Alerian Index : Drop-Down MLPs

Fans of market anomalies celebrated this year as the January effect—higher prices—took hold, and the Alerian MLP Infrastructure Index (AMZI) gained 12.9% on a total return basis for the month. The S&P 500 returned 5.2% during the same time period.

MLPs grow by building new assets or by acquiring existing assets from other parties. Acquisitive growth can be further dissected between third party and drop-downs. In 2012, out of the $40 billion in merger and acquisition activity, drop-downs represented 36% of acquisitions.

Drop-downs can loosely be defined as acquiring assets from a related party, typically the general partner of an MLP, which could be a publicly traded Ccorp or a private equity firm. Familiar examples include Spectra Energy Partners and Spectra Energy, or Holly Energy Partners and HollyFrontier Corp. Usually, agreements are structured so that if the Ccorp or private equity firm plans to sell certain assets, the MLP has a right-of-first-refusal option. In order for the acquisition to be fair to both sides, conflicts committees are established and independent-fairness opinions are issued.

Investors place a premium on MLPs with drop-down models because they provide a more visible road map for future growth. Additionally, if the asset is owned by a public company, investors are already familiar with the performance and cashflow stability of such assets. MPLX LP, formed by Marathon Petroleum Corp., went public in October 2012 and has already appreciated more than 50%. While no assets have been dropped down since the initial private offering (IPO), analysts estimate that between $400- and $600-million of droppable midstream EBITDA still exists at the parent level.

Fans of market anomalies celebrated as the January effect took hold and the AMZI gained 12.9% on a total return basis for the month.

This compares to an MPLX EBITDA run rate of $150 million to $170 million for 2013, as estimated by industry analysts. Other drop-down infrastructure MLPs that went public in 2012 include Rose Rock Midstream from its parent SemGroup Corp., EQT Midstream out of EQT Corp. and Summit Midstream Partners backed by Energy Capital Partners.

While some MLPs are categorized as drop-down MLPs at the time of their IPO, as the MLP begins to grow in size and establish capital-market experience, some begin to acquire assets from third parties, but most begin to invest in organic-growth projects of their own. An example of this is Targa Resource Partners, which went public in February 2007. Its private parent, Targa Resources Inc., backed by Warburg Pincus, dropped down many assets to natural gas liquids (NGLs) in the earlier years. However, by the end of 2010, the MLP had acquired all of its parent’s assets and began to focus on increasing investment in newbuild projects.

Like NGLs, some drop-down stories play out slowly, with many $150 million to $300 million transactions taking place over the course of years, whereas others change strategies and acquire nearly all of the parent’s remaining midstream assets in one fell swoop. After two years of being public, Access Midstream acquired $2 billion of assets from Chesapeake Energy Corp., and, after 4.5 years of being public, Williams Partners acquired $12 billion of assets from Williams Cos.

In 2013, we expect a similar amount of drop-down acquisitions and drop-down IPOs to occur.

While dropping down does not create new midstream assets, it does create opportunities for a new owner—the MLP— to find ways to improve efficiencies and increase synergies, all of which translate into incremental cash-flow growth. And we’ve said before, when it comes to MLPs, cash is king.