Thomas E. Kelso, Managing Director & Principal, Cedric C. Fortemps, CFA, Managing Director & Principal and Stephen C. Lynch, CPA, Associate

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Introduction
One of the most frequently discussed topics in our industry over the last couple of years has been Master Limited Partnerships (“MLPs”), and in particular, the role that MLPs play in M & A activity and valuations. Our goal in this issue is to try and demystify the MLP through discussion of what MLPs are (and aren’t) and how valuations are affected by MLPs both in current terms and prospectively. We have also analyzed certain existing MLPs and created a series of proprietary charts and graphs, which we will introduce in this issue.

What is an MLP?
MLPs are publicly traded partnerships, defined under section 7704 of the Internal Revenue Code, which have a partnership’s flow-through taxation characteristics, an LLC’s limited liability, and a public corporation’s liquidity and access to capital markets. To qualify for MLP treatment, the entity must generate 90 percent of its income from qualifying activities.

Qualifying income includes the following:

• • Income from the exploration, production, mining, processing, refining, storage, transportation, or marketing of natural resources such as oil, gas, coal, and renewable fuels among others
  • Downstream income from refineries, storage facilities, distribution of fuels to retail and wholesale customers, and transportation of fuels to non-retail customers by pipeline, barge, rail, and truck
  • Any real property rental income, interest income not from insurance or financial businesses, dividends, and commodity derivative income

The income generated from sales to the retail customer from operating retail gas stations and convenience stores is not considered qualifying income.

Under a typical partnership agreement, an MLP is required to distribute to its unitholders all of its available cash. However, the board of directors has discretion in determining the amount of cash that can be distributed based on forecasted maintenance capital expenditure needs, required liquidity to operate, and its definition of “sustainable” cash flow.

MLP Structure & Ownership
MLPs are typically owned by two types of partners; Limited Partners (“LPs”) and General Partners (“GPs”).

General Partners:

• • Manage the operations of the MLP and are usually selected by the company that spun-off the MLP (“Sponsor”)
  • Under most structures, receive Incentive Distribution Rights (IDRs), which entitles the GP to a larger share of the MLP’s distributions as the MLP’s performance and distributable cash flows improve over time. These are analogous to employee stock options

Limited Partners:

• • Are passive investors in the MLP and are called unitholders, which are analogous to shareholders in a corporation
  • After GPs have received an allocation to cover operating costs, LPs are usually paid Minimum Quarterly Distributions (MQDs), which are outlined in the MLP’s prospectus and are similar to a dividend that C Corporations pay, without the double taxation of the earnings and distributions that C Corporations face. An MLP’s unit value would significantly decline if it failed to pay its MQDs
  • LPs have limited liability from claims against the MLP, but usually have little say in corporate governance issues

In a typical MLP formation process, a Sponsor owns assets that generate qualifying income and chooses to contribute some or all of its assets into an MLP. The Sponsor retains control of the management of the MLP by owning the General Partner interests (typically 2.0% of the MLP) and also owns typically 49% of the MLP units (which are initially classified as “subordinated units”), while the other 49% of the MLP units are sold to the public (common units or LP units). During the subordination period, which is a period of time that can last from three to five years in which units held by the public receive preferential treatment over those held by the Sponsor, the public unitholders receive protections that entitle them to receive the minimum quarterly distribution amounts set in the offering. In other words, the Sponsor’s subordinated units may not receive any distributions until the minimum quarterly distribution has been made to all of the public unitholders. However, if certain distribution targets are made, the subordination period can actually be less than three years. Once the subordination period is over, the Sponsor can convert its subordinated units into common units. The diagram below illustrates the typical MLP structure and provides an example structure of IDRs for the General Partner.

MLP Taxation
At the MLP entity level, an MLP is a flow-through entity that pays no corporate tax.

At the MLP Unitholder Level, each common unitholder gets their proportionate share of income, gains, deductions, losses, and credits in a Schedule K-1, which is notorious for being complex, arriving late in the tax season, and requiring state returns for everywhere the MLP operates. However, an investor would need to be a large unitholder to generate enough state specific income to file a state return, while states such as Texas, Nevada, Wyoming, and South Dakota have no state income tax, and states such as Virginia require state income of $3,000 or more to be subject to state taxes.

