A Brief History of MLPs
Master limited partnerships (MLPs) were first formed in 1981 as publicly traded partnerships to raise capital from individual investors through the public markets. As the number of MLPs grew, the U.S. Internal Revenue Code (IRC) was changed by Congress to limit the size, scale and scope of publicly traded MLPs.
As part of a 1987 enactment, Congress specifically permitted an exemption for public MLPs to derive income from natural-resource businesses to promote the development of these resources and the associated infrastructure. For this reason, the majority of MLPs today generate income from the production, processing, transportation and storage of oil, natural gas, coal and refined products.
Initially, MLPs were generally pipeline companies that transported crude oil, refined products and natural gas. Over time, other qualified assets were placed in MLPs to benefit from the tax efficiency associated with the MLP structure. More recently, MLPs have been formed that derive income from the wholesale distribution of refined products to convenience stores. MLPs may also own real estate and collect rent, because real-estate rental income qualifies under the tax code.
In the next several years, it is likely that more assets involved in the wholesale distribution of refined products will end up in an MLP. However, note that the income from convenience-store retail operations, including the final transfer of fuel to consumer motor vehicles, is not qualified MLP income under the tax code.
—Mark Huhndorff, Scott Garfinkel and Roger Woodman of Raymond James
Just a decade ago, Valero Energy, then a modest regional refiner, stunned the retail world. The company paid $4 billion in stock and cash to acquire Ultramar Diamond Shamrock, suddenly making Valero the nation’s second largest refiner-marketer.
“We’re taking two of the best independent refining and marketing companies and really becoming the premier U.S. refining and marketing company,” said Bill Greehey, Valero’s chairman and CEO at the time, which was May 2001.
Over the next 10 years, San Antonio-based Valero would jump-start from local powerhouse to a national brand, extending its yellow and teal moniker across much of the country, most recently in the South. It also would embrace convenience retailing, transforming the tired Diamond Shamrock chain into an upstart motif and experimenting with new brands such as Road Runner and larger footprints topping 4,000 square feet.
So when Valero executives this summer announced plans to divest the company’s nearly 1,000-unit retail portfolio, some eyebrow lifting was certainly understandable.
More than 1,700 miles east, a similar story has been playing out: Pipeline company Energy Transfer Partners (ETP) last month closed on a $5.3-billion deal to acquire Philadelphia-based stalwart Sunoco Inc. In addition to the 7,900 miles of pipelines and terminal assets, ETP scooped up the network’s 4,900 gas stations. And, like Valero, ETP is expected to divest Sunoco’s retail portfolio.
Why the sudden retail liquidation? The answer can be found in a simple abbreviation: MLP, which stands for master limited partnership. Valero and ETP are among the wave of fuel marketers embracing the tax-friendly, publicly traded structure as a path toward greater prosperity, capital leverage and operational discipline.
A two-month CSP investigation found the following:
- Downstream flow: While earlier MLPs gravitated toward oil exploration and production (E&P), the structure has recently become popular among downstream players.
- Growing standing line: Over the past year, several prominent downstream companies have either formally filed plans or are actively considering launching an MLP. Among them are Valero, Susser Holdings, Alon USA, Delek, Lehigh Gas, Northern Tier and Marathon Petroleum. And the pipeline of prospective applicants is growing, according to multiple sources.
- Consolidation: The nation could see a major consolidation in the fuel marketing and convenience retailing sectors over the next two to three years, several analysts say. Many of the entities entering into the MLP structure are positioning themselves to retire a backload of debt and/or entertain a growth surge.
“What I see in MLPs,” says Mike Ross, senior vice president of C&G industry for Cadence Bank, “is they’re going to inject more capital into the convenience-gasoline space because you have cheaper costs to the capital. Those who don’t access the capital will be at a competitive disadvantage.”
A Good Tax Situation
MLPs are limited partnerships publicly traded on a securities exchange such as NYSE, NASDAQ and AmEx. MLP ownership interests are known as units as opposed to share of corporate stock; cash paid out to unit holders is known as distributions rather than dividends. In its purest form, an MLP combines the favorable tax treatment with the liquidity of publicly traded securities.
