Billion by Billion
Over the past two years, one of the major themes in the MLP space has been the simplification of sprawling midstream empires.
In the late ‘90s, burgeoning pipeline giants like Kinder Morgan helped supercharge the once sleepy industry’s business model by pioneering a twist on private equity’s compensation scheme—the so-called 2 and 20, or a 2% annual fee for assets under management and 20% of any profits.
Similarly, an MLP’s general partner typically has a 2% ownership stake in its subsidiary along with incentive distribution rights (IDRs).
IDRs are what compel the owner of a general partner to grow an MLP and its payout over time. The sponsor sells stable, contracted assets to its subsidiary that generate steady cash flows.
The MLP gets an accretive asset without having to compete for it in the marketplace.
In exchange, the sponsor gets to monetize a mature asset, which gives it cash to invest in new growth (or pay down debt). Further, it still gets a taste of its former asset’s cash flows via its stake in its MLP subsidiary.
As an MLP’s distribution hits certain thresholds, a general partner’s IDRs entitle it to an increasing share of marginal cash flow. Eventually, this share hits what’s known as the high splits, with some general partners siphoning off as much as half of all cash flows generated above a certain level.
Not All Fees Are Bad
In an age when investment fees are in a race to the bottom, most retail investors would consider the notion of paying 2 and 20 to be an outrage.
After all, fees are just another performance hurdle. In general, the lower the fees, the higher your long-term returns.
Even so, MLPs’ underlying fee structures are hopelessly obscure to the average retail investor. Instead, they’re simply happy to collect a high and rising, tax-deferred payout.
But institutional investors don’t play like that—and they’re helping drive the midstream space’s consolidation of general partners and limited partners.
Nevertheless, IDRs aren’t all bad. It really depends on the circumstances.
Indeed, IDRs help spur growth for a young MLP.
As an MLP matures, however, the IDR obligation becomes increasingly onerous, eventually making the cost of capital too expensive.
Think about it: Once an MLP hits the high splits, the equity it typically issues to fund half of all new growth spending doesn’t earn the same return it did in its early days.
That’s because there are now more drains on its cash flows—higher distributions to common unitholders and much higher distributions to the general partner.
And when that coincides with a commodity crash and the attendant drop in share prices, it becomes an unsustainable burden.
That’s why so many midstream players have begun eliminating their IDRs.
But these moves don’t come without a price. The general partner must be compensated in exchange for giving up its IDRs.
That payment generally comes in the form of a higher stake in an MLP’s common units, a cash payout, or some combination thereof.
Relative old timers like Enterprise Products Partners LP (NYSE: EPD) and Buckeye Partners LP (NYSE: BPL) eliminated their general partners in such transactions back in 2010.
The energy crash then forced a number of others to follow suit more recently.
Among the geezers, one of the few holdouts is Energy Transfer Equity LP (NYSE: ETE).
But it’s been subsidizing its MLP subsidiaries, particularly its flagship Energy Transfer Partners LP (NYSE: ETP), by forgoing some of its IDR income stream until leverage and financial performance improve.
Ultimately, ETP will combine with ETE, though that won’t happen until late 2019, at the earliest. But obviously, their fates are closely intertwined, so good news for one is good news for the other.
Accordingly, the Energy Transfer empire is making moves to get its financial house in order.
This week another such move took place.
ETP agreed to monetize its gas compression business—compression is what helps move natural gas more efficiently through transmission pipelines—by selling it to USA Compression Partners LP (NYSE: USAC).
The $1.8 billion cash-and-equity deal, which is expected to close by the end of June, gives ETP $1.3 billion in cash, which it will use to pay down debt.
The balance of the deal’s value is based on two classes of equity units—19.2 million of the common and 6.4 million Class B units. The latter won’t pay distributions for the first 12 months following the close. Thereafter, they’ll automatically convert into common units.
The equity units will give ETP a 27% stake in USAC, so it will still get a taste of its former asset’s cash flows.
The Second Leg
Pursuant to this transaction, ETE has agreed to buy out USAC’s general partner and eliminate its IDRs for $250 million. This leg of the deal gives ETE about 12.5 million common units, or a 22% stake in USAC, and effectively adds another MLP to the Energy Transfer family.
I know what you’re thinking: Doesn’t Energy Transfer already have enough moving parts?
In this case, however, the deal looks like a win-win situation: It helps Energy Transfer reduce debt at a time when it absolutely needs to do so, while still receiving cash flows from its former assets.
And it doubles the size of USAC and gives it exposure to more producing basins.
The series of transactions is confusing, but the net result from USAC’s perspective is that they help shore up its financials as well, while greatly expanding its business.
So Energy Transfer’s stake in USAC comes with a potential growth kicker down the line—all for assets that may be important, but were probably an afterthought. Not bad.
The one irony, of course, is that ETE just helped another business—one that it will soon effectively control—eliminate its IDRs, when it can’t do that for its own longstanding MLP subsidiary just yet.
ETE remains a Buy.