What's Happened with Master Limited Partnerships and What Matters
Master Limited Partnerships (MLPs) have been the recipient of many news headlines creating investor angst and questions for future return prospects. Since August 2014, with the downturn in oil, MLPs have largely been under pressure for reasons ranging from distribution cuts to the effects from the Tax Cuts and Jobs Act.
In recent history, the passing of the Tax Cuts and Jobs Act (tax reform) in December 2017 impacted prices and volatility and raised questions whether the General Partner (GP) and Limited Partner (LP) structure will be jettisoned. The Federal Energy Regulatory Commission (FERC) reignited the concern in March, with a surprise announcement that it will no longer permit income tax allowances in cost of service rate agreements for pipeline MLPs.
This Q&A offers an explanation of notable MLPs events and an analysis of their impact.
Will companies choose a C corporation structure over a limited partnership (LP)?
A number of MLPs have converted to C corporations through an acquisition by their parent companies. There are many reasons given for the consolidations, but, at the crux is the cost of capital.
Incentive Distribution Rights (IDRs) is the contractual relationship between the GP and the LP where the GP receives a percentage of the LP’s cash flow. Typically, the percentage increases as the distribution improves and the LP grows. This can be a drag on the cost of capital which can result in LPs paying more than half their cash flow to the GP. By consolidating and removing the IDR structure, companies can significantly lower their cost of capital. The question then becomes, “Doesn’t that mean every MLP will have to consolidate at some point?”
A buyout of a C corporation by a parent company isn’t the only means to eliminate IDRs. Investment managers estimated that a decade ago, 97% of the constituents in the Alerian MLP Index had IDRs in place. Today, 62% have removed the structure, less than a dozen through a buyout. Also, an LP can buy the GP or the two parties can enter into a contractual modification of the IDR. The future of C corporations compared with LPs is important to weigh because C corporations have lower distributions than LPs, which has ramifications for investors’ returns.
What’s the tax liability when an MLP is acquired?
If an MLP acquires another through a stock transaction, there is no tax liability on behalf of the client; it is an exchange of LP units. If cash is tendered instead of stock, the cash is recognized as a capital gain. If a C corporation purchases an MLP (cash or stock), the investor’s gain and tax liability is determined on an adjusted cost basis. The longer the MLP has been held, the larger the potential tax liability. Non-taxable clients can also incur a tax liability for the recapture of passed-through depreciation.
Can we expect more distribution cuts?
Distribution coverage is the amount of cash flow produced by the company relative to the size of the distribution paid. Today, it is at an all-time high 1.3x coverage ratio. That implicitly says for every $1.00 pledged for distribution, LPs have $1.30 to cover the distribution. Historically, that coverage has ranged from 1.0x – 1.1x. In conversations with investment managers, the cushion provides a secure distribution and minimizes further cuts. That is not to say all are managing their business today at a 1.3x ratio.
Are MLPs too levered?
MLPs are less levered today than in the past. Seventy-five percent of the index has an investment grade credit rating. This is significant because MLPs have increased distribution coverage to ensure their good standing with the ratings agencies. That has led to a significant divergence between MLP debt (which has had positive performance) and MLP equity (which has been underwhelming). Previously, MLPs accessed the equity and debt markets to fund projects. Maintaining better distribution coverage, MLPs are able to self-fund more projects and reduce debt.
How does FERC’s announcement affect MLPs?
The unexpected announcement by FERC in March jolted investors. The actual impact from the announcement is small for the vast majority of MLPs, particularly those with newer pipelines or a small number of interstate pipelines. The most affected are very old pipelines (10+ years) that were under a “cost of service” contract and ran across state lines. By most estimates, the negative cash flow impact to MLPs will be accounted for over the next 12 months. You can read our response to the FERC ruling in detail.
What effect has tax reform had on MLPs?
On the run-up to the tax reform announcement at the end of 2017, there was uncertainty around MLPs and the future of their tax status. Since then, the impact is well known. The change in corporate tax rates (from 35% to 21%) had little impact on decision-making at MLPs. MLPs pay no tax as a result of their pass-through status. This remains below 21%. The appetite to purchase MLPs has grown, satiated by the advantage of a “tax holiday.” The ability to acquire and roll forward the net operating losses (NOLs) at an MLP and also receive a step up in basis, which helps in the form of future depreciation, is a benefit acquiring companies. This tax shield lowers the tax rate to below 21% for five to seven years or until the benefit runs out and the parent resumes full tax liability.
What is Fi3 Advisors’ biggest concern with MLPs?
It is that GPs will realize the value of the assets held within the MLP and purchase them – not because of taxes or IDRs – but rather, they are high-quality assets trading at attractive prices. As a result of the MLPs subordinated structure, premiums during an acquisition are much smaller than premiums paid in other takeout transactions. Investors are raising the chorus in opposition and MLPs are forming conflict committees to ensure both sides are fairly rewarded. Another mitigating factor is that consensus suggests the runway for acquisitions is finite and the remaining opportunities for consolidation are well known across the space.
The opportunity in MLPs comes with risk. There are numerous moving parts in this asset class that contribute to today’s attractive valuations. Balance sheets have seen strong MLPs funding growth for years now, providing a cushion when cash flows slow. The capacity to self-fund more projects is a positive for equity holders, resulting in less issuances and fewer shares hitting the market.
Compared with years past, today’s MLP buyer is a long-term institutional investor. In addition, the macroeconomic backdrop continues to be positive. In December 2015, a self-imposed ban on exporting oil was lifted allowing shipments to resume to countries other than Canada.
This chart reflects what occurred when the ban was lifted and this trend is expected will continue.
The uncertainty in the MLP space has created an opportunity, particularly relative to other seemingly more-expensive areas of the market today. We remain constructive on allocations to the asset class and believe there remains significant long-term opportunity.
Contact our advisors at Fi3 if you have questions about this article or MLPs.
While this article addresses generally held investment philosophies of Fi3 Advisors, it does not represent a specific investment recommendation for any individual client or prospective client. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice. Information has been obtained from a variety of sources believed to be reliable but not independently verified. Past performance does not indicate future performance.