It’s a bit early to be thinking of back to school season, but the long layoff from school in the summer tends to dull accumulated skills of young students. As students emerge from the haze of summer, the first few weeks/months of the year is usually just a review of what was learned the prior year.
Similarly, I have recently been receiving a flurry of more basic questions from advisors who appear to be circling back to the midstream and MLP sector after a long layoff. The questions sometimes reflect implied misconceptions in the question itself, but also reflect how little time advisors care to spend to delve into the nuance of the midstream sector.
Why are MLPs all converting to corporations?
- MLPs aren’t generally converting outright to corporations
- Almost all the transactions that have seen MLPs end up as corporations have been IDR eliminations that left a corporation as the last entity standing
- That’s what happened with KMI, OKE, WMB, TRGP, ENB and their respective subsidiary MLPs
- Each of those situations had a corporation as a parent of an MLP so they removed the IDRs and did it by using the corporation as acquirer
- These MLPs took IDR simplication as an opportunity to remove IDRs and also potentially open themselves up to broader ownership group (index funds, foreign investors)
- So, the shift to more corporations over MLPs is a function of IDR eliminations and anemic MLP fund flows
- No midstream MLP has outright checked the box to be taxed as a corporation, making a direct switch
- The way that it has happened is via mergers between an MLP and its publicly-traded general partner holding company (G.P.) where the G.P. is the acquirer and the G.P. was already a taxpayer. Examples of these “conversions”:
Read more about the evolution of the sector in the following posts:
Follow-Up: Why are IDRs bad again? (and remember to keep it as simple as possible, assume I don’t even know what IDRs are)
- IDRs are a carried interest on the cash flows of the MLP
- They grow as the distribution to the LP grows
- So, when an MLP is older, and has successfully grown distributions per unit, they can be essentially paying a tax to their general partner sponsor of 30%-45% of their total cash flow
- This leakage creates bad incentives for management teams and makes it really hard for MLPs to grow
- With IDRs gone, there is more cash flow available to return to shareholders, there is also more willingness from management teams to sell assets and buyback stock, and to allocate capital more efficiently
- However, the price paid to remove the IDRs is usually dilutive upfront, which has made the transition from IDRs a painful one in some cases.
Read more about IDRs in the following posts:
Are the distribution cuts over?
- Pretty much. BPL last year was a big one, APU this year was another notable one. Not many more expected. It has lost some of the stigma it used to have, however, and I would expect in the future MLP management teams will be less inclined to defend the dividend at all costs.
- Back in the 2008/2009 crisis period, only a few MLPs cut their distributions. If a similar short term discloation happened again today, I would expect distribution cuts would be more prevalent, because the market is just more used to seeing cuts as a way to stave off credit downgrades or worse.
See more about distribution cuts in our distribution checks piece, which you can read here.
Are MLPs going away?
- Aged pictures from the Face App dominated the Internet this week. A projection of what you might look like at some distant point in the future. I won’t subject you to another here.
- But, coming up with a FaceApp-like scenario for the MLP space is fairly simple: there will be fewer, larger companies with better financials and more bargaining power
- The challenge isn’t what the sector will look like in 5-10 years, its how do we get there. Achieving consolidation and capital discipline doesn’t happen without some volatility and potential private equity blowups to reduce the flow of cheap capital.
- The in-between face, the transition, will continue to dominate in the meantime
- There are a number of possible futures for the MLP structure. One possible one is that it reverts back to a collection of small companies.
Shouldn’t I just go passive and buy AMLP?
- Absolutely not.
- Passive MLP exposure does not get you exposure to the whole midstream value chain
- By going passive with AMLP, you are making an active decision to have more oil and liquids exposure and less natural gas pipeline exposure
- Read more about that in our piece called Under-Piped: Holes in Your MLP Exposure
- Also, AMLP is a bad tax answer and has much higher fees than you’d get with a “normal” ETF that owns stocks
If they can’t issue equity, how can MLPs keep building more pipelines?
- It is somewhat discouraging to see growth capex continue to trend higher each year
- Investors would prefer more capital discipline, but the midstream sector is positioned to fund its growth capex plans through retained cash flow, leverage and asset sales
- Financing without common equity is causing leverage to creep for a few major players as they build out their backlogs, but the expectation is that at some point the capex cycle will slow and de-leveraging will accelerate
- Tension in the market today is around those who are wary of midstream overbuilding and leverage creep vs. those who believe in the midstream 2.0 model as a sustainable way to fund capex backlogs
- Asset sales to hungry infrastructure and private equity investors seems to have tipped the scales towards the believers side of the equation this year, but skepticism remains.
- See below chart based on Wells Fargo data as of different dates that shows how estimates for capex for each year have grown as we get closer to the actual year.
Why do Midstream companies keep announcing new projects?
- It feels like we are always approaching the end of the capex cycle, but the opportunity set is largely spoken for at this point
- Constraints in the Permian, Bakken and in Gulf Coast NGL infrastructure have projects underway that should solve those issues
- Midstream operators will keep building infrastructure when their customers say they want it
- At some point customers won’t want it, and that point is fast aproaching, perhaps accelerated by forced capital discipline by producers
Why hasn’t there been more consolidation?
- Availability of private capital to support growth aspirations of smaller midstream operators
- Availability of “attractive” development projects
- When the above situations change, expect accelerated consolidation, because midstream companies love to spend capital, so if they can’t find anything to build, the best-positioned names will look for things to buy.
What is the likely exit for infrastructure funds who buy midstream assets?
- The assumption is they have a longer holding period than private equity
- The capital markets do not appear equipped to support exits
- It may come to pass that the capital situation could changes such that private equity will be sellers not buyers and midstream companies will be buyers and not sellers
- Smart management teams should ready themselves for that day by putting themselves in the best possible financial position