As most midstream veterans are aware, the public capital markets (equity and debt) drive midstream merger and acquisition (M&A) activity and valuations and to a lesser extent, organic growth activity. This is especially true given the importance of master limited partnerships (MLPs) and their yield-based valuations due to the distribution model used by most of the MLPs currently existing.

Strong capital markets drive competition in the midstream and MLP space in three primary ways: (i) by compressing MLP yields and thus reducing, and in some cases eliminating, the cost of capital advantage previously enjoyed by certain MLPs; (ii) by facilitating market access, increasing confidence among MLP management teams that they will be able to permanently finance large acquisitions at attractive rates; and (iii) by increasing the number of participants with access to the public capital markets through IPOs. The net effect of these impacts on competitive dynamics is higher valuations and the ability to pursue larger transactions.

Leveling force

The currently strong capital markets, in which investors are aggressively pursuing yield, have, in a certain sense, become a leveling force by offsetting the benefits of size, liquidity, credit rating and management track record enjoyed by certain MLPs. One of the lessons supposedly learned from the MLP market crash (mid-2007 through mid-2009) was that size matters, meaning MLPs must have sufficient equity trading liquidity, sufficient access to the debt capital markets and sufficiently diverse sources of cash flow to withstand market downturns.

Accordingly, MLP yields should vary based on these characteristics as well as relative distribution growth rates. Currently, however, most midstream MLPs are trading in a relatively tight yield range of around 5.5% to 7.5%. This yield compression puts smaller, less liquid MLPs and those with exposure to commodity prices on a similar footing with larger, more liquid and more stable MLPs from an equity cost of capital standpoint (excluding the impact of incentive distributions) making them more competitive for midstream acquisitions and capital projects.

Equity

Management teams are now able to finance large acquisitions far more easily than in years past. Year-to-date, MLPs have issued over $11 billion of equity and raised almost $14 billion of debt. Annualizing the first half 2011 figures, MLPs are on track to raise more equity this year than in 2008 and 2009 combined and exceed the record set in 2007 of roughly $18 billion.

The average public equity offering as of July 2011 to date is about $220 million, and the market has seen six offerings in excess of $400 million so far this year. Given the strength of demand in the MLP equity market, the vast majority of these offerings are follow-on offerings that are executed almost exclusively on an overnight basis. The "overnight" format improves deal security (fewer leaks) and generally reduces the discount the issuer must absorb to clear the market.

Given that most MLPs finance acquisitions and capital projects using a mix of roughly 50% equity and 50% debt, access to $400 million to $600 million of equity in a single offering means that it is far less difficult to finance large transactions. Interestingly, the currently robust demand for MLP equity is being led largely by retail investors seeking higher yields in a low interest rate environment as demand from institutional investors has dropped considerably compared to the run up to the MLP market crash in mid-2007.

Debt

MLPs tapping debt capital markets are experiencing a similarly robust environment, with investment grade MLPs raising debt at rates as low as 2.95% for medium term maturities and, for one issuer, less than 6.0% for 30 year paper. Most seasoned high yield issuers are currently able to raise debt at 7.0% or less.

The result

The result of the currently strong midstream capital markets is both an increase in average transaction size and EBITDA multiple paid. As of July 2011, the average MLP transaction size is roughly $425 million compared to $416 million in 2010 and $335 million in 2009. Similarly, the average EBITDA multiple as of July 2011 is 10.8x, compared to 9.9x in 2010 and 7.6x in 2009. In terms of total dollar value, 2011 should exceed the $27 billion of MLP M&A activity in 2007 although it may fall short of the record $35 billion of MLP M&A activity in 2010.

Robert A. Pacha is a senior managing director and Christopher C. Juban is a managing director for New York-based Evercore Partners, an independent investment banking advisory firm that provides strategic advisory services for mergers, acquisitions, divestitures and capital markets transactions.