Something was off.
The BlackGold Capital Management LP team was analyzing the capital structure of SemGroup Corp. (NYSE: SEMG) in the wake of the company’s $2.1 billion deal to purchase the Houston Fuel Oil Terminal Co. from Alinda Capital.
Investors had their reservations, evidenced by the more than 20% drop in SemGroup’s stock price in the two weeks following announcement of the acquisition June 6. But that wasn’t what caught the BlackGold team’s attention.
SemGroup’s debt was yielding more than its equity, contrary to how investments typically work.
“Given that the bonds higher up in the capital structure have better asset protection, their higher yield than the common equity meant something is off and misaligned,” Shalin Patel, BlackGold’s director of research, told Hart Energy. “We think there is an opportunity for the bonds to move up or compress the yield, which should be the natural relationship between bonds and equities or units.”
SemGroup is not an isolated case. BlackGold, based in Houston, believes that with commodity prices stuck in a lower-for-longer mode, the rapid growth the sector experienced during the shale boom won’t return any time soon. Investors, they believe, should consider a shift in strategy to adjust to the times.
“Ultimately, if your viewpoint or an investor’s viewpoint is that commodity prices are going to be much higher and volumes are going to be growing substantially from current levels, then you probably are going to get a better return profile from MLPs because they are equities,” Sharam Honari, partner, told Hart Energy. “But I think for those investors who are looking for yields, our viewpoint would be that you’re better off in terms of risk/reward total returns perspective being in the credit.”
Faith In Equities
Jim Hanson, Houston-based managing director of Duff & Phelps, said he can see that perspective, though he still has faith in equities.
“The nice thing about MLP debt or midstream debt in general is that you likely won’t get your yield cut,” he told Hart Energy. “It’s fixed unless something drastic happens like a bankruptcy or a restructuring. Whereas eventually, as you continue to move into a more mature MLP that eventually needs to do something with its incentive distribution rights [IDR], you could potentially see an effective distribution cut as part of the simplification transaction.”
The maturity issue has been a concern for investors in MLPs. The IDR structure at some point will hamper the ability of an MLP to grow. When that happens, Hanson said, the cost of capital for equity increases, making it difficult to make acquisitions that are accretive or attractive.
“It makes it harder to continue growth on a balanced basis by issuing equity and debt,” he said. “That’s one of those things that people have always known about. However, if the MLP eventually gets into those high levels of the IDR, that’s one of those ‘good’ problems for the MLP investor because it also means that you’ve enjoyed a run-up in your own distribution.”
There are two paths that MLPs have taken when they reach the mature stage of growth, Hanson said:
- Targa Resources Corp./ONEOK Inc./Kinder Morgan Inc. model: The general partner essentially buys the MLP. Hanson noted that some investors have lamented that the exchange of units for shares can result in an effective distribution cut. He also noted that in each case, there has been a step-up in basis. So from a tax perspective, it’s as though the investor sold units outright for cash, which for some created a tax hit; and the
- Williams Cos./Plains All American Pipeline LP model: The general partner foregoes the IDRs, exchanging them for a specified number of LP units.
These two methods essentially achieved the same thing: eliminating IDRs and aligning the MLP’s cost of capital to make it more competitive with its peers, Hanson said.
“I wouldn’t say that one of these two methodologies is better than the other,” he said. “Just two different ways to achieve the same thing—Williams and Plains went one way, and Kinder and ONEOK went the other.”
How Debt Works
Investing in debt is not a new concept. Credit was a key component of Treasury Secretary Alexander Hamilton’s strategy in the 1790s to grow the fledgling American economy, and that was based on the success that Great Britain had experienced for a century.
It’s not, however, something that just any investor can undertake.
To invest in loans, for example, an investor typically has to set up an account that has been approved by the counterparty, usually banks. The borrower (typically a company) must then approve the investor and list that account as one of the holders of the debt.
This differs from midstream bonds, which can be accessed either through a midstream credit focused fund or a separately managed account. Individual midstream bond tranches (multiple issuances) can also be purchased on retail platforms, but it can be difficult to differentiate among the numerous bonds available within the capital structure of most midstream companies. That’s why credit does not work for retail investment vehicles like a 401(k).
Why Credit Is An Option
So why bother when MLPs dominate the midstream investing space? BlackGold returns to the goal: returns.
“One of the things that we are seeing in the marketplace as a result of the downturn is that companies in the midstream space remain volume dependent,” said Honari. “If you look at oil and gas volumes, obviously ... they’re not growing at 1 million barrels of crude oil per year. That, in itself, is changing the dynamic where these companies were built for volume and distribution growth overall.”
With the slowdown, companies are focused on de-levering their balance sheets, he said. This is common in the energy space; however, in the midstream, it benefits credit-holders more than equity-holders.
That’s because distributions have, for the most part, taken dramatic hits. Credit, which typically pays off at lower levels because of the lower risk assumed, is delivering the superior return on investment in many cases.
“E&P equity holders are not focused on yield per dividends,” he said. “Primarily they are looking at the company’s stock price, production growth or share growth. They are usually buying into these equities for capital appreciations. The MLP investor is generally looking for yield with some capital appreciation.”
The complementary nature of midstream credit alongside MLPs means that for an investor seeking yield within the midstream sector—given the attributes of stable cash flows, fixed fee base, contract take-or-pay nature of many pipelines—the debt of those companies can offer similar yields with less downside, he said.
Still Opportunities For MLPs
For investors who have wearied of the extended slump and dreary outlook for commodity prices and their drag on equities, lower risk may be a sight for sore spreadsheets. Hanson, though, still sees opportunity on the equity side.
“It’s hard for me to tell people what they should do but I still feel like if you’re an MLP equity investor there are a lot of opportunities out there for really attractive yields or attractive growth stories. In 2017, there have been several IPOs that have taken place or filed, some with strong sponsors and a deep backlog of dropdowns,” he said. “I think some of those are pretty attractive growth stories.”
He concedes that there are instances in which the units of an MLP may yield a lower rate than the debt.
“But there’s a good reason for that,” Hanson said. “The investors are expecting future growth in that distribution.”
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