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Bankruptcy case shutting off flow of interest in distressed MLP deals

Michael Underhill
Michael D. Underhill is a big fan of more traditional midstream MLPs.

A bankruptcy decision put the brakes on private equity firms' accelerating interest in the troubled master limited partnership sector. Now only short sellers and a few hearty energy and real asset investors are interested.

Master limited partnerships are public companies that mainly build and own oil and gas pipelines. Investors like MLPs because they are more liquid than private energy investments, they produce income and they have long-term contracts from oil and gas producers for use of their pipelines.

Private equity executives have considered MLPs an investment opportunity because of the mismatch between MLPs' dwindling stock prices and the value of the assets they own. In January, EnCap Investments LP, EnCap Flatrock Midstream, The Energy Minerals Group, Kayne Anderson Capital Advisors LP and First Reserve Advisors LLC together bought Plains All American Pipeline LP, an MLP, for $1.5 billion.

The total MLP market was about $481 billion as of Dec. 31, according to the Capital Innovations Institute, the research arm of Pewaukee, Wis.-based real asset manager Capital Innovations LLC. Most — about 82% — of MLPs are in the energy and natural resources businesses, primarily pipelines. Some 44.2% of outstanding MLP units are owned by institutional investors, according to Capital Innovations Institute, Thomson Reuters and Credit Suisse.

Large institutional investors have about $3 billion in MLP investments, according to Pensions & Investments' Research Center.

The significant drop in stock price “seemed overdone compared to the quality of the businesses,” explained Brian Murphy, managing director at Darien, Conn.-based alternative investment consultant and fund-of-funds manager Portfolio Advisors LLC.  

“The dislocation in the MLP space may unlock additional opportunity,” said Jamie Weinstein, a member and co-head of KKR & Co.'s special situations unit in New York. “The opportunity is that when the capital structures break down, those assets will reprice to levels that are a lot more attractive.”

But, a bankruptcy court decision stunned the industry, slashing the key feature that was thought would shield MLPs from the ups and downs of the oil and gas market.

In March, U.S. Bankruptcy Judge Shelley Chapman in New York ruled that Sabine Oil & Gas Corp. could reject contracts to transport oil and natural gas. While the ruling only applies to this case, it could nevertheless serve as a road map for other courts to follow. If other courts reach the same conclusion, this means that oil and gas producers would no longer be stuck with pipeline contracts and could break or change the terms.

Not insulated

MLP and other pipeline investors have long contended that these generally long-term contracts — called take-or-pay contracts — insulate them from oil and gas prices because the contracts require oil and gas producers to pay for the ability to use the pipeline even if they aren't using it.

“When the judgment came out, it allowed people to walk away from contracts in bankruptcy. It scared people,” Mr. Murphy said. “They had tremendous confidence (in the contracts) and all of a sudden that might not be true anymore.”

In another highly anticipated bankruptcy — that of oil and gas producer Quick Silver Resources Inc. — the company rescinded its request to reject a contract with an MLP. Instead, the contract was restructured, according to an April 4 bankruptcy filing. 

In light of these cases, it remains a question how many private equity firms with capital to spend on energy investments remain eager to take advantage of the MLP investment opportunity. 

Interested firms are proceeding cautiously. “The fundamental assumption in the MLP space was that those take-or-pay contracts were inviolate. Those contracts can now be renegotiated or broken,” KKR's Mr. Weinstein said. “It is just now getting tested, which is sending a shock wave through the industry.”

KKR's special situations group, does not invest in energy, leaving those investments to its energy unit, but Mr. Weinstein as a special situation investor is knowledgeable about the distressed MLP industry.

Other firms that have big troves of capital to invest in energy include Blackstone Group LP, Warburg Pincus LLC, Natural Gas Partners and Encap.

Sources close to Blackstone said the New York-based alternative investment firm is not now focused on MLPs. Blackstone has about $15 billion dedicated to energy investments, according to its fourth-quarter earnings report. Christine Anderson, Blackstone spokeswoman, declined to comment.

Over the past six to 12 months — even before the Sabine bankruptcy decision — oil and gas producers were renegotiating contracts with MLPs, said Andrew O'Conor, an energy credit analyst at Morningstar Inc., Chicago. “There was already concern by investors that the outlook for MLPs was dimming,” Mr. O'Conor said. ”The court opinion added to the angst.”

But that doesn't mean private equity and other alternative investment managers are giving up on MLP investment opportunities, said Michael D. Underhill, chief investment officer of Capital Innovations, a real asset manager that invests in MLPs. Roughly 20% of Capital Innovations' $162 million in assets under management is invested in MLPs.

“There are some pretty divergent valuations right now. While the market will punish MLPs that are highly leveraged, those with stronger credit, good contracts and enough cash flow to cover their dividends will be rewarded and purchased by private equity buyers,” Mr. Underhill said.

Capital Innovations is shying away from MLPs that invest in oil and gas exploration because of their debt and risks of dividend cuts or bankruptcy, said Mr. Underhill.

“Instead, more traditional midstream MLPs, such as those that own pipelines, could be a better buy,” he said. “For an investor that has patience and doesn't get shaken up by volatility, it's a good time to dip your toe in the water.”

What's more, “this precise issue has never been litigated to conclusion,” because the Sabine decision is not a final order in the case, Mr. Underhill said. “So far, Sabine seems to be having better luck in court.”

The ruling is not binding on other courts because it can be appealed, but it is giving oil producers at least a negotiating position to break contracts, said George Schultze, CEO of Purchase, N.Y.-based hedge fund manager Schultze Asset Management, with about $190 million in assets under management.

Some hedge funds including Schultze are shorting the distressed MLP sector. He said the pipeline industry could turn into a big distressed investment opportunity.

But even without the Sabine ruling, Mr. Schultze said MLPs and other pipeline owners had issues because they service the distressed oil and gas industry.

It's a good bet that vendors for oil and gas producers will have to contend with bad debt, lose clients or lose negotiating leverage, he said. This will, in turn, cause prices to drop and volumes to decline.

“The MLP business model is in play,” especially because many of the oil and gas producers will likely go bankrupt, Mr. Schultze said. “Oil and natural gas and MLPs are two industries that will probably get worse before they get better.”

World of hurt

Joshua B. Kohn, portfolio manager, for real asset manager CenterSquare Investment Management Inc.'s global listed infrastructure business, said MLPs are in for a world of hurt even without the Sabine bankruptcy ruling. CenterSquare is a subsidiary of The Bank of New York Mellon (BK) Corp. (BK)

MLPs have not been as safe an investment as investors believed for years now, he said. The shale revolution of the early 2000s created a tremendous need for infrastructure, Mr. Kohn said. This led MLPs to transition from steady-yielding entities to growth companies.

Since MLPs must pay out cash flows to investors, the only way MLPs can grow is through the public markets.

“This worked well until the capital markets dried up about a year ago,” Mr. Kohn said. “Suddenly these companies have real problems.”

CenterSquare is staying away from MLPs but is investing in parent companies of the MLPs' general partners, such as Kinder Morgan Inc., which converted from an MLP to a different type of corporation in November 2014, he said. “I prefer to bet with the house rather than the management.” n

This article originally appeared in the April 18, 2016 print issue as, "Bankruptcy case shutting off flow of interest in distressed MLP deals".