ECM 2006: Signs of maturity
The master limited partnership, a high-yielding, tax-advantaged corporate structure, is showing signs of maturity. However, there have also been growing pains, particularly in the capital markets. The IPOs of MLPs’ general partners have had mixed results, and the emergence of an institutional class of investor threatens to impose discipline. Stephen Lacey reports.
Master limited partnerships (MLPs) have quietly outperformed the broader markets in the US as yield-hungry investors take advantage of suddenly moderating interest rates. A third-quarter return of 4.9% through the end of August is particularly impressive given the precipitous decline in the prices of commodities that the industry transports and stores. The oil-field services index (OSX), against which the industry has historically exhibited a high degree of correlation, is off 6.1%, by comparison.
The decoupling of the sector from commodity prices is only partially attributable to the light issuance of equity, with only one follow-on offer pricing during the quarter so far. In addition to strong earnings reports, analysts point to the introduction of the Alerian MLP Index (AMZ) in June as a significant development in the industry’s evolution. Comprised of 50 energy partnerships, the index expanded the potential base of investors to include institutional, foreign investors and retirement accounts, which historically shunned the sector because of onerous tax-reporting requirements.
Now, say analysts, MLPs may be poised to assume their place alongside REITs, utilities and other mature, yield-oriented asset classes. The industry, which evolved out of Congressional legislation in the 1980s, has seen its market capitalisation grow from just US$5bn in 1996 to about US$85bn, with a two-fold increase since the beginning of 2004 alone.
Perhaps most telling of future growth prospects was the US$22bn management-led buyout of Kinder Morgan. While Kinder Morgan is itself not an MLP, the company does own the 2% general partnership (GP) interest and 13.5% of the limited partner stake of pipeline-operator and MLP Kinder Morgan Partners. To many, one motivation to take Kinder Morgan private was that the value of the GP stake was not recognised by the public markets. In 2005, Kinder Morgan received 51% of all the quarterly distributions by the MLP, 42% from the GP stake and 9% from its LP holdings.
The rationale for the higher gearing resides in so-called incentive distribution rights (IDRs). As the operator of the MLP, the general partner receives an increasing share of the distributions above pre-defined levels as an incentive to grow the business. When Kinder Morgan Partners went public in 1992, the upper threshold was set at US$0.895/annually (split-adjusted), above which the GP was entitled to a 50% share of the distributions. The MLP currently pays out US$3.24/annually.
Ironically, as Kinder Morgan is looking to retain the value of its GP holdings, others have monetised their stakes through IPOs. Inergy Holdings, the general partner of propane distributor Inergy LLC, was the first to undergo the transformation through its sale of a 19.5% stake in a June 2005, US$87.9m IPO. At the time of the IPO, the MLP’s annual distribution was US$2.00, above the upper threshold of US$1.80 for the IDRs.
Buyers of the Inergy Holdings’ IPO are entitled to a 48% share of distributions above the threshold, putting the initial yield at 4.00% versus 6.40% at the MLP level. When the MLP increased its payout in the fiscal 2006 second and third quarters to US$2.18, a 9% increase from the GP IPO, the GP holders saw their annual payout increase by 55.6% to US$1.40. A similar 55% run-up in Inergy Holdings’ GP units since the IPO has kept the dividend yield steady at 4.00%.
The key to such higher gearing is the ability to grow the distribution at the MLP, and that is generally achieved through acquisitions and/or organic growth. Inergy LLC is tackling growth on both fronts: purchasing natural-gas storage facility operator Stagecoach for US$205m last August and targeting US$350m of capital grow the business. The MLP initially funded the purchase with revolver borrowings and then returned with a US$93.4m equity raise in June.
That type of growth has not always been evident, and a lack of visibility has weighed on other GP IPOs. The GP units of Magellan Midstream Holdings fell to 22% below their debut in February before recovering to US$22.43, marginally below the US$22.50 offering price.
In the pricing of a GP IPO there is an inherent conflict between retail and a new breed of institutional investors. Some have accused the investment banks of relying too heavily on retail – the principal channel of distribution because of the securities’ yield and tax complexities – on initial deal allocations, in an effort to force a new breed of institutions to pay up.
“There are still only 15 to 20 institutions that you can sell these to,” noted one sector banker. The lack of institutional sponsorship on some GP IPOs is partially to blame for the poor performance of recent deals, suggested the banker.