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.