The infrastructure necessary to transport and deliver electricity is vital to the continued economic advancement of the United States. At the national level, demand for T&D infrastructure is driven by several factors, including population growth, changes to a more environmentally-friendly generation mix and demand for a smarter grid. EEI estimates that its investor-owned utility members invested approximately $17.5 billion in the nation’s transmission grid in 2013, after investing $14.8 billion in 2012. This transmission investment cycle is expected to remain robust, with EEI estimating that over the next 10 years its members plan to invest over $60 billion, an approximate 18% increase from the prior year’s 10-year forecast. We believe we are well-positioned to capitalize on the opportunity created by the need for electric infrastructure spending in the United States and to execute our strategy.

 

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T&D Infrastructure in the State of Texas

Texas, as one of the fastest-growing states, is expected to require significant T&D investments. Electricity demand has been increasing due to above-average economic growth, particularly as a result of oil and gas development and population growth. These two demand-side factors, as well as aging generation infrastructure, low natural gas prices and policy objectives to take advantage of the State’s attractive wind corridors, are driving significant T&D investments and support the $3.7 billion in transmission investment that ERCOT identifies in its five-year plan as of November 2014. Based on the location of our T&D assets and our service territory, we believe the opportunity to make investments in T&D assets that increase our rate base will be driven largely by extensive oil and gas production in West Texas, interconnections with renewable generation, particularly wind, in the Texas Panhandle and population growth in South Texas.

The Permian Basin, where our Stanton service territory is located, covers an area 250 miles wide and 300 miles long and is one of America’s most prolific hydrocarbons fields, having produced more than 29 billion barrels of oil and 75 trillion cubic feet of natural gas since 1921. It also remains highly productive, with annual production in excess of 280 million barrels a year. According to the Texas Railroad Commission, which regulates oil and gas production in the State, issued drilling permits in the Permian Basin increased over 32% in five years, from 6,711 in 2008 to 8,872 in 2013 as new technologies in exploration have expanded recoverable resources. The U.S. Energy Information Administration expects this strong growth to continue, predicting that the region will see an increase in production from 1.3 million barrels per day in 2013 to 1.8 million barrels per day in 2015.

Power generation growth in Texas, particularly wind generation in which Texas leads the nation in operating MW, is a second driving factor for transmission infrastructure need. ERCOT expects total installed wind capacity to grow from 11,065 MW by the end of 2013 to 21,557 MW in 2017, an increase of approximately 95% based on signed interconnection agreements. Further, according to the ERCOT Regional Planning Group, as of August 1, 2014, there was 6,266 cumulative MW of wind generation capacity planned in the Panhandle region that has signed an interconnection agreement to connect to the ERCOT grid. The PUCT expects the completed CREZ system will ultimately transmit 18,500 MW of wind power from West Texas and the Panhandle to highly populated metropolitan areas of the State. In addition, ERCOT’s 2012 System Assessment forecasted that 16,500 MW of non-wind generation would be coming online in the next decade to help offset retiring coal units and other old assets. This demand from wind and other generators to connect to our Panhandle transmission facilities and other transmission systems should provide us with opportunities to construct or acquire interconnecting transmission lines, new substations and additional equipment and lines to support the increased electricity supply these developments will bring.

Finally, above-average population growth is driving electricity demand in the State and our service territories. According to the Texas State Data Center, the Texas population is projected to grow by 17.2% from 2013 to 2025. The Midland County population grew by 30.6% between 2000 and 2013 and is projected to grow by 16.4% between 2013 and 2023. In addition, the Texas State Data Center estimates that the population of the Lower Rio Grande Valley (LRGV), which includes the service area near McAllen as well as other border cities such as Edinburg, Harlingen and Brownsville, will grow more than 50% in the next 20 years from approximately 1.3 million in 2013 to nearly 2.0 million in 2033. We believe that substantial infrastructure investments will be required to ensure system reliability and serve growing demand in the LRGV.

T&D Infrastructure in the Southwestern United States

The southwestern United States, considered to be Arizona and New Mexico in addition to Texas, has seen significant investment in its electricity grid in response to new generation investment, particularly renewable generation, and a growing population.

Regional renewable energy generation is expected to double in the next ten years in Arizona and New Mexico to meet renewable portfolio standards (RPS), which we believe will provide transmission

 

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investment opportunities to connect new generation sources to local utility grids. Arizona’s renewable energy standard (RES) requires investor-owned utilities (IOUs) and cooperatives that have the majority of their customers in Arizona to meet 15% of their retail electric sales through eligible renewable technologies by 2025. According to the National Renewable Energy Laboratory (NREL), by 2025 this will require Arizona to purchase between 7.9 and 8.5 terawatt-hours (TWh) of renewable energy annually, compared to 3.2 TWh of annual production from existing or under-development assets as of 2012. This suggests that Arizona will need an additional 4.7 TWh to 5.3 TWh of annual renewable energy production by 2025, an approximate 150% increase. In New Mexico, the State’s RPS requires the IOUs to have 20% of annual sales from renewable energy by 2020. NREL suggests that the resulting demand for renewable energy related to the RES will be between 3.0 and 4.0 TWh in 2025, while the State’s existing facilities provide 2.0 TWh annually. This suggests an additional 1.0 to 2.0 TWh per year will be needed by 2025, a 50% to 100% increase.

Growing populations in the southwest are also expected to drive investment opportunities. According to the Arizona Department of Administration, the population of Arizona is expected to increase by approximately 25% between 2013 and 2025, increasing from 6.6 million to 8.2 million individuals, while the New Mexico Bureau of Business and Economic Research expects the population of New Mexico to increase by approximately 20% by 2025, increasing from 2.1 million to 2.5 million individuals. The population increase of approximately 2 million in those states is expected to be concentrated in the cities of Phoenix, Tucson and Albuquerque and is expected to require additional grid transmission capability from the region’s generation sites.

Business Strategy

Focus on T&D assets. We intend to focus on owning T&D assets with long lives, low operating risks and stable cash flows consistent with the characteristics of our current portfolio. We believe that by focusing on this asset class and leveraging our industry knowledge we will maximize our strategic opportunities and overall financial performance.

