May 2016 - SL-Advisors

The Limited Rights of Some MLP Investors

May 29, 2016/1 Comment/in Midstream Energy Infrastructure/by Simon Lack

Examining the Risk Factors in a company’s 10-K is not everybody’s idea of light entertainment, but as you’ll see below it can provide useful insight about how management may treat certain of its stakeholders.

Many Master Limited Partnerships share a legal structure that is similar to hedge funds and private equity funds, in that the investors put their money in the fund whereas the manager gains most of his wealth from controlling the General Partner (GP). MLP investors don’t think of themselves as hedge fund investors, and to be sure the 9% ten year annual return on the Alerian Index is far better (for example, the HFRI Fund-Weighted Composite Index has only managed 3.3%), including as it does both the 2008 Financial Crisis and the 2015 MLP Crash.

But from the perspective of governance rights, MLP investors do look a lot like the passive Limited Partners (LPs) in these other asset classes. They surrender many of the rights taken for granted by equity investors in public corporations. Here are some examples lifted directly from the relevant 10-K. It’s one of the reasons why MLP managements typically invest in the MLP GP rather than the MLP itself, and it’s why we do too.

Williams Partners (WPZ)

“Our general partner has limited duties to us and it and its affiliates, including Williams and Access Midstream Ventures, and may have conflicts of interest with us and may favor their own interests to the detriment of us and our common unitholders.”

“…Williams’ directors and officers have a fiduciary duty to make decisions in the best interests of the owners of Williams, which may be contrary to our best interests and the interests of our unitholders.”

“Except in limited circumstances, our general partner has the power and authority to conduct our business without unitholder approval.”

“Our general partner may cause us to borrow funds in order to permit the payment of cash distributions, even if the purpose or effect of the borrowing is to make incentive distributions.”

“Our partnership agreement limits our general partner’s duties to unitholders and restricts the remedies available to such unitholders for actions taken by our general partner that might otherwise constitute breaches of fiduciary duty.”

“Holders of our common units have limited voting rights and are not entitled to elect our general partner or its directors, which could reduce the price at which the common units will trade.”

“Even if public unitholders are dissatisfied, they have little ability to remove our general partner without the consent of Williams.”

“Our partnership agreement restricts the voting rights of unitholders owning 20 percent or more of our common units.”

Explanation: The management of WPZ has no fiduciary obligation to WPZ LPs, can cause WPZ to borrow money in order to pay management, and can’t be fired.

Plains All American (PAA)

“Unitholders may not be able to remove our general partner even if they wish to do so.”

“…generally, if a person acquires 20% or more of any class of units then outstanding other than from our general partner or its affiliates, the units owned by such person cannot be voted on any matter.”

Explanation: You can’t fire the management of PAA either.

Energy Transfer Partners (ETP)

“Unitholders have limited voting rights and are not entitled to elect the General Partner or its directors. In addition, even if Unitholders are dissatisfied, they cannot easily remove the General Partner.”

“Unlike the holders of common stock in a corporation, Unitholders have only limited voting rights on matters affecting our business, and therefore limited ability to influence management’s decisions regarding our business.”

“Furthermore, if the Unitholders are dissatisfied with the performance of our General Partner, they may be unable to remove our General Partner. The General Partner generally may not be removed except upon the vote of the holders of 66 2/3% of the outstanding units voting together as a single class, including units owned by the General Partner and its affiliates. As of December 31, 2015, ETE and its affiliates held approximately 0.5% of our outstanding Common Units and our officers and directors held less than 1% of our outstanding Common Units. Furthermore, Unitholders’ voting rights are further restricted by the partnership agreement provision providing that any units held by a person that owns 20% or more of any class of units then outstanding, other than the General Partner and its affiliates, cannot be voted on any matter.”

Explanation: You can’t put the people you’d like in senior management positions, and you can’t fire us.

These three names were selected simply because they’re well-known. Such provisions are not uncommon, and they do at least provide plain disclosure. If you’re not happy with your private equity manager you have very limited recourse; you can’t easily fire him and you have to wait for liquidity events to get your money back. At least if you dislike the management of your MLP you can sell your position.

