Inside the MLP Factory

Inside the MLP Factory

Igor GreenwaldThe Wealth Summit

May 2014

Do You Like Sausage?

I know I do; let me count the ways:

• Grilled, with onions

• Smoked with sauerkraut • On a stick, fried in pancake batter (Not really, but someone out there does.)

What does sausage have to do with master limited partnerships?

Only this:

The end result is much more appealing than the preparation process

Why the bad rap for sausage factories?

“If you like laws and sausages,You should never watcheither one being made.” ─ Otto von Bismarck, maybe

Another thing The Iron Chancellorprobably didn’t say:

“If you like pithy quotes, don’tworry too much about attribution.”

Blame this man:

How are MLPs like laws and sausages?

Complex process

Assembled by specialists

Defects hard to spot

Fill a need for the public

Producers can profit by fooling consumers

The insinuation: If only you knew“The $500 billion master-limited-partnershipsector is the sausage maker of the investmentworld. Buyers love the yields ─ now averagingabout 6% ─ but many know little about how theyields are generated. And Kinder Morgan, thecountry's largest energy-infrastructure company,may be the biggest sausage maker of them all.”

“Kinder Morgan: Trouble in the Pipelines?”

Barron’s, Feb. 22, 2014  

And yet, here’s what we know:

• Sausage is tasty

• Laws keep anarchy at bay

• MLPs have been the best investment so far in this century

Deal of the Century

Source: Pension Consulting Alliance

Source: Pension Consulting Alliance

Source: Pension Consulting Alliance

Source: Pension Consulting Alliance

How Fresh Is That Sausage?

• Past performance does not predict future

• Outperformance won’t last forever

• Risk of reversion rises over time

• The role of sentiment in market cycles

Reality Check

Source: William Blair

The People’s Choice Predictable tax-deferred income

Exempt from corporate income tax

Long-term contracts, regulated tariffs

Yield above bonds, REITs, utilities

Growth industry amid US shale boom

Great long-term track record

No Contest

Source: Alerian

Drill, Baby, Drill

Source: US Energy Information Administration

Projected US energy production

Moveable Feast

Source: RBN Energy

Government shale forecasts keep missing low

Good Times, Not So Bad Times

Five Best Years

2009: 76%

2000: 46%

2003: 45%

2001: 44%

2010: 36%

Selected Alerian MLP Index annual returns since 1996

Five Worst Years

2008: -37%

1999: -8%

2002: -3%

1998: -3%

2012: 5% Sources: Alerian, Hinds Howard

The Price of Success

MLP Bulls Come LatelyNew investment vehicles by year of launch

Drilling for Cheap Capital

Source: Hinds Howard

C-Corps ♥ Selling MLPs

Recent Spinoffs: Phillips 66 Partners (PSXP) from Phillips 66 (PSX) – top ‘13 MLP IPO Valero Energy Partners (VLP) from Valero Energy (VLO) Western Refining Logistics (WNRL) from Western Refining (WNR) EnLink Midstream Partners (ENLK) from Devon (DVN) and Crosstex (XTXI) Enable Midstream (ENBL) from CenterPoint (CNP) and OGE Energy (OGE)

More In Store: Dominion Midstream LNG MLP from Dominion (D) Antero Resources Midstream MLP from Antero Resources (AR) LNG tanker MLP from GasLog (GLOG) Offshore drilling rig MLP from Transocean (RIG) LNG processing MLP from Energy Transfer Equity (ETE)

Devon’s Sweet Deal

• Devon valued (still!) at less than 5x EV/EBITDA

• Deal valued auxiliary midstream assets at 11x EBITDA

• Devon’s contribution to MLP valued at $4.8 billion

• Market has since repriced to more than $7 billion, or 16x

EBITDA

• MLP trading at three times Devon’s cash flow multiple

MLP Alchemy

PSX vs. PSXP

PSXEV = $49.3BEBITDA = $3.4BEV/EBITDA = 14.5

The high cost of the extra “P”

PSXPEV = $3.5BEBITDA = $67.7MEV/EBITDA = 51.7

• PSX owns 72% of PSXP LP units plus 2% GP interest• Investors paying more than triple for PSXP over PSX• Fast distribution growth is nice, but at 1.6% yield, not fast enough• PSXP up 93% in 9 months since IPO, 48% year-to-date• Troubling faith in perpetual growth

A Different Yardstick

Bonds Have More Fun

• Fixed income in fourth decade of bull market

• Government bonds don’t have business risk

• On plus side, bond coupons don’t grow like MLP payouts

• If rates rise, MLP yields could follow via capital losses

Why comparisons with credit yields may prove misleading

What’s Wrong

With This Picture? Anchoring bias assumes starting

price is the right one

No guarantee distribution growth builds partnership value

No guarantee yield is justified by business prospects

Many MLPs are beyond reproach and have very bright prospects, but the exceptions to this rule can be very costly

The MLP Profits Philosophy

We recommend investments, not tax shelters

We do so based on long-term fundamentals, not yield

We’re bullish on many strong MLPs and GPs

But we’re also not afraid to sell and criticize

Or to admit mistakes and change course

Strong Performance Record• Last year’s picks returned nearly 40% annualized by year-end

• Portfolio comfortably beat MLP benchmark as well as S&P 500

Timely buys:Energy Transfer Equity (ETE) +66% since 6/7/13EQT Midstream Partners (EQM) +64% since 8/12/13Sunoco Logistics Partners (SXL) +42% since 8/12/13Targa Resources (TRGP) +35% since 11/15/13

Timely sells:Eagle Rock Partners (EROC) -49% since 5/29/13Boardwalk Pipeline Partners (BWP) -42% since 11/15/13

Timely re-buys:Boardwalk Pipeline Partners (BWP) +15% since 4/4/14

Key MLP Profits Growth Themes

• LPG Exports (EPD, TRGP, NGLS)

• LNG Exports (ETE, WMB, KMI, TGP)

• Oil, Fuels Surge (MMP, SXL, BPL, OILT)

• Northeast Energy (EQM, WMB, MWE)

• GPs With IDRs (ETE, KMI, WMB, AHGP)

• Propane Logistics (APU, NGL)

A Margin Of Safety

Top 3 Best Buys (EPD, MMP, SXL) averaged excess coverage of more than 50% of distributions at end of 2013

Excess coverage can fund capital projects in place of equity/debt issuance, aiding returns

Top 3 up 16% YTD, 38% in year before yield

Let’s Talk IncentivesIncentive Distribution Rights (IDRs) pay general partner (GP) growing percentage of MLP cash flow

Typical: 15% of payout above X, 25% above Y, 50% above Z, per unit

Stated rationale: incents GP to grow MLP

Unmentioned: dilutes rewards of growth for limited partners

Perverse: Top hedge funders charge 2/20 fees; many GPs 2/50

Means GP can profit even from losing investment; fund with debt then collect almost 50% of notional cash flow boost. A sweet deal.

Or fund with equity and collect extra IDRs on new units long before any return. Also why some GPs turn their MLPs into serial acquirers

IDRs can have huge effect on returns and are main reason we tend to favor GPs over affiliated MLPs

Follow the Bouncing IDRs

In Summary

MLPs in sweet spot of domestic energy boom

Lofty valuations suggest increased risk

Downside from higher rates, lower energy prices

Returns can be tasty, but insiders eat first

We watch sausage get made so you can enjoy

Thank You.