Leucadia National


, a decidedly low-flying conglomerate, is using its house hedge fund in an attempt to upend billionaire Paul Allen's all-cash bid for Houston energy partnership

Plains Resources

(PLX) - Get Report


Why is the tiny $54 million hedge fund going up against Goliath? Because that's where the money is -- other people's money, that is.

The winner of the Plains Resources bid would -- for a price of around $400 million -- take ownership of a company that exists to receive greater and greater sums of money from the

Plains All America Pipeline

(PAA) - Get Report

, a limited partnership.

Listing a limited partnership separately from a general partnership is a common structure in the energy business, but some analysts say the arrangement conceals obscure yet critical financial information and dilutes shareholder value.

According to Douglas Gill, editor of the

Gas Processors Report

, a Houston newsletter, it usually works this way: Companies sell assets to investors for a market price in return for an agreement to pay out the cash flow after maintenance expenses, plus they get to keep control. That makes the company the general partner.

"As the general partner raises the payout to the investors, now known as the limited partners, the GP gets to go back in for a progressively higher share of the income," he wrote in a 2002 report. "So they take their investment out up front and still get to share in the income from the asset they've just sold. Not bad."

As part of a takeover in this case, the new owners of Plains Resources would benefit from increasing cash flow, while holders of the pipeline company's stock would see more of their holdings' cash flow fill Vulcan or Leucadia's coffers.

"Either way, Vulcan or Pershing will end up receiving the cash flow associated with the assets of PLX," says Alan Septimus, a research analyst with Oscar Gruss & Son.

Vulcan Ventures, the private investment vehicle for Paul Allen's estimated $21 billion fortune, currently has the go-ahead for a management-led buyout of the general partnership, which it would then take private for $16.75 a share.

Plains Chairman James Flores and CEO and President John Raymond are leading the private equity buyout. The private equity group first bid $14.25 a share for Plains Resources last November, but its board rejected the offer on Jan. 22. Vulcan came back with a $16.75 bid, which the board accepted on Feb. 19.

Executives at Plains Resources, which has a market capitalization of about $402 million, did not return calls for comment on the deal. Michael Nank, a spokesman for Vulcan, declined to comment on the firm's interest in the company, but he said, "I think this demonstrates some diversification in the portfolio."

A Feb. 13 offer from Pershing Square brought the deal further into the public eye, and interest in the shares of the general partnership soon rose above Vulcan's offer price.

According to a recent

Securities and Exchange Commission

filing, Pershing Square, which now owns 5.33% of the general partnership, proposed a $75 million cash offer, which would pay Plains Resources shareholders $3 a share, with the balance in new, unregistered securities to be issued by a new holding company. Those securities would be valued between $17 and $17.60 a share, according to filing documents.

Pershing founder William Ackman says his fund -- backed by Leucadia -- is ready to follow through on its takeover bid. "The stock is trading well north of their bid," he says of the Vulcan offer. "People are clearly saying they're voting in favor of our deal vs. theirs. In relation to the size of the company, our pockets are as deep as Mr. Allen's pockets," Ackman says. "It's a very interesting situation."

The long-term ownership of an oil company may not be suitable for a hedge fund, though Ackman's investment history suggests that full company ownership is not out of the question. His Gotham Partners fund, which once managed about $300 million, folded its tent last year after investors demanded their money following a failed merger between

Gotham Golf Corp.


First Union Real Estate Equity


Mortgage Investments



Plains management rejected the hedge fund's offer, saying the new securities would have "an uncertain trading value," and added that "after-tax distributions to new security holders likely would be less than after-tax distributions to holders of Plains All American Pipeline" shares.

Plains management says Pershing's offer is a "highly conditional" alternative to a solid all-cash offer. Though it has not yet filed a merger agreement with Vulcan, Plains released a statement Monday saying Kayne Anderson Capital Advisors, which now owns 7.4% of the outstanding shares of Plains Resources common stock, and EnCap Investments, which holds a 4.9% stake, will vote in favor of the Vulcan proposal. (EnCap didn't return calls for confirmation. Kayne filed its intention with the SEC.)