It is this favorable equation that spurred Susser Holdings Corp., a successful, multi-generational retailer with strong marketing origins, to form Susser Petroleum Partners (ticker symbol SUSP), and for which it launched an initial public offering (IPO) in September.
In essence, the Susser leadership team led by CEO and president Sam Susser Jr. is splitting its fuel marketing and c-store retailing arms into two entities, the former being an MLP, the latter the more conventional publicly traded C corporation. In September, 9.5 million common units representing 49.9% interest in Susser Petroleum went to market.
Citing federal restrictions, Susser executives Sam Susser and Steve DeSutter declined comment on the move or its strategic underpinnings. Indeed, executives with a half-dozen companies pursuing MLPs said they could not comment for this story due to SEC restrictions.
But several observers familiar not only with Susser’s move but also that of other industry companies pursuing similar structural changes say the MLP model provides Susser with greater access to capital, reduces corporate risk and allows leadership to leverage the advantages of the limited partnership structure and that of a traditional publicly traded company.
“One of the main factors of an MLP is generating consistent growth and cash flow year over year,” says Ross of Cadence Bank. “By having both the holdings company and the MLP, Susser can buy a diverse pool of assets and move the consistent revenue-generating assets to the MLP.
“The last thing you want to do,” he continues, “is roll into an MLP an acquisition that is going to have assets that drag down your revenue base.”
Susser Holdings, unlike its MLP cousin, can take the time to invest in slower-performing assets, infuse capital and commit the necessary funds to turn a turtle into a hare.
“Susser is really the first true convenience-store operator to realize the potential of their fuel assets,” says Michael Johns, managing director of Toronto-based BMO Capital Markets, citing that the company controls about 1.3 billion gallons annually. “On the distribution side, there is perceived stability in this kind of investment.
“MLP investors are looking for growth and a dividend yield.”
The advantages of MLPs are several, notably:
- Tax benefits: MLPs do not pay corporate taxes (a.k.a. double taxation) as long as the business is generating at least 90% of its income from qualifying income as defined by the tax code. (See “A Taxing Situation,” p. 70.)
- Control: Under the structure, MLPs give virtually all decision-making powers to the executive team. Unit holders are not vested with voting rights, so unlike C corporations, unit holders cannot trigger a power grab. In return, MLPs can offer attractive yields relative to alternative investments.
According to Philip Trinder, president of MLP Protocol, a Houston-based independent MLP analysis and investment firm, the assets/cash flows that moved Susser Holdings into Susser Petroleum went from being worthy roughly $245 million to more than $500 million overnight because of the tax incentives.
One of the leading institutions behind MLPs in the c-store and fuel marketing sectors is investment-banking and capital-raising specialists Raymond James. In addition to assisting Susser, the company has been working with other entities in the convenience and petroleum community eyeing the structure.
“This is a new universe of well-capitalized companies able to monetize their assets,” says Roger Woodman, managing director of investment banking group for Atlanta-based Raymond James.
Another benefit, says colleague Mark Huhndorff, managing director of investment banking for midstream and coal, is the large potential pool of investors. A growing number of institutional and retail investors are seeking ways to invest in income-producing securities that benefit from the growth of energy infrastructure-related assets.
Risk Factor
Nearly a dozen investment institutions and holding companies interviewed by CSP have embraced MLPs as a low-risk, highly accretive investment that promises companies greater capitalization and fluidity, and consistent dividends for its investors—a win-win in the otherwise high-risk financial markets.
But a small chorus of financial experts is warning of a canary in a coal mine. It’s not that MLPs don’t have a strong upside; they do. But, these dissenters argue, the investment vehicle is evolving, with new forms and players. And, as with any investment, there is risk. And their fear is that effusive optimism is drowning out inherent risks.
“The trend has clearly been pushing the IRS envelope in terms of what gets approved and what they say is qualifying income for an MLP,” says Hinds Howard, an Austin, Texas-based asset manager and investment banker for Guzman Investment Strategies who specializes in MLPs. “On the upstream, downstream, oil-field services—anything/everything is going into an MLP.”
