MLPs have been an integral part of the midstream sector of the oil and gas industry, and to a lesser extent, the upstream sector, for most of the past 30 years. After Congress acted in 1987 to limit the scope of MLPs to busi-nesses in a limited number of in-dus-tries (most notably, oil and gas), MLPs experienced relatively steady growth and generally represented a convenient way for qualifying businesses that gen-erate regular cash flows to attract retail investors willing to pay for yield and some potential growth.

Following the recovery of the capital markets after the financial

crisis of 2008-2009, MLPs got hot. The number of IPOs of MLPs exploded, and a significant number of MLPs were launched focusing on the upstream and downstream sectors of the oil and gas business. MLPs expanded into more cyclical businesses like oilfield services and shipping.

The IPO halt

With the plunge in oil and gas prices over the past 18 months, the number of MLP IPOs ground to a halt. While 21 such IPOs occurred in 2013 and 19 in 2014, only six such offerings were completed in 2015.

None have occurred since July 2015.

A similar pattern occurred in the years leading up to and during the global financial crisis of 2008 and 2009.

There were 12 MLP IPOs in 2007, only two in 2008 and none in 2009. At that time, oil and gas and stock mar-ket indexes had taken a dramatic dive, but improvements in technology and predictions of future economic growth were causes for optimism. Moreover, government stimulus and historically low interest rates provided strong inves-tor appetite for yield-based securities. As indicated, the MLP market experienced a surge in IPOs beginning in the sum-mer of 2010, and 16 MLPs conducted IPOs in the following 18 months.

While economic indicators are different today than they were in 2010, and predictions of oversupply and overbuilt infrastructure have cast a pall over the oil and gas industry, the foundational basis for MLPs remains: For qualifying businesses that generate regular cash flow, an MLP represents a means to raise capital from yield-focused investors, while maintaining control and a significant portion of the upside growth in the business.

Unlocking value

For a company with multiple lines of business, an MLP may also serve the purpose of unlocking the value in one of those lines—by providing a public valuation for an interest in that line of business—without the complications entailed in an offering of voting securities in a corporate subsidiary, e.g., common stock, to public investors. Although tax law

changes have been proposed that could eliminate the favorable tax treatment of MLPs as “pass-throughs” not subject to federal income tax, the lack of consensus in Washington is expected to remain an impediment to such fundamental changes.

If history repeats itself, we will again see MLP IPOs return to favor. Likely candidates for the first IPOs after the current lull include businesses expected to generate steady cash flows over the long term.

The current spate of restructurings, due to the downturn in commodity prices and investor sentiment, could paradoxically make such assets available at attractive prices and lead to a wave of new market participants that look to the equity capital markets to help fund capital needs. For those considering the possibility of a future MLP IPO, now may be a good time to consider preparing for such an offering.

Planning to go public

As an initial matter, potential sponsors should engage competent MLP counsel to advise on the types of assets that may be included in an MLP. Federal tax law limits the kinds of businesses an MLP can hold. Generally, to qualify as an MLP, at least 90% of the MLP’s gross income each year must be “qualifying income.”

Qualifying income includes, among other things, income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil or products thereof) or the marketing

of any mineral or natural resource, as well as certain passive-type income including interest, dividends and real property rents. Recent proposed regulations (expected to be finalized this year) expound upon the meaning of these terms.

For businesses that do not clearly generate qualifying income, it may be possible to seek a private letter ruling from the Internal Revenue Service con-firming qualification.

Assets may be “qualifying” but still not “suitable” for inclusion in an MLP. A sponsor’s investment bankers will assist in identifying those assets that would be most attractive to investors. Hallmarks of such assets generally are long-life and steady cash flow generation. In some cases, an MLP’s

foundation can be purely contractual— its relationship with its sponsor providing the basis for the cash flows to be distributed to investors—but the MLP’s actual ownership of assets, i.e., through its wholly owned subsidiaries, generally provides a simpler and more transparent basis for description in the MLP’s offering documents.

Bankers’ role

Investment bankers will also assist in “sizing” the assets to be included in the MLP at IPO, in order to achieve the appropriate balance between common units to be issued to public investors and the sponsor’s retained equity (including “upside” potential in the form of incentive distribution rights), after taking into account the MLP’s out-standing indebtedness.

Substantial planning may be required to ensure that the sponsor’s financing agreements will permit the proposed MLP, and counsel with experience in evaluating MLP-friendly financing agreements should be consulted when obtaining credit in order to gain maximum flexibility. In any event, additional work will doubtless be required when proceeding toward IPO, when the assets expected to be included in the MLP have been identified. Obtaining lender consents and amendments to credit agreements can be a time-consuming process.

Asset separation

During the preparation stage, assets that will be included in an MLP IPO may be segregated into a separate limited liability company, or LLC, or other business entity in order to facilitate a future MLP IPO.