Pursue sustainable dividend per share growth. We believe our platform will enable us to grow our rate base and, as a result, increase the amount of distributions we make to our stockholders. To achieve this growth, we will pursue the following:

 

    Grow Rate Base by Investing in Footprint Projects. We expect to make significant capital expenditures in Footprint Projects, driven primarily by investments to improve reliability, meet customer requirements and support oil and gas activities in our Stanton territory in the Permian Basin and interconnections to our Panhandle transmission assets. Based on current estimates, we expect our aggregate capital expenditures for Footprint Projects from 2015 to 2017 to be between $745 million and $775 million.

 

    Acquire ROFO Projects and other T&D projects from Hunt. Hunt Developer has agreed to offer the ROFO Projects to us prior to their completion. We are not obligated to purchase, and Hunt is not obligated to sell, these projects if we do not agree upon the price and other terms of the purchase. Hunt has informed us that it intends for us to be the primary owner of Hunt’s T&D development projects as those projects are completed and placed in service.

 

    Acquire other T&D assets from third parties. We intend to leverage relationships that we, Sharyland and Hunt maintain in the energy industry to source acquisition opportunities. We have a track record of acquiring T&D assets from third parties as a result of relationships maintained by Hunt and Sharyland’s business development teams. We believe that our structure, which relies on an ongoing relationship with operating lessees, combined with Sharyland’s operating track record and Hunt’s reputation as an innovative and credible developer of energy assets, will competitively position us to acquire other T&D assets.

 

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Focus on Texas and southwestern United States initially. We are primarily focused on two main markets, Texas and the southwestern United States, where we believe the electric transmission sector will continue to grow significantly. This also allows us to leverage our existing relationships and a proven track record of identifying, developing, constructing and acquiring critical infrastructure assets. Substantially all of the ROFO Projects are located in Texas or the southwestern United States. Over time, we may expand our focus to other jurisdictions with favorable regulatory and growth characteristics.

Maintain a strong financial profile. We intend to maintain a balanced capital structure that enables us to increase our dividend over time and serve the long-term interests of our stockholders. Our financing policies will seek an optimal capital structure through various capital formation alternatives to minimize interest rate and refinancing risks and position us to pay stable and growing long-term dividends and maximize value.

Competitive Strengths

Our assets generate stable cash flows. We generate revenue by leasing T&D assets to Sharyland. Sharyland’s lease payments to us are largely comprised of fixed base rent, with the remaining lease payments to us derived from a percentage of Sharyland’s gross revenue in excess of a specified threshold. Sharyland receives revenues from DSPs and REPs, which pay Sharyland PUCT-approved rates. The PUCT-approved rates are designed to allow the applicable utility to recover costs associated with maintaining and operating the assets and earn a return on invested capital. Through our leases, which include mechanisms for rent increases as we grow our rate base, we expect to benefit from the stability of Sharyland’s rate-regulated revenue stream. See “Business and Properties—Our TenantOur Leases.”

Our T&D assets are located in high-growth areas. Our Stanton territory assets serve a region atop the Permian Basin, which has experienced a rapid expansion in oil and gas investment. Our transmission assets in the Texas Panhandle are located in one of the most attractive wind corridors in the world and, we believe, will benefit from expanding wind power generation investment. Our McAllen territory is located in one of the most rapidly-growing population areas of the State and benefits from its border with Mexico, where we recently expanded power interconnection facilities through a long-standing relationship with CFE.

The ability to update transmission rates through interim TCOS filings, combined with Sharyland’s current distribution customer and load growth, reduces the necessity of filing frequent rate cases. The majority of Sharyland’s expected 2015-2017 capital expenditures are for transmission assets. Like other utilities in Texas, Sharyland is able to minimize regulatory lag through interim TCOS filings. See “—Our Revenue Model—Regulatory Recovery.” With respect to capital expenditures for distribution assets, Sharyland’s revenues, and its lease payments to us, will grow as new customers connect and/or existing customers increase their electricity usage. We believe this growth will enable us to invest in our Footprint Projects and receive increased lease payments from Sharyland, without the need for Sharyland to frequently file rate cases to request increases in rates to cover such costs.

We benefit from our strong ties to and our alignment with Hunt. Hunt, and members of the Hunt family, own and control Hunt Manager, Sharyland and Hunt Developer. Hunt will own 3,176,878 shares of common stock and 13,213,619 OP Units in our Operating Partnership following this offering and the Reorganization, which will be subject to long-term lock-ups with us. See “Certain Relationships and Related Transactions—Arrangements with Hunt—Lock-Up Agreement with InfraREIT, Inc.” This ownership would constitute 27.1% of our outstanding equity if all OP Units were exchanged for shares of our common stock. In addition, the incentive payment under our management agreement with Hunt Manager is linked to our financial performance, requiring payment only if our quarterly distributions exceed $0.27 per share.

Sharyland has a proven development, construction and operating history and a strong reputation in Texas. Since Sharyland began operations in 1999, it has successfully developed, constructed and operated several T&D projects, including the CREZ project and the Railroad DC Tie, and successfully integrated and improved

 

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the operations of Cap Rock following our acquisition of it in 2010. Sharyland completed the CREZ project in November 2013, within the original timeframe outlined by the PUCT and under budget. Sharyland’s expertise and reputation helps Sharyland maintain positive customer and regulatory relationships, which we believe increases our ability to generate the returns we expect on our T&D assets.

We have rights to Hunt’s T&D pipeline. Our development agreement with Hunt Developer requires Hunt to offer all ROFO Projects to us prior to their completion. Hunt and Sharyland are responsible for Sharyland’s growth from a start-up operation to a utility that operates approximately $1.1 billion in rate base as of September 30, 2014.

Hunt originated, and Hunt Manager and Hunt have expertise in applying, the REIT structure to regulated T&D assets. In 2005, Hunt and Sharyland employees, led by our Chairman, W. Kirk Baker, initiated the process of owning regulated T&D assets through a REIT structure. Over the last nine years, Hunt and Sharyland gained significant experience applying the REIT structure to a high-growth, regulated T&D business. Furthermore, in 2010, Hunt and Sharyland successfully acquired and integrated the Cap Rock T&D assets and operation directly into our REIT structure. Hunt’s team also successfully sourced, structured and negotiated on our behalf debt and equity financing arrangements to fund our organic growth, construction projects and the Cap Rock acquisition. We believe Hunt’s and Hunt Manager’s knowledge and experience gives us a competitive advantage in analyzing the complexities associated with our expected rate base growth, executing on development and acquisition opportunities within a REIT structure, obtaining regulatory approvals and structuring lease agreements with tenants.