While Howard acknowledges it creates an opportunity for specialists such as himself to sift through the MLPs for investors, “It also creates a risk of a lot of investors buying something based on an idealistic view of what an MLP is: These are all safe, high-yield pipeline assets. But here’s one that will give you 19% yield. Those things don’t match up in a world where you go to a bank and can’t get 0.5% yield.”
Trinder agrees that the evolution from MLPs based in stable, conservative upstream and midstream assets into new downstream entrants has introduced new questions.
“A pipeline is a really good type of asset to have in an MLP because people will deliver product into that pipeline over a long-term contract,” he says. “That long-line asset with large corporate customers is a much different risk profile than Susser.”
Trinder cites Susser’s foray into MLP as a risky investment. For one, it is brand new, and he views any new MLP IPO as inherently riskier for the first year of its publicly traded history because it has not yet proven it can maintain and grow its distributions.
Second, “It’s a little different: It’s wholesale fuel distribution and some rental income from actually having real estate for some locations, and that is just different, and different to me is always riskier.”
Trinder is careful to say he sees no fundamental flaws in Susser’s business operations and praises what he—and many others—say is a top-notch executive team. That said, he contends that SUSP’s IPO would have been attractive to him at a unit price of $17 to $18, maybe $20. But not $23, which is where it ultimately opened.
“Clearly,” he says, “the management team did a great job on the road show, and underwriters did a great job of getting them in front of potential investors for this IPO, and must have done a great job also on focusing on just the yield— ignoring the tax-deferred portion.”
Another fundamental concern of MLPs, Trinder says, is the business structure. Typically, a general partner (GP) has a 2% ownership stake in the partnership and can receive an incentive distribution through ownership of the MLP’s incentive distribution rights (IDR). In the case of SUSP, the general partner’s interest will be 0%, or “non-economic.”
“I would prefer to see that 2% equity in there down the road,” he says. “If you look at the history of larger MLPs, GPs have been putting 2% in over 20 years— that adds up to a lot of money.”
An official at Wells Fargo, who spoke on condition of anonymity, echoed the same concern. Though the official said he generally supports the expansion of MLPs into non-traditional sectors, notably the convenience and petroleum channels, he acknowledged what he considers a “conflict of interest with the general partner.”
Specifically, it is the same management team that controls both the MLP and the parent company. So, taking Susser as an example, in theory a conflict could arise about the proper price in a sale between assets moving to and from Susser Holdings and Susser Petroleum.
Huhndorff of Raymond James isn’t concerned. “I’ve seen this concern raised before, and the response is pretty simple,” he says. “If someone could provide a tangible example of a precedent where this issue has negatively impacted the MLP value, then it would be a more credible risk. I’m not aware of any.”
Generally speaking, Huhndorff says he understands the fear of conflict of interest, but IDR upsides and other benefits are “greatly mitigated by the GP’s ownership of common and subunits.”
“The GP is highly incentivized to not do anything (dilute cash flow per share, overpay for an acquisition, cut distributions, pay excessive management comp, etc.) that would negatively impact the value of the common units,” he says. MLPs should clearly define in the partnership agreement transfer of assets, he says, and most MLPs require third-party fairness opinions to confirm transfer valuations.
Howard of Guzman Investment Strategies says he sees potential in the wholesale-fuel-based MLPs.
“The Susser and Lehigh cases—I think those can work in an MLP just fine and can grow over time by adding other sources of distribution, or eventually buying other companies,” he says. He cites the example of Global Partners LP, an MLP formed in 2002 based on terminal assets and a wholesale fuel distribution business, and the acquirer of large wholesale distributor and c-store operator Alliance Energy earlier this year.
“That’s a traditional MLP structure, in terms of having a minimum quarterly distribution,” says Howard. “This sector is so much about management and being conservative with all of these levers you can pull to make your distributions do whatever you want. So management is supremely important. Almost any asset can be an MLP and be successful if they have good management teams.”
Variable Rewards and Risks
Because of the seasonality and cyclical nature of certain energy businesses, the variable-distribution MLP has become a popular structure to assume for operators who want an MLP’s tax advantages but are not able to pay out a minimum quarterly distribution. Instead, the MLP distributes all of its available cash generated in a particular quarter.