It is frequently determined to be more convenient and less costly to transfer the equity interests of a wholly owned LLC into an MLP at the time of an IPO, rather than attempting to assign assets. Contractual and legal restrictions on transfers of assets, e.g., “change of control” clauses, should be reviewed early on to determine any impediments to proposed asset segregations or transfers to the MLP. In some cases, contractual or legal restrictions on transfer will permit transfers by operation of law, thus requiring intercompany mergers or consolidations to accomplish the inherent goals.

The MLP’s prospects for growth are also an important topic for discussion at IPO, and a financial model will be required in the offering documents. Thus, the process of identifying assets to be contributed to the MLP at IPO will also generally involve a discussion of assets to be retained for future dropdown.

For this purpose, some equity interests in subsidiaries to be contributed to the MLP at IPO may be retained by the sponsor for future contribution to the MLP. The sponsor’s retention of assets to be contributed after the IPO is sometimes referred to as a “built-in” growth story.

Additional structuring may be required to assure that any interests in MLP subsidiaries to be retained by the sponsor do not affect the MLP’s qualification as other than an “investment company” under the Investment Company Act of 1940, which can be implicated if “investment securities” represent a significant component of the MLP’s assets.

Tax minimization

Preparation for an MLP IPO will also involve planning to minimize taxation of the sponsor on the receipt of cash proceeds from the IPO. While distributions of the proceeds of an MLP debt issuance generally may be received tax-free to the extent of the sponsor’s just two years of audited financials for such companies.

An emerging growth company for purposes of the JOBS Act is generally a company with annual revenue of less than $1 billion in its most recently completed fiscal year.

Preparing separate financial statements can be a time-consuming task and should therefore be addressed during the planning stage. For example, particular challenges can arise when the business being dropped into the MLP at IPO has been conducted by management team, an independent management team may be beneficial and minimize conflicts of interest. As the MLP IPO gets closer, important issues such as compensation and equity incentives to be provided to management will need to be fleshed out.

Throughout the planning process, sponsors need to be careful to observe the requirements of securities laws regarding disclosures about a potential MLP IPO. For this reason, it is sometimes advisable to limit the personnel involved in the process and “share” of this debt, distributions of equity proceeds may be taxable unless a special exception applies. For this purpose, the manner in which the sponsor has organized itself internally, including whether it has funded the development of the assets to be included in the MLP through debt or equity, can have an impact.

As a result, tax counsel should be consulted early in the process in order to help determine the best structure for the acquisition, development and ownership of the assets that may potentially be included in the MLP, as well as the timing for the inclusion of these assets (at IPO or later dropdown).

Financial statements

Potential sponsors should also attend early to the preparation and audit of financial statements for those portions of a business that will be dropped into the MLP at IPO. The MLP will need to present at least three years

of audited financial statements in its IPO prospectus, unless it qualifies as an “emerging growth” company and chooses to take advantage of an exemption provided by the Jumpstart Our Business Startups Act, or JOBS Act, which permits the provision of the sponsor as part of and along with other similar assets that will not be part of the MLP. In such cases, separate financial statements will not exist for the MLP assets, and it is frequently the case that no basis exists for apportioning overhead and similar expenses between the MLP and the sponsor. In that case, the sponsor will need to work with its lawyers and auditors to seek pre-approval from the Securities and Exchange Commission staff for the presentation of more limited, carve-out financial statements.

Selecting management

Consideration during the planning stage also needs to be given to the MLP’s board of directors and management team, as well as the other employees that may be needed to service the assets included in the MLP, and the continuing relationship between these employees and the sponsor.

The MLP will require its own board of directors, and certain of these directors must meet applicable independence requirements at various stages of the IPO. While the MLP’s sponsor generally controls the MLP’s general partner, and the general partner or its affiliates typically employ the management team, an independent management team may be beneficial and minimize conflicts of interest. As the MLP IPO gets closer, important issues such as compensation and equity incentives to be provided to management will need to be fleshed out.

Throughout the planning process, sponsors need to be careful to observe the requirements of securities laws regarding disclosures about a potential MLP IPO. For this reason, it is sometimes advisable to limit the personnel involved in the process and for legal counsel to conduct a tutorial regarding the disclosure rules for the working group.

Looking ahead

MLPs have shown resilience through prior downcycles, and in our view, remain a viable means for raising capital. Substantial time and effort are required to plan and execute an MLP IPO. Additional time and effort may be required in the event proper consideration is not given to the potential for an MLP IPO at the time assets were acquired or developed or financing agreements were negotiated.

With proper planning, the time and effort required to accomplish an MLP IPO can be reduced and the tax costs associated with receipt of IPO proceeds minimized. Sponsors that may benefit from an MLP IPO should consider using the current downturn as an opportunity to review these matters in order to plan and prepare for an MLP IPO that can be conducted once favorable market conditions return.

Comments