If you have been watching the market for initial public offerings this year, you have probably noticed that three of the five largest IPOs so far in 2015 have been of either master limited partnerships (MLPs) or general partners of MLPs. Columbia Pipeline Partners, LP (NYSE: CPPL) closed its initial public offering on February 11, 2015, raising over $1.2 billion in gross proceeds. A few months later, Tallgrass Energy GP, LP (NYSE: TEGP) raised over $1.3 billion in gross proceeds in its initial public offering that closed May 12, 2015, and EQT GP Holdings, LP (NYSE: EQGP) raised over $700 million in its initial public offering that closed May 15, 2015. The stage was set for this strong first half of 2015 by the first two MLP IPOs to exceed one billion dollars in proceeds in late 2014 - Shell Midstream Partners, L.P. ($1.1 billion) and Antero Midstream Partners LP ($1.2 billion).
Moreover, we are in the midst of a period of record-setting growth for the MLP marketplace. MLP capital markets activity generated gross proceeds of $23.0 billion in 2014 and a record $24.5 billion in 2013. There were 18 MLP IPOs for a record $7.2 billion in gross proceeds in 2014 and there were a record 19 MLP IPOs for $5.2 billion in gross proceeds in 2013. Although overall MLP capital markets activity has gotten off to a slower start for 2015, generating gross proceeds of $9.0 billion in the first half of 2015, the IPO market has seen a small number of MLP IPOs generating significant amounts of proceeds. During the first half of 2015 there were 6 MLP IPOs for $2.4 billion in gross proceeds (in addition to the TEGP and EQGP general partner IPOs that together generated over $2.0 billion in gross proceeds).
At a time like this, we examine why being big matters to an MLP, why general partner IPOs are so large and what might be the next source of rapid growth in the sector.
MLP Basics and the Need for Growth
The MLP sector is comprised of approximately 120 MLPs with a combined market capitalization of approximately $800 billion. Of all MLPs, 80 percent by number and 90 percent by market capitalization are in the energy industry. Even after accounting for acquisitions of several MLPs, the sector has grown at a rapid pace in the last few years. Activity in MLP creation and capital markets was the heaviest between the second quarter of 2010 and the fourth quarter of 2014, and more than half of existing MLPs are less than six years old. Since the beginning of 2013, 42 MLP IPOs have priced raising approximately $17.8 billion of gross proceeds. Within all of this activity, MLPs in the midstream sector have raised the most capital and publicly traded general partners of MLPs provided the greatest total return among MLP equities.
An MLP is usually a state law partnership that has a class of public securities traded on a stock exchange. The MLP is governed by a general partner, which in turn is controlled by the entity that created the MLP (the Sponsor'). An MLP does not pay corporate-level income taxes and unitholders generally do not pay taxes on the distributions they receive from the MLP. Instead, there is only one level of tax, which is paid by the unitholders (on a partially deferred basis) on their allocable share of the MLP's income. In order to avoid the double taxation that corporations face, a publicly traded partnership generally must receive at least 90 percent of its income from qualifying sources (i.e., qualifying income.' as defined in the Internal Revenue Code). For example, the most important categories of qualifying income for midstream MLPs are from transporting, gathering, processing, terminalling, and storing crude oil, natural gas and refined petroleum products, and certain alternative fuels, such as ethanol.
An essential feature of an MLP is that it makes a quarterly cash distribution (similar to a corporate dividend) to its unitholders. The general partner determines the amount of cash from operations to distribute each quarter, after taking into consideration reserves for future operations and debt service or covenants. It is a common misconception that there is a legal requirement for an MLP to distribute a certain percentage of its cash flow, like a REIT. When determining the amount of the distribution, the general partner pays attention to the coverage ratio, or the ratio of the amount of cash available that could be distributed over the amount actually distributed. As the MLP grows and the coverage of the distribution increases, the general partner has room to increase the distributions. However, there is no guarantee or requirement that the MLP distribute a certain, or any, amount of cash to its unitholders.