Our REIT structure and balance sheet provide us with long-term cash distribution advantages. We believe our REIT structure positions us well to make enhanced cash distributions to our stockholders over the long term as compared with utilities and power oriented yield vehicles. Additionally, on a pro forma basis, we expect to be able to fund estimated capital expenditures from Footprint Projects through the end of 2017 without raising proceeds from additional equity offerings. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” for a description of our liquidity and target credit metrics.

Our Revenue Model

We lease our T&D assets to our tenant, Sharyland, which makes lease payments to us consisting of fixed base rent and percentage rent. To support its lease payments to us, Sharyland delivers electric service and collects revenues directly from DSPs and REPs, which pay PUCT-approved rates. Under the terms of our leases, Sharyland is responsible for the operation of our assets, payment of all property related expenses associated with our assets, including repairs, maintenance, insurance and taxes (other than income taxes) and construction of Footprint Projects. As our rate base increases through Footprint Projects, ROFO Projects or other acquisitions, we generally expect our lease revenue to increase.

 

LOGO

 

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Regulatory Recovery

General rate making

In Texas, an electric utility’s T&D rates are determined pursuant to rate case proceedings, which occur periodically, and are adjudicated by the PUCT to ensure that rates remain just and reasonable. Rates are determined after considering the utility’s annual operating cost of rendering service, adjusted for known and measurable changes, in addition to a reasonable return on invested capital. Sharyland makes all regulatory filings with the PUCT regarding our T&D assets. Per the terms of the leases, we have the right to request that Sharyland file a rate case proceeding.

Updating Rates

Sharyland’s rates may be updated through three different mechanisms:

 

    A general rate case. A rate case is usually initiated by the utility or the PUCT, on its own motion or on complaint by an affected stakeholder. In general, a rate case is initiated when one party believes the amount of capital invested or the cost of service (operating or cost of capital) has changed significantly enough to warrant a review by the PUCT. In Texas, once a rate case is filed, it is generally concluded within one year.

 

    TCOS filing. For transmission assets, Sharyland is permitted to update its transmission tariff up to two times per year, outside of a general rate case, for certain changes such as additional capital expenditures, through interim TCOS filings. If there are no material deficiencies in the TCOS filing, or objections from intervenors, Sharyland’s transmission rates generally will be updated within 60 days of the TCOS filing.

 

    DCRF filing. For distribution assets, Sharyland is permitted to update its distribution tariff once a year, outside of a general rate case, for changes in the amount of invested capital for distribution and certain associated costs. Sharyland historically has not used DCRF filings to update its distribution tariffs.

Sharyland’s 2014 Rate Case

In January 2014, the PUCT approved a rate case filed by Sharyland applicable to all of our T&D assets other than our distribution assets in McAllen, Texas, providing for a capital structure consisting of 55% debt and 45% equity, a return on equity of 9.70% and a return on invested capital of 8.06% in calculating rates. The new rates became effective May 1, 2014. We expect Sharyland’s next rate case to be filed during the first half of 2016. For more information on how rates are determined see “Regulation and Rates—Regulation of T&D Utilities.”

Rent Revenue

Rental Rates

All of our current revenue is comprised of rental payments from Sharyland under leases that were negotiated at various times between 2010 and 2014. Historically, we and Sharyland have negotiated rent payments intended to provide us with approximately 97% of the projected regulated return on rate base investment attributable to our assets that we and Sharyland would receive if we were a fully-integrated utility. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors Expected To Affect Our Operating Results and Financial Condition—Regulatory Recovery” and “—Our Tenant—Sharyland’s Regulatory Proceedings.” We and Sharyland have negotiated these rental rates based on the premise that we, as the owner of regulated T&D assets, should receive most of the regulated return on our

 

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invested capital, while leaving Sharyland with a portion of the return that gives it the opportunity to operate prudently and remain financially stable. Our leases require us to continue to negotiate rent payments in the future in a manner similar to this historical negotiation.

Sharyland makes lease payments to us that consist of fixed base rent and percentage rent (based on an agreed-to percentage of Sharyland’s gross revenues, as defined in our leases, in excess of a specified threshold). Because our existing rate base will decrease over time as our T&D assets are depreciated, revenue under our leases will decrease over time unless we add to our existing rate base by making additional capital expenditures to offset the decreases in the rent resulting from depreciation. The weighted average annual depreciation rate of our assets as of September 30, 2014 was 2.67%. We negotiated our current leases to provide for fixed base rent to comprise approximately 80-90% of the total expected rent (with the exception of the lease related to our Stanton transmission loop assets, which does not provide for percentage rent).

Lease Renewals

We expect to renew our leases with Sharyland prior to expiration. Our leases provide that we and Sharyland negotiate lease terms based on our historical negotiations and the return that utilities in the State of Texas are allowed to earn at the time of the negotiation. We generally expect that renewal terms will be at least five years. If either we or Sharyland do not wish to renew a lease, or we cannot agree to new lease terms, we expect that our rent negotiations with a new third-party tenant would be based on the rate base of the assets subject to the expired lease and the rate of return expected at the time a new lease is negotiated, among other factors. Our S/B/C lease, which relates to less than 25% of our existing assets, expires on December 31, 2015, and leases relating to our remaining assets expire at various times between December 31, 2019 and December 31, 2022.

Lease Supplements

Our leases provide that as the completion of Footprint Projects increases our rate base, we and Sharyland will negotiate lease supplements so that Sharyland makes additional rent payments to us on this incremental rate base. Various factors could cause Sharyland’s expected lease payments on incremental rate base to be different than its lease payments to us on our existing rate base. For instance, if a rate case was finalized since the last lease or lease supplement, the new lease supplement would use regulatory assumptions from the most recent rate case. Also, our leases provide that either party can negotiate for economics that differ from our existing leases based on appropriate factors that our leases do not specifically list. However, the negotiation of lease supplements relates only to the revenue we expect to be generated from the incremental rate base subject to the negotiation, and in no circumstance will the negotiation change the rent payments negotiated with respect to prior leases and lease supplements.

