Investors are focusing carefully on the response of Master Limited Partnership (MLP) managements to the impact of a higher cost of equity on their growth plans. Those firms that moderate their growth forecasts in response so as to rely less on issuing equity and maintain their distribution coverage are acting thoughtfully with the best interests of their investors. To that end, Oneok (OKE) announced that they don’t anticipate issuing any equity at their MLP, Oneok Partners (OKS) until well into 2017. Their distribution coverage at OKE is expected to rise to 1.3X. It currently yields 10.2%. OKS yields 10.9% (both based on trailing distributions).

MLPs are reconciling their growth plans with the constrained appetite of investors to provide financing. MLP investors don’t tend to trade their positions that frequently because the tax deferral benefits grow over time for direct investors. Selling causes the  recapture of income previously received and a corresponding tax liability. Their long term investment horizon is rare today, with so much focus on the near term trend. OKE and OKS are recognizing the multi-year partnership with their investor base and behaving in a way that’s consistent with retaining their stakeholders.

The lifting of the U.S. ban on oil exports was quickly followed by an announcement by Enterprise Products (EPD) that it would provide pipeline and marine terminal services for the export of domestic, light crude. The first shipment is expected next month. It’s not a game-changer for midstream infrastructure, but is clearly good for them as well as for domestic crude oil producers.

We have concluded that an overlooked but important factor behind the collapse in MLP prices this year relates to capital flows and the investor base. In our first blog of 2016 we will publish a more detailed analysis of why understanding MLP capital flows is important and what it means for the sector going forward.

The chart below lines up the Alerian Index as it performed through the 2007-08 Financial Crisis and subsequent rebound with its performance through the crude oil collapse of 2014-15. An optimistic visual interpretation might suggest better days are ahead. We’ll see.

Thursday saw another example of tone-deaf decision making by the management of an MLP. Teekay LNG Partners (TGP) is an operator of ships that transport Liquified natural gas, petroleum gas and crude oil. Shipping is a horrible business; unlike pipelines, ships are highly mobile and so you’re never the only transport solution from A to B. On top of that, when industry overcapacity drives a ship owner out of business the ships live on, still contributing to the pressure on rates. Bankrupt shipping companies could provide a service to their competitors by scuttling their ships, but unfortunately they never do.

TGP cut their distribution by 80% on Thursday, claiming that they would fund their growth plans with internally generated cashflow since the equity markets are effectively closed to them.  In other words, the opportunities to reinvest cash in their business are so good they’re taking the decision out of their investors’ hands and redirecting the cash for them. Even though TGP was yielding 15% prior to the announcement, this implausibly high distribution yield evidently wasn’t reflective of widespread expectation of a cut since the stock promptly sank 50%. This may be due to the fact that although TGP’s press release claimed that “cash flows remain stable and growing” the company declined to provide any guidance for 2016 EBITDA. So it’s hard to know if they’re telling the truth. MLP investors value their regular distributions, and the persistent high yields on MLPs indicate that investors would prefer growth plans to be cut. A management that ignores this is looking for a new set of investors, a betrayal of the trust placed in them by the original ones. In fact, there’s something bordering on dishonesty about what TGP has done. If your operating results aren’t good enough to cover the quarterly payout, well that’s a risk that investors accepted. But TGP claims that business is good, cashflows “stable and growing.” Deciding to stop making payments to investors in order to reinvest the cash in new projects is to deny the message that the already high yield communicates. Investors don’t value those growth opportunities very highly, which is why TGP had already fallen 50% this year before the cut. There’s not much difference between TGP’s behavior and a hedge fund manager who prevents withdrawals by claiming unreasonably low prices on the securities he’d have to sell to meet the redemption. If they’re telling the truth about operating performance then they’re taking investors’ money to invest as they see fit, simply because they can, in spite of the fact that investors would clearly prefer that they did not. Or, operating performance is not as good as they say. Either way, it’s hard to see how management can regain trust after such  betrayal.

The other day one MLP investor was reeling off to me a list of tickers of MLPs that he owns, including well-known names such as EPD, ETP and PAA. He noted his portfolio also included regrettable overweights to OMG and WTF. It’s been that kind of year.

While we’ve wrestled with understanding operating performance, it’s increasingly clear to us that investor psychology is far more important in explaining returns on MLPs this year. U.S. K-1 tolerant high net worth investors remain the chief source of capital for MLPs. Crossover buying by U.S. and foreign institutions is impeded by significant tax barriers, so the sales made by ’40 Act MLP funds as their investors flee have a limited set of potential buyers. We’ll be exploring this more in our 2015 letter.

We are invested in EPD.

This week Kinder Morgan (KMI) did the right thing, after doing the wrong thing last year. By slashing their dividend they finally acknowledged that the MLP model of returning most free cashflow to investors and issuing new equity to finance growth doesn’t work in the C-corp structure they adopted in 2014. The square peg jammed in the round hole. Typical corporations pay out around a third of their profits in dividends and fund most growth with internally generated cashflow. KMI is conforming. Their mistake was committed last year (see Kinder’s Blunder), as was ours in not recognizing it sooner.