As recently as ten years ago, MLP investors were principally focused on yield and an MLP traded more like a bond. Today, an MLP trades like an equity security and its growth prospects are at least as critical as the yield it generates. This requires distributable cash growth through organic growth or acquisitions. When preparing for an IPO, the future MLP must not simply determine that it has qualifying income today but also that it has sources of additional qualifying income in the years after the IPO. The market will have a strong expectation that an MLP will increase its distributions over time. A solid growth story has been one of the main selling points in each of the largest MLP IPOs. Even as recently as a year ago, a distributable cash growth rate of 12 to 20 percent annually was considered high. But some recent IPOs of high-growth MLPs have targeted closer to 20 percent initial annual distribution growth. The Sponsor's significant ownership interest in the MLP, including its ownership of incentive distribution rights (which entitle the holder to an increasing percentage of the MLP's cash distributions as certain cash distribution thresholds are achieved), incentivize it to increase cash distributions to all unitholders by growing the MLP's distributable cash flow. The increased emphasis on growth has favored large companies and large IPOs. On the demand side, a significant component of the growth of the MLP markets and IPO size can be attributed to increased participation by institutional investors. No longer are strong MLPs only a retail product, as institutions often purchase a significant majority of the public equity. This increasing access to institutional buyers supports larger securities offerings and contributes to less volatility in MLP equity, although overall institutional ownership of MLPs still remains at a level below that of other yield stocks.
As a result of this market expectation and the Sponsor's economic incentive, MLPs are generally designed at the IPO stage to provide increasing distributions over time, either through organic growth, expansion capital projects or acquisitions of assets from the Sponsor or third parties. Recent MLPs have provided visibility into their growth stories by presenting a portfolio of assets with qualifying income that they expect to acquire from the Sponsor, by describing in detail well-developed organic growth opportunities, or by using an OpCo Structure in which the Sponsor will sell to the MLP additional interests in one large entity that holds qualifying income over time. These MLPs will fund most of their acquisitions and expansion projects with external capital, such as bank borrowings and the issuance of debt and equity securities. Therefore, the cost of these growth capital expenditures will not reduce the amount of cash available for distribution to the MLP's unitholders.
General Partner IPOs Are Big
Two of the five IPOs discussed at the beginning of this article are GP IPOs,' or IPOs of a new public entity that holds interests in the general partner of an existing MLP. In order to understand why GP IPOs are so big, you have to look at the ownership structure of an MLP.
When an MLP is doing well and growing its quarterly cash distributions, an increasing percentage of the cash flows (most commonly up to 50%) are distributed to the incentive distributions rights, which are typically owned by the general partner. The impact of this structure is magnified even further if the underlying MLP issues additional equity interests to fund acquisitions and other growth activity while maintaining the same or higher distribution levels. As a result, there can be significant value in the interests held by the general partner of an MLP that has increased its distributions well above the minimum quarterly distribution and into these high splits.' This value is not reflected in the market price of the common units for the underlying MLP, and one way the owner or owners of the general partner can fully unlock this value is to take the GP entity public. Because the share of the cash flow paid to the IDRs increases as the distribution per common unit increases, MLP GPs are high growth securities and trade at low yields and high multiples. The downside risk is that a reduction in distributions on the common units would trigger a proportionately larger decrease in the incentive distributions.
How Does a Public GP Work?
The general partner entity will typically hold the general partner interest in the underlying MLP, which may or may not include an economic interest that entitles the general partner to a percentage (e.g., 2%) of the quarterly distributions made by the MLP, and the incentive distribution rights. In addition, it is fairly common for the GP entity to also have some ownership of the underlying MLP common units (although there are some pure play GPs that do not hold any common units), which reduces the risk of quarterly variability in cash flow from owning only incentive distribution rights. Unlike the underlying MLP, the GP entity does not typically own any operating assets. Rather, its only cash generating assets are the partnership interests that it owns in the underlying MLP. A public GP is generally structured to distribute all cash received from these partnership interests in the underlying MLP, less reserves for items like general and administrative expenses, debt service, and income taxes (if it is taxed as a corporation), to the unitholders or shareholders in the public GP. Public GP entities do not typically issue incentive distribution rights, subordinated units or other equity interests that would provide for a non-pro rata distribution of cash.
There are two primary ways in which a GP IPO can be structured from a tax perspective. If the GP entity will be treated for tax purposes as a partnership, which it can do because the underlying MLP provides it with qualifying income, then investors will own common units representing limited partner interests in the GP entity, and will receive a Schedule K-1 with respect to their share of the income of the GP entity, similar to the underlying MLP. The majority of GP MLPs are structured this way. However, this can result in some level of cannibalization of the underlying MLP's existing investor base, who could choose to invest in the GP entity rather than directly in the underlying MLP. As an alternative, several public GPs have elected to be taxed as corporations.
Treating the public GP entity as a corporation allows a broader institutional investor base to invest in the GP entity, and indirectly in the underlying MLP, which can be increasingly important the larger the anticipated size of the GP IPO. The first example of a GP IPO structured as a limited partnership, but taxed as a corporation, was Plains GP Holdings LP (NYSE: PAGP), which raised nearly $3 billion in its IPO in October 2013, the largest US IPO of that year. TEGP is the second GP IPO structured as a limited partnership to elect corporate tax treatment, and at approximately $1.3 billion is the largest US IPO of 2015 to date.
