Dropdowns—when a parent company drops down assets into its master limited partnership—may not be new, but they are quickly changing the energy infrastructure landscape. If a parent company has a surfeit of projects to finance—or perhaps just has assets whose values are not fully recognized—then moving the assets into the MLP may be just the answer to provide additional growth capital at more favorable terms or gain enhanced recognition of asset values from the Street.

Certainly, there has been no shortage of drop-downs in the news. Leading the charge this summer was Spectra Energy Corp., which announced plans for a dropdown of its remaining US transmission, storage and liquids assets by year-end. On the same day, Enbridge Energy Partners LP unveiled plans for an initial public offering (IPO) of Midcoast Energy Partners LP, a new MLP into which it would drop down all its natural gas and natural gas liquids (NGL) midstream business over four to five years. At its IPO expected to raise $400- to $500 million the MLP would hold an approximate 40% interest in the parent's midstream business.

Other dropdown activity has picked up pace as well. Later in the summer, the first drop-down of assets by EQT Corp. took place with the midstream MLP it formed via an IPO a year earlier, EQT Midstream Partners LP (NYSE: EQM). The transaction, valued at $680 million, involved dropping down the parent's Sunrise Pipeline LLC subsidiary. Further periodic drop-downs are anticipated to fund EQT Corp.'s growing capital program in the Marcellus.

In addition, Devon Energy Corp. plans to form a publicly traded midstream MLP. And Anadarko Petroleum Corp. is continuing its history of successful dropdowns to its midstream subsidiary, Western Gas Partners LP.

Ideal structures

How important can dropdowns be?

Spectra Energy Corp. outlined preliminary plans for a new, substantially larger set of assets to be dropped down to its MLP, Spectra Energy Partners (NYSE: SEP), in June of this year. Between then and the release of updated plans for the dropdown, to coincide with quarterly earnings due out in early August, the latter's stock climbed by 18.2%. This compares with a rise of just over 1% for the Alerian MLP Index.

Coupled with smaller drop-down moves previously, Spectra estimates it has created for investors $6 billion of appreciation from the gains the parent's share price and the MLP's unit price since third-quarter 2012, said Spectra Energy Corp. president and chief executive officer Greg Ebel as he provided more detailed information on Spectra's strategy on the quarterly conference call.

Spectra's initial plans in June involved dropping down all its remaining US transmission and storage assets. Those plans were subsequently updated to include an accelerated drop-down of the other half of Spectra's Express-Platte pipeline, as well as its one-third interests in the Sand Hills and Southern Hills NGL pipelines. This will result in virtually all of Spectra's US assets, apart from its interest in DCP Midstream, being dropped down to its MLP by year-end.

The Spectra dropdown is noteworthy for its transaction size, which Wells Fargo senior analyst Michael Blum values at about $11 billion. Consideration received by the parent in exchange for the assets in the dropdown is valued as follows: 172 million newly issued SEP limited partnership (LP) units ($6.2 billion); 3.5 million newly issued general partner (GP) units ($0.1 billion); and cash ($2.2 billion). In addition, SEP will assume third-party debt associated with the dropdown assets ($2.5 billion).

In terms of acquisition metrics, the dropdown transaction is being done at a multiple of 9.3 times the estimated 2014 EBITDA (earnings before interest, taxes, depreciation and amortization) for the assets in the transaction, according to Spectra, based on a 10-day volume-weighted average unit price of $36.12. This was toward the high end of management's prior guidance of a multiple range of 8.5 to 9.5 times EBITDA.

Blum, based in New York, says the Spectra and other MLP-related transactions highlight a growing acceptance of MLPs as the “ideal structure to maximize value of midstream assets,” as well as managements' attempt to take advantage of MLPs' “cost of capital advantage” to grow their businesses. For its part, Spectra's business plan is one of “strategically employing our MLP to efficiently fund our US growth,” says Ebel.

The transaction is a “win-win” for investors of both the MLP and parent, continues Ebel, citing “best-in-class assets” and strong earnings underpinning the two entities. Also, “SEP will be one of the largest fee-based MLPs in the country,” and with its greater scale after the dropdown will represent a “more robust MLP to access attractive capital markets, allowing us to efficiently fund large US growth projects.”

Upon closing of the transaction at year-end, SEP unit holders are projected to see a 9% compound annual growth rate in distributable cash per unit over 2013-2015, driven by an increase of $0.03 per unit in the first quarter of 2014 and a $0.01 per unit quarterly increase thereafter. These distribution levels are based on a 2014 projected EBITDA, pro forma for the expanded asset base, of $1.48 billion, and cash available for distribution of about $900 million.

In addition, the MLP asset base post-drop-down will be much larger and more diversified, with visibility of a significantly enhanced backlog of organic growth opportunities. The MLP is projecting some $8 billion of organic capital spending through the end of the decade, or roughly $1.1 billion per year. In aggregate, these projects will achieve returns on capital employed in the range of 9% to 10% as compared to a cost of capital of around 7%, according to Ebel.

The growing popularity and acceptance of MLPs as a financing tool offering lower costs of capital have clearly played a role in what has seemed to be a wave of dropdown activity. But what other factors have been at work? And is dropdown activity a truly new phenomenon or just a newly coined one?

Becca Followill, head of equity research at US Capital Advisors LLC, Houston, says that dropdowns have been going on under one name or another for more than 10 years, “and there's more of this to come.” She notes that there are more companies going public with assets that can be dropped down into MLPs, and cites as one example the recently public Phillips 66, which launched its MLP, Phillips 66 Partners LP, in the second quarter. “The parent has a huge backlog of potential dropdown opportunities,” she says.