Like the management teams that run these three MLPs, we are invested in the GPs of these as well as others. We are generally supportive of the people that run them, although we withhold judgment for now on one (see Is Energy Transfer Quietly Fleecing its Investors?). Even if you don’t expect management to fully avail themselves of the powers they’ve granted themselves, it’s good to know what those powers really are.

We are invested in Williams Companies (WMB), Plains GP Holdings (PAGP) and Energy Transfer Equity (ETE).

Please note publication of our June newsletter will be delayed by a few days as I’ll be attending the 2016 MLP Investor Conference in Orlando.

Tallgrass Energy is the Right Kind of MLP

May 22, 2016/2 Comments/in Midstream Energy Infrastructure/by Simon Lack

Tallgrass Energy is the Right Kind of MLP

If Linn Energy was the wrong kind of MLP (see last week’s blog), Tallgrass Energy is the right kind. They have an MLP, Tallgrass Energy Partners (TEP) and a publicly traded General Partner, Tallgrass Energy, GP (TEGP). It’ll come as little surprise to regular readers that we are invested in TEGP alongside CEO David Dehaemers because, as Willie Sutton knew, that’s where the money is. Dehaemers runs a great conference call, combining plain talk with a little levity, such as promising to finish a recent call in time for analysts to get their opinions from Jim Cramer’s Mad Money.

Last week Tallgrass held a webcast to discuss their Rockies Express natural gas pipeline (“REX”). The slide below is from that webcast. REX runs from Wyoming to West Virginia, from “Shale to Shining Shale” if nonetheless short of being completely transcontinental. TEP recently acquired a 25% interest in REX from privately-held Tallgrass Development. It’s a great asset, with the ability to connect to many population centers across the northern U.S. states it traverses. However, the recent abundance of natural gas in the north east U.S. out of the Marcellus and Utica shales has hindered the traditional west-east flow of gas from the Rockies, and had especially affected demand in the Zone 3 eastern section of the pipeline from Illinois.

The webcast provided a positive update on the contracting of capacity on REX. Last year Tallgrass implemented a pipeline reversal on Zone 3 to allow two-way flow on that part of the network. They anticipate extending this to the rest of REX in the years ahead. The increased capacity and flexibility create substantial optionality to meet future demand, and have brought improved visibility to the EBITDA REX is expected to generate. Consequently, TEP is guiding to 20% distribution growth. More interestingly for Dehaemers and other investors in the GP, TEGP is expecting to grow its cash distributions at twice the rate of TEP. Since TEGP’s entitled to half the additional Distributable Cash Flow generated by TEP, growth at TEP is magnified for TEGP, whose economic relationship with TEP resembles that of hedge fund manager to hedge fund. Tallgrass is midstream infrastructure operating a toll-type business model. Tallgrass is the right kind of MLP.

Is Irrational Exuberance Returning to MLPs?

Such a question seems premature by at least several years, and yet is prompted by the issuance last week by Credit Suisse of a 2X levered note linked to the Alerian Index. Its buyers must desire to make money in a hurry, a quest which invariably results in the opposite outcome.

At the risk of being a party pooper, below is a simulation of the performance AMJL would have delivered to its thrill seeking holder had he invested at the beginning of 2014. Here I’m unapologetically sexist; only a man would buy AMJL (see June 2014 newsletter How to Invest Like a Woman). The highs would have been high, but the lows would have been, well, low. AMJL’s creator is unburdened by the need to design products for which a long term holding period is preferable. Lots of products are sold that nonetheless are bad for you, including tobacco products, cocaine and non-traded REITs. Add enough warning labels and (with some exceptions) you can meet consumer demand. However, you are unlikely to find a CFA charterholder near AMJL because the CFA’s Integrity List includes “Place the client’s interests before your own”, a requirement inconveniently at odds with distributing securities whose holders, “…intend to actively monitor and manage their investments” (as noted in the 14 page section on Risk Factors).

