Transaction Trends in Master Limited Partnerships
Transaction Trends in Master Limited Partnerships
The master limited partnership (“MLP”) has become a major asset category in U.S. capital markets, attracting substantial capital flows and acquiring and developing vast energy assets. As of June 30, 2013, MLPs had a total market capitalization of approximately $480 billion, with about 90 percent of this attributable to energy and natural resource MLPs. MLP’s tax-efficient organizational structure and growth in distributions have created unparalleled returns for investors over the last 15 years. Given the low interest rate environment, as well as a generally positive energy commodity price environment creating favorable operating conditions and growth prospects in the energy industry, MLPs have increasingly served as attractive investment options for investors seeking yield-oriented investments. The adjacent chart highlights the outperformance of the Alerian MLP Index (AMLP) relative to the S&P 500 since the AMLP’s inception.
The increased appetite for higher yields (and in return, greater tolerance for risk) has given rise to initial public offerings (“IPOs”) of MLPs in more diverse industries that potentially offer investors higher yields than those offered by MLPs in the midstream segment of the energy industry. Within the last decade, MLP structures began to be utilized by other segments in the energy supply chain, including companies operating in segments of the industry with greater earnings volatility. With this shift in operating exposure, the complex structuring of MLPs has evolved to support more variable operating results.
In addition, MLPs have become dominant players in certain aspects of the energy merger and acquisition transaction market. In particular, assets that are utilized in the midstream segment, as well as certain oil and gas properties, are frequently acquired by MLPs as their access to capital markets and low costs of capital on a pretax basis create a compelling valuation proposition in the transaction markets. The MLP participants continue to seek creative transaction structures to enable the broadening of the transaction targets, including MLP and C corporation merger transactions structured as tax-deferred reorganizations.
An MLP, commonly used by businesses operating in certain segments within the energy sector, is a state law partnership or limited liability company that is publicly traded on a securities exchange. MLPs traditionally pay out almost all available cash flow on a regular basis. The higher yields offered by MLPs generally stem from their legal and tax structure, as well as the underlying companies’ operating business. While most publicly traded companies are structured as C corporations that pay entity-level corporate taxes, MLPs pass-through their taxable income along to their unitholders (rather than incurring taxes at the entity level). As a result and in contrast to investors in C corporations (where the company must pay corporate income taxes, while shareholders are also subject to taxes on any dividends received), MLPs avoid double taxation and offer higher distributions and yields to investors. MLPs have provided distribution growth through increasing volumes of products processed on existing assets, reducing costs through improved operations and scale, making accretive acquisitions, developing new assets, and capitalizing on new trends.
In addition to the avoidance of double taxation, MLP investors also receive tax-deferral benefits. MLP investors have historically allocated only a small portion of ordinary income—typically between 0 to 20 percent1 of cash distributions for midstream MLPs —while the remainder of the distribution reduces the investors’ bases and is deferred until the investor sells the security or is taxed at capital gains rates if no basis exists. Distributions have exceeded taxable income allocations due to MACRS depreciation, amortization, and other deductions against taxable income.
Initially, there were no federal limitations on which assets or operating business was allowed to become an MLP. Companies operating in the hotel, restaurant, cable television, investment advisory, amusement park, and sporting industries were structured as MLPs. At one time, even the Boston Celtics NBA franchise was structured as an MLP. As concerns arose regarding MLPs abusing their tax-advantaged structure, Congress placed qualification restrictions with the passage of the Revenue Act of 1987, requiring at least 90 percent of gross income from qualifying sources as defined under Section 7704 of the Internal Revenue Code of 1986, as amended (the “Tax Code”). Qualifying sources generally include the production or processing activities related to natural resources or minerals, including the mining, processing, refining, compression, transportation, storage, marketing, and distribution of oil and gas products, coal, timber, and other depleting resources under Section 613 of the Tax Code.
