Maturation of MLPs

Viewpoints

October 04, 2018

Life as an adolescent is difficult. Offering well-intentioned, parental advice and counseling to an adolescent can be just as difficult and contentious. For the adolescent, learning to make wise and responsible decisions is one of the hallmarks of this painstaking transition from childhood to adulthood. Those with remarkable foresight courageously embrace this new reality whereas others procrastinate. This notion has many parallels with the North American energy midstream industry.

For years leading up to the 2014-2015 global energy market correction, the midstream sector thrived on high commodity prices, domestic production growth, and an abundance of cheap capital to fund growth. Master Limited Partnerships (MLPs) played a central role in raising capital, funding, and building out the needed infrastructure to transport and manage the growing volumes of crude oil and natural gas production. Investors were drawn to MLPs due to generous and tax-advantaged “full payout” distributions that were expected to grow far into the future. MLPs routinely replenished ongoing capital needs by regularly tapping receptive equity and bond markets to finance an ever-growing backlog of expansion projects.

Most MLP ownership structures are complex and highly-engineered. Limited partners (LPs) provide most of the equity funding in the form of publicly-traded common units and receive quarterly distributions. The general partner (GP) manages the partnership and typically receives a 2% common unit interest plus supplemental distributions referred to as Incentive Distribution Rights (IDRs). Instituting IDRs incentivizes the GP to grow the MLP and its underlying distributions. As aggregate distributions grow and established per-unit distribution targets or tiers are met the IDR payout captures a higher percentage of incremental distributions. The marginal IDR “split” or “take” typically increases from 2%-15%-25% and is capped at 50% into perpetuity. For mature MLPs that have grown deep into their “IDR splits,” IDRs can typically account for up to 40% of an MLP’s total distributions. Because IDRs are levered to MLP distribution growth, the GP stands to realize significant economic upside at the expense of LP unitholders due to the complex ownership structure, higher cost of capital for the LPs, and weaker distribution coverage.

The following illustrates the expected life cycle of a hypothetical MLP from Year 1 (IPO launch) to Year 12. Projected LP distributions (represented in blue) grow initially but stagnate in the latter years. GP distributions (represented in yellow) are mostly deferred for a few years until IDRs kick in, at which point the rate of growth significantly outpaces that of the LPs by a factor of 2-3 times. From Year 4 to Year 12, LP and GP distributions grow at a CAGR of about 17% and 44%, respectively. This is the anchor that drives equity cost of capital higher as growth slows.

Hypthetical MLP Distribution and IDR Burden

Hypothetical MLP modeling assumptions: (i) 9.0x EBITDA multiple for growth capex, (ii) 50/50 debt-equity funding mix, (iii) 4.5% cost of debt, (iv) Year 1 leverage = 2.0x, (v) Year 1 distribution per unit of $0.50, (vi) Year 1 distribution coverage = 1.6x, (vii) Year 1 EBITDA = $100mm, (viii) maintenance CAPEX = 10% of EBITDA
Source: Bloomberg, S&P LCD

MLP investor sentiment shifted dramatically after commodity prices fell in 2015. In response to lower commodity prices, producers scaled back energy production, which in turn reduced pipeline capacity demand and forced postponement of expansion projects. The upstream growth MLPs depended on to meet distribution growth targets came to a standstill. This retrenchment created havoc in the investment community and capital markets. As MLP equity valuations plummeted, funding dried up. Distribution growth sustainability, the “IDR burden,” balance sheet leverage, lack of external funding, and credit rating downgrades dominated investor discussions. IDRs in particular drew the ire of MLP investors. IDR sentiment shifted from an incentive tool tailwind to an impediment headwind to cost of capital and financial stability. MLPs carrying heavy IDR burdens lost investor confidence as growth prospects faded. In other words, adolescent tantrums kicked in.

The following chart graphically highlights the sudden de-rating of MLP equity valuations that coincided with the energy market correction. The weighted average equity yield of the sector went from 4.5%-5.0% (2010-2014) to the 7.0%-9.0% range (2015-Q2’18).

Historical MLP Sector Equity Yield (2010 - Q2 2018)

Equity yields represent a composite of the following issuers: AM, BWP, BPL, DPM, ENBL, EEP, ENLK, EPD, EQM, ETP, KMI, MMP, MPLX, OKS, PSXP, PAA, SEP, TCP, TEP, NGLS, WES, WPZ
Source: Bloomberg, TCW

As headwinds persisted, IDRs (which are structured for rising distributions) became a drag on cost of capital and growth. The investor community began agitating for greater financial discipline and stability. MLPs which carried aggressive balance sheets, required additional cash infusions, and/or were burdened by costly IDRs were penalized by the markets. Eventually, MLPs began to acquiesce and respond to investor pushback. IDRs were restructured and distribution payouts reset, all under the broader theme of “corporate simplification.” The essence of corporate simplification was the unwinding of highly-complex MLP structures. This would be accomplished by (i) cancelling IDRs by exchanging them into additional common units and (ii) consolidating (or collapsing) the GP and LP entities into a single entity. While each MLP had its own unique set of challenges and self-help resources to work with, the common narrative behind all corporate simplifications was restoring balance sheet strength, improving the partnership’s cost of capital, pivoting towards greater self-funding, and simplifying the investment story devoid of structural complexity such as IDRs and multiple classes of units. In other words, some MLPs transitioned into adulthood by accepting more fiscal accountability.

While structural uncertainties and distractions associated with a potential corporate simplification can create a negative overhang for equity sentiment, such corporate actions are broadly constructive for credit. The so-called “back-door” distribution cuts and IDR cancellations reduce cash leakage to equity investors, enabling partnerships to retain more cash flow. Higher retained cash flow, in turn, facilitates self-funding and reduces dependence on capital markets availability. This renewed financial flexibility can be directed towards debt reduction or other funding needs. A stronger and simplified capital structure rebuilds credibility with not only equity and credit investors, but also the rating agencies. The resulting positive price action (in the form of tighter credit spreads) reduces refinancing risks.

Midstream Spreads vs. U.S. Corporate Index

Source: Bloomberg-Barclays

The following is a survey of MLPs that have either (i) recently undertaken or announced some form of corporate simplification (shaded in blue) or (ii) are perceived to be potential near-term simplification candidates (shaded in yellow).

1 As of 9/26/18, ticker is retired and no longer active. Source: TCW, SEC filings, management commentary

Highlighted in the following chart are the WACC estimates of three large MLPs that have undertaken comprehensive simplification transactions since 2017. MLPs that have taken remedial steps have been rewarded by the capital markets by an improved and more competitive WACC.

Pre and Post Simplification Effect on the WACC

Source: Bloomberg-Barclays, TCW

Many MLPs have either restructured, or are in the process of adjusting, to the new reality of the post-2015 energy markets. Lower commodity prices compelled E&P producers to reassess growth capital plans and production goals, leading to growing pains for the MLP sector. This weighed on MLP equity valuations which made raising equity difficult and expensive. Diminished and punitive access to external funding left MLPs with virtually no choice but to pivot towards internal self-funding, forcing the prioritization of financial strength over distribution growth. The quest to rectify their cost of capital forced MLPs to consider a more comprehensive, and arguably long overdue, action plan. By engaging in self-help, such as eliminating burdensome IDRs, rationalizing distributions, and simplifying corporate structures, MLPs have mitigated funding risks and improved their cost of capital over a longer term horizon. Despite the recent recovery in commodity prices since 2016, it is our view that the capital markets will continue to impose this newfound financial and credit-friendly “adulthood” discipline on MLPs.

 

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