If a non-financial company issued a security like AMJL, potential buyers would reasonably assume that the issuer’s objective was simply to raise money cheaply. Credit Suisse has the same objective, and yet as their brokers promote it some confused investors will assume Credit Suisse has their best interests at heart and will be persuaded that it is a good investment.

There are worse securities than AMJL to be sure. It is not in the league of non-traded REITs. But it is one whose proponents have fingers crossed while promoting, and will hopefully inflict less damage on clients than two similar ETN’s issued by UBS which collapsed far enough to trigger mandatory redemptions as recently as January (see the second section of this blog post from January). Standards in Finance are not yet unreasonably high.

We are invested in TEGP.

Why Linn Energy Was the Wrong Kind of MLP

May 15, 2016/0 Comments/in Midstream Energy Infrastructure/by Simon Lack

Last week Linn Energy (LINE) filed for bankruptcy. Over the past year or so we’ve come across quite a few people whose exposure to Master Limited Partnerships (MLPs) regrettably included LINE. They were attracted by the yield, whose steady rise until 2013 belied the unpredictability of their cashflows. LINE was engaged in Exploration and Production (E&P), and so they were always going to be a bet on the price of crude oil. The company bought acreage when crude was at $100, so it was always going to be challenging for them once it collapsed. The stability of their distribution didn’t reflect economic reality.

Back in 2013 there were also questions raised in Barrons about LINE’s accounting treatment for options that were used to hedge their output. The SEC subsequently investigated. We typically avoid E&P companies anyway, but whether the criticisms of non-GAAP treatment were justified or not, LINE wasn’t making it easy for investors to analyze their financial statements. Their website, which now includes information on their restructuring, says, “LINN Energy’s mission is to acquire, develop and maximize cash flow from a growing portfolio of long-life oil and natural gas assets.”

MLP investors were originally seeking stable income, although the 2015 rout has in our opinion created the most deeply undervalued sector in the equity markets. A cute bit of Math is that a 2% drop in yields (through price appreciation) will generate no less than a 30% total return[1] over one year for any equity sector (or individual equity security). Only MLPs offer this kind of potential.

Although E&P companies can and do structure themselves as MLPs, their returns are ill-suited to the traditional MLP investor base. During 2014-15 every single E&P MLP in the Alerian Index cut or eliminated their distribution. This drove the drop in distributions on the index and fueled fears of further distribution cuts across the rest of the sector. The rules under which the index is constructed require that a distribution cut causes the offending name to be ejected from the index, so although there are still E&P MLPs, the leading index has gradually been relieved of their burden.

Because MLPs normally pay out most of their cashflow, an E&P business is particularly ill-suited to this form of organization. If you own an asset (crude oil in the ground) and you distribute the net proceeds from its extraction to your equity investors, your underlying asset base is depleting. You may confuse the issue by investing in new crude oil acreage with new capital raised, but eventually the music will stop. The collapse in crude kicked the CD player off the chair sooner than expected for some, but it’s not a sustainable model.

This contrasts with owning an asset that’s appreciating, such as an installed pipeline whose replication becomes ever more expensive as development goes on around and above it. Many pipelines would cost multiples of their original cost to build today with population centers having grown up, easements harder to obtain and regulatory approvals ever more demanding. This is a business built on sending back the recurring cashflows earned from renting out its capacity.

Both business models, the depleting asset and the recurring cashflow from rented capacity, can legally exist as MLPs. But they’re not to be confused with one another. The market dislocation of last year is cleansing the sector of weaker models, leading to a quality upgrade. LINE was the wrong kind of MLP. Their distributions were the result of using up their reserves in the ground. In effect, they were returning capital to investors rather than profits, although the collapse in crude oil hastened their demise. While it was unpleasant for investors in LINE, they’ll better appreciate the more secure foundation of their other MLP holdings.

[1] For example: a security priced at $6 pays a $0.60 dividend, yielding 10%. Over the next year its price rises to $7.50, causing its yield to drop to 8%. The $1.50 price gain plus the $0.60 distribution equals a $2.10 return on the original $6 investment, or 35%.

