An Activist Chooses an MLP

We’ve written before about the benefits of being the General Partner (GP) in a Master Limited Partnership (MLP) rather than a Limited Partner (LP). MLPs are a great asset class; the more stable, midstream businesses that invest in energy infrastructure operate a toll-type of business model with fairly predictable cashflows. Their 5-6% distribution yields are largely tax-deferred and generally grow anywhere from 4-5% and higher, annually. One of the disadvantages of investing in MLPs (beyond the K-1s) concerns the very weak corporate governance afforded LPs. The GP runs the business on behalf of the LPs, and it’s virtually impossible to fire an underperforming GP no matter how many LP units you hold. You don’t see activist hedge funds buying LP units for that reason. The GP potentially has substantial power to act in ways that are not always in the interests of the LPs. For example, since the GP earns a chunk of the Distributable CashFlow (DCF) an MLP generates (often as much as 50%) they benefit from increasing the DCF. LP unitsholders want that too, but acquisitions funded by a secondary offering of LP units and debt will always benefit the GP. They’ll benefit the LP only as long as the return on the new capital exceeds its cost (i.e. is not dilutive). The GP can benefit even from a dilutive offering, since he never gets diluted. The trick is to treat the LPs just well enough that the price of LP units stays high enough to support that next secondary offering of stock.

Which brings us to hedge fund managers, whose role is in many ways similar to that of a GP in an MLP. New assets raised by a hedge fund manager may not hurt returns for existing investors if sufficient investment opportunities exist to deploy the additional money. New assets will ALWAYS benefit the hedge fund manager though, because he’ll earn fees on those assets. No doubt many hedge fund managers look in awe at the economic enjoyed by an MLP GP. Hedge Fund managers, with their 20% incentive fee and limited ability to abuse their LPs, can look in envy at the 50%” earned by an MLP GP.

This has not escaped the attention of Keith Meister, manager of Corvex Management LP, a hedge fund manager. Corvex filed a 13D this morning disclosing an investment in Williams Companies (WMB), in partnership with another hedge fund manager called Soroban Capital Partners run by Eric Mandelblatt. WMB is the GP for Williams Partners, LP (WPZ). Corvex and Soroban together own 8.8% of WMB through shares and unexercised options. The 13D includes a list of issues they’d like to discuss with the board of WMB, most interestingly, “…participating in strategic combinations given the rapid pace of consolidation in the midstream energy industry.”

WMB’s investor presentation includes a forecast of 20% annual growth in dividends from over the next few years, driven in no small part by their GP stake in WPZ (they expect the Incentive Distribution Rights, or IDRs, to grow at 30%). WPZ itself is forecasting 6%. But this need not even be the Upside Case; WMB could, for example, sell the 279 million units of WPZ it owns and use the cash to buy back WMB shares. They could use their WPZ units to acquire other assets and then drop them down into WPZ. They could even buy an MLP that had no GP and then drop the underlying assets into WPZ where their cashflows would then be subject to the 50% IDR split. There are numerous other, possibly more imaginative steps.

We have no idea what Meister and Mandelblatt have in mind. We have long owned WMB because we like their prospects. The involvement of an activist raises the possibility of faster wealth creation for WMB at the expense of WPZ.

Quite recently, Keith Meister abruptly sold his position in ADT, a company we owned. We wrote about the “Corvex Discount”. Based on his past, Corvex could switch gears and dump WMB. It may be an obvious statement, but following other investors into positions is not a great model. In our case we’ve owned WMB a long time, since we much prefer the GP side of the MLP story to the LP one. We are also short WPZ. We think it’s vulnerable to wealth creating moves at the WMB level as described above.

The Economist Writes About MLPs

This weekend’s Economist discussed Master Limited Partnerships (MLPs). Their Leader article primarily focuses on the different forms of corporate structure that are developing both to minimize corporate taxes as well as in response to legislation such as Sarbanes-Oxley which raised the cost of compliance (disproportionately for smaller firms) for many traditional corporations.  It’s interesting to see The Economist probing a relatively unknown segment of the capital markets, but as usual they bring their clear-headed analytical skills to bear and pose some thought-provoking questions such as the absence of a public policy debate over a shift away from the traditional corporate, or “C-corp” structure widely used.