While this format had previously attracted nitrogen-fertilizer manufacturers, the new players in this format are refiners, who play in the higher reward/higher risk world of commodities and volatile margins.
In July, Northern Tier Energy LP (NTI) formed as a variable-rate MLP whose assets are a St. Paul Park, Minn., refinery and a 17% pipeline interest. Its parent company, Northern Tier Energy, was formed by Acon Investments and TPG Capital after they acquired Marathon Oil’s downstream assets—including 166 SuperAmerica locations—in 2010.
(SuperAmerica now exists in a C corporation subsidiary along with SuperMom’s Bakery, a baked-goods operation that supplies the c-store chain. After-tax income from the retail operations is distributed to the MLP.)
“If you look at the refining industry, there has been a lot of shareholder activism,” says Maria Testani, director of planning and strategy for Northern Tier Energy LLC, Ridgefield, Conn., citing Marathon Petroleum’s change of heart regarding forming an MLP with its midstream assets. “Investors have demanded they get their money back, and the refiners save cash for a rainy day. We said, ‘Why don’t we distribute the cash back?’ We’ll make a promise to distribute it back every quarter.
“If we need the cash for growth projects, we’ll come to the market and ask for it. If we’ve performed well, [the] market will give it to us. If we haven’t, then the market won’t.”
This latest evolution of MLPs makes some analysts nervous, for various reasons.
“If you’re a refiner, you’re exposed to the crack spread, which, when it’s good, it’s really good,” says Trinder. “When it’s bad, you lose money with every barrel of input you put into the refinery. You lose cash flow. That’s really bad if you have to distribute all of your cash flow for the quarter.”
“The refinery MLPs are scary to invest in,” says Howard. “They will have a high yield and investors will jump on them; we’ve just never seen the down cycle for these variable-distribution MLPs.”
Testani acknowledges that variable-distribution MLPs are not for every investor. “If you’re looking for a minimum quarterly distribution, stable income like a pipeline company, it will undoubtedly be more risky,” she says. “That’s why these companies demand a higher yield. We traded at a much higher yield than a traditional distribution pipeline company within an MLP structure.
“But if you look at it compared to a refining C corporation,” she continues, “it’s definitely less risky because we’re distributing cash every quarter. What we make we’ll go ahead and pay out, and you’ll get that cash. If we need money back, we will come to market and ask for it.”
Although it was hoping to price at $19 to $21 per unit, Northern Tier Energy LP’s IPO of 16.25 million units priced at $14 a share. Investors’ initial trepidation “surprised us,” Testani admits, but she believes two factors were at play. First, it was four days into a down market. “Investors felt they weren’t willing to pay a certain price given the market conditions of that time,” she says, “and they knew they could demand a lower price.”
Secondly, another variable MLP that debuted about a week prior was trading at only half its price. “They were unsure of the variable MLPs at the time,” she says. “I think now they’re getting more comfortable with it; when we start distributing our cash, they’ll get more comfortable.” In fact, as of press time, NTI was trading at $21.20.
Adding to investors’ confidence is the fact that NTI beat its own projections on adjusted EBITDA, projecting $220 million to $240 million and ultimately reporting $246.5 million in its second-quarter 2012 earnings report. “Investors are becoming more comfortable with our story and the fact that we’re exposed to crack spreads in the upper Midwest, and sourcing crude from the Bakken [Oil Formation] and Western Canadian oil sands, so they’re getting more comfortable with the fact that we’re a pure-play, mid-continent refiner who will distribute cash on a quarterly basis,” says Testani.
“When I’m looking at an MLP, I like to see a story about how they will grow,” says Howard, who cites Tesoro Logistics, which started as an MLP with a very small pool of assets and then grew them by investing in production of oil at the Bakken Oil Formation and aiming to fix bottlenecks. “That’s a great story. But with the variable distribution MLP, you’re buying a single asset—let’s say it’s a refinery. It might have great cost advantages; you can buy cheaper crude and have higher margins than other refineries. That’s OK, but beyond that, there’s no story, no growth.
