Howard: Midstream’s M&A Renaissance

Publicly traded midstream companies are having a dealmaking renaissance. Through a combination of actions taken by the companies themselves and of broader market trends, the sector finds itself in a dealmaking environment reminiscent of the sector’s early days in the late 1990s and early 2000s.

I don’t mean we are in an era that will see the largest deals or the most deals ever. I just mean the conditions exist for the large midstream companies to buy assets from willing sellers at reasonable valuations with limited competition.

Reminiscent of the early days

Not many other buyers: In 2000, the midstream sector included just 14 listed companies with market caps greater than $250 million. There just were not that many companies, and even fewer that were actively pursuing M&A.

Today, there are around 20 publicly traded U.S. midstream companies and the number continues to fall.  Also, like in 2000, there are not many dedicated pools of private capital actively investing in midstream assets. The massive infrastructure funds that were active in midstream M&A in 2017-2020 have been allocating elsewhere, for the most part.

Valuations: Transaction multiples on asset acquisitions in midstream in the early 2000s were around 8x-9x EBITDA. The last two years, the average asset acquisition multiples are in that same range. Even with midstream companies trading around 9x-10x EBITDA, the math works for midstream companies to buy assets at 8x-9x current EBITDA, especially if the deals are funded without equity issuance, and if the deals are “bolt-on” in nature such that they drive synergies over time.

Now and then

Midstream companies today have:

• Lower payout ratios of around 50% versus 100% plus back in the day.
• Lower leverage of around 3.5x net debt to EBITDA, down from more than 4.5x on average historically, peaking at around 5.0x in 2016.
• Actual free cash flow, with many midstream companies considering buybacks and dividend increases to avoid leverage falling too far below stated targets.
• No reliance on external financing, a result of the model of retaining cash flow.
• Not as much new infrastructure needed. In the late 2010s, as competition for M&A grew more intense, many midstream companies shifted to major projects. So-called “organic growth” became the new way to grow for companies like Enterprise Products Partners, Energy Transfer and MarkWest Energy.
• No incentive distribution rights (IDR). MLPs used to have the burden of paying out extra distributions to their sponsor as their per unit distributions or number of units grew. IDRs are long gone for 95% of the midstream space (Sunoco (SUN) and Cheniere Energy (CQP) are the only meaningful IDR payers out there).

So, the model today is quite different. In the early days of midstream, acquisitions were generally funded by equity offerings because there was no free cash flow and limited debt capacity. Deals were still accretive because the offerings were in high demand and the multiples paid for assets were lower than the trading multiple of the companies. The more evolved model works well for bolt-on acquisitions. 

How conditions arose

In addition to the self-help of distribution cuts, IDR eliminations and capital discipline, several factors have led to the current dealmaking environment.

The market hated the volatility of midstream, and the broken promises reflected in distribution cuts across the sector did not help. Capital moved out of the midstream sector from around 2014 to the early 2020s. More recently, midstream volatility has shifted lower and stock prices have consistently grinded higher for going on four years now. 

The market hated the fossil fuel nature of their businesses. This impacted stock prices of listed midstream companies and contributed to negative fund flows for a time. But the longer lasting impact of the ESG movement was the shift away from midstream investments by large infrastructure private equity funds. That large pool of capital moves slowly, but several years ago, most private infrastructure investors came to believe investments in midstream were not worth the effort. Because even if a given midstream investment were small in the context of a broader portfolio, there was a view that the fund managers would end up spending all their time in client reviews and in marketing meetings justifying these high carbon midstream investments. Infrastructure funds have instead targeted less “controversial” investments such as renewables, data centers and transportation investments. 

The market has not been interested in new company formation in midstream. We have not had a midstream MLP IPO in the last seven years, not since 2017. That has left dedicated energy private equity firms without IPOs as an exit option, limiting alternatives for sellers of assets.

The market viewed midstream as a proxy for oil prices, with correlations above 0.50 from 2016 to 2022. As the sector’s financial situation has improved, correlations of midstream stock prices and commodity prices have trended lower as well

In 2024, midstream stock price correlation to oil prices is around 0.24. Correlation for midstream stocks to energy stocks is down as well, from a five-year average correlation to the XLE of 0.84 to 0.73 in 2024 (through the first half of the year).

Finally, time and precedent transactions have helped seller expectations settle lower, into the dealmaking zone.  In the early days of some of the above changes to the dealmaking environment, sellers were clinging to high expectations for the value of their assets upon a sale. Over time, those expectations drifted lower. Capital-constrained buyers have been disciplined over several years, which helped. The result is an ideal setup for midstream companies to continue to deploy some of their growing free cash flow into M&A at reasonable valuations, supportive of a virtuous cycle of returns. 

Dealmaking spoiler-makers

Nothing is permanent, and something will disrupt the recent equilibrium. I came up with a non-exhaustive list of potential disruptors:

• The anti-fossil fuel sentiment could swing back the other way and there could be too much enthusiasm for energy investment. That could manifest in the return of big private infrastructure capital into the bidding processes that raises valuations of assets or prices out midstream companies;
• Cheap money could return to the market in general, encouraging more reckless capital allocation in the midstream space. This is part of what happened to MLPs and midstream in the late 2000s through mid-2010s. Capital was cheap, midstream companies pursued growth aggressively, asset acquisition multiples shot up, returns on capital fell and the midstream business model broke down; or
• Investment bankers take a shot at the IPO market. If a private midstream company successfully executes an IPO that prices at a valuation above where transaction valuations would settle, it could encourage more IPOs as the primary exit alternative. That could lead to fewer attractive assets for midstream companies to acquire, while at the same time creating new competition for future potential assets.

The current conditions rhyme with the early days of MLPs, which is a good thing, because in those early days the midstream model worked well. Growth through acquisition works … if asset valuations remain checked by capital discipline and limited fund flows.

Without the accelerant of cheap capital and other aggressive bidders, I don’t see the midstream business model collapsing as it did in the mid-2010s. But like everything in the energy space, these things operate in cycles. Right now, the cycle favors the shrinking number of large, well-capitalized buyers, but that music will stop at some point.

Hinds Howard is a portfolio manager at CBRE Investment Management.