• • The investor’s share of income is taxed at the investor’s marginal rate. An MLP investment is usually subject to special passive activity loss rules. If the MLP investment generates a loss to the investor, it cannot be offset against any other income, even against another passive activity. The loss is suspended to offset future MLP income and then only offsets other income upon completely exiting the MLP investment
  • An investor’s basis in the MLP is the unit’s initial cost. Cash distributions from the MLP lowers basis, the allocated share of MLP income increases basis, and the allocated share of deductions like depreciation lowers basis. If basis is above zero, all cash distributions are 100 percent tax deferred until a sale. If basis is zero, cash distributions are a capital gain recognized in the year received
  • When the investor sells a stake in the MLP, total gain is calculated as the amount realized from the sale minus the investor’s adjusted basis. The portion of the gain due to basis reductions from depreciation is taxed as ordinary income according to section 1245 depreciation recapture rules. The portion of the gain due to “hot assets” or substantially appreciated inventory and unrealized receivables is taxed as ordinary income according to section 751 rules. The rest of the gain remaining is taxed as a capital gain

Comparison of MLPs to C Corp. and S Corp. Structures

The History of MLPs
MLPs were initially established in the 1980s, with the first IPO occurring in 1981, Apache Corp. (NYSE: APA). There were more than 100 MLP IPOs between 1981 and 1987, primarily due to the lack of restrictions on the type of businesses that MLPs could conduct and operate which resulted in entities such as motel owners, amusement park companies, casinos and professional sports teams (Boston Celtics Limited Partnership) being formed as MLPs and raising capital in the public markets. In reaction to the number of companies that were taking advantage of the tax benefits of MLPs, Congress closed this loophole in 1987 by restricting the type of income (primarily from energy-related activities) that was deemed to be qualifying income for an MLP. Additionally, many of the original energy-related MLPs founded in the 1980s could not maintain their distributions unless they held midstream assets with limited commodity exposure and stable cash flows. Upstream and downstream MLPs have recently returned due to their ability to minimize their commodity exposure through hedging instruments or better inventory management.

Growth in MLPs as a Suitable Asset Class for Investors
Over the last few years, retail and institutional investors have been increasingly attracted to MLPs’ relatively high yields, better performance than other diversified and sector-specific equity indices, low correlation to the overall equity market, inflation-adjusted returns, and notable tax advantages.

In the chart below, we have graphed the last 10 years of total returns generated from investing in one of the most popular MLP Indexes, the Alerian MLP Index, a composite of the 50 most prominent energy MLPs, versus the total returns from the S&P 500 during that same period. Due to the significance of the distributions from the MLP structure, a total return perspective should be used as this metric includes both a capital appreciation component and a component that includes income received on the portfolio. The Alerian MLP index is available on a price return basis (NYSE: AMZ) and on a total return basis (NYSE: AMZX). The SPDR S&P 500 ETF (NYSE: SPY) was used as a proxy for the S&P 500 and has been dividend-adjusted to provide a total return measure. Over this period, the Alerian MLP Index has nearly doubled the returns that an investor would have generated from investing in the S&P 500 index. An investment of $1,000 in January 2004 would be worth $4,092 on January 1, 2014 versus $2,032 for a $1,000 investment in the S&P 500 index. That means that the Alerian Index has outperformed the S&P 500 by 780 basis points on average over the last 10 years on a compound annual growth rate basis. A basis point (BPS) is 1/100th of 1%, or stated as an interest rate equivalency, 100 BPS equal 1%. Thus, this annual 780 basis point outperformance by the Alerian Index is equivalent to 7.8%.

Historically, approximately 50% of the returns from MLPs are generated through distributions to unitholders with the remaining 50% being generated from appreciation of the unit value. The consistent outperformance of the MLP asset class versus the historical performance of other indices is one of the driving factors behind the increasing popularity of this asset class as an increasing allocation of investors’ investment portfolios. The total market capitalization of energy MLPs has increased from $220 billion in November 2010 to more than $445 billion as of October 2013, which is partly due to the increase of the LP interests’ values over the last three years but also due to the fact that the number of publicly traded MLPs has increased from 72 to 107 over that same time period [1].