The stock rose after Plains accepted the $16.75 Vulcan offer, going from a $16.65 close on Feb. 19 to end last week at $17.12. A protracted bidding war is in the best interest of the arbitrage funds that have jumped into Plains Resources shares, particularly because the company is about to start raking in more money from a stake in Plains All America. Shares of the pipeline partnership, Plains All America, are up slightly from the start of the takeover attempt, trading at $30.72 the day before Vulcan's first bid in November and closing Friday at $31.89.

According to Gill, the standard scale of this legal rake-off of cash flows starts with a 2% cut. As income rises, using a formula equity analyst Alan Septimus describes as "very complicated," the next stage typically gives the general partnership a 15% distribution. The next stage is at 25%.

"The next stage is a 50% take, after which the LPs and the GPs each take 50 cents out of each new dollar that comes in," Gill writes.

The upside for an investor in the limited partnership is a tax-deferred stream of income that grows fast up front, then slows down as the GP's cut increases.

Kurt Wulff, an independent energy analyst, has a problem with the end results, though. The 50% levy a general partnership can eventually impose is a hidden dilution to the limited partners' return that often gets ignored or downplayed in brokerage reports. "The problem with these partnerships is that they have a disguised compensation arrangement that doesn't get fully reflected in the accounting statements or public disclosures," he says. "It's structured in a non-shareholder-friendly way."

The downside of owning the limited partnership is that a general partner determines how much to spend on maintenance. The general partnership has an incentive to limit these payments, and that can lead to expensive, capital intensive repairs later on. That can increase overall debt, or force the sale of more partnership shares, or units as they are called in the energy sector, further diluting the value of existing shares.

"The downside is that on a long-term basis you may find that the partnership has a lot of debt and a lot of capital has gone back to the general partner. All the capital is being taken out of it, and presumably the asset doesn't last forever."

This is especially relevant, because whoever walks away with Plains Resources is lined up to receive bigger golden eggs from the Plains All America goose. Plains Resources is now getting a 25% distribution, and if Plains All America continues its current growth rate, that could hit the 50% bracket within three to five years, according to Septimus, the research analyst.

Figures from Plains Resources show that its distributions from the limited partnership hit $15.3 million for the first half of last year. The annual distribution has grown from $1.80 a share of Plains All America in 2000 to $2.20 by the second quarter of last year.

"That percentage will ratchet up," he says. "That's what's prompting this attempt to capture the valuation. What may in the past have been of modest value will in coming years be of increasing value. I consider the Pershing proposal to be a rather creative way of splitting up these parts."

But because Plains attracts little notice from analysts, it's difficult to gauge where the stock will go.

Septimus, who also likes Plains All America, estimates that Plains Resources stock could go as high as $20, but not all analysts see it as a good buy.

Richard Segarra of Ford Investor Services, a San Diego quantitative research firm, says the numbers suggest that Plains Resources will dry to a trickle.

"The operating earnings show negative momentum, and over the past couple of years they've been decelerating pretty strongly," he says. "We consider it a low-quality company based on its size and financial condition."

Leucadia, which has a market capitalization of $3.57 billion, owns, through subsidiaries, financial companies such as American Investment Bank, which makes mobile-home loans, and small-business lender American Investment Financial, as well as most of Tulsa, Okla.-based WilTel Communications.

The Pershing offer will either succeed or push Vulcan to pay more, according to Gordon Kaiser, a lawyer specializing in mergers and acquisitions.

"The market believes there's a higher price coming," he says. "The same property may have different values in the hands of different entities. It's not unusual for people in a competitive situation to have really divergent views of where value is."

The situation remains fluid, and rising share prices could sink the Vulcan deal, according to Kaiser. He pointed to the phrase "customary fiduciary termination rights" in the notice posted on Plains Resources' Web site.

"That's code for an ability -- usually with some kind of payment coupled with it -- of the board to terminate the arrangement with Vulcan if it concludes it is its duty to accept on behalf of shareholders," he says. "That fiduciary duty is going to be based on whether shareholder are getting more money or not."

Andrew Shpiz, a senior analyst with Mellon HBV Alternative strategies, which runs a merger arbitrage hedge fund, says Pershing's entry means more bidding. The hedge fund spent almost $20.9 million building up its stake, which would be valued at $21.08 million under Vulcan's terms -- a potentially meager profit of $324,000.

"Anybody doing any sort of event-driven investing says: 'There's a deal on the table, and there's a chance I could get some more,'" he says. "I don't think they were in this to make $300,000. Just because this

offer has been rejected doesn't mean it's over."