Rate Base Growth

We will add to our rate base through capital expenditures for Footprint Projects, acquisitions of ROFO Projects or acquisitions of other T&D assets from Hunt or third parties.

For Footprint Projects, we generally fund all of the capital expenditures during the development or construction phase of a project, and these expenditures increase our rate base when they are placed in service. In advance of the time assets are placed in service, we will work with Sharyland to negotiate a supplement to our leases. Sharyland also may make a regulatory filing to update its rates to reflect the additional rate base.

When we acquire ROFO Projects or other T&D assets from Hunt, we would expect to assume any lease that is already negotiated with Sharyland or another tenant with respect to those T&D assets, and we will work with Sharyland or another tenant to update existing rates, as appropriate, for the addition to our rate base.

Prior to closing an acquisition from a third party, we will work with Sharyland, or another tenant, to pursue the addition of new leases and updating of existing rates, as appropriate, for the addition to our rate base.

 

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Described below are the key steps by which placing new assets into service increases our rate base and/or our expected lease payments, although the order and timing of each step will vary by asset:

 

LOGO

Our Tenant

Overview

Our tenant, Sharyland, has been a regulated utility since 1999 and currently serves over 50,000 electricity delivery points in 29 counties throughout Texas. Sharyland is responsible for construction management, operation and maintenance of our T&D assets and regulatory oversight and compliance. See “—Our Leases” and “Financial Information Related to Our Tenant.”

Our Relationship with Sharyland

In 2005, under the leadership of Hunter L. Hunt, a Hunt team directed by W. Kirk Baker, our Chairman, initiated the process of owning regulated infrastructure assets through a REIT structure. The objective of this structure is to provide for efficient access to capital markets to fund infrastructure additions while positioning a qualified utility to operate and control the infrastructure assets. We believe that the REIT structure that we have established with Sharyland meets this objective.

A REIT is required to lease its assets to third-party tenants and to generate a substantial portion of its income from lease payments from these tenants. As a result, we have structured ownership of our T&D assets through a lessor/lessee structure, with Sharyland acting as the tenant under each of our leases. Sharyland, as lessee, has control of, and is responsible for operating and maintaining, our T&D assets. We are a passive owner of our T&D assets, with no operational control over those assets. We have memorialized Sharyland’s operational control primarily through the leases. However, the PUCT order approving our structure also requires that Sharyland maintain operational control of SDTS as the managing member. Under the PUCT order and the SDTS company agreement, we are not able to remove Sharyland as managing member without prior PUCT permission. We have negative control rights over SDTS that passive owners would expect such as the right to approve renewals of the leases or any new leases, sales or dispositions of assets, debt issuances and annual budgets, subject to some exceptions. To the extent that day-to-day operations of SDTS involve matters primarily related to passive ownership of the assets, such as capital sourcing, financing, cash management and investor relations, Sharyland has delegated those responsibilities and authorities to us pursuant to a delegation agreement. See “SDTS Company Agreement and Delegation Agreement” for more details.

The leases assume that Sharyland, as lessee, should earn a regulated return to compensate it for the capital it has invested and for the risks that it is taking as the tenant under the lease. Sharyland bears the risks that most utilities face such as changes in regulatory policy, changes in regulated rates, change in usage and demand, credit risk of counterparties, damage to properties, increases in operating expenses and increases in taxes. Many of these risks may ultimately lead to lower revenue, or increased costs, which would affect Sharyland’s ability to fulfill its lease obligations or its willingness to enter into new leases or renewals of existing leases under similar economic terms. We believe that Sharyland is incentivized to operate the assets in accordance with good utility

 

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practice to ensure that it is able to continue to lease the assets and be a utility in good standing with the PUCT. As a public utility, Sharyland’s practices, cost structure and its investments are subject to review by the PUCT, and Sharyland understands that we expect a regulated return on the investments we make in our T&D assets. Therefore, Sharyland is incentivized to only incur costs and investments that are reasonable and necessary, while also honoring obligations to customers.

The leases also assume that, as lessor and owner of the T&D assets, we should receive a regulated return on the capital we have invested in our T&D assets. The combined return that we and Sharyland receive should be comparable to the return that other integrated T&D utilities receive. As part of our negative control rights in the SDTS company agreement, we have the right to approve the annual financial plan of SDTS and any leases between Sharyland and SDTS. We intend to negotiate the leases to ensure that we receive our expected regulated return, keeping in mind that Sharyland has to be willing to enter into the lease. Thus, both parties will negotiate the leases keeping in mind the current and expected economic environment, current and expected regulatory environment and current and expected capital market environment. It is in each party’s best interest to negotiate leases that are expected to result in beneficial economic outcomes. To the extent that conditions change, both parties are incentivized to negotiate long-term solutions.

Separation of Utility Functions

Pursuant to our leases, the SDTS company agreement and the delegation agreement, we have separated, between Sharyland and us, the functionality that is typically combined under one commonly owned group in an integrated utility. Through Hunt Manager, we are generally responsible for debt and equity financing, capital markets planning, investor relations, tax administration and accounting for the substantial portion of the combined utility’s assets and liabilities. Sharyland is responsible for operating, repairing and maintaining the T&D assets, planning new T&D projects, handling customer billing and complaints, managing regulatory matters and relationships with various regulatory bodies, handling community relations matters, accounting for substantially all of the combined utility’s operations and maintenance costs, ensuring that the T&D assets and the combined utility’s operations comply with applicable environmental, safety and other laws applicable to operations, working with us to forecast the combined utility’s capital needs, construction management and all other matters related to the operation of the combined utility. Since we separated these functions in 2010, Hunt Manager and Sharyland have developed expertise in ensuring that the relationship functions properly and that electricity is effectively and efficiently provided in a safe and reliable manner to Sharyland’s customers.

Competition

The market for acquiring and developing energy infrastructure assets is highly competitive. Within the State of Texas, namely ERCOT, Sharyland competes with other TDSPs such as AEP, CenterPoint Energy, Oncor Electric and Texas New Mexico Power (PNM Resources), with municipally-owned electric utilities such as Austin Energy and CPS Energy and with electric cooperatives like South Texas Electric Cooperative to develop transmission projects. Given the robust growth and business-friendly environment in Texas, there are several private developers who are seeking transmission development opportunities as well. However, we are not aware of any other utility that is structured as a REIT.

