On Sunday evening, giant Houston-based pipeline operator Kinder Morgan announced it was buying up its three independently traded partnerships for an all-in price of $US71 billion, the second-largest energy transaction ever.
Investors loved the deal: Shares in all four Kinder units were rallying Monday morning.
CEO Rich Kinder has made $US1.5 billion today alone on the increase in his shares.
The reason: Kinder Morgan has been under pressure to lower its cost of capital. The announcement instantly blows up those concerns by creating an entirely new corporate structure.
It’s also a sign that Rich Kinder remains one of the canniest players in the energy world.
“One thing Rich Kinder has shown an absolute brilliance for is reinventing his company to drive growth going forward,” Morningstar energy analyst Jason Stevens told Business Insider on Monday. “It’s very much unique to their current structure.”
The Kinder Morgan family comprises Kinder Morgan Inc., a general partner, and three master limited partnerships. MLPs are publicly traded firms that pay no corporate income taxes, which allows investors to avoid getting levied twice on dividends.
Most MLPs have two obligations: paying out to investors, and paying what amounts to a performance fee to a general partner. This gives the GP an incentive to grow returns to the MLP’s investors, so that returns to the GP investors can also grow.
But the “fees” to the GP increase with each increase in distribution to MLP investors. Morgan Stanley says that in many cases they can reach of 50% of the MLP’s total cash payout.
And one morning, KMP investors woke up to find themselves paying out close to a 50% fee to KMI.
According to Tudor, Pickering, Holt & Co.’s Bradley Olsen, KMP now sits on a $US17 billion queue of “great near-term and medium-term projects: Marcellus pipes, Mexican gas exports, Canadian crude pipelines, and coastal dock expansions, to name a few, along with exciting growth in the CO2 production and transport business.”
But the returns on those projects were getting shifted to KMI.
“We assume that KMP’s backlog will generate unlevered [returns] of 14%, in-line with historical averages. With the current GP burden sucking up 45% of total cash payout, a staggering $US16B in projects will generate only ~$0.40-0.50/unit of [cash] at KMP, or 8% LP accretion.”
Hedgeye Risk Management analyst Kevin Kaiser highlighted this issue last September, calling it “an enormous transfer of wealth from KMP [the MLP] to KMI [the GP].”
Morningstar’s Stevens estimates that KMP’s all-in cost of capital was hitting as much as 12%, endangering returns to both KMP and KMI investors.
“[For KMP] to do deals or put forward new capital growth — that’s a pretty high hurdle rate,” Stevens said.
So, everyone began forecasting KMP would someday “take out” KMI, the parent, eliminating its albatross.
But no one expected the opposite would occur: that KMI would simply capitalise on its own lopsided cash receipts.
“The deal announced Sunday turns this on its head and takes advantage of the relative discount the market had assigned to KMP and other Kinder family master limited partnerships,” Stevens said in a note.
RBC came up with a nifty graphic showing what the Kinder family looks like under one roof:
Kinder itself had once raised the prospect of a merger. In response to a February Barron’s article from Andrew Bary restatingthe KMP payout balancing act problem,the firmreleased a six-page response that addressed the prospect of consolidation:
Q: Would KMI ever merge with KMP the way Enterprise Products merged with its GP?
As was mentioned in our analyst day materials, KMP would consider other options if we get to a point where we cannot deliver attractive returns to LP investors. However, we do not believe we are at that point. We would point out that KMP has a highly attractive total return prospect, with a current yield of nearly 7% and a target distribution growth rate of 5% for the next three years supported by organic expansion capex projects of nearly $US14 billion that we expect to place in service over the next 5 years.
Since February, the Kinder family has rallied about 8%.
And on Sunday, Kinder decided that now is the time to get even more appealing. In a note this morning, RBC capital management said the move comes a bit earlier than they’d foreseen, but that it will allow the Kinder Morgan empire to cut its capital costs by nearly half by knocking out those cash distribution obligations.
Meanwhile, everyone is crediting Rich Kinder’s manoeuvring. Forbes’s Chris Helman points out that he “has shown an uncanny ability to move ahead of the market,” citing things like his early purchase of Enron’s pipeline business before the energy giant collapsed; a 2006 leveraged buyout of Kinder Morgan Inc. for $US21 billion, and re-IPO’ing in 2011.
“Why should this be any different?” Helman says.
And that seems to be the big takeaway from the deal: Kinder Morgans problems were real, but anyone who believed they wouldn’t be able to find a way out of it was setting themselves up for some pain.
There may be implications for other MLP players. Some analysts, including Morningstar’s Stevens, are saying that at least one other firm, Energy Transfer Partners, is in a similar position that Kinder was in, and that there may be others.
“There is a very strong argument that general partners get too much of the incremental cash flow, and these mergers help to address the problem,” SeekingAlpha user “SeekingProfits,” wrote on that site.
Meanwhile, once the deal goes through (which won’t happen until Q4), Kinder Morgan will likely be in a position to take on even more projects, including other MLPs. RCB notes KMI now expects about $US20 billion of tax savings over the next decade and a half.
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