Golden age of master limited partnerships may now be over

Let's hope, for the convenience of lawyers, that there are direct flights between Wilmington in Delaware and Houston, Texas. Three years ago, a Delaware corporate court rebuked the energy company El Paso Corporation (confusingly headquartered in Houston) for running a flawed sales process when it sold itself for $21bn to Kinder Morgan. That sale process, however, is better remembered because El Paso's investment banker, Goldman Sachs, also faced sanctions as it had interests on multiple sides of the transaction. Fast forward to two weeks ago, and another El Paso unit was in trouble in the Delaware Court of Chancery over a troubled deal. This time, the spotlight was on master limited partnerships - one of the most controversial corporate structures of recent years.

MLPs have prospered as they have been able to exploit two lucrative trends: securities that pay big cash yields and the explosive growth in US oil and gas production.

Most listed American companies are registered as corporations, a structure that has many advantages. But the key disadvantage is that corporations themselves must pay tax (although they are getting more skilled at avoiding that), as must their investors.

Partnerships, however, are "pass-through" entities that do not pay corporate tax. Partners pay tax at the personal level. MLPs cleverly combine this pass-through advantage with the liquidity and other benefits of a public listing. These days, MLPs are restricted to the natural resources industry, where they have historically been used for infrastructure activities, such as pipelines, where revenues tend to be steady. But investor appetite has allowed riskier groups, such as drillers, to list as MLPs.

In the US, the number of MLPs has risen from 71 at the end of 2009 to 121 today, and they now have a collective market capitalisation of around $500bn. Between February 2005 and February 2015, they achieved a juicy annualised total return of 13 per cent, according to the benchmark Alerian MLP index. That return was balanced between the dividends and capital gains. But to achieve capital gains, MLPs need to become bigger. And chasing growth is what ensnared the MLP unit of El Paso.

A common way for MLPs to get bigger is through the innocuously-titled "drop down" transaction. This involves the MLP purchasing assets from its parent company, called a sponsor. In El Paso MLP's case, the sponsor, El Paso Corporation (now part of Kinder Morgan) served as the general partner of the partnership - a role that comes with some handy benefits. These include having 2 per cent of the economic ownership of the MLP, the power to pick the board and the right to receive disproportionate dividends as the MLP gets bigger. The sponsor also holds a large chunk of the ordinary ownership units.

However, in a transaction between the sponsor and the MLP there is a risk that the MLP board might have divided loyalties and approve an overpriced transaction. This is precisely what the Delaware court found in the case of El Paso - determining that, in a 2010 drop down deal, El Paso MLP paid El Paso Corporation $171m too much.

El Paso, like all MLPs, had three independent directors who formed a "conflicts" committee to negotiate with the sponsor. But the court ruling showed that they signed off on the deal simply because, juicy valuation aside, adding the assets would boost the MLP's cash distribution. Once again, the investment bankers did not drape themselves in glory. The Texas energy boutique Tudor, Holt, Pickering & Co, was rapped for steering the board towards a deal.

The case is the latest blow in what has been an annus horribilis for MLPs. Crashing commodity prices have sent the Alerian index down 13 per cent since last summer and impending monetary tightening is expected to hurt performance further.

But the most intriguing development occurred last August. Richard Kinder, the billionaire entrepreneur most associated with the MLP revolution, consolidated his $100bn+ partnership empire into a single, traditional corporation. As part of the transaction, El Paso MLP was then combined into the single Kinder Morgan. For Mr Kinder, the demands of multiple partners became too unwieldy.

MLP champions might argue that the structure's advantages, including the ability to raise capital cheaply, helped make the US an energy superpower. This power will no doubt remain - but the MLP golden age may be over.

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