The Current Market Environment

It has been a rough ride for U.S. equities. Between July 15 and August 12, the S&P 500 lost 10.4% of its value while VIX volatility spiked to a year-to-date high of 48. During that same period, U.S. equity mutual funds saw outflows of over $50 billion, as fear and uncertainty dominated investor sentiment. While many investors took shelter in Treasuries, others looked for safe havens with better overall return potential.

As the broader markets continued to see wild gyrations, investors sought out the relative safety of yield-oriented equities, believing the yield-cash flow would provide some support for underlying valuations. Not surprisingly, yield stocks have fared better during the recent market turmoil, and midstream names are no exception.

MLPs outperform

For this same period, midstream master limited partnerships (MLPs) declined by only 3.2%. This outperformance is part of a multi-year trend driven by investors’ continued desire for total return (yield + growth) in what has been a very protracted low interest rate environment with only modest economic growth. Since the beginning of the year, the midstream sector has been flat on a total return basis, versus a 5.1% decline for the S&P 500. This is on top of a 27.6% total return in 2010 and a 63.3% total return in 2009, versus 15.1% and 26.5%, respectively, for the S&P 500.

Despite the recent market weakness, there is reason to be cautiously optimistic that equity markets should stabilize and strengthen in the weeks and months to come. Currently, equity valuations are at historically low levels with the S&P 500 trading at just 10.9 times 2012 earnings. This compares to a more recent historical average of approximately 17 to 18 times forward earnings, suggesting that the markets are already pricing in a higher likelihood of recession. This, combined with strong second quarter earnings, and the expectation for a sustained low interest rate environment, makes equities more attractive than many other asset classes.

However, volatility is expected to persist, as many of the geopolitical and economic issues currently plaguing the markets will not likely come to resolution anytime soon. With this backdrop, midstream stocks represent an intriguing value proposition for investors: 1) stable underlying cash flows; 2) visible and sustainable growth; and 3) tax-advantaged income (for MLPs). The midstream sector should continue to benefit as investors seek yield and growth.

Robust equity market

Transaction flow has been light in recent weeks, primarily due to market volatility and earnings-related blackouts. However, 2011 as a whole has been very active, with 30 midstream equity offerings raising $10.7 billion. This compares to 27 offerings raising $7 billion for the same period in 2010 and puts 2011 on pace to set new highs. The last two years have also seen the IPO market return for midstream issuers, with four new issues coming to market in 2010 and five in 2011 year to date, raising an aggregate of $5.6 billion.

Pricing trends have been favorable, with all of the midstream initial public offerings (IPOs) pricing at the midpoint of the range or higher. In addition to the historically strong retail interest, recent IPOs have also garnered strong institutional interest. The midstream IPO backlog should remain healthy heading into 2012. Follow-on issuance has been active in 2011, and execution has been efficient. Year to date, there have been 25 follow-on offerings raising $6.7 billion.

The largest offering of the year, and the largest MLP offering ever, was Energy Transfer Partners’ $718 million raise in March. Transaction sizes have been getting steadily larger over the past few years. All of the midstream follow-on offerings this year have been on an overnight basis, as issuers look to avoid potential market risk. Barring any unforeseen changes in market dynamics, this trend should continue.

The vast majority of issuers have been using the proceeds to fund acquisitions or capex, but there was some secondary selling by existing shareholders. Pricing ranged, depending on the size and liquidity of the issuer, but has generally been favorable and steadily improving over the past few years.

Looking forward to the remainder of 2011 and into 2012, one is likely to see an active calendar for both IPOs and follow-on offerings. In the near term, market volatility may factor into offering activity post-Labor Day. However, if markets continue to stabilize, offering activity will likely be robust, and the calendar could be fairly crowded. Over the next 12 to18 months, the frequency and size of midstream offerings should continue to grow, driven by several new entrants and increasing spending on capex and acquisitions. Investors’ continued appetite for total return opportunities, combined with the growing institutional investor base, should provide adequate investible dollars to finance this growth.