MidstreamBusiness.com September 2011

MLP IPO Trends

t is almost beyond debate that during the past decade,pipeline master limited partnerships (MLPs) have beenmajor contributors to the growth and vibrancy of themidstream space. That growth has been fueled, in part, bythe absolute numbers of midstream businesses that havebeen formed or restructured into MLPs. And, given recent announcements, more MLPs are on

the way. This summer, a number of major energy com-panies announced plans to separate their upstream, mid-stream and downstream business lines or drop downassets into new MLPs. Among the most notable compa-nies planning to de-integrate are El Paso Corp., WilliamsCos. Inc., ConocoPhillips, Marathon Oil Corp. and Sem-Group Corp.

Although the past months have been difficult for stockmarkets, MLPs have persevered. Recently, the AlerianMLP Index had its greatest rally in its history, rising froma recession low of 152 in November of 2008 up to a highof 390 on April 28, 2011. Volatility continued even atpress time, when the index dropped to 316 on August 8,but then soared to 342 on August 10.Despite the volatility, MLP sponsors perceive that the

MLP structure offers a cost of capital advantage over sim-ilarly situated public corporations, in part due to theMLP’s efficient capital structure that eliminates entity-layer federal income taxes. Investors view the MLP as anopportunity for a superior yield relative to other invest-ment choices, as well as a growth play. Although MLPs

With the U.S. stock market on shaky legs, MLPs are looking better than ever. As a result, MLP initial public offerings (IPOs) are being hotly pursued by both management

and their advisors.By Tim Fenn

As seen in the September 2011 issue of

September 2011 MidstreamBusiness.com

have experienced the same ups and downs in the marketas similarly situated corporate stocks, more often thannot investor interest has remained keen. Today, potential sponsors and the investing public

show more interest than ever in the MLP. As a result,MLP initial public offerings (IPOs) are being hotly pur-sued by both management and their advisors. To better understand why the current interest in MLP

IPOs is so robust, it is necessary to take a short walkthrough the evolution of MLPs.

Early historyDuring most of the presidency of Ronald Reagan, no re-strictions existed in the tax laws on the types of businessesthat MLPs could conduct and operate. Between the firstMLP IPO in 1981 and 1987, there were over 100 MLP IPOs. Although the MLP space began with its attention directed

at oil and gas upstream assets, the focus soon shifted to anassortment of operating business, many of which had no re-lationship to oil and gas, or even energy. For example, MLPswere formed around motels (La Quinta Motor Inns LimitedPartnership/Aircoa Hotel Partners LP), real estate (NationalRealty LP), amusement parks (Cedar Fair LP), cable televi-sion systems (Falcon Cable Systems Co.), and even profes-sional sports (Boston Celtics Limited Partnership).

When Congress saw the proliferation of MLPs in thepublic markets, it enacted legislation intended to severelyrestrict the types of businesses that can operate as MLPs.Specifically, Congress sought a means to stem the per-ceived loss of tax revenue from publicly-traded partner-ship vehicles, because MLPs, unlike corporations, do notpay federal income taxes.More specifically, unlike a corporation, which pays

taxes on its own income, the income earned by an MLPis passed through to its owners—the public investors.These public investors, in turn, pay the income tax attheir individual rates.

Asset typesIn 1987, when Congress passed legislation that restrictedthe use of MLPs, it did not necessarily throw all indus-tries under the proverbial bus. Instead, Congress ex-pressly carved out much of the energy industry from thedraconian effects of these new rules, thereby preservingthe ability of the energy industry to operate as MLPs. Under this legislation, for an MLP to be taxed as a

flow-through entity, at least 90% of its gross income foreach taxable year must be income that is considered tobe “qualifying income.” If an MLP fails to satisfy this test,the MLP will be taxed as a corporation for federal incometax purposes, thereby eliminating any advantage fromoperating as an MLP rather than a corporation. So what is qualifying income? Qualifying income in-

cludes, among other things, income and gains derivedfrom the exploration, development, mining or produc-tion, processing, refining, transportation (includingpipelines transporting gas, oil or products thereof) or themarketing of any mineral or natural resource, as well ascertain passive-type income including interest, dividendsand real property rents.For purposes of the qualifying income rule set forth

in the tax code, with respect to natural resource-relatedactivities, the term “mineral or natural resource” meansfertilizer, geothermal and timber as well as any productfrom which a deduction is allowable, which includes oil,gas and oil- and gas-related products.Typically, anything that is dug or pumped out of the

ground qualifies, such as coal, lignite, potash, salt, ag-gregates, limestone, sand and many other hard rockminerals. Moreover, Congress made it clear in the legis-lation accompanying these qualifying income rules that,for purposes of determining the limits of what consti-tutes oil, gas, or products thereof, such term includesgasoline, kerosene, number-2 fuel oil, refined lubricat-ing oils, diesel fuel, methane, butane, propane and sim-ilar products that are recovered from petroleumrefineries or field facilities.

