Apocalypse Never

The notion that master limited partnerships’ tax status might be at risk from tax reform legislation is a perennial conspiracy theory. It feeds on investors’ often justified suspicion of politicians and the awareness that MLPs reap major benefits by avoiding double taxation on their distributions, an option not available to corporations.

The odds of such a calamity were much inquired about at the big industry conference in Stamford last week.  And yet the money bet remains that an “MLP massacre” along the lines of the one Canada perpetrated on its income trusts in 2006 is all but inconceivable given the voting power of the energy industry in the Senate as well as the undeniable need to expand the energy infrastructure and provide well-paying jobs. The industry is selling itself as an economic success story with every justification, and is in the process of ramping up exports to boot.

Mary Lyman, the executive director of conference organizer National Association of Publicly Traded Partnerships, is among those who want you to rest easy. “I want to assure you that we have things in control in Washington,” she said in her opening remarks. “ Congress is still thoroughly gridlocked and we’re doing our best to keep it that way. The IRS has been helping us a lot lately and we appreciate that.”

It’s Complicated

Do you know how much distributable cash flow your MLP is bleeding to its general partner, now that distributions have cleared the final tier? Or how protection the subordinated units will provide in the event of a commodity correction?

Even if these questions sound hard, there are defensible reasons for the growing complexity of MLP arrangements. Incentive drawing rights (IDR) reward the general partner for growing the profit stream; subordination protects investors, for a time and to an extent, against unexpected reverses.

But IDRs are looming as a much bigger issue than ever these days, because years of strong distribution accretion have turned them into a progressive tax on future growth. I will return to this topic in the next issue, but in brief it the general partners with IDRs are capturing a growing proportion of the total profit stream. And the longer distributions increase the more valuable their IDRs become, while limited partners in the MLPs they manage get stuck with a rising cost of capital.

The higher cost of capital can sometimes be solved with a buyout of IDRs with one-time equity dilution, but the smart play in these cases also points to the general partner side of the exchange. And while complexity certainly has attractions for some, the largest MLP is advertising itself as a simpler proposition.

Enterprise Products Partners (NYSE: EPD) used to pay IDRs, but no more.  Now the lack thereof has made it onto the “Key Investment Considerations” slide leading off conference presentations. “We’ve been complicated once upon a time, we’ve been simple and we think simple is better,” said CEO Michael Creel.

The Line on Linn

And speaking of complexity, controversial upstream MLP and Growth Portfolio holding Linn Energy (Nasdaq: LINE) gave a presentation largely focused on the benefits of recent acqusitions, notably February’s landmark deal for Berry Petroleum (NYSE: BRY), the first takeover and conversion by  an MLP of a corporate-tax paying corporation.

The message was that operation integration is proceeding full speed ahead of shareholder approvals expected over the next couple of months. Management continues to forecast strong long-term accretion from Berry’s long-lived assets, which will make California a leading production focus for Linn after the merger.

The deal was made possible by a complicated bit of financial engineering by Linn, which last year offered to the public shares of related entity Linn Co (Nasdaq: LNCO), whose sole business activity is to hold LINE units. This has the secondary benefit of letting institutions and retirement accounts take advantage of Linn’s distributions without bothering with K-1 forms or unrelated business income taxes. But the primary point of the structure is to create a currency for Linn to purchase C corps without triggering immediate adverse tax consequences for those companies’ shareholders, with the added lure of sheltering sale proceeds in an MLP.

In effect, Linn is a rentier, with a stated mission “to acquire, develop and maximize cash flow” and the implied one of doing so under a more favorable tax regime. What it brings to the table in negotiations with a target C-corp is its favorable tax situation, ample credit and much loftier valuation, which after all is the main reason Linn is buying. When I asked Linn CFO Kolja Rockov to quantify Linn’s tax advantages in a transaction, he noted that Berry shareholders would have faced an immediate tax hit of $800 million or so had they tried to convert into an MLP on their own. Exchanging Berry shares for Linn Co  units carries no such consequence. And because Linn’s acquisition currency is so much pricier than the C corps it continues to target, allowing it to deleverage its own balance sheet as it does so, there are few practical limits to such transactions, Rockov said.

In practical terms, Linn has already become a target of short-sellers based on the leverage accumulated to this point, and the hedging done to offset commodity risks over the medium term. So Linn’s lagging unit price, described by management as “bouncing around a bit,” may serve as a practical albeit temporary brake on acquisitions, at least until the deal for Berry closes. Complexity can be very lucrative, but it doesn’t come without risk and cost.

The Bakken Hillbillies

There’s nothing like an array of brightly colored presentations to make the industry’s plans look like a meticulously orchestrated march toward ever higher profits. But you don’t have to talk to MLP executives too long to gather that the energy boom is really a bit more chaotic than depicted in the PowerPoints. One executive suggested Bakken wildcatters often fail to adequately plan the transport and marketing of their barrels. Another complained about the difficulty of recruiting and retaining specialized staff, with newcomers quickly moving on to greener pastures in an industry hungry for talent.

Is This the Comp You Want?

From the panel on the growing popularity of MLPs with non-traditional investors such as funds and institutions comes the factoid that retail investors hold just 4 percent of the shares in the top five real estate investment trusts, versus the 50 percent retail share of capital for the MLP industry as a whole. The stated implication is that there are more valuation gains in stores as new classes of investors buy into MLPs. The unfortunate corollary is that greater liquidity will come at a price, that price being increased volatility, because retail investors tend to be long-term investors and many face immediate adverse tax consequences if they sell. Twitchy institutional investors are likely contributing to the greater volatility of REITs, which haven’t been right since last week’s interest-rate scare and continue to slump today. The MLPs in contrasted, have been quite resilient. But higher institutional ownership won’t help when selling pressure does emerge, though it will certainly buoy valuations in the long run.