MLP’s Valuation Metrics
Due primarily to the MLP structure’s competitive tax advantage versus C Corporations and investors requiring lower equity returns due to more consistent profitability of most MLP businesses, MLPs typically have a lower cost of capital than C Corporations. This lower cost of capital combined with investors seeking investments with high current yields have resulted in MLP units being valued at significantly higher valuation multiples (P/E, Enterprise Value/EBITDA, etc.) than similar C Corporations. For example, Susser Petroleum Partners, LP (NYSE: SUSP), the real estate and fuels distribution assets that Susser Holdings Corporation (NYSE: SUSS) spun off in 2012, currently trades at a trailing twelve months Enterprise Value/EBITDA multiple of 20.0x while Susser Holdings trades at 10.6x (adjusted to 8.4x when factoring in its General Partnership and Limited Partnership ownership interest in Susser Petroleum). Below is a table that compares the valuation metrics of the two fuels distribution and convenience store real estate MLPs (both of which went public in 2012) versus six pure-play publicly traded convenience store companies.

It’s these premium valuation multiples that allow MLPs to acquire companies or assets at higher prices than C Corporations and still have them be accretive to their earnings.

As you can see from the table on the previous page, as of February 13, 2014, SUSP yields 5.34% and LGP yields 7.51%, which is 261 basis points and 478 basis points, respectively, greater than the current yield on the United States 10 Year Treasury Note, which stands at 2.73% on that same date. This spread is closely watched by MLP investors, potential investors, and analysts, as it, along with changes in distributions to unitholders, are the primary drivers of unit values. On the chart below, we compare the yield of the Alerian MLP Index historically versus the U.S. 10 Year Treasury. Over the 18 year period in the chart, the Alerian Index yield is on average 320 basis points higher than the 10 Year Treasury.

The U.S. economy has been in a decreasing interest rate environment for over 14 years, but the analyst consensus is that rates will begin to increase in the future, although few agree as to the exact timing and severity of the expected increase. If rates do begin to increase, the only way for MLPs to continue to maintain the existing spread between their yield and the 10 Year Treasury yield, while holding unit price constant, is to increase distributions to unitholders. The table below displays the distribution increase that would be required for LGP and SUSP to maintain a current yield spread of 4.78% and 2.61%, respectively, over the 10 Year Treasury at several different interest rate scenarios.

To maintain the current yield spread in an increasing interest rate environment, MLPs must increase per unit distributions; otherwise, the MLP units would need to decrease in value to maintain this differential. However, given that many prognosticators do not believe interest rates will increase quickly and the fact that many MLPs have managed to increase their distributions significantly, as seen in the table below, there is no reason to believe that the outperformance of MLPs versus other asset classes will end soon. The only conclusion that can be reached is that it will likely take future distribution growth to drive unit prices higher going forward.

MLP Unitholder Base
MLPs impose several tax restrictions that limit the tax advantages that help drive MLP yields and returns for owners. Tax-exempt entities such as non-profits and endowments or accounts held by individuals such as IRAs, 401(k)s, and other retirement funds that hold MLPs generate unrelated business taxable income (UBTI). UBTI in excess of $1,000 annually is taxable at the owner’s highest marginal rate, requires the fund’s custodian to file a Form 990-T, and requires payments on expected taxes of $500 or more. For these reasons, investment in MLP units is more attractive to retail investors than it is to many institutional investors, with some notable exceptions.

A Regulated Investment Company, such as a mutual fund, will lose its flow-through status if it owns more than 10 percent of a single MLP or if more than 25 percent of the fund’s portfolio is invested in MLPs. Additionally, foreign MLP unitholders are also generally required to file a federal income tax return. Despite these limitations, institutional investors have been consistently increasing their share of MLP ownership, with institutions owning 30% of MLPs in 2012 which is up from 23% in 2005 [1]. However, the retail investor, especially those that are seeking higher yielding investments, continues to be the largest owner of MLPs, resulting in retail investors owning 65% of MLPs in 2012. With more and more baby boomers reaching retirement age, there is a continually and increasing need for their portfolios to generate sufficient yield to cover their living expenses without eating into their capital base. This search for yield, particularly in a low interest rate environment, has resulted in a higher proportion of their portfolio being invested in the MLP asset class.