In addition, Sharyland is subject to customer conservation and energy efficiency activities and research and development activities are ongoing to improve existing and alternative technologies to produce electricity, including advancements related to self-generation and distributed energy technologies such as gas turbines, fuel cells, microturbines, photovoltaic (solar) cells and concentrated solar thermal devices. It is possible that advances in these or other technologies could result in a reduction of demand for Sharyland’s T&D services, but these have not been a significant factor to date. Furthermore, in small portions of our service territories, existing and potential customers have a choice between Sharyland and other utilities and may choose the other utility over Sharyland.

 

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Regulation

Sharyland is subject to regulation by the PUCT, including with respect to approval of Sharyland’s rates for T&D service, setting reliability and safety standards, and ensuring that Sharyland does not discriminate in its treatment of customers, REPs and generators in the delivery of electricity. Below is a description of some of Sharyland’s more significant recent regulatory proceedings.

Sharyland’s Regulatory Proceedings

2013 Rate Case

In Texas, an electric utility’s T&D rates are determined pursuant to a rate case proceeding adjudicated by the PUCT to ensure that rates remain just and reasonable. On January 23, 2014, the PUCT approved a rate case settlement applicable to all of our T&D assets other than our distribution assets in McAllen, Texas providing for a capital structure consisting of 55% debt and 45% equity, a return on equity of 9.70% and a return on invested capital of 8.06% in calculating rates. The new rates became effective on May 1, 2014. Sharyland agreed in that settlement to file its next rate proceeding in 2016, based upon the test year ending December 31, 2015. For more information on how rates are determined see “Regulation and Rates—Regulation of T&D Utilities.”

Transmission Tariff

In Texas, Sharyland is permitted to update its transmission tariff by making interim TCOS filings twice a year with the PUCT. Sharyland is currently collecting transmission revenue pursuant to a tariff approved in connection with an interim TCOS filing that Sharyland made in August 2014, which updated Sharyland’s tariff from a March 2014 reconciliation filing that updated its transmission tariff to incorporate the results of the 2013 rate case (the reconciliation filing). Furthermore, as a result of the amount of capital expenditures we expect to fund over the next several years, we expect that Sharyland will continue to use the twice yearly interim TCOS mechanism to update its revenue requirement and wholesale transmission tariff.

The following outlines, by way of example, the manner in which Sharyland’s TCOS filing on August 15, 2014 (the August 2014 interim TCOS filing) updated Sharyland’s transmission rates:

 

    The August 2014 interim TCOS filing compared Sharyland’s revenue requirement as of July 31, 2014 (approximately $136.6 million) to Sharyland’s revenue requirement established in Sharyland’s reconciliation filing in March 2014 (approximately $128.5 million). The August 2014 revenue requirement updated rate base, taking into account changes in the original cost of plant in service and accumulated depreciation. The August 2014 revenue requirement also updated for changes in depreciation expense, taxes other than income tax and federal income tax.

 

    The difference in the revenue requirement for the August 2014 interim TCOS filing and the reconciliation filing in March 2014 was approximately $8.1 million. Sharyland’s interim annual transmission rate was then calculated by dividing its updated annual transmission revenue requirement of approximately $136.6 million by 2013 ERCOT 4CP of approximately 65 gigawatts, deriving a transmission rate of $2.094/kW.

The PUCT approved the August 2014 interim TCOS filing on October 3, 2014, giving Sharyland the right to begin billing DSPs at the updated transmission rate of $2.094/kW, instead of the rate established in connection with the reconciliation filing that applied through October 3, 2014. Effective October 3, 2014, each DSP paid Sharyland, monthly, an amount that on an annualized basis equaled $2.094/kW multiplied by the DSP’s ERCOT 4CP usage during 2013. In other words, the amount the DSP paid Sharyland after the effectiveness of the August 2014 interim TCOS filing depended on the DSP’s 2013 usage, and not the DSP’s 2014 usage. We have amended our lease supplements with Sharyland to reflect the increased rent that Sharyland owes with respect to the additional transmission assets added in the August 2014 interim TCOS filing.

 

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Move to Competition

In the late 1990s and early 2000s, upon direction from the Texas legislature and the PUCT, utility incumbents in the ERCOT market unbundled business functions and, thereafter, most retail customers in Texas began purchasing electricity in a competitive market from REPs. However, not all markets unbundled at that time. We acquired Cap Rock’s T&D assets in 2010, and, at that time, none of Cap Rock’s service territories had moved to competition. In other words, in each of these territories, customers purchased bundled electric service from Sharyland and did not have the option of choosing the REP from which they purchase electricity. In connection with the regulatory approval for the Cap Rock acquisition, Sharyland agreed to study whether the territories that had not yet moved to competition, which included the Stanton territory in West Texas near Midland, the Brady territory Northwest of Austin and the Celeste territory Northeast of Dallas, should be moved to the competitive market. These territories comprise, in the aggregate, approximately 50,000 customers, which is more than 90% of Sharyland’s total distribution customer base, and we lease the distribution assets situated in these territories to Sharyland pursuant to the S/B/C Lease (defined below). As a result of the study, it was determined that the customers should be moved to competition. Sharyland commenced the move to competition on May 1, 2014, and it is now complete. As a result, Sharyland no longer delivers bundled electricity service to retail customers in these service territories. Instead, retail customers purchase electricity in the competitive market from REPs. As is the case with other DSPs with service territories that are part of competitive electricity markets, Sharyland now receives payments from REPs, rather than directly from retail customers. The move to competition has not materially affected Sharyland’s financial condition or results of operations, although it has resulted in lower reported revenue for Sharyland because its service charge to REPs no longer includes the cost of purchased power it used to charge to retail customers.

Our Leases

We lease all of our T&D assets to Sharyland under the following five separate leases:

McAllen Lease. SDTS and Sharyland are party to a lease pursuant to which Sharyland leases our assets located in South Texas, including our Railroad DC Tie and our transmission operation centers in Amarillo, Texas. We refer to this lease as the McAllen Lease.

