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April 21, 2011

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General Thoughts on General Partners

Investment bankers created the GP product as a way to solve the principal dilemma of the successful founder of an MLP: how do I monetize a piece of the value I have created at the GP level of an MLP, particularly when MLP valuations are at all-time highs?  The answer at the time was either a sale of the GP or a large loan to the GP owners backed by ongoing cash flows to the GP.  Those two options were usually not attractive to an owner seeking to maintain control of the underlying MLP while at the same time taking some money off the table without incurring too much additional risk.
My former employer, Lehman Brothers, was at the forefront of these discussions and offered the solution that caught on: take your GP public as a partnership (although AG Edwards deserves credit for proving the GP IPO model with XTXI, a corporation, in 2004).
Inergy Holdings, L.P. (NRGP) was the test pilot for this new product (and new fee stream for Lehman), launching its IPO in June 2005.  I was on that IPO team and travelled with management across the country pitching the deal (enduring memories from that trip include a lavish dinner at Gibson’s in Chicago, and my room at the Beverly Wilshire Hotel in LA – it was my first IPO).  The IPO priced above the range and was a considerable success.
That IPO was followed closely by Enterprise GP Holdings L.P. (EPE) in August.  With those two GPs trading well, there was a rush to market for others as Lehman and other banks rolled out this product to their clients.  In 2006, 8 additional GPs went public, bringing the total number of public pure play GPs to 12 (including 10 structured as partnerships) at the end of 2006.
The investment marketing was simple: if you like MLPs, you’ll love GPs!  Essentially the argument that was made in SEC filings was that if the MLP raises its distribution at X% rate, you will see GP’s distribution increase Y%, with Y% being usually a multiple of X%.  Often however, if you looked at the yield spreads between the MLP and GP, it would take many years of outsized growth for the GP yield to cross the MLP yield, all else being equal.


Hypothetical distribution chart from PVG S-1.  Source:

The x-factor in all of this was the fact that all else wasn’t equal and MLPs would issue equity over time that would change the initial picture in the S-1s.  The best situation to be in was to own the GP of an MLP that not only raised its distribution, but also issued lots of equity, you’d get the IDR cash flow multiple, plus extra juice from the GP getting more cash just because there were more units outstanding at the MLP.  Read more about IDRs here.
In the past few years, many of those GPs were subsequently taken out by being folded into their MLP subsidiaries, eliminating the general partner’s incentive distribution rights.  This was usually a very lucrative deal for owners of the GP units.  The rationale was with the elimination of the IDRs, the cost of capital at the MLP level would be lower and the MLP would be able to pay more for acquisitions and growth projects without the pesky GP taking 50% of marginal cash distributions.
Unspoken in the rationale for eliminating public GPs that were structured as partnerships was the fear that carried interest taxation might affect public GPs as derivative securities that earned a preferred return.
In the past 2 years, amidst consolidation of 6 GPs into MLPs, there were 2 GP IPOs.  Those two GP IPOs, Targa Resources Corp (TRGP) and Kinder Morgan, Inc (KMI), were launched by private equity backers seeking an exit.  They were each structured as corporations.  The GP IPO gold rush seems to have ended to a large degree, and now we should expect to continue to see one-off GP IPOs like these two as parent corporations seek to cut loose their MLP subsidiaries, or as private equity backers exit their investments.
There was a time, however, in late 2008 and early 2009 when the GPs were trading at yields higher than their MLP subsidiaries, which represented a great opportunity for those who still had cash to invest in late 2008.  Currently, GPs trade at a significant premium (i.e. lower yield) than their MLP subsidiaries, as they should.  GPs have largely worked, with the exceptions being when the underlying MLP faltered, like in the case of HPGP, XTXI and AHD (although those last two have recovered).
See below for a summary chart of the landscape of GPs that are or were publicly traded, I’ve left off Markwest Hydrocarbon, Inc. and Kaneb Services, LLC, both of which were sort of spun out of larger organizations as opposed to taken public on their own.

DISCLOSURE: No information accessed through the MLP HINDSight website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on “About Hinds Howard” page.

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