As a rush of MLP IPOs—including two offerings that raised more than $1 billion each during the last quarter—closed out 2014, sentiment grew that the MLP IPO may not be a sure thing to reign supreme, as the midstream vehicle of choice when it comes to raising capital.

Investors have some compelling reasons to weigh other structures, such as the real estate investment trust (REIT) and the Up-C structure, Elizabeth McGinley, head of the tax practice at Bracewell & Guiliani LLP, said at the third Midstream Oil & Gas Law Conference in December organized by the Institute for Energy Law.

“We have to consider there are new sources of capital emerging for midstream development, and a lot of it is coming from tax-exempt sources like pension funds and school endowments. Other money for U.S. infrastructure is coming from foreign investors,” she said. “We obviously have to continue to satisfy the investors’ demand for high yield, and we’re seeing now more market acceptance of these different structures used for midstream development.”

Tax treatment

When one of those tax-exempt entities, say a university endowment, invests in an MLP, the partnership itself continues to operate as a flow-through for tax purposes that isn’t subject to federal income tax. But that’s not the case for the investors themselves. They are treated as directly engaged in the activity of the MLP and are taxed as if they are conducting the business themselves as co-ventures, McGinley said.

“If they’re directly involved in the business, they’re treated as having active income, which is ‘UBTI’ (unrelated business taxable income to tax-exempt investors). So, even though these investors are widely known as tax-exempt—they’re pension funds, they’re school endowments—they are subject to tax on actively generated income and most of the income from an MLP would be taxable to them,” she explained.

“It also subjects the foreign investors to tax return filing requirements in the United States, which in many cases, is less palatable than the obligation to pay the actual tax,” she said.

“So when they invest in MLPs, they have these negative tax consequences, whereas a REIT, with the proper specifications, will not yield UBTI or ECI to tax-exempt or foreign investors.”

This year, CorEnergy Infrastructure Trust Inc. officially transitioned into a REIT structure from a business development corporation. CEO David Schulte noted that an influx of cash from individual retirement accounts and other forms of tax-exempt funds represent a significant pool of capital that can participate in the midstream, but not corporate tax, by investing in a REIT.

A second structure that may see a surge as exempt or foreign investors look to avoid corporate taxation is through the Up-C structure, which has been used in other industries such as film and cable. It’s applicable across the energy spectrum, especially in the midstream space, McGinley said.

She explained that there is a tax preference for operating a business as a partnership. But only as an MLP can a partnership be traded on the public markets. The Up-C structure brings those elements together.

Up-C advantages

“Historic owners” may be private equity firms, founders or corporate subsidiaries in an Up-C structure. Within the “partnership,” they form a “Pubco” and hold “high vote” Class B shares of the entity. Interests in the partnership are recapitalized to ensure they will be exchangeable on a one-for-one basis with the Pubco’s shares; the Pubco makes an IPO using Class A shares to the public.

“The Up-C structure is the way to take a partnership public without denying the historic owners the advantages of the partnership structure. Also, it can provide additional liquidity to historic holders through a tax receivable agreement,” she said.

What’s more, the Up-C structure allows the historic owners of the entity to continue to control operation of the business—they’re not giving the business to public shareholders—but both the managers and the shareholders enjoy a tax-advantaged partnership status.

In 2013, three upstream companies filed IPOs as Up-Cs: Athlon Energy Inc. in Fort Worth, Texas (which was since acquired by Encana Corp.); Frank’s International NV in Houston; and Jones Energy Inc. in Austin, Texas, went public using the Up-C structure. McGinley said midstream companies are likely next to join the Up-C structure trend.

Deon Daugherty can be reached at ddaugherty@hartenergy.com or 713-260-1065.

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