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Tune In, Drop Down

By Peter Staas on Jan. 25, 2017

The so-called drop-down transaction—where a sponsor sells an asset to its associated master limited partnership (MLP)—has a long history (dating back to 1983) as a strategy for energy companies to monetize their midstream (pipelines and processing) assets.

Not only does this approach unlock the value of midstream assets that a refiner or upstream operator may not have run for a profit, but the parent also retains control of this critical infrastructure and garners a growing stream of cash flow via their incentive distribution rights.

The number and total value of drop-down transactions announced surged in 2010 and continued to climb in subsequent years, peaking in 2015. Deal flow slowed considerably in 2016 but remained elevated relative to historical norms.

(Click graph to enlarge.)Annual MLP Dropdown Transactions

The upsurge in asset drop-downs from 2010 through 2015 reflects robust demand for midstream MLPs among investors seeking above-average yields and leverage to the US shale oil and gas revolution. Over this period, the number of fund products offering significant exposure to publicly traded partnerships increased exponentially.

(Click graph to enlarge.)
MLP Fund Launches

Robust investor demand and elevated valuations ensured that most energy-focused MLPs encountered few problems issuing equity to raise capital for growth projects and acquisitions.

Not surprisingly, this sanguine environment brought a boom in MLP initial public offerings, many of which offered exposure to growth stories that involved a significant drop-down component.

(Click graph to enlarge.)
MLP IPOs Drop Downs vs Total

Over this period, the universe of energy-focused publicly traded partnerships also expanded to include businesses outside the midstream category. New entrants ranged from petrochemical firms to contract drillers and producers of the crush-resistant silica sands used in hydraulic fracturing.

MLPs with highly visible drop-down pipelines also tended to deliver massive outperformance after their initial public offerings (IPO), as investors piled into these names for outsized distribution growth. From 2011 to 2015, many of these stocks—highlighted in green—appeared among the top 10 performers by total return.

MLP Performance

This strength was particularly pronounced in 2014 and 2015, when weakness in oil prices prompted investors to gravitate toward safety-first fare. Our investment strategy also veered in this direction, with a handful of drop-down stories joining the MLP Portfolio over this period.

Although this overweight position worked for a time and these stocks held their value reasonably well during the down-cycle, MLPs that rely heavily on drop-down strategies have underperformed since the start of 2016.

Over this period, the Alerian MLP Index has rallied 8.7 percent, while the Energy & Income Advisor Drop-Down MLP Index–an equal-weighted basket of partnerships that expect to generate the bulk of their cash flow growth through asset acquisitions–has gained only 1.5 percent. Both return figures exclude distributions.

(Click graph to enlarge.)Dropdowns vs AMZ

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