In 2008, legislation was expanded to allow for the transportation and storage of biofuels such as ethanol, biodiesel fuels, liquefied hydrogen, liquefied petroleum gas, liquefied natural gas, and liquefied fuels derived from coal or biomass as sources of qualifying income. The Internal Revenue Service (“IRS”) has also issued private letter rulings (“PLRs”) that provide a specific taxpayer with clarification regarding the IRS’ interpretation of qualifying income. In 2012, the IRS issued 18 PLRs according to Morgan Stanley.2 In April of 2013, the IRS issued PLRs clarifying that the processing of natural gas liquids (“NGLs”) into olefins, the storing, marketing, and transporting of olefins, and the wholesale marketing of refined petroleum products qualified as sources of qualifying income. The increased number of PLRs in recent years, as well as the expansion in qualifying sources of income in 2008, represents a trend that will likely contribute to further broadening of the types of businesses that will adopt the MLP structure in future years.
Although MLPs have been in existence since 1981, many of the original oil and gas MLPs left the market when they became unable to maintain distributions following a decline in energy prices. The emergence of the modern MLPs began in 1997 and 1998 with the creation of Enbridge Energy Partners LP, Kinder Morgan Energy Partners, L.P., and Enterprise Products Partners L.P. The modern trend really took hold during the late 1990s and early 2000s when energy companies began divesting their midstream operations.
Midstream activities in the energy industry include the operations and infrastructure to transport, process or separate, and store oil and gas products between the wellhead and refiners and end users of the products. The economics of midstream activities are generally driven by commodity volumes transported or processed often based on fee-based contracts with limited direct commodity price exposure. Not until the mid-2000s did coal, oil and gas E&Ps, and marine transportation entities return to the public markets as MLPs. More recently, MLP offerings on the heels of PLRs have expanded to include offerings by refiners, fertilizer producers, and oilfield services companies. As the following chart reflects, higher distribution yields among these segments reflect the increased risks and commodity exposure of these segments relative to the midstream segment.
The pipeline of midstream MLPs completing IPOs since the beginning of 2012 has continued to be strong, including several offerings of midstream operations by sponsors with primary operations in downstream (refining) and upstream segments. Additionally, Phillips 66 recently had an IPO of its midstream assets in July of 2013 and Devon Energy Corporation has also announced plans to form an MLP for certain midstream assets. Overall, however, the opportunities for new midstream MLPs have become more limited, and investor demand continues to support MLP concepts outside of the relative safety of the midstream businesses. IPOs of MLPs have also ventured into operations in the oilfield services industry, including Seadrill Partners, LP, an offshore contract driller, and Hi-Crush Partners and Emerge Energy Services, both of which have substantial fractionation sand operations.
Varying the Formula
Recent IPOs have included three refining offerings, two nitrogen processing offerings, and a propane dehydrogenation offering. As the business models underlying MLPs have offered differing risk/return characteristics, sponsors of MLPs have sought alternative MLP structures to those typically employed by the midstream MLP segment. Recent trends include MLPs offering variable distributions.
In contrast to MLPs that typically involve midstream assets and have stable, recurring distributions, variable distribution MLPs (or variable MLPs) involve companies operating in industries, such as petroleum refining and nitrogen processing, whose earnings and distributions are expected to be much more directly impacted by energy commodity prices and, therefore, more volatile and cyclical. Additionally, variable MLPs are operationally focused, with relatively few facilities or even a single facility comprising the entire enterprise. Variable MLPs are more focused on maximizing distributions every quarter, although such distributions will fluctuate, depending on the underlying company’s financial performance and risk exposures. However, investing in variable MLPs offers the potential for significantly higher yields.
Unique Merger and Acquisition Structures
MLPs have been very effective vehicles for growth through merger and acquisition activities since the modern trend began. Sponsors of MLPs (frequently, public C corporations) dropped assets down into their MLPs over time, executing on distribution growth strategies. Additionally, MLP units have made excellent acquisition currency as valuations have been strong relative to valuations for asset acquisitions—enabling accretive transactions for LP unit holders—and generally open capital markets have enabled MLPs access to capital to support such asset transactions. Additionally, MLP unit-for-unit merger transactions have been an additional means to grow distributable cash flows for MLPs. In typical transactions involving entities, the sponsor of the MLP has executed the merger or acquisition with a C corporation and the assets are dropped down to the MLP to achieve the tax benefits of the MLP. However, MLPs have had limitations when it comes to executing, in a tax-efficient manner, on direct merger and acquisition transactions with C corporations due to challenges with creating a tax-deferred transaction for the C corporation stockholders while avoiding tax inefficiencies of having a C corporation subsidiary that generates meaningful taxable income as an MLP subsidiary.