YieldCos as the Next Frontier for Growth
Renewable energy assets, such as solar and wind, do not currently qualify for MLP tax treatment, although legislation has been introduced in Congress to permit that. Because certain renewable assets, such as long term power purchase agreements with utilities, can provide a stable stream of cash flow from investment grade entities over many years with minimal maintenance capital expenditure requirements, a new vehicle, called a YieldCo, has been gaining popularity as a way for renewable energy companies to use the successful MLP growth template to go public. Though some YieldCos are structured as traditional state law corporations, more recent ones, such as NextEra Energy Partners (NYSE: NEP) and 8point3 Energy Partners (NASDAQ: CAFD), have been formed as state law partnerships with MLP features, such as subordinated units and incentive distribution rights, and MLP governance and fiduciary duty provisions. In these YieldCos, the Sponsor and the public YieldCo form an operating company, similar to an MLP OpCo, in which both own an economic interest. Unlike in an MLP, the Sponsor does not own an economic interest in the YieldCo but does have the right to exchange its interest in the OpCo for public YieldCo securities. This structure, combined with the rapid tax depreciation write-offs available for renewable assets, results in the YieldCo paying no or very low federal income taxes for a significant period of time, thereby obtaining one of the principal benefits of an MLP.
Though the YieldCo IPOs have not been as large as some of the recent MLP IPOs, the IPOs for TerraForm Power, Inc., NextEra Energy Partners, NRG Yield, Inc. and 8point3 Energy Partners have all been in the $400-500 million range. TerraForm Global, Inc. has registered up to $800 million of common stock for its pending international YieldCo IPO. Furthermore, these YieldCos all have aggressive growth strategies based on a stated strategy of the Sponsor's offering the YieldCo assets from an identified pool of retained ROFO' assets on which the YieldCo has a right of first offer should the Sponsor choose to sell these assets. YieldCos have been in the forefront of giving multi-year, high distribution growth targets (12-18% per annum) in the IPO itself. The combination of relatively large IPOs, identified ROFO assets, and high targeted growth rates should result in significant increases in size for many of the YieldCos.
YieldCos have been well received in the marketplace by institutional investors. The potential universe for YieldCos is very large as the current market is much smaller than MLPs, the prospects for Congress expanding the MLP universe to encompass alternative energy is uncertain and companies with foreign assets have shown significant interest in accessing the YieldCo market.
The Future of the Big MLP
Our expectation is that the current trend of large, high growth, dropdown MLPs and YieldCos with an OpCo strategy will continue for the foreseeable future. However, as we examine the drivers of some of the largest IPOs so far this year, it is important to note that these MLP and GP IPOs were accomplished in the midst of a difficult overall market for MLPs during the first half of 2015. Investors in the MLP market will continue to focus on quality and long-term growth potential, particularly as the energy industry adjusts to recent commodity price volatility, but we believe the fundamental structural drivers of the Big MLP are here to stay.
About the Authors
Working as a Partner at Baker Botts, Mollie Duckworth represents public and private businesses in a wide variety of corporate and securities matters. She represents both public and private companies in connection with M&A transactions, and represents issuers and investment banking firms in public offerings and private placements of equity and debt securities. In addition, she advises public and private companies with respect to general corporate and transactional matters, including compliance with federal securities law issues, state corporate law issues and general corporate matters.
As a Baker Botts Partner, Hillary Holmes focuses her practice on capital markets transactions for master limited partnerships (MLPs) and corporations in the energy industry. Ms. Holmes also has deep experience with mergers and acquisitions in the energy industry and complex SEC, securities law and corporate governance matters. Ms. Holmes' clients include issuers and underwriters in securities offerings; buyers, sellers, conflicts committees and financial advisors in M&A transactions; and public corporations and MLPs in day to day corporate counseling.
Josh Davidson is a Partner at Baker Botts. He handles a wide range of corporate and securities work, and he is nationally recognized for his experience in transactions involving master limited partnerships, (MLPs), YieldCos and royalty trusts. Mr. Davidson is head of the firm's Capital Markets and MLP/YieldCo Practice and has concentrated on MLP companies for over 20 years. He has participated in hundreds of equity and debt public offerings and private placements of MLPs, including approximately 60 initial public offerings. Mr. Davidson works with other alternative entities in the pipeline, midstream, oil and gas, renewable energy, shipping, refining, coal, propane and heating oil industries.