S/B/C Lease. SDTS and Sharyland are party to a lease pursuant to which Sharyland leases our T&D assets located in and around Stanton, Brady and Celeste, Texas, other than our 138 kV transmission loop, which is described below. We refer to this lease as the S/B/C Lease.

CREZ Lease. SPLLC, a wholly-owned subsidiary of SDTS, and Sharyland are party to a lease pursuant to which Sharyland leases substantially all of our Panhandle transmission assets. We refer to this lease as the CREZ Lease.

Stanton Transmission Loop Lease. SDTS FERC, a wholly-owned subsidiary of SDTS, and SU FERC, L.L.C., which is a wholly-owned subsidiary of Sharyland, are party to a lease pursuant to which Sharyland leases our 138 kV transmission line that loops around our Stanton, Texas territory in the Permian Basin. This transmission line formerly was subject to FERC regulation prior to the move to ERCOT, which was completed effective January 1, 2014. We refer to this lease as the Stanton Transmission Loop Lease.

ERCOT Transmission Lease. SDTS and Sharyland are party to a lease pursuant to which Sharyland leases a small portion of our Panhandle transmission assets. We refer to this lease as the ERCOT Transmission Lease.

 

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The table below provides a summary of lease revenue and certain other information with respect to our leases:

(Dollar amounts in thousands)

Lease

 

Lease Expiration

Date

   

Net
Effective
Rent (1)

   

Percentage
of Net
Effective
Rent (2)

   

Annualized

Rent (3)

   

Percentage
of

Annualized

Rent (4)

   

Total

Electric

Plant, net (5)

   

Percentage
of Total
Electric

Plant,
net (6)

 

CREZ Lease

    December 31, 2020      $ 24,918 (7)      34.0   $ 83,394        57.0   $ 643,618        61.0

S/B/C Lease

    December 31, 2015      $ 32,384 (8)      44.3   $ 48,984        33.5   $ 289,593        25.8

McAllen Lease

    December 31, 2019      $ 9,371 (9)      12.8   $ 9,084        6.2   $ 149,026        9.8

Stanton Transmission Loop Lease

    December 31, 2021      $ 6,520 (10)      8.9   $ 4,788        3.3   $ 35,401        3.4

ERCOT Transmission Lease (11)

    December 31, 2022      $                 $                    $                     
   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

    $ 73,193        100.0   $ 146,250        100.0   $ 1,117,638        100.0
   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Consists of lease revenue under the lease for the year ended December 31, 2013, determined on a straight-line basis under GAAP. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Summary of Significant Accounting Policies—Revenue Recognition.”

 

(2) Calculated as lease revenue for the applicable lease for the year ended December 31, 2013 divided by lease revenue for all leases.

 

(3) Annualized rent is calculated by multiplying (i) rental payments (defined as cash fixed base rent and cash percentage rent (based on an agreed percentage of Sharyland’s gross revenues, as defined in each lease)) for the month ended September 30, 2014, by (ii) 12. Cash base rent for the month ended September 30, 2014 was $5.9 million for our CREZ Lease, $2.4 million for our S/B/C Lease, $618,000 for our McAllen Lease, $399,000 for our Stanton Transmission Loop Lease and $0 for our ERCOT Transmission Lease. Cash percentage rent for the month ended September 30, 2014 was $1.1 million for our CREZ Lease, $1.6 million for our S/B/C Lease, $139,000 for our McAllen Lease, $0 for our Stanton Transmission Loop Lease and $0 for our ERCOT Transmission Lease.

 

(4) Calculated as annualized rent for the applicable lease divided by annualized rent for all leases.

 

(5) Consists of electric plant, net for the applicable lease as of September 30, 2014.

 

(6) Calculated as the electric plant, net for the applicable lease divided by total electric plant, net for all leases as of September 30, 2014.

 

(7) Consists of lease revenue for the year ended December 31, 2013. We did not recognize any lease revenue under our CREZ Lease before January 1, 2013.

 

(8) Consists of lease revenue for the year ended December 31, 2013. Lease revenue for each of the years ended December 31, 2011 and December 31, 2012 was $27.1 million.

 

(9) Consists of lease revenue for the year ended December 31, 2013. Lease revenue for the years ended December 31, 2011 and December 31, 2012 was $8.9 million and $9.2 million, respectively.

 

(10) Consists of lease revenue for the year ended December 31, 2013. Lease revenue for each of the years ended December 31, 2011 and December 31, 2012 was $6.5 million.

 

(11) We did not receive lease revenue under our ERCOT Transmission Lease during the applicable periods. We began receiving lease revenue under the ERCOT Transmission Lease in December 2014.

 

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In general, our leases include the following terms:

Net Lease

Each of our lease agreements is a net lease that grants Sharyland exclusive rights to and responsibility for the maintenance and operation of our T&D assets, requires Sharyland to maintain appropriate insurance with respect to our T&D assets, requires Sharyland to pay any property, franchise, sales and other taxes related to the T&D assets and gives Sharyland responsibility for regulatory compliance and reporting requirements related to our T&D assets. See “—Insurance” for disclosure regarding the waiver we have provided to Sharyland regarding the insurance requirements in our CREZ Lease.

Operation of Our T&D Assets

The leases require that Sharyland operate the T&D assets in a reasonable and prudent manner in accordance with PUCT guidelines and applicable law. Sharyland must obtain and maintain any licenses, permits or other approvals required by applicable law to operate the T&D assets under the leases.

Expenditures

The following chart demonstrates how the leases define and assign responsibility for various expenditures related to our T&D assets:

 

Type of Expenditure

  

Definition

  

Sharyland’s Responsibilities

  

Our Responsibilities

Footprint Projects

   Expenditures for T&D projects primarily situated within our distribution service territory or that are added to an existing transmission substation or physically hang from our existing transmission assets and that are characterized as capital expenditures under generally accepted accounting principles (GAAP) that are used to acquire real property assets    Send us three-year capital expenditure budgets, request that we fund these Footprint Projects as prudent, construct T&D assets with the capital we provide, and pay us rent with respect to these capital expenditures, typically commencing when the related assets are placed in service    Fund capital expenditures requested by Sharyland
Repairs    Expenditures related to our T&D assets that are expensed, and not capitalized, under GAAP    Make and fund all repairs    None

Whether a particular expenditure is characterized as a Footprint Project (which we are required to fund) or a repair (which Sharyland is required to fund) depends on its characterization under GAAP. Expenditures relating to Footprint Projects are capitalized under GAAP, and expenditures relating to repairs to our existing T&D assets are expensed under GAAP. As a result of this construct, capital expenditures that we fund related to Footprint Projects increase our net electric plant.