However, while the precedent for dropdowns may have existed for some time—Followill points to parent Kinder Morgan Inc. dropping assets down to Kinder Morgan Energy Partners—there is no reason to hold out against the trend.

“Anyone who has not done this, who has assets that are MLP-qualifying, has to step back and look at what Spectra and other companies have done since they have made these announcements and dropped down the assets, and question why they shouldn't be doing it themselves,” she says.

Ethan Bellamy, a Denver-based senior research analyst with Robert. W. Baird & Co., attributes the wave of dropdowns to a variety of key factors: rising infrastructure capital needs to catch up with the development of new basins and changing oil flows; the fact that lower profile or noncore assets are often given partial or no credit by investors while in a C-Corp versus an MLP, offering arbitrage opportunities in their valuation; and the Federal Reserve's highly accommodative monetary policy that is, directionally, expected to become less loose in the months ahead.

Of these, he views the Fed's policy as the single-most important, driving interest rates lower and equity markets higher, and “creating massive amounts of capital availability.”

In the current policy environment, “managements are doing everything they can to effect an arbitrage of high-rate-of-return projects versus very low capital costs,” says Bellamy. “The opportunity set is huge. If you can do a deal, there is no reason to wait. Financing is unlikely to get cheaper in the future. And if the market offers you money, you take it; you make hay when the sun shines. I think that is the single biggest piece of the puzzle.”

Value accretion

Bellamy describes conditions necessary for a dropdown strategy to become a “virtuous cycle of value accretion.” The process is helped, at the end of the day, by the potential for the parent company's stock to reflect a fuller, more transparent value—hopefully based on an improved post-dropdown stock price of its MLP—once assets in the MLP receive greater credit for their cash flows as compared to a previous discount valuation at the parent level. The degree to which that may happen—and how quickly—often depends on a sense of enlightened greed on the part of the parent.

The key to achieving “value accretion,” says Bellamy, is for the parent to think in terms of being “long-term greedy over short-term greedy.” What is important is for the market to believe that the MLP will benefit from a transaction being accretive in terms of EBITDA and distributable cash flow per share and not “a fully priced monetization of assets that leaves nothing on the table for the MLP unit holders,” he says. “The problem is when you delay or push through a value at a high multiple.”

In the short term, doing a large transaction at a lofty multiple and “low single-digit” accretion may be feasible. “But that short-term greediness is not going to maximize value accretion over the long term. The best thing you can do is drop it down to the MLP at a reasonable or very attractive multiple, which will allow you to raise the distribution and also improve the value of the MLP unit.” And in turn, this will help raise the value of the parent's holding in the MLP.

Bellamy cites Anadarko Petroleum Corp.'s MLP, Western Gas Partners (NYSE: WES), as “a model of a well-executed dropdown.” The synergy of the two companies' businesses, coupled with the fact that MLP investors have benefited from accretive dropdown transactions, has led to high credibility for their strategy. “They are not just monetizing and moving assets from one pocket to the other. There is an extremely high degree of activity at the parent. They're building infrastructure assets to expedite their unconventional oil and gas development, and so they are constantly feeding the MLP.”

Another important variable in dropdowns, says Bellamy, is the degree to which incentive distribution rights (IDRs) come into play. IDRs give the parent, as general partner of an MLP, an increasing claim on distributions if certain distribution thresholds to unit holders/limited partners have been met. It is not unusual for IDRs granted to some parents/general partners to be as high as 50% of distributions after threshold levels have been exceeded.

If a parent company as general partner of an MLP has a long-term perspective, a fair and accretively structured dropdown of assets may result in greater distributions coming back to it on several fronts: from the parent's previous ownership of limited partnership (LP) units; from the LP units issued to the parent in the drop-down transaction; and from units that the parent holds as general partner. A rise in distributions resulting from an accretive transaction would benefit the parent through all these, but disproportionately via the general partner units if an IDR threshold were reached.

In light of this, Bellamy suggests suitable investors consider holding a position in MLPs made up of limited partnership interests as well as general partnership interests. Holding Western Gas Partners in tandem with its general partner, Western Gas Equity Partners (NYSE: WGP), is one example. Other things being equal, the attraction would be that if a short-term event, like an equity raise to fund an acquisition, were to dampen the limited partnership (WES) units, the general partnership (WGP) units would likely enjoy an offsetting benefit, helped by the IDRs. “It's almost like a hedge,” says Bellamy.

Can the wave of dropdown activity continue to sweep forward in a benign interest-rate environment?

“Every time you look and you think the story is over, the underlying asset base with MLP-qualifying assets just continues to expand,” says Bellamy. “As long as that asset base is growing, the dropdown story is going to be in play.”

In terms of the growing size of dropdowns, “critical mass is important, because producers increasingly want a soup-to-nuts solution,” he says. “A producer wants to focus on drilling wells. They want somebody who can get the product to market and give them the highest netback with the fewest hiccups. Typically, we're seeing the bigger entities have the advantage there.”

What could derail the dropdown trend?

Interest rate hikes by Federal Reserve chief Ben Bernanke, or a regulatory intrusion of some kind by the Environmental Protection Agency affecting activity levels in the oil and gas sector, Bellamy says. In addition, a change in the tax treatment of MLPs is unlikely, but not out of the question: “It's not zero possibility, but I think it's very unlikely.”

In the meantime, the dropdown trend continues, exhibiting what Bellamy calls “mimetic isomorphism.”

Akin to a copycat effect, mimetic isomorphism relates to when, for example, “company A does something and the stock price goes up, and they attribute that to a strategic move, and then company B is going to do it and so forth,” says Bellamy. “And so far the market has been paying for these dropdown stories.”