With its plans to acquire and consolidate its family of Master Limited Partnerships (MLPs), Kinder Morgan Inc. (NYSE: KMI) is on the verge of transacting the second largest deal in the history of the energy business, according to Investment News. The company’s announcement has attracted a lot of attention in the business press, and speculation about the near- and long-term implications of the transaction is rampant.
Two of our funds – Oppenheimer SteelPath MLP Income Fund and Oppenheimer SteelPath MLP Select 40 Fund (the “Funds”) – are affected by this transaction as each holds a position in El Paso Pipeline Partners (NYSE: EPB), one of the three entities being acquired by KMI. As of June 30, 2014, the EPB position represented 7.9% of Oppenheimer SteelPath MLP Income Fund’s net assets and 2.6% of Oppenheimer SteelPath MLP Select 40 Fund’s total assets. OFI SteelPath is not invested in the other two entities (more on that below).
The OFI SteelPath team has analyzed the nuances, merits and implications of the announced Kinder Morgan transaction and believes the following are most relevant to our investors:
- Although the transaction will likely create a taxable event for some EPB unitholders at completion, our Funds accrue for potential tax obligations on a daily basis, resulting in a deferred tax liability (DTL), and, therefore, will not experience an additional impact at closing. The DTL accounting mechanism is a feature of the Funds’ C-Corp structure.
- KMI’s consolidation plan will not affect the NAV or performance of the Funds, according to our analysis. At the close of this transaction, EPB unitholders are expected to receive on a per-unit basis 0.9451 shares of KMI and $4.65 in cash, which represents a 15.4% premium over the EPB’s closing price on Friday, August 8. KMI management has said that the future distribution growth rate will be higher post-acquisition – which is a positive – but that lower cash receipts will lead to cash flow dilution for EPB unitholders.
- KMI, which will become one of the largest North American C-Corp energy infrastructure companies as a result of this transaction, remains well within OFI SteelPath’s investable universe. TransCanada and EnBridge, both well-established and successful companies in this sector, also employ the C-Corp structure.
- We do not believe this transaction indicates a shift in the use of the MLP structure, which we believe is well suited to remain the dominant form of organization among energy infrastructure operators. Further, the asset class remains well positioned to benefit from the expansion and growing use of energy infrastructure to accommodate growing North American oil and gas production. In accordance with our investing approach, the OFI SteelPath team will keep seeking to provide access to a broad portfolio of energy infrastructure companies that generate the benefits of tax-advantaged MLPs without the hassle of K-1 forms.
- We believe KMI’s proposal sheds light on the implications of MLPs structured with Incentive Distribution Rights (IDRs): A growing MLP with IDRs must pay an increasing amount of its incremental cash flow to the owners of the IDRs, a development that can inhibit the MLP’s ongoing growth. In recent years, a number of MLP limited partners have purchased the general partner as a way to reduce their IDR burden. With its decision to purchase the units from its MLP limited partners, KMI has done the reverse.
- Aside from their EPB holdings, our Funds do not currently hold any equity investments in KMI or in the other MLP it is acquiring, Kinder Morgan Energy Partners (NYSE: KMP), as our analysis revealed unattractive valuation metrics relative to the peer group. With regard to EPB, the investment team will assess the transaction and act accordingly. Kinder Morgan Management (NYSE: KMR), the third affiliated company to be acquired by KMI, provides investors a paid-in-kind security meant to track the performance of KMP and is not an operating MLP.
KMI remains within our universe of potential portfolio holdings, similar to other energy infrastructure focused C-Corps and, as such, we will continue to consider investment. However, we cannot comment on any future portfolio plans.
Additionally, it is likely that the transaction will have a significant impact on the primary MLP benchmark indices, the Alerian MLP Index (AMZ) and the Alerian MLP Infrastructure Index (AMZI). KMI itself is not included in either index and, as a C-Corp, will not be added to the index. According to Alerian, the MLPs that are being consolidated into KMI currently and in aggregate comprise approximately 10% and 12% of the indices, respectively. Therefore, the makeup of each index will be considerably different once the transaction closes.
Finally, we believe that the assets KMI plans to acquire are well suited to the MLP structure in the long run. It would not surprise us to see KMI eventually revisit its organizational structure and perhaps re-enter the MLP space. As always, the OFI SteelPath team is monitoring developments closely as it seeks to provide investors with competitive, tax-advantaged, and risk-adjusted returns.
Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Each Fund’s investments are concentrated in the energy infrastructure industry with an emphasis on securities issued by MLPs, which may increase volatility. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling. Additional management fees and other expenses are associated with investing in MLP funds.
The Oppenheimer SteelPath MLP Funds are subject to certain MLP tax risks. An investment in an Oppenheimer SteelPath MLP Fund does not offer the same tax benefits of a direct investment in an MLP. The Funds are organized as Subchapter “C” Corporations and are subject to U.S. federal income tax on taxable income at the corporate tax rate (currently as high as 35%) as well as state and local income taxes. The potential tax benefit of investing in MLPs depend on them being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation, its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution which could result in a reduction of the fund’s value. MLP funds accrue deferred income taxes for future tax liabilities associated with the portion of MLP distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments. This deferred tax liability is reflected in the daily NAV and as a result a MLP fund’s after-tax performance could differ significantly from the underlying assets even if the pre-tax performance is closely tracked.
The majority of distributions have been classified as “return of capital,” which reduces the investor’s adjusted cost basis.