Why are the MLPs' performances this second half so weak? A number of technical factors are weighing on the group and may continue to do so for the next quarter or so. While the universe of MLPs has expanded, it is still a relatively small and immature group with a combined market cap of roughly $132 billion. (By comparison, the market cap of ExxonMobil alone is $507 billion).

By Wachovia Capital Markets' count, a small number of MLP-dedicated closed-end and hedge funds control roughly $15.8 billion of assets, or 12% of the total MLP market. Thus, actions by any one of these funds can affect MLP stock prices.

The other end of the PIPE: What goes in must eventually come out. PIPEs (private investments in public equity) have created concentration risk among certain MLPs in the sector, as a large percentage of these partnerships' available float is held by a relatively small group of institutional investors. Of the $11.5 billion of total equity raised in 2007 through early October, $8.4 billion, or 73%, has been raised through PIPE transactions.

The expiration of lock-up periods on recent PIPE transactions could create downward pressure on the underlying MLPs. Typically PIPE participants are restricted from selling units for 90 days after the closing date of the PIPE agreement. Notably, some of the worst-performing MLPs since August have been those with significant PIPE investor exposure. Even though the lock-up periods may not have expired, the market may be reflecting the large overhang of equity that may come to market in the near future.

By early October, the lock-up periods for 16 PIPE transactions totaling $3.5 billion of equity had expired, which could create downward pressure on the underlying MLPs. Notably, partnerships could have as many as 275 days from closing before having to actually register the units or incur penalties. Therefore, the repercussions of the lock-ups expiring still might not be felt as there could be a delay between when investors are allowed to sell units and when the units are actually registered and available for resale. An estimated 12 PIPE transactions have lock-ups expiring in this quarter, representing $4.9 billion of new equity that could hit the market.

Institutional demand-where art thou? Institutional capital in the space has diminished due to a number of factors. Increased institutional (i.e. hedge fund) demand for MLPs propelled the group's strong performance in first-half 2007. However, after the August correction, it seems some of these (momentum) investors have left the MLP sector (either by choice or out of necessity).

A tightening credit environment may be causing leveraged funds to liquidate positions. In addition, some funds may be experiencing redemptions after a drop-off in performance.

Another telltale sign that some institutional investors may be exiting the MLP sector is the recent increase in large block trades. By Wachovia's count, there were 61 large block MLP trades (100,000 units or more) in August and September (as compared with 90 between January and July 2007).

In addition, with recent IRS inquiries concerning total-return swaps, the market apparently has been diminished, which is likely to reduce demand for MLPs. Finally, while PIPE deals continue to get done, discounts have widened dramatically despite the increase in the number of participants. This indicates that investors are being more discerning and MLP institutional investors' available capital may have shrunk as it is taking more participants to "fill" the PIPE.

The unknown on the demand side remains retail investors. With a dearth of public-equity offerings, it is hard to gauge retail demand for MLPs, though it is suspected that it is quite healthy. The Wachovia MLP team believes the follow-on offering for Targa Resources Partners was a litmus test for retail demand.

The partnership was looking to raise approximately $350 million to fund its drop-down acquisition from its parent. It raised more than $400 million. Notably, the partnership chose to forego the PIPE market, as discounts widened to the point where they were unattractive relative to a traditional secondary offering.

Increased volatility tied to derivatives trading. A spike in derivatives-contract trading since July may be causing additional volatility in the sector. With more institutional investors involved in the MLP sector, some of these institutions may have employed certain higher-risk strategies using options to enhance portfolio performance. With the August decline in MLP prices and the continued underperformance, these funds may be unwinding positions to satisfy margin calls.

A potential equity overhang. On the supply side, a large pipeline of IPOs remains (mostly upstream), which could test the supply/demand dynamic during this and the coming quarter. Based on S-1 filings, there were 12 potential IPO candidates by early October, which in aggregate could raise approximately $4 billion during this and the next quarter.

Furthermore, some five MLPs will need to raise $2 billion (including BreitBurn Energy Partners LP's announced $1.2-billion PIPE) in this quarter to shore up their balance sheets and/or finance announced drop-downs. Another three MLPs could raise an additional $700 million of equity to finance organic and acquisition-related growth. In total, approximately $2.5 billion of equity will be raised in this quarter, excluding financings for assumed acquisitions/organic growth projects.

However, some of these MLPs with relatively solid balance sheets could potentially postpone equity offerings or drop-downs. Additionally, retail investors could absorb some of the equity coming to market, given the greater number of brokerage firms with large retail systems that are now in the space and the fact that mostly institutional investors participating in PIPE transactions have been involved in equity offerings in the first three quarters of 2007.



Where to from here?

If fundamentals win out in the end, then in retrospect, the uncertainty surrounding the current MLP environment should turn out to be an attractive buying opportunity. Investors with medium- to long-term time horizons (who can weather a little pressure) could be aggressive buyers in the MLP space.

Alternatively, investors could stay on the sidelines until the dust settles, but picking the bottom is easier said than done.

A revaluation to re-occur? It's also instructive to frame the current environment against the backdrop of this year's events in the MLP sector. Back in January, Wachovia predicted that MLPs would undergo a revaluation driven by new institutional capital flowing into the group, investors becoming more comfortable with the structure and strong prospects for distribution growth (a good fundamental backdrop).

By the end of March, this prediction had proven prescient (or so it appeared). MLPs reached their peak valuations in 2007 on July 13, with an average yield of 5.3% and a median price-to-discounted-cash-flow (DCF) multiple of 15.8. This is compared with 6.5% and 13.0 at the end of 2006. Along with the rest of the market, MLPs gave back most of their year-to-date gains in August, down 6.5% for the month. In early October, MLPs had a median yield and price-to-DCF multiple of 6.5% and 14.6.

So where to from here? Is the revaluation thesis still valid? It appears so, but perhaps the revaluation could be more gradual. MLPs could undergo a revaluation á la the REITs. Despite the pullback in August and recent pressure, the Wachovia team believes fundamentals for the group remain solid. The team looks for 2007 distribution growth of 9.2% (i.e. excluding GPs and 10.9% including GPs), supported by organic projects and acquisitions.

Despite some concerns, MLPs should continue to have reasonably good access to capital, albeit at a higher cost. While there will likely be additional fits and starts, the team believes a revaluation will occur as the MLP market matures, and investors continue to understand the importance of MLPs in the energy value chain.

For MLP-centric investors and analysts, it's easy to forget that MLPs are still not a mainstream security, which the team believes is good news. As more investors become familiar with the structure, MLP valuations should mature. Lastly, demographics should only help drive MLP performance over time as more retiring baby-boomers search for stable, yield-oriented securities.

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