Two substantial transactions involving MLPs acquiring C corporations closed in 2012: Energy Transfer Partners, L.P. (“ETP”) and its traded general partner, Energy Transfer Equity, L.P. (“ETE”) acquired Sunoco, Inc., and Southern Union Company, respectively. Following the closing of ETP’s transaction with Sunoco, ETP and ETE reorganized its C corporation subsidiaries into a wholly owned subsidiary of ETP to simplify its organizational structure. The MLPs have also made substantial transfers of assets and operations from the C corporation subsidiary into pass-through subsidiaries of the MLPs since the initial acquisition, which has further improved the tax efficiency of the structure.
In the first stock-for-stock merger of a C corporation by an E&P MLP, a recent proposal by Linn Energy, LLC (the MLP) through LinnCo, LLC (a C corporation that owns LINN Energy stock) to acquire Berry Petroleum offers a nuanced structure for MLP-C corporation transactions. The complex transaction is expected to be structured as a tax-deferred reorganization under Section 368 of the Tax Code for Berry’s stockholders.
In an attempt to broaden its investor base, Linn Energy created a new publicly traded entity in 2012, LinnCo LLC (“LinnCo”), to hold one unit of Linn Energy for every unit outstanding in LinnCo. Taxed as a C corporation, LinnCo provides an opportunity for certain institutional investors and individuals investing through retirement accounts to invest in Linn Energy without certain negative tax consequences that MLPs can create for such investors. In LinnCo’s brief history, distributions from Linn Energy have carried no taxable income. LinnCo passes through such distributions as qualified dividend income and no taxable income has been realized by LinnCo’s stockholders.
LinnCo has proposed a merger transaction with Berry Petroleum in a 1.25:1 stock merger, which was initially valued at $4.7 billion. Following the merger, Berry Petroleum will be converted from a C corporation to a limited liability company. LinnCo will then contribute all of its outstanding membership interest in Berry Petroleum to Linn Energy for the newly issued Linn Energy units. Berry will then be an indirect wholly owned subsidiary of Linn Energy.
The merger is expected to be beneficial to both Linn Energy unitholders and Berry Petroleum stockholders. Berry Petroleum’s stockholders are expected to be able to defer the recognition of gains on the stock portion of the transaction until the sale of their LinnCo stock. Following the transaction, Linn Energy is expected to continue generating tax-deferral shields (arising from intangible drilling costs and other deductible expenses). Linn Energy unitholders are also expected to see accretion in earnings as Linn Energy realizes benefits from the valuation premium of Berry Petroleum’s assets under an MLP structure. Furthermore, as Linn Energy is using its existing units as an acquisition currency, the deal is expected to improve Linn Energy’s balance sheet.
This transaction could serve as a precedent for similar transactions in the future involving stock-for-stock mergers between MLPs and C corporations. However, such transactions would likely require certain key prerequisites, including the existence of sufficient tax shields within the MLP to minimize the potential tax implications following the transaction and the presence of an affiliate C corporation through which the MLP could achieve reorganization treatment under Section 368.
The MLP entity structure has become a substantial asset category among U.S. Capital Markets. MLPs have offered investors a compelling investment option, and have creatively capitalized on a wave of favorable operating and capital market trends. As discussed in this article, the market capitalizations of these entities has grown from its infancy in 1997 to $480 billion.
Given the recent trends in the last few years, it is highly likely that the market will see continued transaction activity, particularly new IPOs and further broadening of operations represented by MLPs. Private letter rulings have played an integral role in expanding the potential pool of MLP candidates. The MLP Parity Act, initially introduced in 2012 and reintroduced in 2013, may continue the trend to broaden MLP candidates. Moreover, investor appetite for yield-oriented investments continues to be strong, and MLPs continue to offer investors compelling income options, even with the recent escalations in yields. However, with the broadening of industries operating in MLPs, it is incumbent on investors to become more educated about the individual offerings and their respective risk/reward characteristics.
As evidenced by the LinnCo and Berry Petroleum transaction, the industry is also continuing to refine its substantial merger and acquisition capabilities with creative transaction structures. Such cutting-edge structuring may broaden the MLPs’ potential to execute transactions with a wider pool of transaction targets, creating another significant catalyst for growth of market power for the asset class.