Outlook for master limited partnerships (MLPs)
November 2016 | 10QUESTIONS | FINANCE & INVESTMENT
FW speaks to G. Michael O’Leary, a partner at Andrews Kurth Kenyon LLP, about the outlook for master limited partnerships (MLPs).
FW: Could you provide an overview of the current master limited partnerships (MLPs) landscape? What key trends and developments have you observed within this asset class?
O’Leary: The decline in energy commodity prices in the US, which began in July 2014 and continued through the third quarter of 2016, has adversely affected the MLP industry. For example, the first 11 months of 2016 saw just one MLP initial public offering. In addition, the prolonged decline in hydrocarbon commodity prices and the expectation that prices may not recover until mid-2017 have been particularly painful for the existing upstream MLPs, with the result that the upstream MLPs have significantly reduced or eliminated the regular quarterly cash distribution on their equity as they struggle to refinance or restructure their debt. Several of the upstream MLPs are currently in the US bankruptcy courts trying to restructure or eliminate their indebtedness. With US upstream oil & gas companies significantly curtailing their drilling activities in response to the low commodity price environment, the need for the construction and development of additional midstream infrastructure facilities has declined substantially, which has adversely affected the growth opportunities of many midstream MLPs. As a result, those midstream MLPs that do not have a financially sound sponsor with assets that can be ‘dropped down’ to the MLP or significant internal expansion projects, and are dependent upon the acquisition or development of unidentified projects to serve the needs of third-party producers or marketers, under current conditions are without foreseeable growth prospects. Until hydrocarbon commodity prices stabilise and increase for a prolonged period, the MLP industry will continue to see those MLPs with a strong strategic or financial sponsor with drop-down opportunities valued at or premium to those MLPs without foreseeable growth prospects.
FW: What advantages does the MLP format offer to companies – especially in the energy sector – that are looking to reorganise their business? Are there any disadvantages?
O’Leary: One of the principal advantages of the MLP format is that an MLP is not subject to US federal income taxes, provided at least 90 percent of its gross income constitutes so-called ‘qualifying income’ within the meaning of a particular US provision of the US Internal Revenue Code. As a result of not having to pay US federal income taxes on its taxable income, an MLP is generally able to distribute significantly more cash to its equity investors than an entity, such as a corporation, that has to pay federal income taxes on 35 percent of its taxable income. As a result, MLPs have attracted large groups of individual and institutional investors that invest in this asset class in the expectation of high total returns. The MLP asset class has been a particularly attractive vehicle for energy investments, as the principal sources of ‘qualifying income’ are those from hydrocarbon energy related activities. Since 1986, MLPs have been owners and developers of substantial US midstream infrastructure assets, such as gathering and transportation pipeline systems, processing plants and storage facilities, and the MLP industry has been one of the principal reasons for the extensive development of the network of midstream infrastructure assets needed to service the resurgent US oil & gas industry as it develops unconventional hydrocarbon resource plays. One of the other principal advantages of an MLP is that the MLP sponsor maintains control over the assets owned and operated by the MLP. Sponsors are often concerned about selling an undivided interest in a strategic asset as the sponsor is unwilling to risk losing control over the operation of such an asset, because the ability to maintain control is important to the sponsor’s business. As a limited partnership, however, the control of the entity is held by the general partner, and in most cases ownership and control of the general partner resides with the MLP sponsor. As a result, sponsors can be assured that even if more than a majority of the common equity of the MLP is owned by the public, the sponsor, through the ownership of 100 percent of the general partner, will retain control over the MLP’s assets since, unlike a typical corporation in which the public stockholders elect the directors, neither the general partner nor its directors are elected by the public investors.
FW: How have MLPs performed in recent months, following a period in which investment in energy was deemed to be a non-starter and earnings suffered across the upstream and midstream space?
O’Leary: From 1 August 2014 to 30 September 2016, the performance of the MLP industry in the trading market was adversely affected by substantially reduced prices for oil & gas and the forecast that a sustained recovery in those prices would not likely begin until 2017 or later. Investors began reducing their exposure to MLPs as early as August 2014, and subject to limited exceptions, did not resume investing until the third quarter of 2016. In addition, recent decisions reached by US bankruptcy judges have caused investors to become concerned that certain MLPs with gathering or processing arrangements with upstream producers experiencing liquidity problems could have their contracts rejected by a producer, should it seek bankruptcy protection, and should the producer with the commitment to deliver produced volumes to an MLP’s gathering, processing or other midstream assets seek to reject the contract as an executory contract. As US commodity prices began increasing in the first quarter of 2016 and the consensus outlook for improved conditions began firming in the second and third quarters of 2016, the trading prices of many midstream MLPs improved significantly and many of these MLPs have been able to access the capital markets for capital to fund their operations as institutional investors resumed investing in the MLP space. In fact, in late September 2016 the first MLP IPO since July 2015 was successfully launched and it was very well received by the institutional and retail markets. Upstream MLPs continue to be weighted down with too much leverage and too little revenue, and many are in or near bankruptcy. The current prolonged downturn in hydrocarbon prices has exposed the upstream segment of the energy industry as being not particular well suited for the traditional MLP structure.
