Anatomy Of A $38-Billion Deal

Striking a midstream deal is no easy task. It involves regulatory red tape, countless hours of negotiations and a little good luck. And then there are the legal issues, Federal Trade Commission (FTC) requirements and an assortment of other Olympic-caliber obstacles to tackle. The process can be exhausting, but in the end can pay off with the deal of a lifetime.

Just ask Kinder Morgan Inc. In an acquisition that was more than a year in the making, Kinder Morgan purchased El Paso Corp. for $38 billion. The transaction helped Kinder Morgan become the largest midstream, and third-largest energy company in North America. It now boasts 75,000 miles of pipelines and an enterprise value of about $100 billion.

When the acquisition was announced in October 2011, Kinder Morgan Chief Executive Richard D. Kinder deemed the deal a "once in a lifetime transaction."

Kinder Morgan's top executives had been eyeing El Paso's midstream assets for years. Previous attempts were made to discuss a transaction, but the talks never gained traction. El Paso and Kinder Morgan failed to identify an arrangement that would be beneficial to both company's shareholders. It's not unusual to waste effort when a company is seeking to acquire or combine a set of assets, says Kinder Morgan President Park Shaper.

"Most of the time, it doesn't work out. One of the main reasons it doesn't work out, typically, is because of price," Shaper tells Midstream Business. "Lots of times it's difficult to find a price where a potential seller would be willing to transact."

Sometimes, making it work can boil down, in part, to good timing and luck.

Pricing the pipe

In the world of buying and selling, part of the challenge involves determining the worth of a set of assets. David Howell wrote the book on pipeline appraisal—literally. He penned the "Pipeline Appraisal Handbook." His company, Pipeline Equities, also salvages and rehabilitates pipelines. He says he's seeing an increasing amount of natural gas pipeline sales due to a drop in gas prices. This trend is in sharp contrast to the market tendencies of just a few years ago, when master limited partnerships (MLPs) were snapping up all the pipeline they could get.

The map indicates the combined assets resulting from Kinder Morgan's acquisition of El Paso Corp. Source: Kinder Morgan Inc.

"Now with the price of gas down, they want to get rid of pipe they bought and maybe don't need," says Howell, who has been in the business 30 years. "But there are always buyers. One man's trash is another man's treasure. And so it goes: There's always a market going back and forth."

Howell doesn't involve himself in appraisals of the Kinder Morgan-El Paso scale and played no role in that transaction. Instead, he focuses on smaller acquisitions, usually in the $5- to $15-million range. Determining the price of a set of assets, he says, typically boils down to a few key variables. "The basic things are always where, when and what," says Howell. "Ultimately, somebody has got to want it, and it's got to have some value."

Speaking in generalities, he says a company will sometimes buy another company—or its pipeline assets—even if it is only interested in one part of the package. Once the deal closes, the buyer simply sells off the unwanted assets and hangs onto the rest. On the flip side, the seller might include some of its undesirable assets in a package sale, in order to shed them. "They'll bunch the entire thing together in with the sale of other assets in order to get rid of the liabilities," says Howell. "It behooves them to get rid of them one way or another."

In today's lively market, he says companies often turn to one another when looking to make a sale, without using a middleman. Selling companies are always looking for buyers that are reliable and have deep pockets, Howell says. But whether a company is buying or selling, he says it's crucial for them to practice due diligence.

"I would tell them to get a third-party valuation on two or three fronts," he says. "I would find out ultimately what the assets are worth and what the liabilities are. That's what I would tell somebody to look at before they buy, or before they sell. The market is always changing."

Making a move

It was a fortuitous twist that ultimately allowed Kinder Morgan to make its successful move toward El Paso. In May 2011, El Paso said it was splitting its company. It would separate its exploration and production unit from its pipeline system.

Kinder Morgan initially planned to wait until after the split occurred to approach El Paso. However, one bank, Evercore, convinced Kinder Morgan that it made sense to evaluate the opportunity before the split. So, behind closed doors, numbers were crunched and analyzed for two months during the summer of 2011. Kinder Morgan was working to see whether it could create an attractive proposition for El Paso that also made sense for its own shareholders.

In late August 2011, the company determined it could offer a potentially appealing combination of cash and Kinder Morgan stock. This time, a variety of factors worked to Kinder Morgan's advantage. It was a unique opportunity—the possibility of acquiring a tremendous set of natural gas assets and a transaction that would benefit the shareholders of both companies. Additionally, El Paso's net operating loss could offset the taxes associated with the sale of the E&P company, enabling the resulting cash raised by the sale to be used by Kinder Morgan to substantially reduce the debt borrowed to fund the cash portion of the acquisition, according to Kinder Morgan.

"All of those things allowed us to get to a price that El Paso ultimately found attractive," says Shaper. "Clearly there was a lot of negotiation back and forth on that price. Ultimately what we thought was a very attractive price to their shareholders, they agreed with, and it was also attractive to KMI [Kinder Morgan Inc.] shareholders because it generated immediate accretion to the dividend and gave us long-term growth opportunities. And so we were able to approach them at a price level that got their interest. Clearly they negotiated on behalf of their shareholders, but we were able to come to an agreement that was very attractive to them and very attractive to us."

