Monday Mailbag: Decisions, Decisions

Given the choice, shouldn’t I always invest in the GP over the LP?

We’ve been getting this question a lot since Tesoro Logistics (TLLP) announced last week that it would be acquiring the midstream assets of independent E&P QEP Resources (QEP). The two LPs involved – TLLP and QEP Midstream Partners (QEPM) – traded down 14% and 13% the next day, respectively, while the two GPs – QEP and Tesoro Corp (TSO) – traded up 4% and 8%, respectively.

The answer is, as you might expect from an organization that equips investors to make informed decisions about MLPs and energy infrastructure, it depends.

In favor of the GP

Like the US federal government’s take via its progressive income tax system, IDRs entitle their holder(s) to a higher percentage of incremental distributions above certain tiers, despite an economic interest of 2% or less. At the “high splits”, the GP take is 50% of incremental distributions paid. So the first argument in favor of investing in the GP is leverage, assuming you strongly believe in the fundamentals of the LP.

It’s worth reiterating that the GP take is 50% of incremental distributions paid. It is not, as sometimes believed, based on LP distributions per unit. So there’s actually two ways to grow the amount of cash paid to the GP: raising the LP distribution per unit, and increasing the number of units. While it is unlikely that a GP would issue LP units solely for this purpose, it does mean that in an acquisition, a deal may be near-term dilutive for the LP but still enable the GP to receive more cash immediately. So a second argument in favor of investing in the GP is being on the winning side of a potential conflict of interest between the GP and LP. This is also true if the company is the target as opposed to the acquirer, as the buyer typically pays a higher multiple of cash flow to the GP than its leveraged exposure would imply as compared to the LP. This is known as the control premium.

And third, some investors are firm believers in following the equity, i.e. investing alongside management whenever possible. Most executives have their bread buttered by the GP when both the GP and LP entities are publicly traded.

In favor of the LP

If the above paints a pretty grim picture for LPs, there are some counterpoints. First, sometimes the GP is not a pure play on the underlying LP. As we’ve recently seen more C Corporations take all or a portion of their midstream assets public to highlight the value of those assets in a sum-of-parts analysis, investing in the GP may mean exposure to different types of business risks that aren’t at the LP level, such as commodity price fluctuations in the case of E&P companies, or local regulatory dynamics in the case of utilities.

2014.10.27 Yield Premiums

Second, if your portfolio has a minimum income requirement, LPs trade at a yield premium of more than 200 basis points versus their GPs. If that portfolio sits in a taxable account, LPs offer tax-deferred return of capital, while most GPs do not.

On a related note, you can see from the list above that there are only 16 publicly traded pure play GPs, and scarcity value may drive up valuation. So third, if you have access to borrowed funds, you may want to consider if you’re better off creating your own form of leverage to the LP in today’s low interest rate environment.

And finally, remember that leverage is great when the company is firing on all cylinders. It’s less great when front-month crude falls more than $100 in the span of five months, gathering volumes are down due to reduced drilling activity, processing margins aren’t fully or cleanly hedged, and your distribution stagnates for several quarters or has to be cut.

Shouldn’t I only invest in LPs that don’t have IDRs?

Not necessarily. More on why in this week’s Research Spotlight.

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