NEW YORK--(BUSINESS WIRE)--The conversion from master limited partnerships (MLPs) to a more traditional tax paying corporate structure will likely be unique to the Kinder Morgan entities, according to Fitch Ratings. We do not believe Kinder's move is likely to start a trend of MLPs moving away from the partnership structure in the near term.
Earlier this week, Kinder announced it would be acquiring its two MLP subsidiaries, Kinder Morgan Energy Partners, LP (KMP) and El Paso Pipeline Partners, LP, (EPB), effectively rolling its partnership subsidiaries into a more traditional tax-paying corporate structure.
Kinder's main driver behind the move to consolidate was a desire to lower the cost of capital for the combined entity in order to make it more competitive and enable it to grow at a faster rate. The cost of equity capital at KMP, Kinder's largest subsidiary, was particularly high relative to smaller MLP peers due in part to the high incentive distributions that were paid out to Kinder, its general partner (GP). Following the announcement Fitch placed Kinder, KMP and select KMP and EPB pipeline subsidiaries on RWN.
The move provides an option for large-scale, mature growth MLPs facing the incremental burden of high incentive distribution rights (IDR) payments to GPs and given the positive equity response will likely be considered across the sector. However, a corporate roll-up is not the only method to address the IDR issue.
Several MLPs have taken different steps to mitigate their GP obligations - some have acquired their GPs and associated IDRs to lower their cost of capital. Others have capped their IDR splits below 50% or reset them at lower levels, which maintains some level of management incentive but provides a lower cost of capital relative to MLPs with a top distribution tier of 50%/50%. Fitch typically views the absence of or lower cap distribution tiers as a mild credit positive for MLP issuers as it helps keep cost of equity capital lower than for an MLP with high IDR splits.
MLPs are tax pass-through entities structured as partnerships that typically offer a lower cost financing vehicle for qualifying projects and assets. The lower cost of capital allows MLP-structured companies to build, acquire and operate assets with lower return hurdles and continue to grow accretively.
IDRs are usually included in an MLP's partnership agreement to promote growth by providing the GP an increasing share of an MLP's incremental cash flow. IDRs typically start with 2% of available cash going to the GP, with the distribution growing to between 25% to 50% of available cash flowing up to the GP as targeted distribution levels are reached.
As MLPs move into the higher tiers of their distribution structure, and more incremental cash goes to the GP, an MLP's equity cost of capital rises. This effectively erodes the cost of capital advantage that MLPs have relative to tax paying corporate entities. As their cost of capital rises, MLPs in the higher distribution tiers must earn higher returns on projects to support the same level of total distribution growth. KMI's consolidation plan seeks to address this issue.
For KMI, the roll-up of entities into one single creditor class simplifies KMI's corporate structure and provides meaningful benefits to KMI's credit profile, in particular, by doing away with the structural subordination that limited KMI's ratings to a notching below its operating subsidiaries and by relieving the burden that KMP and EPB's IDRs put on their ability to grow.
With cross guarantees expected to extend from and to every significant EBITDA-generating rated issuing entity within the Kinder Morgan family, Fitch expects its ultimate ratings will reflect a consolidated ratings approach that equalizes the outstanding ratings at the ratings level for KMI, which is expected at 'BBB-/F3'.The combined entities will target between 5.0x - 5.5x leverage, which is relatively high for the sector., However, KMI's asset size, scale and cash flow profile is relatively unique and much more reflective of an investment grade rating, offsetting concerns around the high leverage targets.
For further information on MLP structure please see: 'Rating Pipelines, Midstream and MLPs - Sector Credit Factors' (January 2014); 'Credit Considerations for the GP/LP Relationship (November 2013); 'Non-Traditional MLP Assets Changing Mix, Changing Risk' (May 2014).
Additional information is available on www.fitchratings.com.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.
Applicable Criteria and Related Research:
Non-Traditional MLP Assets (Changing Mix, Changing Risk)
Rating Pipelines, Midstream and MLPs - Sector Credit Factors
Credit Considerations for the GP/LP Relationship