Is Energy Transfer Quietly Fleecing its Investors?

May 10, 2016/3 Comments/in Midstream Energy Infrastructure/by Simon Lack

The Energy Transfer-Williams deal has been a rich source of material for this blog, as well as an important driver of MLP performance. Energy Transfer Equity (ETE) was creative in its pursuit of Williams Companies (WMB); as buyer’s remorse quickly set in they were equally creative in pulling all the levers at their disposal to force a renegotiation. As part of this effort to alter the terms of the deal, ETE has taken some steps that transfer wealth directly to ETE CEO Kelcy Warren and other insiders, at the expense of the rest of the ETE unitholders. Whether this was done to drag WMB back to the negotiating table will be clear if the steps are undone once the transaction is deemed to not close, or renegotiated. In other words, ETE management has engaged in blatant preferential self-dealing; we’re watching to see how it plays out. The SEC filing describing the offending security is here.

The original merger agreement consisted of WMB shareholders receiving 1.5274 shares of Energy Transfer Corp (ETC) per WMB share and $8.10 in cash. ETC shares were designed to be worth the same as ETE units, and were created so that WMB investors wouldn’t have to deal with the K-1s issued by ETE. On September 28, 2015 ETE valued the transaction at $43.50 per WMB share, based on where ETE had been trading just prior to the announcement.

The $8.10 per share in cash promised added up to $6.08BN, and ETE’s intention to finance this with debt steadily weighed on the stock price. As ETE fell, the value of the deal to WMB fell, and ETE management quickly concluded that they needed to renegotiate the terms. Whatever overtures were made in this regard evidently did not draw the desired response, so ETE dropped the gloves.

Suppose for a moment you committed to reinvest a portion of your future dividends back into the company you run; this show of confidence would be welcomed, and reinvested dividends typically buy shares at the current price when the dividends are received. The Duncan family has done this with Enterprise Products Partners (EPD), of which they own 34%. Or, suppose you felt your company’s stock was ludicrously cheap and worth buying; you’d get as many shares at today’s price as you were willing to pay for, today. NuStar’s chairman Bill Greehey continuously does so on the open market with MLP NuStar Energy LP (NS) and its General Partner NuStar GP Holdings (NSH).

It seems pretty simple: if you pay today you get today’s price, and if you pay in the future you get the future price. But on March 8, Kelcy Warren and a few insiders created for themselves a special security that allows them to be both senior in the capital structure to the common unitholders and to buy units of ETE in the future but at a price that’s roughly half of where it trades today.

To show how riskless this transaction is for them, the $6.56 price of ETE at which they can buy priced ETE at a yield of 17.37% (based on its 4Q15 $0.285 quarterly distribution). This is where ETE was trading in early March. Clearly, the market held serious doubts as to whether the distribution was secure. The convertible units ETE has issued require ETE insiders representing 31.5% of the company to invest future distributions in excess of $0.11 per share back into newly issued ETE units. There’s a wonderful circularity to this – if the 17.37% yield on ETE from March turns out to be prescient and future distributions to common unitholders are eliminated, the insiders don’t have to stump up cash to buy the extra ETE units. But if the 17.37% yield turns out to be a grossly pessimistic forecast, and distributions continue to be paid, the insiders will get to use the distributions paid to buy units at a price whose existence the subsequent payment of distributions has rendered ludicrously low.

Put another way, ETE has raised capital at the exorbitant rate of 17.37%, although that capital will only be available to them if they’re able to continue paying distributions, which would suggest they didn’t need it in the first place. If they are unable to keep paying, the capital won’t be there.

It’s a form of heads I win, tails you lose. Most investors in a stock that had lost 90% of its value (as was the case with ETE at that stage) would jump at such an opportunity.

But it gets better. The insiders who own this convertible security now have seniority, in that the $0.11 per unit “Preferred Distribution Amount” is paid to them “prior to any distribution on the Partnership’s common units”. So the new security is really a Convertible Preferred, not simply a Convertible which is what they’ve called it in the SEC filing. Kelcy and his friends have moved themselves up in the capital structure.

