MLP Structural Simplifications: Part 1 — Reorganizations

Several transactions in the MLP space have been proposed or completed in the name of simplification. Simplification is generally a good thing as it typically means more transparency and lower costs. In the MLP space, we tend to hear about structural simplifications through reorganizations and elimination of incentive distribution rights (IDRs) . This week, we’ll look at reorganizations, and next week, we’ll look at IDR eliminations.

Simplification can be achieved through reorganizations that typically involve consolidating two related entities into one public entity. A lower cost of capital, increased transparency, improved efficiency, a reduction in overhead costs, and an enhanced credit profile can all be motivations for restructuring. Restructurings can also be undertaken to improve valuations, attract a broader investment base or better align investors’ interests. As listed below, there have been several reorganization announcements in the MLP space already this year.

Will the new, lower corporate tax rate trigger more reorganizations in the MLP space?

Under the new tax act, MLPs maintain their tax advantage relative to corporations, but the lowered corporate tax rate of 21.0% (down from 35.0%) has made the C-corporation structure relatively more attractive than it was previously. Some investors have expressed concerns that MLPs will restructure into corporations. Of the three transactions with a stated plan for consolidation into one entity, the MLP is the surviving entity in two of the transactions (NS and ARLP). In other words, we’re not seeing an abandonment of the MLP structure in favor of the C-corporation structure with the lower corporate tax rate.

Certainly, a 21.0% corporate tax rate is more palatable, and it’s possible that we could see more reorganizations of MLPs into the C-corporation structure. However, for existing MLPs, we think it’s unlikely that there will be a broad shift to the C-corporation structure. Why? There are many other considerations that go into restructurings besides corporate taxes. The valuation of the entities involved, their cost of capital, and their balance sheet positions are among some of the many issues, as well as potential tax implications for the unitholders. And management and members of the board are often unitholders. While it may be tempting to attribute the latest wave of reorganizations to tax reform, we think the impetus for recent reorganizations is similar to what we’ve seen with past reorganizations — reducing the cost of capital.

Reorganizations aren’t new.

While there have been a number of reorganizations announced recently, reorganizations aren’t new in the MLP space. Kinder Morgan (KMI) reorganized in 2014, consolidating a total of four publicly traded entities into the one corporation. Targa Resources (TRGP) announced that it would acquire Targa Resources Partners in November 2015. More recently, ONEOK (OKE) announced in February 2017 that it would acquire ONEOK Partners. These reorganizations and others were motivated by reducing the cost of capital, and we would expect that to be a primary rationale for future reorganizations.

Reorganizations don’t mean the business is broken.

To some investors, reorganizations may carry negative connotations. Some may think reorganizations reflect an underlying issue with the business of energy infrastructure. In the MLP space, the fundamental picture is robust. US oil and natural gas production is at record highs, exports of hydrocarbons from the US are growing, and MLPs continue to boast a quiver of organic growth projects. WTI oil prices have seemingly stabilized around $60 per barrel, which is a price point that supports production growth. Energy infrastructure is still very much needed and will be needed in the future as the US increasingly becomes the world’s swing producer of hydrocarbons. The problem really isn’t the underlying business. OKE, TRGP, and KMI are still infrastructure companies and still pursuing the same kind of growth projects that they did prior to reorganizing. The problem tends to be the cost of capital.

So, why have there been so many reorganizations?

It’s no secret that the equity performance of the MLP space has been lackluster over the last several months. Weaker unit performance drives up the cost of equity for MLPs. Meanwhile, IDRs are an added burden to cost of capital for those MLPs that have them, as we’ll discuss next week. Management teams frustrated with unit performance may look at reorganization as a lever they can pull to try to improve their positioning for the long term, in conjunction with the motivations outlined above. In general, the primary driver for reorganizations in the MLP space continues to be lowering the cost of capital, though that’s certainly not the only benefit of simplification.

Next week, we’ll look at IDR eliminations, which are also aimed at lowering the cost of capital.

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