Whenever an energy pipeline company says it is taking an action in order to simplify its structure, a wise investor prepares for complexity. The Williams Companies Inc. (NYSE: WMB) is following the lead set last week by Marathon Petroleum Corp. (NYSE: MPC) of swapping some of the general partner’s incentive distribution rights (IDRs) for common stock in their midstream pipeline master limited partnerships (MLPs).
IDRs are the profits that general partners of MLPs keep for themselves once the prescribed level of distributions have been made to common unit holders. The value of the IDRs over time has been huge for MLPs. Just ask Richard Kinder or Energy Transfer Partners L.P. (NYSE: ETP) CEO Kelcy Warren. Kinder’s personal fortune is currently estimated at more than $7 billion, while Warren’s is above $4 billion.
At the end of 2015, Williams IDRs for its general partner interest in Williams Partners LP (NYSE: WPZ) amounted to a 48% cut and 31.2% of the WPZ’s distributable cash flow. ETP’s cut was 48% and 38.1% of distributable cash flow.
So why did Kinder Morgan Inc. (NYSE: KMI) dump its MLP, Kinder Morgan Energy, a couple of years ago and convert to a C-corporation? The short answer is access to capital, of which pipeline companies need vast amounts.
To help insure access to capital, the MLPs have to continually boost distributions to common unit holders, but in the constricted production environment of the past year or so this has been difficult to achieve. Trading IDRs for common units helps lift distributions for all unit holders, and that perks up the share price and keeps the company’s valuation high, as well as makes it easier to get the financing the companies need to continue growing and starting the cycle over again.
MLPs are notorious for their complexity. Here’s how a portfolio manager at Silkworth Capital Partners described the Williams deal to Barron’s:
The hook is how these [divestments of IDRs] can continue to change the perception of the midstream space among diversified portfolio managers. While there are some broad equity managers that dabble in the space, many find the space to be fraught with a lack of transparency and burdened by a massive amount of financial engineering, and therefore avoid it. There are now nearly 10 high quality large cap companies (c-corp or MLP) that have simplified their structure, enabling the analyst/portfolio manager to focus on the underlying assets and cash flows, rather than financial complexity.
Simplification through complex financial finagling can pay off, for both the parent and the MLP. Williams sold 65 million shares of common stock on Tuesday at $29 a share, a discount of $3 to the closing price. The company is using the cash to buy WPZ common units at around $36.09 per common unit and is giving up distributions for the quarter ended in December 2016 and the prorated portion of the first quarter of 2017 up to the closing of the private placement.
WPZ common units traded at round $40.30 in the early afternoon Thursday, up nearly $2 per common unit since the Williams move was announced. And both Williams and WPZ shares will adjust to the new order, and prices for both are very likely to increase over the rest of this year.
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