HOUSTON—At the recent Mergermarket Energy Forum, panelists told attendees how they expect the recent large structural changes from some of the biggest midstream players to impact the M&A space. With the recent announcement from Williams Cos. Inc. that it would roll up Williams Partners LP into a C-corp in a transaction similar to last year’s announcement from Kinder Morgan Inc. that it would absorb its MLPs, the future landscape of midstream transactions as they relate to MLPs seemed in doubt.

It’s unlikely that these transactions signal the end of MLPs in midstream, however. The creation of new MLPs is still “outstripping MLP collapse,” Will Bousquette, managing director, Goldman Sachs, told the audience. The Williams and Kinder Morgan transactions were unique in that they were “mature MLPs that had reached a point where the burden from the general partner was making it difficult for the MLP to grow because the IDR [incentive distribution right] burden with the general partner had gotten to a very high percentage of total cash flows,” he said.

The larger midstream M&A market will instead be defined by the current “massive shift in the ownership of midstream from something that was primarily controlled by retail equity investors to something that is primarily owned by institutional equity investors,” he said. The change in investor-type is leading to a shift away from traditional expectations of “yield-based valuations and relatively slower growth” to the expectation of much more significant growth, Bousquette added.

The growth expectations from institutional investors can be difficult to meet, as the cascade of recent MLP IPOs has increased competition for available acquisition targets.

“Basically, having more MLPs with robust valuations, the IPO window’s been opened,” said Jeremy Goebel, managing director, business development and strategic planning, Plains All American Pipeline LP. “These are small companies looking to gain critical mass, so they’ve been very aggressive with new entrance into new basins or business lines.”

The entrance of new MLPs into the space increased competition for assets in more than one way, Goebel continued, as it also “reduced the amount of asset transactions or company transactions that have taken place.”

“Effectively, companies that used to go through an auction process when there was no capital market availability or the IPO window open, they now run either dual-track processes or solely going down the IPO process, because the valuations are there to stop enforcing the processes in IPO valuation, but a lot of times that's not met in the open process part,” he said.

Not Enough To Go Around

Increased competition for acquisitions among the growing number of MLPs in the space means that “that there are not enough deals to go around for the number of buyers looking for deals and the amount of capital,” Jonathan Nathanson, senior vice president, corporate development, Boardwalk Pipeline Partners LP, told the audience.

“I think that midstream has got to be one of the most overcapitalized industries across the economy currently,” he said, with “an enormous variety of financial investors” looking for investment opportunities in the sector. “We’ve talked about MLPs, there are infrastructure funds … and seemingly an unlimited number of buyers in these processes.”

Several of the panelists noted the emergence of infrastructure funds as major competitors with MLPs for midstream assets. The funds are “very aggressive buyers of enormous size at very, very low rates of return,” Bousquette said. A few years ago, those funds “had return thresholds that were closer to 15% and … they wouldn’t take any kind of downside risk,” he said. “Now infrastructure funds have too much money relative to the opportunities.”

The heightened aggression of infrastructure funds in the M&A market has created “an auction dynamic where they push prices up very dramatically, and even if they aren’t the winner provide leverage to sellers on strategies that are pushing up the multiples on M&A relative to historic norms and depressing the returns that you'd expect to see,” Bousquette said. “It’s hard to know if there’s really fewer assets but there are definitely more buyers, and I think most M&A is being done to much lower returns than it was even a couple of years ago.”

Where Will It Go?

According to Bousquette, the current state of midstream M&A is typical for the progression of U.S. industry. When an industry is attracting atypically large amounts of financial capital, companies focus on internal, organic growth. “That’s where midstream is right now,” he said.

“At some point, the U.S. upstream production growth will slow, and associated with that midstream will slow,” he said. “When that happens, at that moment, as happens with basically all industries, there will be a very sharp spike upward in what I’ll call large-cap M&A in midstream.”

“So while right now large-cap M&A and corporate-to-corporate M&A is relatively uncommon compared to most other industries. That’s not something that will persist forever,” he said.

A major driving factor toward this destination, Bousquette said, is that “you cannot put the genie back in the bottle in the terms of who owns the midstream industry, which is overwhelmingly institutional investors.” When growth begins to slow and valuations come down, those institutional investors “tend to put pressure on management teams to do something,” he said, which will drive up the rate of large-cap and corporate-to-corporate M&A.

In closing, Bousquette said he expects that in a few years, M&A activity in the space will be many multiples greater than it is currently, and the majority of them will be corporate-to-corporate transactions.

“The percentage of midstream that is owned by companies that ultimately need to be responsive to the public markets is at an all-time high and only going higher, meaning there is some percentage of the industry that is and always will be controlled by private general partners who can do whatever they want for reasons that may be different than what would be typical for large public companies in other industries,” he said.

Contact the author, Caryn Livingston, at clivingston@hartenergy.com.