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December 1, 2011

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Are you the Keymaster? MLP Issuers and Banks to Avoid

So far this year, up until yesterday, buying into a follow-on equity offering by an MLP has been a losing proposition.  Aftermarket performance of all follow-on equity deals in 2011 has on average trailed the Alerian MLP Index in the first day of trading (T+1) by 0.5% and in the subsequent week (T+7) by 0.7% on average.  Those numbers have gotten worse lately, with deals since the end of June on average under-performing the MLP Index by 1.2% at T+1 and 1.8% at T+7.

Sidenote: I say “up until yesterday” above, because the latest MLP equity deal that priced Wednesday morning: a secondary sale of 7mm Breitburn Energy Partners ($BBEP) units owned by Quicksilver ($KWK).  BBEP units purchased in the overnight deal outperformed the MLP index by 11.78% today, by far the best performing equity deal since at least the beginning of 2008 (when my database begins).  Yesterday’s outrageous performance by BBEP is likely a result of institutions finally jumping into an attractive situation.  BBEP has carried a massive equity overhang for a few years, and today’s sale of KWK’s units removes that overhang.  So, while almost all of the facts were the same as the deal KWK did to sell 7.0 million units of BBEP in June of this year, including the lead underwriter, the net re-offer discount and the deal size, the aftermarket results were much better (so far).

Back to the point: on average buying into an overnight book-built deal (see the end of this post for definitions, some of the terminology is pretty specific) in the last 5 months has resulted in returns that are 1.8% less over the next week than if you bought the Alerian MLP Index.  That’s unacceptable.
Is that deterioration simply a result of a volatile stock market?  Is there just limited interest from an investor pool that is terrified by weak domestic economy, gridlocked politicians, and the European sovereign debt crisis?  Why has institutional participation in equity deals fallen to almost nothing of late? If institutions aren’t buying in these deals, who is?  What other factors could be at play here?
I’ve looked back at almost 4 years of data and more than 200 MLP equity deals to try to pinpoint the important variables of past deals that might help inform future decisions when equity deals arise.
First, I broke down average aftermarket performance by year and by deal type to get an overall picture.  Then I looked at some of the logical deal points that might affect performance, like deal size, the net re-offer discount (which is the discount between the latest closing price before pricing and offering price for an overnight deal), and whether the offering was of primary or secondary equity.

As shown above, the one meaningful relationship seems to be that secondary sales tend to under-perform primary equity issues.  That’s because a secondary sale usually means a sponsor is taking money off the table, which is usually a negative sign for investors.  In the case of KWK and BBEP today, KWK was not a member of management or part of the GP, and it was widely known that KWK would sell, so the finality of it helped BBEP (along with its recent inclusion in the MLP Index).
Are you the Keymaster? I am the Gatekeeper…
If specific deal points don’t matter much, what about who is selling?  Selling involves the actual issuance of units, but also the execution of that issuance, so there are two parties (aside from investors) involved: an issuer and a group of underwriters (led by a lead bookrunner).  The choice of underwriter will determine what kind of order book the deal will have. Ultimately after-market performance is a function of who the paper gets sold to, and some banks have stickier retail clients than others (stickier meaning they hold onto the units for longer).  On the flip side, some wirehouses with their thundering (even if thinning lately) herds of brokers, just don’t care as much who buys the paper.
As shown below, the underwriters that have led more than 10 deals since 1/1/2008 and on average have poorly-performing deals include: Bank of America – Merrill Lynch, UBS, and Citi.  The underwriter with the best aftermarket performance record is Raymond James, followed by RBC Capital, but the sample size is fairly small at only five deals each.  Morgan Stanley and Wells Fargo also tend to lead good deals.  Barclays is hit or miss.

The data above shows that the banks with good deals tend to have deals with better pricing (wider re-offer discount).  For example, B of A – Merrill Lynch averages a discount of 3.51% vs more than 4.3% for Raymond James and RBC Capital.  Some of that difference is likely a result of the size and quality of some of the MLPs with which B of A – ML works, but some of it must be more aggressive pricing.  Beyond the discount offered, under-performance is also driven by the market’s perception or interest in the issuer.
Which issuers have the best equity offerings in the aftermarket?  In the chart below, I include only MLPs that have done at least 2 equity offerings since the beginning of 2008, and sorted them by number of offerings.  Among the serial issuers, it seems like a good idea to avoid offerings from PAA, DPM and TGP, just based on their recent deal history of small discounts and weak post deal trading.

