What is an MLP?
Be they CEOs, bankers, lawyers, or accountants, Ernst& Young tax attorney Greg Matlock has been inundated with requests for information on creating MLPs, master limited partnerships. “Simply stated, an MLP is an investment term used to describe an operating structure,” said Matlock during a recent Texas CEO Magazine Enlightened Speaker Series event in Houston. Why all the inquiries and what’s the big deal?
What makes this structure different than, say, a C-Corporation, or an S-Corporation or an LLC as an operating structure are the MLP’s tax advantages. An MLP is a
publicly traded partnership – so there are units (not shares) and distributions, (not dividends), allowing access to public liquidity in the public markets. “The tax benefits drive this structure,” said Matlock. “Unlike a traditional corporation you’re not paying two levels of tax.”
When a company becomes listed on a public market and starts trading, it becomes a corporation. The corporation pays taxes and it also pays dividends to shareholders who pay tax on that income, as well, so there are two levels of tax. There’s an exception to the rule – the MLP exception. With an MLP, the taxes of the business are passed-through to individual unit holders and not paid by the company, so the company can tap the liquidity in the public market and not pay the same tax burden. What’s the catch?
“Flow-through status is obtained and maintained if 90 percent of the MLP’s gross income is from qualifying sources,” said Matlock. Translation? To qualify to become an MLP, the tax code lists an energy-related section including qualifying activities done with natural resources – the list includes: exploration, development, mining, production, processing, refining, transportation and storage.
On top of the tax benefits to the company, unit holders receive distributable cash and get a large share of deductions, “what’s known as the tax shield,” observed Matlock. “They may get $100 of cash and they also may get $80 in deductions. So, for $100 worth of cash, I’m only paying tax on $20 worth of income.” That’s called a yield-driven investment.
Becoming an MLP
Roger Burks, Managing Director and Board Member of Willis Group Consulting, views MLPs as an investment vehicle. “It will not replace a good asset base or a good management team. I get nervous when someone thinks this is easy, because it’s not.”
Burks sees much of the decision to become an MLP as tax-driven and MLPs do offer low-cost capital. From an operator perspective, what needs to be done to get ready from planning, to preparation, execution and continuing compliance?
“There are three work streams,” said Burks. “First is contract compliance and conversion of your current clients; the second is preparing financial statements with audits; third, you need to prepare your S-1 filing and as part of that, you also need to go through public company readiness.”
And costs? “There will likely be costs for legal review of client contracts, one-time audit fees, accountant and outside counsel fees for the S-1 filing, plus the cost of creating an investor relations group internally if you don’t currently have one, plus filing costs and a review of your selling and G&A expenses,” noted Burks.
Externally, Burks shared a list of what needs to be managed:
Predictable performance is essential and companies need to:
Said Burks, “I am a believer in midstream for MLP, and I’m becoming a believer in MLPs in the E&P space – but there’s still risk if you pay too much.”
Why Form an MLP? Follow the Money
“Forming our MLP was quite a hurdle for our organization,” offered QR Energy CFO, Cedric Burgher. “Why would someone would want to form an MLP and why would an investor want to invest in an MLP? The answer to those two questions comes in three words – follow the money.”
Burgher sees a strong market for tax efficient, yield oriented vehicles. “MLPs produce a much higher yield you can get with a tax efficient structure.” Another benefit? The ability to compete for capital allows MLPs to grow at a competitive rate because of the ability to source capital cheaper. How much cheaper?
Based on data from Bloomberg and Robert W. Baird, Burgher said the large cap E&P cost of capital average is ten percent. Mid-cap E&P’s have a cost of 9.4 percent and small caps just over ten percent. Upstream MLPs, like QR Energy, have an average cost of capital of 7.8 percent. The numbers are a weighted average cost of capital and include the cost of debt.
When looking at assets, “It is critical to have the right ones in an MLP and for an upstream company they need to be conventional, long lived, low decline, steady producing assets because we are cash flow driven,” noted Burgher. The MLP structure is rarely used in the new shale plays very often, but, once the shale plays mature, the decline curves come down and delivery becomes steady and predictable, those assets will likely fit an MLP.
Why Invest in an MLP? Follow the Money
MLPs are intended to have a lower risk profile and most MLPs have a hard asset underpinning, attractive to value investors who look at the assets behind their investment. In upstream that means mature, conventional reserves and in midstream that means pipelines and equipment – the more mature, proven and predictable, the better.
“The target risk profile for an MLP investor should be somewhere between a typical stock and a typical bond,” noted Burgher. “That’s where the asset class should fall, and a high cash payout brings that cash forward so you lower the duration of your investment.”
MLPs have grown 360 percent in a decade, (Figure 1) based on total performance. Upstream MLPs are yielding an average of 8.5 percent and midstream MLPs are yielding an average of 6.8 percent. By comparison, Moody’s Bond Index yield is averaging 3.8 percent and the Merrill Lynch U.S – B high yield fund is averaging 5.7. “MLPs stand tall in yield and you get more back more quickly because of the lower duration of the investment,” observed Burgher.
The Growth Strategy
All three speakers noted the strategy for growth for MLPs both in upstream and midstream is to acquire. For QR Energy, “The assets we have are not built to grow, they are not shale,” said Burgher. “We believe upstream MLPs should not be in the exploration business; rather we should be in conventional, low risk, low decline assets,” While QR Energy does spend maintenance capital to keep their production flat and cash flow flat, to grow they need to acquire assets just like the ones they have – conventional assets.
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