Sharyland is required to provide a capital expenditure budget on a rolling three-year basis that sets forth anticipated capital expenditures related to Footprint Projects, which the leases require us to fund. Because Sharyland is obligated to pay us rent with respect to our capital expenditures, and because of our strong working

 

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relationship with Sharyland and its history as a prudent and responsible operating utility, we do not expect that Sharyland will require us to fund capital expenditures unless Sharyland believes those expenditures are prudent and will be included in our rate base.

Rent

We have negotiated the rental rates under our leases with Sharyland at various times between 2010 and 2014. Historically, we and Sharyland have negotiated rent payments intended to provide us with approximately 97% of the projected regulated return on rate base investment attributable to our assets that we and Sharyland would receive if we were a fully-integrated utility. We and Sharyland have negotiated these rental rates based on the premise that we, as the owner of regulated T&D assets, should receive most of the regulated return on our invested capital, while leaving Sharyland with a portion of the return that gives them the opportunity to operate prudently and remain financially stable.

Actual revenue and expenses incurred by Sharyland will be different from those expected at the time we negotiate rental rates with Sharyland. As a result, we and Sharyland may earn more or less than originally projected. Our leases prohibit both parties from adjusting for the effect of differences between Sharyland’s actual and projected results.

Sharyland makes scheduled base rent and percentage rent payments under each of our leases (with the exception of the Stanton Transmission Loop Lease, which does not provide for percentage rent). The percentage rent is based upon a percentage of Sharyland’s annual gross revenue in excess of specified threshold amounts, which are at least equal to base rent under each of our leases. Our leases define gross revenue to mean all revenue that Sharyland generates from the leasehold T&D assets, subject to the following definitional provisions. First, the definition of gross revenue specifically excludes pass-through items. For instance, Sharyland’s tariff includes rate riders, including a rider allowing Sharyland to recover costs related to its move to competition. Revenue that Sharyland collects pursuant to this rider is excluded from the definition of gross revenue under our leases. Second, we also subtract from revenue an amount necessary to provide Sharyland with a return on any capital expenditures that Sharyland has made related to the leasehold assets. For instance, Sharyland has made capital expenditure investments in rolling stock such as service trucks. We did not fund these capital expenditures because the related assets do not constitute real property under applicable law. Sharyland is entitled to make a return on those investments, just as we are entitled to make a return in investments on our T&D assets. Our leases provide Sharyland with this return by subtracting the related return amount from gross revenue, allowing Sharyland to retain 100% of this revenue. Third, we allocate total transmission revenue based on net plant in service for each lease for purposes of calculating the amount of gross revenue Sharyland has generated under each lease. We make this allocation because Sharyland’s transmission revenue, which is paid by all DSPs in ERCOT, cannot be tracked to a particular lease, which distinguishes it from distribution revenue. We have ERCOT transmission assets in all five of our leases.

Supplements

We negotiated our S/B/C Lease and McAllen Lease payments with Sharyland assuming that we would fund a certain amount of base capital expenditures annually. If capital expenditures are expected to exceed these base capital expenditures, we negotiate rent supplements with Sharyland. No base capital expenditure level is assumed in our CREZ Lease or our ERCOT Transmission Lease, so all expected capital expenditures related to these leases result in a related negotiated rent supplement with Sharyland. None of the capital expenditures we make are allocated to the Stanton Transmission Loop Lease. For purposes of determining whether there are capital expenditures that require rent supplements, we measure capital expenditures based on the date the assets funded by those capital expenditures are placed in service, rather than the date of funding the capital expenditures. Placed in service, in this context, means the related T&D project has been completed and is used and useful to ratepayers. Likewise, Sharyland should start collecting revenue on those assets at the time they are placed in service, not when they are funded.

 

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As our rate base increases, Sharyland is required to agree to supplements to our leases to increase its rent payments to us. The amount of the rent increase is subject to negotiation each time a supplement is agreed to, but our existing leases provide that our historical agreements with Sharyland on target rate of return will serve as the basis for the rental rate increase, subject to limited factors that can affect the negotiation. For example, the negotiated target rate of return on the incremental rate base may be different from the negotiated target rate of return on the prior rate base due to a variety of factors, including the rate of return that utilities in the State of Texas are generally earning at the time of the relevant negotiation. The leases do not explicitly define which factors would be appropriate or the effect that any appropriate factor should have on the negotiation. However, the negotiation of lease supplements relates only to the revenue we expect to be generated from the incremental rate base subject to the negotiation, and in no circumstance will the negotiation change the rent payments negotiated with respect to prior leases and lease supplements (or result in any true-up with respect thereto).

Additionally, the lease supplement process allows us to address and update a number of other matters under our leases, such as updating the amount of revenue attributable to Sharyland’s capital expenditures and related matters. Because we frequently prepare supplements based on the expectations we and Sharyland have regarding various matters, including expected capital expenditures, we have a mechanism, which we refer to as a validation, that we use to true-up previously negotiated supplements in order to reflect the difference between the capital expenditures we expected and the capital expenditures that were actually placed in service and related matters such as the actual placed in service date of T&D assets funded by our capital expenditures. In no event will we use the validation process to account for differences between the expected and actual return on capital expenditures. If we and Sharyland are unable to agree on a rent supplement or a validation, the leases obligate us to submit the dispute to binding arbitration.

Generally, we expect to enter in to lease supplements related to capital expenditures in advance of the year in which the related assets are placed in service. For instance, in late 2014, we entered in to revised lease supplements that memorialized Sharyland’s obligation to pay us rent on the capital expenditures we expect for 2015. As 2015 progresses, if the amount of expected placed-in-service capital expenditures, or the related placed-in-service dates, differ from expectations, either Sharyland or we may request a rent validation in order adjust rent obligations to true-up the difference between actual and expected capital expenditure amounts and placed-in-service dates. Our leases do not require that we follow this exact timeline and process, so we may determine, with Sharyland, that an alternate process is more efficient.