The chart above clearly shows there are some MLP management teams at that are part of the pricing problem as well as banks.  The key is avoid the combination of an underwriter with a history of poorly performing deals and an MLP issuer that likes to pinch every last penny of valuation when issuing equity.  The results of such unholy unions can be tragic for unsuspecting retail investors.  One way to think about it is like this classic clip from Ghostbusters, whereby the Keymaster is looking for the Gatekeeper.  Once they get together, its almost doomsday for unsuspecting citizens of New York City.  Only the Ghostbusters save the day by crossing their proton streams and taking down the monster along with the Stay-Puft Marshmallow Man.

Institutions have caught on to this trend and been more selective of late, choosing not to participate much in follow-on offerings.  What is the incentive to buy in an offering that’s likely to trade poorly in the aftermarket, especially for bigger MLPs that have plenty of trading volume.  MLP institutions are holding back to wait for opportunities to build positions in smaller MLPs when they do equity offerings, for IPOs (which tend to do very well), or for special situations like BBEP.

With such a limited sample size, and many variables at play, it’s hard to say with certainty that the bookrunner or issuer variables are causal, but the trend is worth noting.  Also, I can only speculate that there is more jamming of MLP paper into retail accounts, and more churning of discretionary accounts for fresh paper and fresh commissions that occurs at underwriters that execute poor performing deals than occurs at underwriters with good deal track records.  It seems like a logical conclusion, however, to assume that the underwriters that have executed deals that have traded well probably value their smaller retail client base more than larger firms, and respect the need to maintain those clients until the next deal.


Some Definitions for Terminology Used Above
Initial Public Offering (IPO):
IPO is the first time an MLP issues shares to the public.  These deals are marketed for several days prior to pricing, allowing for the underwriters to build a solid book of orders.  The lengthy marketing process is called a roadshow, during which time management of the issuing MLP (escorted by bankers) travel around the country meeting with institutional investors and pitching the story in front of brokers and investors.  For MLPs, the roadshow rarely lasts more than 5 days and only includes large cities in the U.S., starting in New York City with stops in Chicago, Los Angeles, Dallas, and a few points in between.
Follow On Equity Offering:
The following definitions are all different ways of issuing equity of an MLP that is already publicly traded.  Equity offerings for MLPs that are already public are referred to as follow-on equity offerings.  Follow-on equity deals can be of either primary equity (brand new shares with proceeds going to the MLP), secondary equity (shares sold by some entity other than the MLP, proceeds going to selling unitholder, not the MLP), or some combination of primary and secondary.
Marketed Deal:
Marketed deal is a fully marketed offering issued in much the same way as bookbuilt IPOs. While management is on the road for a few days, the lead underwriter (bookrunner) guages demand for the offering and builds an order book.  The issuer and bookrunner use that order book to help determine the price, then they distribute the shares to the rest of the underwriting syndicate.
Overnight Deal:
Overnight deals are also known as accelerated book build offerings.  Overnight deals work like marketed deals, just much faster.  The underwriters announce an offering immediately after the market closes, then they fill their order books by working the phones that night, then they price the deal in the morning before the market opens.   Issuers don’t have to travel around on a roadshow, don’t have to suffer downward pressure on their stock before pricing (although there is usually plenty after pricing).  The vast majority of MLP follow ons get done overnight these days.  Since the beginning of 2008, 83% of all follow ons were overnight deals, and almost 90% in 2011.
Bought Deal:
Bought deal is when an underwriter buys units from an MLP issuer before a preliminary prospectus is filed.   The underwriter then resells those units to whoever it can, pocketed a spread between its purchase price and the sale.  Issuers like these deals because they don’t have to worry about the deal getting done, and don’t have to worry about pricing, that’s all handled up front.  Bought deals are usually priced at a larger discount to market than marketed deals and overnight deals.  If the underwriter can’t sell the units, it has to hold them, so that’s an underwriter risk and a use of precious capital for the underwriter.

Disclosure: The information in this article is not meant to be financial advice, we are not your financial advisor and I am posting my comments for informational purposes only.

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