Last year marked a break from the master limited partnership (MLP) sector’s three-year streak of outperforming the S&P 500—only the third year in the past 10 this has happened, according to Wells Fargo.

The underperformance was concentrated in natural gas gathering and processing MLPs, which were weakened by low natural gas and natural gas liquids (NGL) prices. However, two other factors weighed on the overall MLP universe: massive equity issuance and concern about possible tax law changes. Last December in particular, investors sold MLPs ahead of expected increases to individual tax rates and broader headline risk that MLPs’ advantaged tax status could be affected amid the specter of corporate tax reform.

According to Bank of America/Merrill Lynch, MLPs raised about $22 billion in equity capital in 2012, compared to only about $16 billion the prior year. Although 13 MLPs went public in 2012, only about 10% of the equity capital raised by the sector reflected initial public offerings (IPOs) while nearly half was raised via secondary offerings. Secondary offerings depress share prices in the short term as issuers sell large chunks of new shares at a discount to current prices. Secondary offerings are dilutive to existing shareholders as the total share count is increased. New offerings also attract short sellers when the deals are announced, leading to further pressure, because the new shares will be priced below prevailing market levels.

In capital-intensive sectors such as midstream energy, when there is a high concentration of equity issued in a narrow time period, the entire asset class tends to experience pressure—not just the shares of the issuers. The share-price volatility can last for up to several weeks following the offering—not merely the days surrounding the announcement and pricing. Secondary issuances are also expensive in terms of marketing and broker fees.

Barely 3% of the MLP capital raised in 2012 reflected a relatively new and growing form of secondary offerings, known as At the Market (ATM) transactions. In an ATM offering, public companies sell newly issued shares into the marketplace through a broker at current market prices, rather than at a discount. Like traditional secondary offerings, ATMs are dilutive to current shareholders because they increase the overall share count, but they wreak less havoc in the marketplace because the issuing company incrementally and discretely trickles shares into the market rather than announcing a singular largescale sale. (ATMs are still registered offerings so savvy investors who read through all the filings will know whether a program is in place). As the exact timing of ATMs are unknown by the public, traders cannot pile on short sales ahead of the ATM, unlike in traditional secondary offerings. Furthermore, the issuer can control the timing of the program and delay if its management is unsatisfied with current market conditions.

Despite the many benefits for issuers of using ATMs to raise capital, major Wall Street investment banks tend not to promote them to their clients, probably because they garner smaller fees as compared to more traditional offerings.

According to Morrison & Foerster LLP, the distribution costs for ATMs usually range from 1% to 3%, as compared to the 5% to 7% charged in a traditionally underwritten deal. With the rapid expansion of energy-infrastructure demand, MLPs will look for more efficient and effective ways to finance their ever-growing and changing capital requirements. Accordingly, we can expect ATM offerings to proliferate among MLPs, which is good because with their active adoption, the asset class might experience less volatility.

2013 speculations

In the middle of last December, a bipartisan group of 29 U.S. senators and representatives wrote a letter in support of the MLP Parity Act to President Obama. If passed, the act would extend the same preferential tax treatment that oil and gas projects currently have to renewable energy businesses. Analysts at Bank of America/Merrill Lynch point out that additional endorsement for this act has come from former Colorado Gov. Bill Ritter, who, according to news reports, is on the short list to replace Steven Chu as Secretary of Energy.

Broad congressional agreement on anything, particularly tax reform, appears increasingly remote, and momentum is on the side of MLP expansion. 2012 saw significant growth in the range of businesses allowed to be incorporated into the MLP structure. The space now includes many non-traditional passthrough assets, such as two retail gasoline distributors, a petrochemical plant, a frac-sand producer and two refineries.

2013 will undoubtedly witness the continued expansion of the MLP asset class in both size and scope. The market capitalization of the group will rise as MLPs engage in more follow-on offerings, be they traditional secondary transactions or ATMs, in order to finance the nation’s burgeoning energy infrastructure needs. And the types of energy assets incorporated as MLPs will continue to broaden. But the more the MLP universe grows, the more conspicuous it becomes and the more likely it is to be a target of tax reform. However, the inclusion of non-fossil fuel projects, particularly renewables, into the MLP structure makes it more likely support will grow to maintain its tax-advantaged status.

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