9. MEZZANINE EQUITY

On June 16, 2014, funds and accounts managed by affiliates of Apollo Global Management, LLC (Apollo) contributed $150 million in cash to HK TMS, LLC, a wholly owned Delaware limited liability company (HK TMS), that, as of June 16, 2014 holds all of the Company's undeveloped acreage in Mississippi and Louisiana that management believes is prospective for the TMS formation, in exchange for the issuance by HK TMS of 150,000 preferred shares. At the closing, the Company also contributed $50 million in cash to HK TMS. Holders of the HK TMS preferred shares will receive quarterly cash dividends of 8% cumulative perpetual per annum, subject to HK TMS' option to pay such dividends "in-kind" through the issuance of additional preferred shares. For the nine months ended September 30, 2014, HK TMS paid Apollo approximately $3.5 million in cash dividends. The cash dividends are presented within "Preferred dividends on redeemable noncontrolling interest" on the condensed consolidated statements of operations. The preferred shares will be automatically redeemed and cancelled when the holders receive cash dividends and distributions on the preferred shares equating to the greater of a 12% annual rate of return plus principal and 1.25 times their investment plus applicable fees (the Redemption Price), subject to adjustment under certain circumstances. The preferred shares have a liquidation preference in the event of dissolution in an amount equal to the redemption price plus any unpaid dividends not otherwise included in the calculation of the redemption price through the date of liquidation payment. If the preferred shares remain outstanding after June 16, 2018 Apollo can require HK TMS to redeem the preferred shares at the Redemption Price. HK TMS may also redeem the preferred shares at any time by paying the Redemption Price, or may be required to redeem the preferred shares for the Redemption Price plus certain fees under certain circumstances. The preferred shares have been classified as "Redeemable noncontrolling interest" and included in "Mezzanine equity" between total liabilities and shareholders' equity on the unaudited condensed consolidated balance sheets pursuant to ASC 480-10-S99-3A. The preferred shares, while not currently redeemable, are considered probable of becoming redeemable and therefore will be subsequently remeasured each reporting period by accreting the initial value to the estimated required redemption value through June 16, 2018. The accretion is presented as a deemed dividend and recorded in "Redeemable noncontrolling interest" on the condensed consolidated balance sheet and within "Preferred dividends on redeemable noncontrolling interest" on the condensed consolidated statements of operations. In accordance with ASC 480-10-S99-3A, an adjustment to the carrying amount presented in mezzanine equity will be recognized as charges against retained earnings and will reduce income available to common shareholders in the calculation of earnings per share. Adjustments to the carrying amount may not be necessary if the application of ASC 810 results in a noncontrolling interest balance in excess of what is required pursuant to ASC 480-10-S99-3A.

Under certain circumstances, Apollo may acquire up to an additional 250,000 preferred shares of HK TMS on the same terms, with HK TMS receiving up to an additional $250 million in cash proceeds (Tranche Rights). The Tranche Rights have been recognized separately as a liability instrument within "Other noncurrent liabilities" in the unaudited condensed consolidated balance sheets, in accordance with ASC 480 as the shares underlying the Tranche Rights are redeemable equity instruments. The Tranche Rights will be subsequently remeasured at fair value each reporting period in accordance with ASC 480, with fair value changes recorded in "Interest expense and other, net" on the condensed consolidated statements of operations.

In conjunction with the issuance of the preferred shares, HK TMS conveyed a 4.0% overriding royalty interest (ORRI), subject to reduction to 2.0% under certain circumstances, in 75 net wells to be drilled and completed on its TMS acreage. The number of wells subject to the ORRI will increase to the extent that Apollo subscribes for additional preferred shares, with a maximum of 200 net operated wells subject to such ORRI if Apollo subscribes for the full additional 250,000 preferred shares. The ORRI has been recognized separately as a conveyance of oil and natural gas properties in "Unevaluated properties" on the unaudited condensed consolidated balance sheets and within "Proceeds received from the sale of oil and natural gas assets" on the unaudited condensed consolidated statements of cash flows. The Company has committed to drill a minimum of 6.5 net wells in each of the six consecutive twelve month periods beginning June 16, 2014.

Of the $150 million initial investment proceeds from Apollo, the Company allocated the proceeds as follows (in thousands):


HK TMS, LLC preferred stock	$	110,051
Tranche rights		4,516
Overriding royalty interest		34,576
Embedded derivative		857


Total initial investment proceeds	$	150,000

For purposes of estimating the fair values of the transaction components, an income approach was used that estimated fair value based on the anticipated cash flows associated with the Company's proved reserves, discounted using a weighted average cost of capital rate. The estimation of the fair value of these components includes the use of unobservable inputs, such as estimates of proved reserves, the weighted average cost of capital (discount rate), estimated future revenues, and estimated future capital and operating costs. The use of these unobservable inputs results in the fair value estimates being classified as Level 3. Although the Company believes the assumptions and estimates used in the fair value calculation of the transaction components are reasonable and appropriate, different assumptions and estimates could materially impact the analysis and resulting conclusions. The assumptions used in estimating the fair value of the transaction components are inherently uncertain and require management judgment. The following table sets forth a reconciliation of the changes in fair value of the Tranche Rights and embedded derivative classified as Level 3 in the fair value hierarchy (in thousands):

	Tranche rights		Embedded derivative

Balances at June 30, 2014	$	4,516	$	857
Change in fair value		151		35


Balances at September 30, 2014	$	4,667	$	892

As part of the transaction, HK TMS is required to maintain a minimum cash balance equal to two quarterly dividend payments, of approximately $3.0 million each, plus $10.0 million, which is presented on the unaudited condensed consolidated balance sheets in "Restricted cash."

The Company recorded the following activity related to the preferred shares recorded in "Mezzanine equity" for the nine months ended September 30, 2014 (in thousands, except share amounts):

	Redeemable noncontrolling interest (Mezzanine equity)

	Shares		Amount
Balances at December 31, 2013		—	$	—
Issuance of HK TMS, LLC preferred stock		150,000		110,051
Offering costs		—		(2,544	)
Deemed dividends on redeemable noncontrolling interest		—		3,201


Balances at September 30, 2014		150,000	$	110,708