LimitationsYet, there are limitations. In 1988 Congress clarified the qual-ifying income rules to provide that certain products, such assoil, sod, turf, water, mosses and minerals from seawater, airand other similar inexhaustible sources are excluded. Thus,items that are renewables, such as agricultural products(wheat or corn, for example), or items that are unlimited insupply, such as solar or wind, do not constitute natural re-sources for these purposes and, therefore, cannot qualify.Also, in 2008, Congress amended the MLP tax rules to

provide that qualifying income includes the storage andtransportation of alternative fuels such as biodiesel andethanol. However, this amendment does not extend toactivities beyond storage and transportation. Therefore,the manufacturing or sale of biodiesel or ethanol doesnot generate qualifying income.

MLP IPOs COMPLETED SINCE 2010

MLP Date CompletedAmerican Midstream Partners LP July 2011Oiltanking Partners LP July 2011Compressco Partners LP June 2011NGL Energy Partners LP May 2011Tesoro Logistics LP April 2011Golar LNG Partners LP April 2011CVR Partners LP April 2011QR Energy LP December 2010Rhino Resource Partners LP September 2010Oxford Resource Partners LP July 2010Chesapeake Midstream Partners LP July 2010Niska Gas Storage Partners LLC May 2010PAA Natural Gas Storage LP April 2010

Source: Latham & Watkins LLP

MidstreamBusiness.com September 2011

Moreover, the 2008 amendment provides that any in-come associated with industrial-source carbon dioxidegenerates qualifying income, which includes activitiessuch as transportation and marketing.For purposes of the midstream sector, as long as the

MLP is earning income from the transportation of oil,gas or liquids, that income will be qualifying income. Inthis context, transportation is interpreted widely, butwith some parameters. First, although it appears that any movement of a nat-

ural resource or mineral from one place to another willgenerate qualifying income, Congress seeks to imposelimitations on what kinds of transportation would gen-erate qualifying income. In the legislative history to sec-tion 7704, Congress indicates that transportation bypipeline of any mineral or natural resource generatesqualifying income. On the other hand, the legislative history states that

the transportation of oil and gas, and products of oil andgas, to a retail outlet, other than by pipeline, does not gen-erate qualifying income. As a result, the transportationof oil, gas and products thereof by truck, rail or barge toa retail outlet does not generate qualifying income. For this purpose, the Internal Revenue Service defines

retail to include not only traditional retail customers, butalso industrial and commercial users. However, the leg-

islative history makes it clear that the transportation ofthose items to a bulk distribution center, such as a termi-nal, or to a utility providing power to customers doesgenerate qualifying income. Also, the transportation of gas or other products by

pipeline to private residences generates qualifying incomefor local distribution companies. Managing, but notowning, a pipeline that transports a natural resource alsogenerates qualifying income.As a result of these generally broad rules permitting

many types of energy operations to satisfy the qualifyingincome test, there have been more than 100 energy-re-lated MLPs formed in the past 25 years. The majority ofthose MLPs focused on energy’s midstream sector.

MLP IPOsDuring the first two decades of the post-1987 rules for

MLPs, one could expect two or three new MLP IPOs peryear. During that period, current MLPs such as FerrellgasPartners LP (1994), Suburban Propane Partners LP (1996)and Enterprise Products Partners LP (1998) were formed.In 2002, the IPO market for new MLP issuers acceler-

ated with the successful completion of six new MLPs, in-cluding Sunoco Logistics Partners LP, MarkWest EnergyPartners LP and Natural Resource Partners LP. Other thana blip in 2003 when there was the absence of any new IPOs,that robust level of new issuances continued unabateduntil the general economic slowdown of 2008 and 2009. For example, from 2004 through 2008, over 30 energy-

related MLP IPOs were completed. During this period,an additional 10 MLP general partners were taken pub-lic. The energy-related industries represented in this dashto raise public equity included upstream, midstream(gathering/processing/interstate transportation/storage),shipping, refining and oilfield services (compression). Inother words, the entire oil and gas value chain was repre-sented in offerings during this period.Between mid-2008 and mid-2010, during the reces-

sion, the MLP IPO market shut down. Then, in the springof 2010, the MLP IPO trend rebounded with the IPO ofPAA Natural Gas Storage LP, the first for the year. Sincethen, the market has returned with gusto, evidenced bythe successful completion of 12 more MLP IPOs.