KMI isn’t an MLP, but they were once and most MLP investors also hold KMI. In many cases this is because they used to hold MLPs Kinder Morgan Partners or El Paso before they were rolled up into KMI last year. We reduced our KMI position in recent months in favor of more attractively valued names, but KMI affects investor sentiment so much that we’re all invested in KMI whether we own it directly or not. The MLP model isn’t broken. It retains its advantage in holding energy infrastructure assets since its freedom from corporate income tax gives it a lower cost of capital. MLP distributions continue to be tax-advantaged to investors. The MLP GP still looks like a hedge fund manager (see Energy Transfer’s Kelcy Warren Thinks Like a Hedge Fund Manager). KMI abandoned all this for the C-corp structure but kept operating like an MLP.

KMI’s operating performance in 2015 hasn’t been much different than expected a year ago. They budgeted $4.8BN of Distributable Cash Flow and are coming in at $4.6BN; EBITDA of $8BN, coming in at $7.5BN. Down 5-6%, because they’re not immune to crude oil prices, but no matter. Like their MLP cousins their stock price has sunk as investors look ahead to substantially worse operating performance next year. It may turn out that way but you won’t find much support for that view from recent financial reports or company guidance. Plains All America (PAA) expects rising EBITDA next year and in 2017, at which time they plan to resume annual distribution increases. They are considering numerous alternatives including a potential consolidation with their MLP and a distribution cut at PAA or PAGP is not off the table. We don’t expect it but can no longer rule it out. Meanwhile, Plains GP Holdings (PAGP) yields 10.0% based on its October 2015 dividend (which was +21% on a year ago). Energy Transfer Equity’s (ETE) CFO Jamie Welch was on CNBC noting their 7.5% yield with 1.2x coverage (based on their last dividend, +37% on a year ago) and predicting continued (albeit slower) growth.

But MLP stocks have collapsed this year so something must be badly wrong. Certainly the volatility of their securities has jumped, and investors will tread more warily for some time as a result. Most fundamental analysis and company guidance are severely at odds with market prices. The two will eventually reconcile.

An alternative interpretation is that the market is rejecting the industry’s plans to finance its growth through issuing new equity and debt. KMI’s problem is not unique, they’re just bigger, more leveraged and have a more extensive list of growth projects than others. They tried to solve it by becoming a C-corp and thereby accessing a bigger pool of investors. Their dividend cut was the traumatic acknowledgment of the problem.

It’s easy to dismiss today’s sellers as mistakenly expecting deteriorating operating performance next year. What’s more interesting though is to ask where are the new investors who ought to find current values compelling. Their absence, which has allowed yields to drive higher, may signal that MLP investors don’t want to provide the financing that’s needed. The pool of traditional, K-1 tolerant investors isn’t big enough to provide the new capital. An industry with decent operating performance and substantial growth plans ought to be funding more of that growth internally. Examining operating performance and distribution coverage is clearly not the solution to establishing the security of a payout. A company’s growth plans and its commitment to them is just as important. KMI may not be the last company to accept this reality. Continued high yields on MLPs reflect a diminished appetite from traditional MLP investors to finance growth and make the use of equity financing increasingly uneconomic.

Many MLP management teams and investors (including us) believed MLP investors would willingly accommodate this growing appetite for capital. Smaller, retail investors were tapped via ETFs, mutual funds and other products that avoided K-1s (albeit in many cases inefficiently). But this class can sometimes be flighty, momentum investors and they have been leaving. The MLP structure is the cheaper legal entity through which to finance energy infrastructure, but the market is coming up short of enough interested capital.

We may be transitioning to a different type of security, with lower payouts that grow faster and more internally financed growth. It’s not what original MLP investors signed up for. The shift is painful.

Casualties so far include investors who interpreted the shocking price collapse as portending something worse and sold as a result. We’re most certainly not in that category, but our reputation as market timers has not emerged unblemished, and maintaining MLP exposure throughout 2015 hasn’t been fun. It may not get any better for some time. Nonetheless, from where we sit last week looks like the low for the year in the sector. Of course, we’ve put in the year’s low numerous times already, and I for one possess the tire tracks across my back as evidence. Humility can be expensively learned. While the industry’s prospects are good, the financing model may be shifting to one of lower payouts, less reliance on external finance and greater use of internally generated cashflow.

If a banker approaches the CEO of a Master Limited Partnership (MLP) with an offer to help, the CEO should run (not walk) in the other direction. The latest victim is the management of Columbia Pipeline Group Inc (CPGX). A month ago management had indicated that they’d be tapping the markets for equity via their MLP, Columbia Pipeline Partners (CPPL). This is how it’s meant to work, with CPGX as the General Partner (GP) directing the MLP it controls to raise capital and invest it, sending half the free cashflow up to CPGX via the Incentive Distribution Rights (IDRs). They currently have $8BN in projects, notwithstanding the market’s current skepticism about MLP growth prospects. To reuse the hedge fund analogy, CPGX is the hedge fund manager (i.e. earning a share of the profits and providing management) and CPPL is the hedge fund (i.e. doing as directed by the GP).

