The (Kinda, Sorta) End of an Era for MLPs

(Bloomberg Opinion) -- This year has felt like the end of an era for master limited partnerships.

This week really brought it home with news that Energy Transfer Equity LP, the parent of Kelcy Warren's pipeline empire, was buying out Energy Transfer Partners LP, or ETP, for $27.5 billion. Energy Transfer was one of the last big hold-outs of the old MLP model. Its primary asset, pipeline-operator ETP, was suffering from a combination of high leverage and skewed incentives funneling cash upstream to the general partner (where Warren holds a 17 percent stake).

ETP's distribution yield averaged about 12 percent over the past year; throw in those incentive payments and its cost of equity was more like 19 percent. That rather undermines the whole point of an MLP, which is to raise capital on the cheap.

Fixing this via a big distribution cut would have savaged payments to the parent, so that wasn't happening. Instead, the two entities will collapse into one. As is usual in these simplification deals, despite getting an 11 percent premium, ETP's limited partners also suffer a stealth distribution cut of 31 percent. That saves $1.1 billion a year in cash, and the incentive payments vanish, letting Energy Transfer Equity start cutting into more than $40 billion of pro forma debt.

The basic logic here of cutting distributions by the back door in order to alleviate complexity and restore both the balance sheet and (hopefully) investors' interest is similar to what drove other simplifications this year at Williams Cos Inc., Enbridge Inc. and Tallgrass Energy GP, LP. It is an admission that the old MLP model of spend-dilute-repeat is dead.

This is actually a good thing. MLPs got a reprieve recently as the Federal Energy Regulatory Commission softened a tax change proposed earlier this year that had sparked a huge sell-off across the pipelines sector. But MLPs have been battling deeper problems of their own making, as the excesses of the former boom alienated previously reliable retail investors. Simplifying, getting rid of lopsided incentives and cutting debt are part of the healing process. The sight of Energy Transfer heading down this path may yet persuade other holdouts to do the same.

Not everything has changed. Energy Transfer retains its knack for surprises (something I wrote about extensively during one of those earlier episodes of excess: the epic, failed bid to buy Williams; see this, this and this). The brief announcement and call with analysts came about a year before people expected and, even more surprisingly, only about a week before Energy Transfer is due to report quarterly results.

Energy Transfer also made it crystal clear that, despite the travails of the past few years and the necessity of this shake-up, this is still Kelcy Warren's show. To get around the dilution of control for him and other insiders resulting from all that new paper being issued, they are to get a new Class A of units to maintain their voting power. More will be granted if there is any future issuance of new paper, “as long as Kelcy is a director or officer of LE GP.”

Meanwhile, even as the company was discussing a transaction designed to help repair the balance sheet, thoughts were already drifting back to the more exciting field of M&A. It was the topic of the press release's second bullet point on the rationale for the simplification. While Warren made it clear he thought some assets are “ridiculously priced” right now, he also said this in answer to an analyst's question on Thursday morning's call:

But there's some players that are not involved in basins that are on fire right now and yet have good assets and would be strategic fits for us. There are others that are involved in those basins ... And so we would like to be very strategic. I don't think there's any bargains to be had right now, [but] … we think M&A is very, very important for our unitholders [and] that we maintain an aggressive M&A view and a smart approach to that.

On the same call, Warren also said he remained open to the idea of potentially converting Energy Transfer to a regular C-corp. This has been another feature of the change in the industry: Corporate tax cuts have narrowed the advantage held by MLPs, and those transferring to a regular corporate structure, such as Oneok Inc., appear to have found favor with institutional investors that balked at holding listed partnerships.

The Energy Transfer simplification is still several months away. But once done, there will probably be a strong incentive for converting the unified group to a C-corp. At least some retail investors will have memories long enough to remember their treatment during the Williams debacle. So if the company is to embark on a new round of expansion, an expansive pool of fresh, institutional capital would be hard to pass up. The latter may not even mind if an Energy Transfer Corp. comes complete with a Silicon Valley-like founders share class.

The end of any era is always the start of a new one – and it needn't be completely different in every respect.

To contact the editor responsible for this story: Mark Gongloff at mgongloff1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal's Heard on the Street column and wrote for the Financial Times' Lex column. He was also an investment banker.