FW: In light of the above, what strategies did MLPs deploy to address the reduction in opportunities in growth, reduced cash flows and over-levered balance sheets?
O’Leary: The US energy industry began to recognise in 2015 that the excess supply of oil on the worldwide market would not be quickly eliminated, which would result in energy commodity prices being ‘lower for longer’. MLPs, much like energy companies in other forms, began to take steps to assure they could survive the downturn by conserving cash and reducing expenditures. Many MLPs announced that they were reducing their cash distribution rate to a sustainable level, given existing conditions, and were unlikely to increase it until market conditions improve. The excess cash from the reduced distributions rate was targeted to fund capital investments or to reduce indebtedness. In addition, many MLPs embarked on a concerted effort to extend the maturities of their indebtedness that would otherwise be due before 2020 to after 2020, or to exchange equity for their indebtedness. In some cases, such efforts have been successful and those MLPs are poised to benefit as market conditions improve in 2017 and beyond. Other MLPs have sought to simplify their structures by eliminating the publicly-traded general partner if they had one, since the high values of many GP’s publicly-traded equity was a function of the expectation that the operating MLP would continue to grow significantly, which was not the case under the then existing market conditions. Finally, other MLPs, particularly upstream MLPs, were unable to service their indebtedness even after completely eliminating their cash distribution, and have had to resort to seeking the protection of the US bankruptcy laws. In order to protect their investors from adverse tax consequences that would result in the cancellation of significant amounts of indebtedness in bankruptcy, some of the upstream MLPs that sought such protection elected, with the prior approval of their equity holders, to convert to a corporation prior to filing bankruptcy.
FW: What are the most significant legislative matters to have affected the MLP/PTP space in recent times?
O’Leary: Since 1986, the US Internal Revenue Code has permitted MLPs to be free from US federal income tax obligation if at least 90 percent of the MLP’s gross income is from specified qualifying sources. Until 2015, the IRS and tax lawyers generally relied on private letter rulings (PLRs) to determine whether or not income from a particular activity would constitute ‘qualifying income’ for purposes of the particular section of the US Internal Revenue Code. In 2015, the IRS published proposed regulations addressing those energy related activities that would or would not satisfy the qualifying income requirement. The proposed regulations were the subject of broad adverse reaction by the MLP community, their investors generally and tax practitioners specifically, as among other effects, they would cause the income from many activities that were generally thought to be qualifying – in fact, some were the subject of specific PLRs concluding the income would be qualifying – to be non-qualifying, resulting in those MLPs being subject to federal income tax after a stipulated three-year grace period. The proposed regulations were the subject of extensive comments, and newly proposed regulations are expected shortly. The MLP community is anxiously awaiting the publication of the new regulations. In addition, as a result of a policy shift at the Department of Justice (DoJ) and Federal Trade Commission (FTC) regarding the enforcement of US antitrust laws, MLPs – as is also the case with entities in other forms – have found that proposed acquisitions or business combinations are being subjected to more rigorous examination by the DoJ and FTC for anti-competitive effects. In many cases this increased scrutiny has only resulted in increased delays before being able to complete a transaction, while in others it has required the disposition of more operations than the constituent companies thought would be necessary in order to receive clearance from regulators. This increased scrutiny is expected to continue for the duration of the Obama administration and perhaps thereafter. Furthermore, several midstream MLPs have been targeted by environmental activists looking to impede the development of interstate and intrastate pipeline projects that the activists believe will only contribute to global warming by furthering the ability of upstream companies to develop oil & gas properties. For example, the likely temporary success of the Standing Rock Sioux Tribe and environmental activists in causing the US Army Corps. of Engineers, the DoJ and the Obama administration to interfere with the completion of the Dakota Access pipeline system being developed in North Dakota and causing the US District Court for the District of Colombia and the US Court of Appeals for the District of Colombia to issue temporary injunctions against further construction of the pipeline system, has emboldened these activist groups and others to seek to delay or stop the development of many other similar pipeline projects that they contend will contribute to global warming by enhancing the ability to develop and deliver to market hydrocarbons. The success of the activists’ efforts with respect to the Dakota Access pipeline system has led them to seek to impede the development of several other pipeline projects planned or underway in the US and could result in significant incremental costs to pipeline system developers or to the inability to secure the necessary easements and governmental permits to commence such projects as US governmental agencies re-examine their approval processes.