Events of Default

Under our leases, a default will be deemed to occur upon certain events, including (1) the failure of Sharyland to pay rent, after applicable cure periods, (2) certain events of bankruptcy or insolvency with respect to Sharyland, (3) Sharyland’s breach of a representation or warranty in a lease in a material manner, (4) Sharyland’s breach of a covenant in a lease in a material manner or (5) a final judgment for the payment of cash in excess of $1,000,000 is rendered against Sharyland and is not bonded, stayed pending appeal or discharged within 60 days.

Remedies Upon a Default

Upon a default under a lease, we may, at our option, exercise the following remedies: (1) subject to PUCT approval, terminate the applicable lease agreement upon notice to Sharyland and recover any damages to which we are entitled under applicable law, (2) subject to PUCT approval, terminate Sharyland’s right to use our T&D assets and recover any damages to which we are entitled under applicable law and (3) take reasonable action to cure Sharyland’s default at Sharyland’s expense.

Renewal

Our leases provide that, if both we and Sharyland desire to renew a lease, we and Sharyland will negotiate rent applicable to the renewal term based on our historical negotiations and the return that utilities in

 

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the State of Texas are generally earning at the time of the negotiation. Generally we expect to begin the process of renegotiating a lease within the six-month period prior to its expiration and that renewal terms will be at least five years, although the leases do not require this length of a renewal term, and we may agree with Sharyland that a shorter or longer renewal term will apply.

Financial Covenants

Under our leases, Sharyland is prohibited from incurring indebtedness other than:

 

    Secured indebtedness, which may be senior to or pari passu with Sharyland’s lease obligations to us, in an amount equal to the greater of:

 

  ¡    $5 million; or

 

  ¡    1% of the sum of, without duplication:

 

  ¡   the consolidated net plant (as defined in our leases) of Sharyland;

 

  ¡   the consolidated net plant of any guarantor under a lease of our T&D assets to Sharyland; and

 

  ¡   the portion of the consolidated net plant of SDTS that is the subject of the applicable lease.

 

    Additional indebtedness, which must be subordinated to the lease obligations that Sharyland owes to us, in an amount equal to the greater of:

 

  ¡    $10 million; or

 

  ¡    1.5% of the sum of, without duplication:

 

  ¡   the consolidated net plant of Sharyland;

 

  ¡   the consolidated net plant of any guarantor under a lease of our T&D assets to Sharyland; and

 

  ¡   the portion of the consolidated net plant of SDTS that is the subject of the applicable lease.

 

    An additional $5 million of loans from us to Sharyland to fund Sharyland’s capital expenditures.

 

    With respect to indebtedness of Sharyland’s subsidiaries that is nonrecourse to Sharyland, an additional amount equal to the product of:

 

  ¡    the lesser of:

 

  ¡   the regulatory-approved debt ratio (expressed as a percentage) plus 5%; or

 

  ¡   65%; and

 

  ¡    Sharyland’s consolidated net plant.

In determining Sharyland’s net plant, the effect of failed sale-leaseback treatment will be reversed in a manner determined by Sharyland in good faith. See “Financial Information Related to Our Tenant” for a description of the

 

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manner in which Sharyland’s reverses the effect of failed sale-leaseback accounting. In addition, under our leases, Sharyland has agreed to comply with certain of our covenants relating to Sharyland under our debt arrangements.

Assignment and Subletting

Sharyland may not assign or otherwise transfer or sublet any of our T&D assets under the leases without our prior written consent and the approval of the PUCT or other applicable governmental authority.

Indemnification

Sharyland is required to defend, indemnify and hold us harmless from and against any and all claims, obligations, liabilities, damages and costs and expenses arising from any act or omission of Sharyland with respect to (1) the operation of the T&D assets, (2) damage to the T&D assets, (3) physical injuries or death (including in connection with the operation of the T&D assets), (4) any breach of any representation or warranty or covenant or (5) any negligence, recklessness or intentional misconduct of Sharyland.

Lease Expiration

The S/B/C Lease, which relates to less than 25% of our existing assets, expires on December 31, 2015 and leases relating to our remaining assets expire at various times between December 31, 2019 and December 31, 2022. If either we or Sharyland do not wish to renew a lease, we expect that our rent negotiations with a new third-party tenant would be based on the rate base of the assets subject to the expired lease and the rate of return expected at the time a new lease is negotiated, among other factors. In any event, because our T&D assets are rate-regulated and necessary for the transmission and distribution of electricity, we expect that they will continue to generate tariff revenue. As a result, we believe we will be able to identify a qualified tenant to operate our T&D assets who will be able to make lease payments to us based on the tariff revenue our assets generate. Before we can lease our T&D assets subject to the expiring lease to a new tenant, we and Sharyland must obtain PUCT approval for the transfer of the related operating licenses. Sharyland is required under the leases to use commercially reasonable efforts to obtain these approvals as soon as is reasonably practicable. Until we obtain those approvals, Sharyland will continue to operate our T&D assets and pay us rent. If it takes longer than 12 months to obtain these approvals, rent payments will be adjusted to 80% of the amounts otherwise due, if the failure to obtain the approval is a result of our failure to reasonably pursue the approval, and will be 105% of the amounts otherwise due, if the failure to obtain the approval is the result of Sharyland’s failure to reasonably pursue the approvals. We also have the right to buy, from Sharyland, any equipment or property that Sharyland uses in connection with the lease, with the price equal to the greater of 110% of book value or fair market value, as mutually agreed by Sharyland and us.

Construction Management

We rely on third parties to manage the construction of our T&D assets. To date, Sharyland has managed all of our construction projects, but, in some circumstances, Sharyland in turn relies on third-party construction contractors to complete these projects.

Project Development

Under the terms of our leases and our development agreement with Hunt Developer and Sharyland, we fund the construction of Footprint Projects, which are defined under our development agreement as transmission or distribution projects primarily situated within our distribution service territory, or that physically hang from our existing transmission assets, such as the addition of another circuit to our existing transmission lines, or that are physically located within one of our substations. Footprint Projects would not, however, include the addition of a new substation on our existing transmission lines or generation interconnects to our existing transmission lines, unless the addition or interconnection occurred within our distribution service territory. ROFO Projects are

 

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