There’s even more though. The insiders get to invest their future distributions back into ETE at the knock-down price of $6.56, but even if those distributions are not paid they still get the additional units of ETE. The irony is that ETE only sunk to such a low price because of management’s poorly conceived merger proposal. They screwed up so badly they felt entitled to grant themselves additional units at the bargain basement price their actions had caused. To show just how scandalous this new security is, ETE could eliminate their distribution and yet Kelcy and his friends would still receive their $0.11 per unit Preferred Return in cash AND be entitled to 79 million new ETE units without having to pay for them. At today’s price this represents a transfer of wealth from the non-insiders to Kelcy and friends of over $1.3BN.

This opportunity was only offered to certain accredited investors. Kelcy Warren owns approximately 18% of the partnership. The recipients of this gift from the rest of ETE are essentially the senior management, notably Kelcy himself but also including John McReynolds (President of ETE’s General Partner), Matthew Ramsey (President of Energy Transfer Partners), Marshall McCrea III (Group Chief Operating Officer) and Ray Davis (retired, co-founder). It’d be interesting to hear any of these gentlemen justify their participation, and to reconcile it with their fiduciary obligation to other ETE unitholders.

You’d think this kind of egregious self-dealing would be illegal. ETE claims that they wanted to offer this opportunity to all the ETE unitholders but because of the merger agreement with WMB they were required to obtain WMB’s approval. Under the deal, each WMB share is worth 1.5274 shares of ETC (in effect, ETE), but because the convertible issue took place before closing the deal it had the effect of reducing ETE’s purchase price for WMB. The converts will increase the number of ETE units outstanding, thus diluting their value. It alters the terms of the transaction. WMB couldn’t possibly agree to this, and so they naturally withheld their approval. ETE went ahead with it anyway, claiming that WMB’s failure to approve the converts limited the offering to the select group of insiders noted above. But since WMB couldn’t reasonably be expected to approve what was in effect an 11% dilution in the value of the equity portion of the deal, their response wasn’t surprising.

We originally thought the converts were issued as part of an aggressive negotiation strategy intended to persuade WMB shareholders to vote against the deal or get WMB’s board to agree to altered deal terms. The $6BN cash payment has hung over both stock prices for months. And the SEC filing noted that the proceeds from the foregone distribution payments would be used to pay down debt incurred in conjunction with the WMB transaction. So you might reasonably assume that if the transaction fails to close, the converts won’t be needed and Kelcy Warren will remember his fiduciary obligation. He can cancel the issue.

However, ETE’s most recent earnings call made clear that these convertible units would remain regardless of the merger closing. The sell-side analysts as usual avoided any tough questions. But the biggest question, which wasn’t asked, was how Kelcy could justify such abuse of his fellow public ETE unitholders.

Equity investors in ETE are referred to as Limited Partners. But following the issuance of this new security they are no longer partners at all, but rather victims of self-dealing by management, owners of an inferior class of securities created by the insiders moving themselves up to a superior position with superior economics for no consideration.

It’s not too late for Kelcy to clarify this issue. On the list of CEOs who have performed as honorable stewards of investor capital, you will not find Kelcy Warren. He may be a billionaire, but he is no Warren Buffett. We hope ETE will revisit this abuse of their unitholders and restore their reputation for honest dealing by canceling the issue. Otherwise, why would anybody ever do business with them again?

We are invested in ETE, EPD, NSH and WMB

Quarterly Report Cards Provide Comfort

May 8, 2016/0 Comments/in Midstream Energy Infrastructure/by Simon Lack

Quarterly Earnings

We’re approaching the time of year when report cards proclaiming, “what a joy your child is to have in my class” are dispatched with varying degrees of sincerity. Quarterly MLP earnings are the report cards of the industry, and a time when investors can similarly consider whether they are happy to have included PCD (Promised Cashflows Delivered, LP*) in their portfolios.

