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October 17, 2011

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Plot Twist in EPB Drop Down Story: Kinder to Buy El Paso

Kinder Morgan, Inc. ($KMI) has transformed itself again, this time from a pure general partner holding company into a company that will own operating assets and the general partner interests in 2 MLPs.  In a deal valued at $38 billion, KMI will buy El Paso Corp ($EP) in a combination of cash and KMI shares that values EP shares at $26.87, a 37% premium to EP’s closing price on Friday.

Kinder has a pretty detailed presentation on the deal, found here.
Only 6 days after Goldman added KMI to its conviction buy list, Goldman shows up as advisor to EP on its sale to KMI, along with many other advisors on both sides.  This deal is a clear positive for KMI, which will benefit from an additional stream of IDR distributions and a renewed growth engine for its MLPs, which will both need to issue mountains of equity to fund drop downs in the future, further adding to KMI’s GP take.

Clearly, its good if you own EP, but what about El Paso Pipeline Partners ($EPB)?  This MLP has become of late a darling of the research community, at the top of most analysts lists.  What was a simple story of a stable MLP with growth from drop downs is now a much more complicated story with less visibility into growth.

EPB investors have to be upset about the deal, because now the pile of assets that was exclusively earmarked to be dropped into EPB, will now be dropped into a combination of EPB and KMP, reducing the total assets that will be dropped down into EPB.  On the other hand, KMI might see the opportunity to pump assets into EPB because EPB is lower in the incentive distribution rights levels than KMP, therefore KMI cash flow will rise faster from dropping assets into EPB than it would with KMP, but its doubtful that many EPB investors will stick around to see if that’s the direction KMI management goes.  There is very good active discussion on this topic on the MLP board at
In the investor presentation, Kinder says that EPB will be able to maintain a 9% distribution growth rate longer term. But in the footnotes, as poster “birdluck1” on points out, it says that distribution growth is based on a 1.05x coverage ratio, which is much tighter than the 1.25x or greater that EPB currently runs.  EPB unitholders won’t be happy with slower potential distribution growth and tighter coverage.   Over the past 3 years, EPB has grown its distribution at a 17.6% annual rate.  As with all drop down stories, investors knew growth would slow at some point, but this deal speeds that process up unexpectedly.
This deal gets to a deeper issue of conflict complications with MLPs these days.  It first popped up with EPE several years ago, when EPE owned TPP’s GP and EPD’s GP at the same time.  Eventually consolidating those entities together solved the problem.  Then, more recently, ETE purchased the GP of $RGP, making it the GP of both RGP and $ETP.  At some point, the complicated array of conflicting entities becomes too cumbersome for investors to get their heads around.
Maybe EPB gets taken out by KMP at a premium and that makes EPB investors whole for this deal somehow, but who knows if or when that might happen.  This deal is unprecedented.  Until recently, pure play public GPs did not typically buy operating assets, but now it seems like all the rage.  We’ve seen ETE win the bidding war for Southern Union, and now this deal.  I guess bankers are figuring out that if a GP buys operating assets with it attractive equity as currency, the GP can re-cast its languishing MLP as a drop down story, and see major value creation at the GP level buy selling recently acquired assets piecemeal down to the MLP.  We’ll see how it works out.
Also, just like in the Southern Union deal, a major owner of the acquired company is none other than Carl Icahn, who seems to have an uncanny ability to sniff out these deals before they happen.

Those are my random initial thoughts on the deal.  I haven’t had a chance to fully digest it, but it will be very interesting to watch how the market reacts to the myriad public entities involved in the deal.  I’m at the Deal Flow Media MLP Conference (see here for details, I’m moderating the first panel scheduled to overlap the market open, unfortunately) today and tomorrow, and am really excited to be able to gossip about this deal in the hallways with my fellow MLP sector investors and professionals, so I’ll have more thoughts later in the week.
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. Long KMI and EPB.

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