Two factors are driving the trend toward simplification. First, management teams are strategically adjusting to a more competitive landscape in the energy infrastructure industry, and second, investors are demanding a better alignment of interest and more shareholder-friendly terms. The trend for simplification, which results in only one class of investors, has and will continue to have a profound impact on the MLP sector and the broader energy infrastructure industry. We believe the simplification trend is a significant positive for the industry.
General Partners and Limited Partners: How It All Changed
MLPs generally have two classes of owners: general partner and limited partner. The general partner controls the operations and typically owns incentive distribution rights (IDRs). The incentive distribution rights enable the general partner to collect an increasing percentage of cash flow as the limited partner grows the distribution payment by exceeding target levels. For example, when the limited partner distribution increases to a higher tier (maximum tier capped at 50%), the general partner increasingly benefits from receiving a higher percentage of cash flow with successive distribution increases.
Over the last decade or so, a wave of MLPs has brought general partner ownership interests public through initial public offerings (IPOs). Seventeen general partner IPO deals raised approximately $12 billion in the period between 2004 and 2015. Many of these deals were brought public by sponsors seeking to monetize a piece of their ownership interests in the general partner and capitalize on investors’ strong appetite for these deals. Participating in general partner IPO deals offered investors the opportunity to invest alongside the sponsors at the general partner level.
In a relatively quick transformation, the industry trend is now for general partners to consolidate with their limited partners. To quantify, 12 of the general partners that went public in an IPO have now consolidated with their limited partners. In some recent cases, the general partner is a public corporation that buys out the limited partner interests. The result is a dissolution of the partnership structure and the creation of a merged entity that is structured as a corporation.
Benefits of Simplification
Simplification has numerous benefits for both management teams and investors. Management team benefits include:
- Reducing dependence on capital markets. Retaining a higher percentage of cash flows reduces dependence on the capital markets for funding growth projects and acquisitions. This expands a management team’s opportunity set by improving the financial flexibility to spend capital on growth projects. In addition, less dependence on capital markets should be a sustainable competitive advantage, allowing the entity to capture market share or make acquisitions during a period when it’s difficult to raise capital due to weakness in the financial markets.
- Facilitating mergers and acquisitions (M&A) for both buyers and sellers. For an acquirer, having a lower cost of capital by not having to pay the general partner incentive distributions expands the opportunity set for making acquisitions. On the other side of the spectrum, management teams interested in selling their businesses should be in a better positon because they no longer have to grapple with conflicts of interest between two separate entities¾general partner and limited partner.
Investor benefits include:
- Improving corporate governance and providing better alignment of interests between general partners and limited partners. As with any partnership structure involving a general partner, there is the risk of conflicts of interest. By having one streamlined entity, conflicts of interest are effectively removed between two classes of investors.
- Taking on less risk, having a more durable growth investment. Like most capital-intensive sectors, one of the primary risks in the MLP industry is access to capital. Historically, MLPs have suffered during a sharp downtum in the financial markets due to investor concerns regarding the MLP’s ability to fund growth projects. While this risk can’t be completely avoided, having a simplified structure dramatically reduces the risk of dependency on capital markets during these periods. In conjunction with a lower risk profile, the MLP will also have a more durable distribution growth rate, as the general partner no longer will receive an increasing percentage of cash flow while the limited partner climbs the incentive distribution splits.
- Expanding the shareholder base with a simplified structure. A broader range of investors may be attracted to the MLP sector by removing some of the complexities related to investing in an entity that involves a general partner. This could potentially provide a positive for fund inflows into the sector.
Going forward, we expect this simplification trend to continue, as several partnerships have provided public guidance for a deal in the next 12 months. Other partnerships have publicly stated their desire to eventually consolidate with their general partners in a simplification deal. With each successive simplification deal, investor pressure is mounting on other management teams throughout the industry to consider simplification eventually. We believe this is a positive for the MLP sector and a win-win for both management teams and investors.
Background: MLP Industry
MLPs are publicly traded partnerships that trade on stock exchanges, the majority on the New York Stock Exchange. MLPs are pass-through entities as partnership income passes through and is taxed only at the individual partner level. Consequently, MLPs do not pay corporate-level taxes. MLPs provide the liquidity of corporate stocks and the tax efficiency of investing in a partnership.
In 1987, Congress provided an incentive for businesses to form partnership structures to invest in energy infrastructure assets. The technical criteria that Congress mandated included that at least 90% of gross income must be generated from "qualifying sources" defined by the transportation, processing, storage and production of natural resources and minerals. The objective of Congress was to stimulate spending on capital-intensive projects in the energy industry to improve infrastructure in the U.S. Today, the majority of MLPs are in energy-related businesses, primarily in the midstream sector, which includes assets in gathering, processing, transportation, treating and storage of crude oil, natural gas and refined petroleum products. The MLP industry has spearheaded much of the construction of energy infrastructure assets in the U.S.
Adam Karpf is a managing director at CIBC Atlantic Trust Private Wealth Management, where he is portfolio manager for MLP strategies.
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