A couple of years ago Master Limited Partnerships (MLPs) used to be a reliably boring sector. The influx of new money from ETF and mutual fund investors quickly turned and fled when oil started declining (see The 2015 MLP Crash; Why and What’s Next) which caused MLPs to be exciting in a decidedly distasteful way.

However, operating results for midstream infrastructure businesses weren’t remotely as volatile as their stock prices, which increasingly supports our theory of last year’s collapse; it was a funds flow issue caused by recent investors following (and thereby accentuating) near term momentum. Most firms have released their quarterly operating results, and they were generally decent with some mild positive surprises. MLPs rarely release figures that are substantially off expectations.

TransCanada (TRP) reaffirmed 8-10% growth in its current C$2.26 dividend (yielding 4.4%). Targa Resources (TRGP) experienced some modest softening of margins in their natural gas Gathering and Processing (G&P) segment although volumes were overall as expected. Western Gas (WES) reported EBITDA 15% ahead of expectations due to sharply higher production by Anadarko (APC), their sponsor. This allowed the GP of WES, Western Gas Equity Partners (WGP), to grow its distribution 24% YoY, twice the rate of WES. It’s why the people who run MLPs don’t invest in MLPs, but instead put their money in the GPs that run them. Hedge fund managers make their money from payments they receive from the hedge funds they manage. So it is with MLP managers. As the chart shows, if you add up where MLP insiders invest their own money they prefer GPs by a factor of 22X.

EnLink Midstream Partners (ENLK) was slightly ahead of expectations and provides 1.09X distribution coverage. Its sponsor and biggest customer Devon Energy (DVN) raised its production guidance by 3% having previously announced moves to shore up its balance sheet (asset sales, secondary equity offering and sharply reduced 2016 capex). Credit enhancement moves by DVN are good for its MLP. ENLK’s GP, EnLink Midstream (ENLC) yields 7.3%.

Spectra Energy Partners (SEP) reported EBITDA that was 7% below expectations as mild winter weather reduced natural gas volumes. They are pressing on with Access Northeast which will enhance natural gas distribution and storage in New England if it is implemented. Kinder Morgan (KMI) recently cancelled their North East Direct project due to insufficient demand, so it’ll be interesting to see how Access plays out. SEP increased its distribution 8% YoY. Their GP Spectra Energy Corp (SE) yields 5.3%.

Energy Transfer-Williams

Energy Transfer Equity (ETE) CEO Kelcy Warren has tried everything to extract himself from his ill-advised pursuit of Williams Companies (WMB). His former CFO lobbied WMB shareholders to reject the deal; with dubious legality and no fiduciary compunction ETE issued preferential securities to management, diluting the deal’s value to WMB; they also slashed the anticipated synergies from the original $2BN figure.

Risk arb traders are not a group that normally draws much sympathy. They buy stock in companies that are being acquired and hedge the position by shorting the acquirer. They bet on deals closing as anticipated, which they usually do. Frequent modest profits are occasionally punctuated by expensive surprises. The chart below shows the price of WMB compared with the actual price implied by the terms of the ETE deal. The smaller the spread (or discount to deal terms), the more likely it is to close. The bigger the spread, the less fun risk arb traders are having. You might also think of it as representing the fluctuating stress imposed on involved traders as the odds of the deal closing oscillated. Even Bobby Axelrod (from Billions) would have been challenged to make money. It’s a curious set of circumstances when the suitor experiences such rapid regret (see Williams Stands Alone at the Altar) and that made it harder for some to assess likely outcomes.

Kelcy Warren recently said of the deal, “We can’t close. We don’t have a transaction that can close. So I want to be very clear, we can’t close this transaction.” Since the absence of an affirmative tax opinion is the basis for this conclusion, we can assume that such insight was arrived at only belatedly (after the other forms of avoidance described above had been used). They may still close on altered terms, although since the WMB board was previously divided on the topic it’s hard to imagine them coming together on less favorable terms given recent history. ETE’s tax counsel has certainly earned their fee.

We are invested in ENLC, ETE, KMI, SE, TRP, WGP and WMB.

*PCD is not a real company

Archive for month: May, 2016