FW: How does the implementation of the US New Partnership Tax Audit Regime – enacted as part of the Bipartisan Budget Act of 2015 – change the way in which the IRS audits and collects tax from partnerships? How is the MLP community responding to the new law, scheduled to take effect from 2018?
O’Leary: As a result of the enactment of the US Bipartisan Budget Act of 2015, changes will be made to how the IRS audits and collects tax from partnerships. The new law will go into effect in 2018, and once in effect it will repeal the current partnership audit rules. The new rules will allow the IRS to collect taxes associated with audit adjustments at a partnership level, rather than passing adjustments through to the individual partners. The new rules apply to all partnerships, including MLPs, regardless of size, and although some smaller partnerships have the option to elect out of these new rules, MLPs will not have that option. Under the new rules, the IRS will assess the partnership, not individual partners, for any ‘imputed underpayment’, which will be subject to the individual or corporate tax rate, although a partnership will be able to use a lower rate if it can prove the partners are subject to a lower rate. The assessment by the IRS is made in the year of the adjustment, not the year that is the subject of the audit. If, within 45 days of notice of a partnership adjustment for an imputed underpayment, the partnership elects to issue statements to the persons who were partners during the reviewed year, then those partners will be required to pay the tax for the year the adjustment is made with interest assessed. The new rules require partnerships to appoint a partnership representative to act on behalf of the partnership before the IRS. New MLPs that have completed their IPO since the enactment of the new rules include provisions in the limited partnership agreement regarding the appointment of a partnership representative and granting authority to that person to act on behalf of the partnership and its partners before the IRS, including electing to have the persons who were partners during the year in question bear the tax payable in respect of the imputed understatement. MLPs that completed their IPO before the enactment of the rules do not grant such authority to the tax matter partners of the partnership. Because the fair treatment would seem to be that the increased tax resulting from an ‘imputed understatement’ should be borne by persons who were partners of an MLP in the year of applicable review and adjustment, the MLP partnership agreements of these partnerships will need to be amended to provide for a tax representative with the authority, among other things, to make such an election. Under the amendment provisions of the MLP partnership agreements, effecting such an amendment will require the prior approval of the MLP’s unitholders. The new rules have several ambiguities that require clarification before the rules become effective in 2018, and the IRS will need to issue regulations for the new rules. While we expect existing MLPs will propose amending their partnership agreement to include provisions addressing the new rules and permitting the partnership representative to make the election related to ‘imputed underpayments’, we believe MLPs will wait before seeking approval to implement the changes for the IRS to provide such clarifications and regulations.
FW: What advice would you give to investors in terms of the due diligence required when buying a stake in an MLP? Could you outline the main differences between investing in an MLP as opposed to a corporation?
O’Leary: If an investor is considering investing in an MLP, it is important that the investor conduct significant due diligence before making the investment. As MLPs are so-called ‘pass through’ entities, one of the important items which must feature in investors’ due diligence is the ratio of taxable income to cash distributions – or tax shield – which indicates the tax deferral that an investor can expect by investing in the MLP units. The tax shield is not the same for all MLPs, so if the investor is a taxable investor, he or she will want to know the estimated tax shield that is expected if an investment is made in the targeted MLP. In addition, as growth prospects are important to MLPs for the purposes of being able to sustain and grow over the long term the cash distribution to unitholders, an investor will want to investigate the internal and external growth prospects for the targeted MLP. Some MLPs have a large backlog of internal expansion prospects that provide a platform for sustaining and growing, over the long-term, the cash distribution to unitholders. For MLPs without such internal growth prospects, the investor should investigate whether the MLP has a strategic or private equity sponsor that can provide a source of future drop-downs of assets or businesses that would support sustained and growing cash distribution. If based on the investor’s investigation the investor determines the MLP is dependent on acquisitions from unrelated third parties or development of unidentified projects for future growth, the investor should determine if that uncertainty and absence of visible growth prospects is properly reflected in the trading price. Finally, the distribution coverage ratio is important for an investor to investigate, which is the ratio of the cash flow available for distribution per unit to the cash distribution to unit. This ratio is important for determining whether the MLP has sufficient ‘headroom’, in terms of cash available for distribution, above the actual distribution rate, to maintain the current distribution rate into the future. Investors in entities taxed as a corporation should undertake a similar diligence review, but the tax shield is not applicable to corporations. Investors in corporations also need to understand the likelihood that a corporation with a high dividend rate can sustain it for the foreseeable future, or if it is a high growth entity the possibility that such growth could be slowed significantly or impeded altogether during the period of such an investor’s investment in the company’s stock.