But a month later, no doubt advised by its self-serving equity underwriters Goldman Sachs and Credit Suisse, CPGX instead issued equity, thereby raising capital at the GP level rather than the MLP level. “Hedge fund manager dilutes itself by issuing equity” is not a headline as commonly viewed as “Investors pile into hedge fund”. In this case, CPGX acted as the former when they ought to know better.

Goldman and Credit Suisse did what they do well, which is to ensure that CPGX stock traded down until the moment of pricing, ensuring a profit for the underwriters and favored clients at the expense of existing CPGX investors. The offering was priced at $17.50 on December 1, an 8% discount to the prior day’s close and a level at which it had never previously traded. Due to strong demand the offering was upsized from 51M shares to 71.5 and the stock quickly traded up while the underwriters exercised their option to buy an additional 10.725 million shares (upsized from 7.65 million shares) on top of the 71 million originally sold. Clearly, the market was not surprised; the circumstantial evidence points strongly to the underwriters alerting clients to the offering in the preceding days and thereby softening the market. This is because only the underwriters had both the advance knowledge of the offering and the incentive to see the stock trade off in the days prior to pricing.  Perhaps the equity capital markets staff use hand signals to alert their colleagues on the other side of the Chinese wall about what’s coming, so as to avoid leaving any evidence of their communication. In any event, the result was a success for all involved, except regrettably for CPGX investors whose shares were valued as high as $22 just a month earlier. Make that another win for Wall Street bankers. My book Wall Street Potholes will soon need a Volume 2. You can never be too cynical.

I reviewed several corporate finance blunders a few weeks ago in Investment Bankers Are Not Helping MLPs. Kinder Morgan (KMI) was part of that with their poorly handled offer of mandatory convertible securities. But on reflection, they may have committed the biggest blunder of all last year with their restructuring in August 2014. It looked clever at the time, and to our subsequent regret we liked it (see Valuing Kinder Morgan in Its new Structure). By acquiring their MLPs, Kinder Morgan Partners (KMP) and El Paso (EP), they were able to revalue their assets to current market prices and thereby create a higher tax-deductible depreciation charge that fueled a faster growth rate in their dividend. It was pretty slick.

But in hindsight, the reasons for the restructuring were a warning. At their size, they were unable to finance enough accretive projects to continue growing their dividend at its previous rate. The hedge fund analogy is useful here, because almost every hedge fund eventually gets too big. KMI, the GP of two MLPs and in effect the hedge fund manager, should have accepted that slower growth was inevitable and been satisfied with 1) a recurring 6.8% distribution yield growing modestly at KMP, effectively its hedge fund, or 2) consolidating and financing growth from retained earnings like all the other large C-corps. Instead, they adopted a structure yielding 5% with 10% projected growth fueled by the higher depreciation charge but reliant on equity markets to provide capital to finance part of their growth. Fifteen months and a more than 50% drop later, they now have a 12% yielding security with 6-10% 2016 growth and questions swirl about their ability to finance accretive projects given that their cost of equity has doubled. Moreover, it’s no longer an MLP, and the pool of potential investors, while large, looks beyond distributable cashflow and distribution yield and to other metrics such as Enterprise Value/EBITDA, against which it didn’t look quite so cheap at the time.

It’s no doubt a better investment today than it was in August 2014, and it remains a modest holding of ours although substantially less than in the past as we’ve switched into more attractive names. But the MLP-GP structure, with its close comparison to the hedge fund-hedge fund manager, is how Rich Kinder became a billionaire. Incentive distribution rights, the mechanism by which KMI earned roughly half the free cashflow from KMP and (more recently) EP, are similar to a hedge fund manager’s 20% incentive fee. Rich Kinder was smart enough to figure that out, but not smart enough to recognize when it’s time to stop accessing the secondary market for financing.  The largest MLP, Enterprise Products (EPD), funds its growth from internally generated cashflow rather than issuing equity  and has 1.3x coverage on its distribution. Perhaps that’s why EPD unitholders have fared better.

Size is the enemy of performance in hedge funds and, at times, in MLPs. Shame on Rich Kinder for not realizing it and instead letting the investment bankers talk him into the value destroying structure. He bet faster growth would drive down the yield on KMI, making it an acquisition currency of less leveraged businesses in a downturn, which would in turn reduce KMI’s leverage. The strategy has backfired. KMI no longer gets credit for the dividend, which leads to questions about its sustainability. While it’s covered by cashflow and they don’t need to issue new equity until 2H16 since doing the mandatory convertible, if KMI still yields >10% in late 2016 it’ll make more sense for them to cut the dividend and thereby reduce or eliminate their need for additional equity. KMI has made the mistake of many hedge fund managers and investors, thinking they can grow indefinitely. Although some commentators are worried about pressure on pipeline tariffs from stressed E&P companies, there’s a stronger case for tariff increases since the cost of equity for pipeline owners (i.e. MLPs) has risen.

Hedge fund managers don’t buy their hedge funds, and MLP GPs shouldn’t buy their MLPs. Management at Targa Resources (TRGP) should take note (see Targa Resources Needs an Activist).

We are invested in CPGX, EPD, KMI and TRGP.