“That’s what worries me about these things: There’s never been a variable-distribution MLP that’s issued equity after its IPO. It’s a prerequisite for growth, to enable them to find new equity capital to fund future growth.”
Because of the small size of the investment class, there is concern that the failure or poor performance of one MLP will reflect poorly on all and scare away investors. In its online edition, the Wall Street Journal warned that MLPs may be heading toward a bubble, citing an announcement from Alon USA that it plans to put its Big Spring, Texas, refinery into a variable-distribution MLP.
“Such expansion of what goes into MLPs comes amid other clues that the sector is overheating,” the Journal article says, citing a report from CreditSights analyst Andy DeVries that a jump in acquisition multiples, several new MLP funds and the “strange resilience this year of several MLP stocks exposed to slumping ethane prices” are signs of a pending collapse.
There is also concern that it will prod the government into cracking down again on which types of assets can be included in the business structure—similar to what happened in the 1980s, when even the Boston Celtics formed an MLP to enjoy its tax savings.
“I worry about regulatory risk,” says Howard. “If the whole S&P 500 energy portion goes into an MLP, then we have a real problem with the MLP structure going away entirely.”
Johns of BMO Capital Markets is not as dire, though he does raise some yellow flags: “We’ve had all sorts of bubbles— the tech bubble, the real-estate bubble. Humans tend to get carried away, and that’s our nature.
“The early stages in an investment opportunity is harder to determine winners and losers,” he says. “But investors will buy and sell, and with MLPs you only need one winner to reap your reward.”
An MLP Rundown
The number of midstream and downstream MLPs has grown over the past year, with assets ranging from terminals and pipeline interests to a single refinery and a wholesale distribution network. Following is a rundown of the more notable offerings, including those already launched and those to come.
IPO Filed • Susser Petroleum Partners (SUSP)
Upside: Strong leadership, consistent performer, great growth capacity in Texas market, option over next 3 years to purchase up to 75 Stripes sites from its sponsor, which the MLP will lease back to its general partner.
Downside: High opening price of $23/unit, first time the company will be committing to dividends.
• Lehigh Gas Partners (LGP)
Upside: Solid distribution base of gasoline and diesel to roughly 570 retail sites, of which half are owned or leased by prospective MLP sponsor.
Downside: Lost $3 million in 2010; it rebounded with a $9.6 million profit in 2011. Last month’s IPO of more than $105 million will repay debt and reimburse its general partner.
• Northern Tier (NTI)
Upside: Owns a refinery in Minnesota and boasts a strong retail network of more than 160 company-run and 67 franchised outlets.
Downside: Refining-based companies face significant exposure to commodity prices and do not set a minimum quarterly distribution. IPO to Come • MPLX LP (MPLX)
Marathon Petroleum Corp. was spun off in 2011 from Marathon Oil. In July, after pressure from an activist investor, the refiner-marketer and pipeline operator—which also includes the Speedway c-store chain—filed a registration statement in anticipation of the formation of an MLP with an initial asset of a 51% interest in pipeline assets and a 100% interest in a butane cavern.
Upside: Classic midstream MLP, strong network of pipeline and terminal assets, reliable revenue streams.
Downside: MPC’s spinoff driven by parent company to drive greater E&P and maximize shareholder value; investors would absorb company’s pipeline tax burdens.
• Alon USA Partners
Upside: Spinoff of independent refiner Alon USA Energy, Alon USA Partners operates a refinery in Big Spring, Texas, that boasts 70,000-barrel capacity and flexibility to produce sour crude oils; can exploit differentials between West Texas Intermediate (WTI) crude oil and Brent crude oil; solid stable of retail outlets.
Downside: Company faces significant exposure to volatile commodity swings and doesn’t set a minimum quarterly distribution.
• Valero Energy
Upside: Robust refiner with 16 refineries and combined throughput of 3 million barrels/day; expecting infusion of $3.5 billion in reported planned divestiture of nearly 1,000 c-stores and gas stations in the U.S. and 775 units in Canada.
Downside: Highly vulnerable to margin volatility in commodity markets.
