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October 19, 2011

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General Partners: The Parasite Trade

I was moderator for a panel at the Dealflow Media MLP Conference this week on the legal and regulatory issues facing MLPs, with great panelists John Goodgame of Akin Gump and Mike O’Leary of Andrews Kurth.  On that panel we touched on the history of the MLP sector and evolution of the structure over the years.   That discussion covered many points I’ve written about before (in MLP Basics – IPOs and MLP Basics – IDRs).

But the most interesting and relevant subject was incentive distribution rights (IDRs) and general partners in general.  We discussed how with the precedents set for including IDRs in your IPO, MLPs will still often go public with IDRs and then have them bought out at some later date when the IDRs start to get in the way of growth.  When the MLP does buy the IDRs out, however, it won’t be cheap.  Many CEOs will acknowledge that having IDRs will limit growth at some point given that it increases an MLP’s cost of capital, but at the same time, very few (the late John Eckel and the late Dan Duncan come to mind) will do anything about it unless they get paid for it, which is usually a dilutive transaction, particularly if the GP is public and MLP must pay market price to take out GP.

And why should they do anything about it? MLPs with IDRs at IPO don’t suffer in terms of valuation. MLPs have limited corporate governance requirements, and often have an investor base of retail investors with no tax basis in their MLP units, and therefore limited ability to reasonably exit as long as the MLP continues to pay its distribution.  That’s the tradeoff that investors make with MLPs.  Accept your role as a LIMITED partner in exchange for favorable tax treatment, high distributions and limited liability.  Most of the structural nuances of MLPs have developed over time and are governed by the partnership agreement between the general partner and the limited partners, not by any regulations. So, there is no incentive to eliminate IDRs from the start.

I was asked a related question on the next panel I was on, and I didn’t have the answer at the time, despite the fact that I was sitting right next to a potential solution.  The question was: “Hinds, you are pretty vocal about how you don’t like the amount of ‘financial engineering’ that exists in the MLP space, what do you think the solution is?”  I said I didn’t think there was a solution to some of the stuff that goes on, like when you get invested in an MLP based on certain expectations management sets and all of a sudden the game gets changed on you.  For example, what are you supposed to believe when NRGY management purchases it’s public GP and touts the need to eliminate IDRs as a drag on growth, only to turn around and file an IPO of its midstream business with full 50% IDRs?


Vote with your Wallet?

The only option is to vote with your wallet and sell the shares or avoid them altogether.  But that doesn’t work for small institutions and for a retail investor in an MLP that has seen their basis whittled down and who’s stake is so small that it wouldn’t make a difference to the MLP if they sold anyway.

The solution is the big MLP investors out there.  Like Jim Baker, the very polished and articulate (particularly in contrast to me) MD from Kayne Anderson who was sitting next to me on the panel when I was asked the question.  Kayne Anderson apparently manages $13 billion in MLP focused capital in its various private and public investment vehicles.  Kayne and others like Tortoise, Swank Capital and Fiduciary have the kind of market clout that could make things change.   Maybe they could do something about it and make an effort to express to issuers that they won’t go for any shenanigans around IDRs, but it’s unlikely to change given how many people depend on the continuous cycle of transactions, and based on how well the MLP model has worked to produce returns to date.  Anyone else have any ideas?


Go Long the Vampires

Someone out there is thinking along similar lines.  Never lacking in creativity and humor, Tudor Pickering research came out today comparing GPs to vampires that need to continue to feed to stay alive, just in time to Halloween.  Tudor Pickering believes that GPs will be the major acquirers of the future, as if a light has just gone off in the sector’s collective head.  GPs have realized they have a lower yield (and perceived cost of capital), relative to their MLP.  So, rather than just have the GP passively benefit if the MLP does a big acquisition, why not acquire the assets at GP level?  This signals the start of a drop down story for your subsidiary MLP, then you can sell down the assets you bought to the MLP at a higher price than the MLP could have afforded when it was not a drop down story.  And, the GP still gets the distribution increase that comes with the MLP issuing tons of equity and doing accretive acquisitions.

It has now happened with SUG and EP acquisitions, and those case studies are likely being written up and put into pitch books to be flipped through in front of CEOs of other slowing MLPs out there.  Maybe TRGP is next to buy a company with assets to drop down into NGLS?  Tudor Pickering highlights OKE and WMB as other potential acquirers.  So, maybe joining up and getting your hands on some IDRs yourself is the solution.


Where is the next Blade?

And if IDRs are becoming viewed as such assets that MLPs need to grow MLPs, maybe you’ll see NRGY re-institute IDRs and take them public again?  I don’t think that’s possible, but the GP IPO may not be completely dead.

All of this action makes EPD’s management and its self-consolidation efforts look very good.  If GPs are vampires, I guess that makes Dan Duncan (or his team now that he is gone) the “Blade” of our day, the vampire killer.  Others who seem to have benefitted from simplifying their capital structure (at a fairly high cost, but have both have overcome that cost) are MMP and BPL, it should be noted.

When you’re complaining about an industry that consistently beats stock market and inflation, its important to note that there are certainly far worse parasites out there, including much of the FIRE (Finance, Insurance and Real Estate) economy that Eric Janszen of has highlighted for years as a root cause of many of our economic problems, but I’ll steer clear of that political landmine for the moment.

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