Two themesTwo themes have emerged with the recent flurry of MLPIPO activity. First, a wide variety of businesses are goingpublic. Coal operators such as Oxford Resource PartnersLP and Rhino Resource Partners LP have taken advan-tage of the MLP space. Also, in April 2011, CVR Partners LP completed the

first pure fertilizer MLP in almost two decades. And QREnergy LP successfully launched its upstream oil and gasMLP in December 2010, thereby providing some clarityto other companies as to whether the upstream MLPmodel was one in which investors would participate fol-lowing the difficulties experienced by many of the up-stream MLPs in the recession. Elsewhere, Golar LNG Partners LP took advantage of

the MLP structure to highlight its international shippingfleet in April 2011. Compressco Partners LP, a compres-

Notwithstanding this general rule, several new MLPs have abandoned the concept of minimum quarterly distributions and have instead embraced the proposition that the operatingbusiness is a commodities business that is cyclical in nature.

sion-services provider, launched a relatively small IPO inJune 2011, after having been in registration with the Se-curities and Exchange Commission since before the re-cession. Finally, a number of midstream companies, inwhat many consider to be the sweet spot of the MLPmarket, hit the market with Tesoro Logistics LP leadingthe way in April 2011. The second major theme that can be discerned from

the recent spate of MLP activities is that investors areseemingly less concerned with the type of asset containedin the MLP than they have been in the past. Now, in-vestors are focused on predictability, stability of cash flowand yield. In today’s interest rate environment, when the 10-year

U.S. Treasury is trading at historically low levels, the av-erage yield-seeking institutional investor, and particularlythe average individual yield-seeking investor, is hardpressed to find ways to earn yield-based returns substan-tially in excess of rates a bank will pay for savings ac-counts. The MLPs are perceived, and rightly so, as aninstrument where the investor can earn a strong quar-terly yield-based return, and also retain the potential forcapital appreciation. Because there are very few other in-vestment opportunities that offer those types of dual-benefits, the MLP sector has seen a tremendous increasein investor appetite for these new IPO issuances.Even today, there are several new MLPs in SEC registra-

tion, including businesses directed at oilfield services,propane, fertilizer and energy upstream and midstream.Other businesses are investigating the space for opportuni-ties to pursue an IPO or sell themselves into an existing MLP.

Tips for successIf a sponsor entity is interested in either converting it-self into an MLP or contributing assets to a newly-formed MLP, there are several important features thatshould be addressed. First, it is absolutely critical that the financial state-

ments of the company looking to becomean MLP are addressed early in the IPOprocess. Ultimately, the IPO registrantwill have to provide, among otherthings, three years of audited finan-cials. Depending on the factualpredicate for the assets that con-stitute the MLP, this exercise mayresult in a long lead time for theIPO process, especially when theassets are being carved out of anexisting business and have notbeen the subject of any previousaudits.Also, although it is critical that

the business of the MLP qualifyunder the tax rules described above,it is equally critical that the business

is one that is appropriate for an MLP. In other words, theMLP’s business should be one that generally entails sta-ble and predictable cash flow, because MLP units aretraded on the basis of cash flow and yield rather than netincome.Notwithstanding this general rule, several new MLPs

have abandoned the concept of minimum quarterly dis-tributions and have instead embraced the propositionthat the operating business is a commodities businessthat is cyclical in nature. Therefore, the MLP investorshould expect greater cash returns when the commodi-ties that are the subject of the MLP are high and dimin-ished cash returns when the commodities are low. Thisis a major deviation from the historic practice of MLPs,but given its limited use outside the midstream space(primarily for fertilizer MLPs at this point), the overallmarket impact of this floating distribution structuremay be limited.Another critical piece of the puzzle relates to the use of

proceeds of any IPO. That is a shorthand way of refer-ring to the legal and tax planning involved in effectuatingan efficient MLP IPO. Many times, it is the use of pro-ceeds of an MLP IPO that determine the tax effect of thepublic offering. Early planning is critical to allow a spon-sor and its legal and tax advisors to prepare a structurethat satisfies both the business needs of the new MLP andthe efficiency of the IPO from sponsor’s standpoint.Another important timing issue relates to manage-

ment. The executive management team should be inplace at the time the IPO process begins because thisteam must represent the business during the IPO processand will be the face of the MLP. Often, the new MLP busi-ness is only a part of a much larger enterprise. In thatcase, it is common for the MLP to search for a dedicatedchief executive, even if many of the MLP functions areserved by existing sponsor employees.Finally, there is no substitute for preparation and or-

ganization in the IPO process. The more upfront workdone on the business plan, operations, financial models, taxstructuring, accounting and the coordination of the rightteam of advisors, the more efficient the process will be.Going forward—and although the macroeconomic

signs are uncertain—one should expect continuing androbust activity in the MLP space, absent major constraintsin the capital markets. As in most years, that activity willbe led by new companies taking advantage of the MLP asa means of operating in a more tax-efficient manner. n

Tim Fenn is a tax partner in the Houston office ofLatham & Watkins LLP, has a particular focus in tax is-sues for partnerships and early-stage structuring, and of-fers advice on market-related and tax issues. He representsclients, corporations, private-equity firms, investmentbanks, partnerships and individuals on tax-related issuesinvolving mergers, acquisitions, restructurings and capi-tal transactions.

TRENDS

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