The Hidden Benefits of Conversion

Although income investors think in terms of years, Wall Street thinks in terms of quarters.

Accordingly, earnings season for the calendar fourth quarter and full-year 2017 is now underway.

However, our companies won’t begin reporting their results until next week.

In the meantime, there are a couple of news items pertaining to our holdings that are worth discussing.

But first, let’s briefly review the fact that rising rates can weigh on the stocks of rate-sensitive securities, such as the ones we cover.

That doesn’t mean we should expect our favorite stocks to continually decline as rates head higher. But it does mean that the market will periodically revalue some of our holdings as expectations about rates change.

Certain sectors, such as REITs and utilities, are in the midst of such a revaluation right now.

By contrast, MLPs took their beating last year, and the market is finally rewarding them with higher valuations, even though they, too, are rate-sensitive securities.

The chart below compares the yield on 10-Year U.S. Treasuries (in red) to key benchmarks for the REIT, utility, and MLP spaces (in blue, orange, and green, respectively). Treasury yields rise, as bond prices fall.

Source: Bloomberg

Although MLPs have enjoyed a nice rebound over the past several weeks, that doesn’t mean they won’t succumb to pressure from rising rates on a short-term basis. That can happen even on days when oil prices are heading higher.

Indeed, higher oil prices weren’t enough to stop MLPs from selling off last year due to other factors. So remember to check the yield on the benchmark 10-year U.S. Treasury to see if that might be affecting your stocks.

Even an increase of just a few basis points in Treasury yields can be enough to cause dividend stocks to decline during a market session.

To Convert or Not to Convert?

One of the consequences of tax reform is that the partnership structure isn’t nearly as attractive as it once was for certain types of companies.

That means fewer companies will choose to organize as partnerships, while some partnerships may choose to convert to corporations.

In fact, early last year some shrewd investors made just such a bet on investment firms organized as partnerships, such as Blackstone Group LP (NYSE: BX).

Such bets were predicated on the potential surge in valuations some firms could see by broadening their investor base.

After all, most investors are leery of dealing with K-1s at tax time, despite the enticement of high, tax-deferred distributions.

Further, conversion could lead to forced buying among passive investors if indexes or investment vehicles that track indexes previously excluded partnerships but now feel compelled to add them.

That could give share prices of some firms a huge boost.

Blackstone founder and CEO Stephen Schwarzman has often lamented that his firm’s share price is still within shouting distance of the price at which its initial public offering was made more than 10 years ago.

Since then, Blackstone’s total return has kept pace with the broad market, but that’s mostly due to distributions, not share-price appreciation.

So if someone is pitching him on the benefits of conversion, he’s probably listening.

In fact, investment firms organized as LPs trade at significant discounts to more conventional asset managers organized as corporations.

Part of that discount may be warranted given the volatility of private-equity returns from year to year versus regularly fund fees.

Nevertheless, Schwarzman does not believe that valuation gap is justified.

Of course, conversion could actually mean a higher effective tax rate for the firm, which is currently in the mid-single digits. The effect that a higher tax rate could have on earnings would partly offset what Blackstone may gain from narrowing the valuation gap.

Still, if conversion ends up making sense, I trust Schwarzman to make the right call. After all, he’s got serious skin in the game—he hasn’t sold any of his shares since the IPO.

Expect to learn more about this possibility when Blackstone reports fourth-quarter earnings next week, on Feb. 1. At the very least, an analyst is likely to broach the topic even if management were otherwise mum. Blackstone remains a Buy.

Another Week, Nearly Another Billion

Last week, I wrote about how Energy Transfer Equity LP’s (NYSE: ETE) flagship MLP subsidiary Energy Transfer Partners LP (NYSE: ETP) monetized its noncore compression business to raise $1.8 billion.

This week, ETE and ETP have entered into a similar series of transaction with fellow ETE subsidiary Sunoco LP (NYSE: SUN).

Sunoco has agreed to redeem preferred units held by ETE for $312.6 million. And it’s also agreed to repurchase 17.3 million of its common units held by ETP for $540 million.

Both ETE and ETP plan to use the proceeds of these sales to pay down debt.

That’s all fine and dandy, but perhaps you’re wondering what SUN gets out of this seeming reshuffling of the deck chairs? Or the Energy Transfer empire overall?

After all, ETE still owns SUN, so we don’t want it to take short-term advantage of its subsidiary in a way that could be destructive to shareholder value later on. ETE’s own position is ultimately dependent on the cash flows its subsidiaries kick up to it in the form of distributions.

The good news is that while ETE and ETP might be forgoing the future income stream tied to the units SUN is repurchasing, they’re cashing them in at a time when it’s imperative to pay down debt.

Meanwhile, SUN is using some of the proceeds from its sale of more than 1,000 convenience stores to 7-Eleven (plus related tax savings) to reduce the drains on its own cash flows—here in the form of distributions. That should help shore up its own distribution coverage.

So the Energy Transfer empire is finally doing what investors have long demanded—simplifying and paying down debt. It’s just that its existing structure can make the path to doing so appear rather complicated at first glance. ETE remains a Buy.

Stock Talk



If BX converts, could existing holders of LP interests see a big tax bill on conversion? I have been caught in a couple of those…

Ari Charney

Ari Charney

Hi Ted,

Yes, conversion could result in tax consequences for existing shareholders. It probably depends in large part on how long you’ve been a shareholder.

For instance, many MLP investors who faced substantial tax consequences due to Kinder Morgan’s series of consolidation transactions had been shareholders of the various entities for many years prior to that. That meant they’d accrued a substantial deferred tax liability.

The thing to remember is that, even before the recent tax bill, asset managers organized as LPs have faced potential legislative threats at both the federal and state levels due to proposed populist reforms regarding carried interest. At least in this case, conversion would be the result of a positive choice from a business standpoint, as opposed to one compelled by fiat.

Regarding the possibility of conversion, in today’s earnings call management noted that tax reform gives them a clear picture of the costs of conversion. But they’re still continuing to evaluate it because while they know the costs of conversion, the benefits are not nearly as readily quantifiable. So either way, it doesn’t sound like they’re in a hurry.

Best regards,

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