MLP investors have done well, and the requirement that profits be substantially distributed to owners rather than accumulate via retained earnings as management’s piggy bank hardly seems a bad idea. Investors in Microsoft (MSFT) and Apple (AAPL) might well wish that those companies were structured as MLPs (since they’re not involved in natural resources they don’t qualify). If MSFT had to raise capital every time they make an acquisition they’d probably find their investments in Skype or Nokia rather less well supported by the investors in the secondary equity offerings whose sponsorship they would need.


Hedgeye's Third Time Lucky?

I’d never heard of Keith McCullough until today when we noticed that Kinder Morgan (KMI), a stock we own, was down 4%. MLPs are weak but KMI and its cousins KMP and KMR are certainly leading the way. The driver appears to be a bearish report on Kinder Morgan to be released to clients of Hedgeye next week. We like KMI for its 4% yield, long history of stable growth and management guidance of 12% dividend growth. KMI owns the IDR’s for Kinder Morgan Partners (KMP) which we also own, and around 50% of distributable cashflow from KMP now goes to KMI. In effect, KMI is a hedge fund manager charging 2 and 50. It seems like a decent investment.

Keith McCullough has in the past made some bold calls. In 2010 he apparently advised clients that France and Italy would both crash as the Euro crisis unfolded, and also at around the same time recommended that they sell all U.S. stocks. I must confess that we didn’t read about those forecasts as the time because we weren’t then (and aren’t now) subscribers. In fact we didn’t hear about them at all until reading about Kevin McCullough today.

Two spectacularly wrong calls don’t tell you anything about whether the KMI call will be right or wrong (and in any case there may have been hundreds of correct calls since 2010). We still like KMI, although we haven’t read Hedgeye’s report. We bought a little more today. He obviously has the ability to cause short term moves in stocks, so we’ll be watching what he has to say (though not as a subscriber).

Annual MLP Conference

Yesterday I attended the National Association of Publicly Traded Partnerships’ (NAPTP) annual conference in Stamford, CT. It was well attended as is normal, and it provided a welcome opportunity to see presentations by several of our portfolio names. The long run prospects remain attractive although we’ve had two years’ worth of return in less than five months of 2013.

Given the strong performance of MLPs so far this year, not surprisingly there was a certain amount of chatter about taxes. Buy and hold MLP investors have certainly seen their unrealized gains grow and consequently so has their associated tax liability. A high class problem no doubt.

Earlier this year I heard of an MLP asset manager who was advising clients that they should cut back their exposure because the market was overextended. With the benefit of hindsight it was poor advice, but even at the time it was of dubious value. Few money managers publish or even care about their clients’ after tax returns. But consider an MLP investor holding a portfolio worth $100 and a cost basis of $40 (believe me, there are many). Liquidating the portfolio to profit from an anticipated near term decline in prices results in a $60 taxable gain. Some of this gain will be subject to ordinary income tax (coming as it has from the tax-deferred nature of the distributions). The Federal Capital Gains tax rate is now 20%, while the top marginal ordinary income rate is 39.6%. Many states impose taxes as well, and investment income tax in support of Obamacare can also apply, so let’s assume that the mix of taxable income is approximately evenly split between ordinary income and capital gains, and it subject to a 30% Federal tax plus 5% state. The $60 in taxable income will throw off a $21 tax bill.

What this means is that the liquidated portfolio needs to be reinvested at prices of 79% (i.e. $100-$21) of its pre-tax value just in order to break even. The manager needs to accurately forecast a 25%+ drop in prices and be sufficiently nimble to get back in to justify such a move.

However, performance is normally reported pre-tax, since everybody’s tax situation is different.  The tax drag from this attempt to time the market doesn’t show up. If the market does drop 10%, the manager may look good even though he has left his clients poorer. MLPs are a great example of inaction often being more profitable than action. Although there is invariably liquidity to sell what you want, staying with a diverse set of names you’d like to own for years is the best way to maximize the after-tax wealth creation that is possible from the sector.