With more than 95% of votes cast in favor of the transaction, El Paso shareholders approved the merger March 9. Kinder Morgan shareholders had approved it days earlier, on March 2.

Yet, the deal was bittersweet and far from over. In order to gain FTC approval for the deal, Kinder Morgan was forced to divest some of its assets. This included Kinder Morgan Interstate Gas Transmission and Trailblazer Pipeline Co., as well as its Casper-Douglas natural gas processing and West Frenchie Draw treating facilities in Wyoming. It also included the company's 50% interest in the Rockies Express Pipeline.

"There's no question we did not want to sell any of these assets," says Shaper. "That being said, we did go into the transaction expecting we might have to sell some. We tried to convince the regulators that it was not necessary, but we actually built an asset sale into our financial expectations."

Negotiations with the FTC determined which assets would be sold, based on what it believed would allow the industry to maintain a fair and appropriate level of competition. Since Kinder Morgan is regulated as to what it can charge—and because it allows for open access to its pipelines—it did not believe competitive issues existed. Of course, the FTC felt otherwise, and so the aforementioned set of assets was sold to Tallgrass Energy Partners LP.

Tallgrass grows

The $1.8 billion (or $3.3 billion if the proportionate amount of Rockies Express pipeline debt is taken into account) deal served as Tallgrass' big entrance into the midstream space. This was the inaugural acquisition for the Kansas-based MLP, which was formed in 2012 to own and operate midstream assets.

Tallgrass saw the Kinder Morgan sale as the prime opportunity to do so. When Kinder Morgan announced its merger with El Paso last summer, Tallgrass—alongside many other energy insiders—suspected it would likely have to divest some assets in order to make the deal happen. Tallgrass used some forward thinking to ensure that it had its affairs in order before KMI announced last March that it would indeed be selling significant pipeline and processing assets. When the sale was brought to market last April, Tallgrass was included in the process from the start. It then began pouring through the paperwork, doing its due diligence, and ensuring the price was right.

"I think it's a good deal for Tallgrass, and I think it's a good deal for Kinder Morgan," says David G. Dehaemers Jr., president and chief executive of Tallgrass in an interview with Midstream Business. "Kinder Morgan needed to sell them as a conclusion to their El Paso deal and I think it's a good deal for Tallgrass in that we immediately have size and scope and infrastructure assets in the United States that are going to be used for a long time. These assets produce a lot of cash flow, and steady cash flow, and those are all things any business is looking for."

Dehaemers has an impressive background of starting small and going big. He was a day-oner at Kinder Morgan and worked directly with its founding members. He served as the company's chief financial officer and executive vice president from 1997 to 2003. When Dehaemers started working at Kinder Morgan, it had 175 employees and $330 million in enterprise value. When he left, it had 5,500 employees. Its enterprise value had ballooned to approximately $25 billion.

"I was there for those challenges, and I think that helped set the stage to accomplish something like this," says Dehaemers. "I view the folks there as mentors and colleagues. I think that was helpful. Obviously we still had to negotiate, but I have a great deal of respect for them. And I believe likewise. I think they knew how we would react to things and was going to make it successful for both of us."

As part of the deal, Tallgrass will be retaining Kinder Morgan's between 375 and 400 employees. Many of those workers have held their current jobs for more than 15 years. "They've been with the company and the assets for a long time. We're really looking forward to having them be a part of all this."

Of course, when it came to Kinder Morgan's divestiture to Tallgrass, both parties met their share of challenges along the way. Some hurdles were bigger than others.

"Doing due diligence is always a major challenge to make sure you get your mind wrapped around the risks and procedures," says Dehaemers. "Negotiating the purchase and sale agreement on this type of agreement is always a major challenge. Just like anything, every day brings new challenges and so far, we've met them all."

Of course, Tallgrass isn't the only company on a growth spurt. As mentioned, Kinder Morgan's acquisition of El Paso helped it become the largest natural gas pipeline and storage operator in North America. Its new, expanded network will give Kinder Morgan exposure to a wealth of plays. This includes all the current new shale plays, such as the Marcellus, Eagle Ford, Utica and Niobrara. Shaper says the deal has positioned the company well over the long term thanks to the natural gas industry's dynamics.

"There is clearly abundant domestic supply, which has had the impact of driving prices down, but we believe over time it will lead to significant growth in demand for natural gas from power generation, from industrial sources, potentially from transportation and potentially from the export of natural gas through liquefaction," says Shaper. "That means that with abundant supply and growing demand, more gas will have to be moved. Utilization of our assets will go up, and there will be opportunities to expand those assets, opportunities to extend those assets, and opportunities to build new natural gas pipelines and related infrastructure.

"This deal was a remarkable combination of short-term benefit and long-term opportunity. You really don't find that in a whole lot of transactions, especially transactions of this magnitude."