Frequently Asked Questions
1. How large does a company need to be to consider becoming an MLP? While there is no exact answer to this question, the best indication of required value is to look at the unaudited pro forma corporate level Adjusted EBITDAs for both Susser Petroleum Partners [2] ($40.8 million) and Lehigh Gas Partners [3] ($32.4 million) for the trailing twelve months ending June 30, 2012 for each, a reporting period both companies used prior to their IPO. Susser Petroleum Partners went public on September 20, 2012, and Lehigh Gas Partners went public on October 17, 2012. It is unlikely that an offering would be well received at less than $25 million of Pro Forma MLP qualifying Adjusted EBITDA.

2. Is an MLP an exit strategy? While all investors in MLPs eventually will want to exit, an MLP is really a growth strategy. An MLP allows a company wishing to grow to access the public equity markets and, potentially, the public debt markets thereby providing greater access to capital than a privately held company has. A substantial unitholder wishing to exit will always be constrained by the restricted period post going public and the average daily float of units traded and the perception of wide selling of the General Partner’s limited partnership units would likely reduce the attractiveness of the MLP as an investment for other unitholders, putting downward pressure on the unit price. The most likely exit for General Partners in small MLPs is to sell to a larger MLP.

[1] MLP Primer Fifth Edition, October 2013. Published by Wells Fargo Securities LLC’s Equity Research Department.

[2] For Susser Petroleum Partners, Pro Forma Adjusted EBITDA based on trailing twelve months ending June 30, 2012 as reported in its SEC Filing Form S-1 Amendment No. 3, dated September 10, 2012.

[3] For Lehigh Gas Partners, Pro Forma Adjusted EBITDA based on trailing twelve months ending June 30, 2012 as reported in its SEC Filing Form S-1 Amendment No. 5, dated October 17, 2012.

Disclosures

1. Nothing contained herein is an offer to sell or a solicitation to purchase any of the securities discussed herein.

2. The contents of this report are presented for informational purposes only. While Matrix Capital Markets Group, Inc. and Matrix Private Equities, Inc. (“Matrix”) believe the information presented in this report is reasonable, this report is provided “AS IS” and without warranty of any kind, either expressed or implied, including, but not limited to, the implied warranty of merchantability, fitness for a particular purpose, or non-infringement. Matrix assumes no responsibility for errors or omissions in this report or other documents which may be contained in, referenced, or linked to this report. Any recipient of this report is expressly responsible to seek out its own professional advice with respect to the information contained herein.

3. Matrix’s professionals, their spouses, family members, and other associated persons covered by applicable FINRA Regulations are not currently permitted to trade in any of the securities discussed herein with the exception of the Alerian MLP Index (AMZ).

4. Some assumptions on which this report is based inevitably will not materialize, and unanticipated events and circumstances will occur. Moreover, as the report contains information pertaining to periods farther in the future, the assumptions become more vulnerable to change, thereby making information contained therein for such periods more speculative. Therefore, the actual events that may occur may vary from the projections contained in this report, and the variations may be material. Matrix is not obligated to notify you of any changes to the information contained herein.

5. The information contained in this report is based on estimates and assumptions about circumstances and events that have not yet taken place, may not have an empirical basis, are subject to variation and are inherently unpredictable. Accordingly, there can be no assurance that information relied upon in preparing this report will prove accurate or that any of the projections will be realized. It is expected that there will be differences between actual and projected occurrences, and actual occurrences may be materially greater or less than those contained in this report.

This report reflects the consensus opinion of the investment bankers in our Energy & Multi-Site Retail Group.

Matrix’s Energy and Multi-Site Retail Group is recognized as the national leader in providing transactional
advisory services to companies in the downstream energy and multi-site retail sectors including convenience
store chains and petroleum marketers.

 

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