FW: With the MLP Index indicating that MLPs continue to offer sustainable dividend yields, how, in your opinion, is global uncertainty helping to add to their appeal among investors looking for stability and predictability?
O’Leary: The extremely low interest rate environment, both in the US and internationally, has helped to enhance the attractiveness of MLPs to the investment community. The returns available to investors in fixed income securities are extremely low in the US and abroad because of existing expansionary monetary policies and zero, or near zero, interest rates. Financially secure MLPs offer an attractive sustained yield – typically with significant tax shield available to taxable investors – and the opportunity for capital appreciation. The total return available to MLP investors can far outweigh the interest rate available for less risky fixed income investments such as a treasury bill, notes or fixed income investments of investment grade issuers. However, one of the risks to investors in MLPs is that if interest rates are increased in the US at an accelerated pace, the attractiveness of the MLP’s equity to investors could be impaired as investors flock to the fixed income security that is less risky and the MLP’s debt financing costs increase materially. Based on the policies of the current US administration, however, it appears unlikely that the US will experience a substantial and rapid increase in interest rates. With the pending change in administration from the US presidential election, investors should closely monitor the results and changes for any significant change in expansive monetary monitoring policy and interest rates, and the effects of such changes on the investors’ investment portfolios.
FW: What advice would you offer to energy companies contemplating reorganising their business into an MLP?
O’Leary: US companies considering reorganising their business or a business segment or segments into an MLP need to have confidence that the business can generate sustainable excess cash for distribution and has significant prospects for growth. The MLPs that perform the best are those with sustainable cash flows over the long term and both internal and external growth opportunities – including the opportunity for drop-down transactions from a strong strategic or financial sponsor. The current low commodity price environment has caused those MLPs that are dependent upon acquisitions to be viewed as less attractive than those with a sponsor that has a pipeline of future drop-down opportunities. In addition, the strength of the management team and its contacts throughout its industry segment is important. As a result, a strategic or financial sponsor considering the formation of an MLP for one of its business segments or portfolio companies should consider the perceived strength of its proposed management team and that team’s ability to connect favourably with the investment community. A company considering forming an MLP will want to engage both tax counsel and independent auditors early. The tax counsel is important to assure that the business proposed to be placed into the MLP will in fact generate sufficient qualifying income under applicable federal income tax laws and regulations so it will qualify for ‘pass through’ treatment for US federal income tax purposes. In addition, the timing of being able to bring a new MLP IPO to market can be adversely affected if the right financial statements are not available. As a result, it is important to engage independent auditors early and to pre-clear with the SEC any uncertainties so unexpected delays can be minimised. Finally, MLPs are expensive and complex, so a sponsor considering the formation of an MLP for one or more of its business segments or portfolio companies needs to understand the cost, the disruption to its ordinary day-to-day operations and the complexity that will be involved in forming the MLP and successfully completing the MLP IPO and, after the IPO, in operating the business and complying with applicable public reporting requirements and investor communication requirements.
FW: Looking ahead, what trends and developments do you expect to define the MLP landscape for the remainder of 2016 and beyond?
O’Leary: As the outlook for stable and increasing commodity prices in the US improves, the MLP market is generally poised for improvement during the remainder of 2016 and during 2017. The prospects for existing MLPs have improved as investors have returned to the energy industry generally, and to the midstream MLP industry specifically. Although it appears to be unlikely, if global interest rates were to increase substantially and rapidly, it would adversely affect the MLP industry as investors shift a significant portion of their investments to the fixed income industry. Given the weakness of the global economy, however, such a rapid and substantial increase in interest rates appears unlikely. As a result, midstream MLPs should remain attractive investments through 2017. It is our view, however, that the effects of the recent prolonged commodity price downturn has resulted in a fatal blow to the upstream MLP segment. We believe that if any upstream MLP is offered in the foreseeable future, it will need to be a variable distribution MLP as opposed to the traditional MLP structure.
G. Michael O’Leary is a partner and a member of the Policy Committee and co-chair of the Corporate/Securities practice. He has an extensive corporate securities and mergers and acquisitions practice with particular emphasis on representation of issuers and underwriters in public and private offerings of equity and debt securities; representation of buyers, sellers and special committees in mergers and acquisitions (domestic and foreign) and of private equity firms’ investments in energy and energy infrastructure; redemptions and exchanges of corporate debt; negotiating complex partnerships and joint ventures; structuring spin-offs and ‘going private’ transactions; and corporate governance. He can be contacted on +1 (713) 220 4360 or by email: email@example.com.
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