An MLP Glossary
Master limited partnerships (MLPs): Limited partnership investment vehicles consisting of units (rather than shares) that are traded on public exchanges. MLPs consist of a general partner and limited partners. Also known as “publicly traded partnerships.”
General partner (GP): Manages day-to-day operations of the partnership. Typically has a 2% ownership stake in the partnership and is eligible to receive an incentive distribution through the ownership of the MLP’s incentive distribution rights.
Limited partners: Provide capital, have no role in the MLP’s operations or management, and receive cash distributions.
Distribution: In a typical partnership agreement, the MLP is required to distribute all of its “available cash.” MLPs typically distribute all available cash flow to unit holders in the form of distributions.
Distributable cash flow (DCF): Cash flow available to be paid to common unit holders after payments to the GP.
Minimum quarterly distribution (MQD): The minimum distribution the partnership plans to pay to its common and subordinated unit holders upon initial public offering.
Distribution coverage ratio: The “cushion” a partnership has in paying its cash distribution. The higher the ratio, the greater the safety of the distribution.
Cash or adjusted yield: An MLP’s current yield adjusted for its GP’s share of cash flow. For example, if the GP is receiving 10% of an MLP’s total distributions and the partnership’s units trade at a 7% yield, the cash yield would be 7.8%.
Current yield: Current declared quarterly distribution annualized divided by current stock price.
Forward yield: An MLP’s estimated next four quarterly distributions divided by an MLP’s current unit price.
Incentive distribution rights (IDRs): Allow the holder (typically the GP) to receive an increasing percentage of quarterly distributions after the MQD and target distribution thresholds have been achieved.
Tax deferral rate: Percentage of the cash distribution to the unit holder that is tax-deferred until the security is sold. The tax deferral rate on distributions ranges from 40% to 90%.
A Taxing Situation
One of the core engines for MLP growth is its pass-through tax status. It’s a benefit designed to support growth of the country’s energy infrastructure.
“The energy-infrastructure business in particular is very capital-intensive; you have to get a lot of capital up front to build a pipeline or buy an ongoing system,” says Mary S. Lyman, executive director of the National Association of Publicly Traded Partnerships, Arlington, Va., a trade association that represents MLPs. “It’s also fairly low return. Particularly if you own a regulated pipeline, there’s only a certain amount you’re going to be able to give back to investors.
“The MLP structure, by taking the corporate tax out of the equation, lowers the cost of capital so that the company can make investments and still provide investors with an attractive rate of return that they will want in an investment.”
That is why it was particularly alarming to the MLP universe when energy MLPs were added to an annual list of tax expenditures circulated by a joint House-Senate Ways & Means committee, which also specifies how much potential revenue is lost due to these expenditures.
According to Lyman, the revenue lost due to the pass-through tax structure of MLPs is “pretty small comparatively,” or about $300 million a year.
“Since we’re now on the list of tax expenditures, that makes us more vulnerable when people say, ‘Let’s get rid of tax expenditures so we can lower the corporate rate,’ ” says Lyman. “That’s one reason we feel vulnerable with tax reform—although the fact that there’s not a lot of revenue in taking our tax benefit away gives us some comfort.”
A perhaps greater threat is that whenever there is a wholesale reform of the tax code, discussion always arise on how business entities should be taxed. “One question is: Should more entities be paying corporate tax?” she says. “Do we have the correct line between entities that pay corporate tax and those that can be pass-through and pass it on to investors like MLPs do? There are some people who say entities that are very large and traded should pay the corporate tax.”
In fact, in a research report by investment firm Wells Fargo, analysts said that if President Obama is re-elected, it would be “on the margin, a net negative for the MLP sector.” The report says the president’s Framework for Business Tax Reform calls out that “large companies are increasingly avoiding corporate tax liability by organizing themselves as pass-through businesses.”
Lyman says the association is “pretty optimistic but cautious” that MLPs will not lose their tax benefit, and her group has been actively meeting with Ways & Means finance committee members to educate them about MLPs. Should they lose the status, it will put the brakes on the growth of the MLPs and the MLP structure.
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