Master limited partnerships as managers of private equity

EDITOR’S NOTE: This is the first of a two-part series on master limited partnerships (MLPs) and how they can use real estate investment trusts (REITs) in enabling private equity investment in energy projects and infrastructure. Timothy Michael Toy and Dan Watkiss of Bracewell & Giuliani discuss the role of publicly-traded REITS in part one. Part two, scheduled for the March issue, focuses on private REIT structures. Views expressed are solely those of the authors.

Publicly-traded real estate investment trusts (REIT) have emerged as significant managers of institutional private equity. Contributions to earnings and expanded equity capital sourcing have been the principal drivers. To date, master limited partnerships (MLPs) have not included private equity management in their growth plans. Can MLPs effectively implement private equity management strategies in order to increase distributable cash and/or fund capital projects? This article considers potential risks, complications, and benefits of an MLP expanding its scope to encompass the management of private equity. For reasons discussed below, a REIT structure may be the best platform on which a MLP might base its private equity management activities.

Overview

Publicly-traded REITs and publicly-traded partnerships, including MLPs, both avoid federal income taxation at the entity level. Generally, a REIT pays no federal income tax because REITs may deduct dividends paid to shareholders; amounts distributed are generally taxable to shareholders as ordinary income. An MLP pays no federal income tax, but instead each partner reports on its income tax return its share of gains, losses and deductions without regard to whether the partner actually receives cash distributions.

Use of publicly-traded REITs and MLPs to reduce tax has burgeoned since 1995. According to the National Association of Real Estate Investment Trusts (NAREIT), aggregate market capitalization of all publicly-traded equity REITs grew from $55.5 billion at the end of 1995 to $312.0 billion at the end of 2007. According to data assembled by Alerian Capital Management and Standard & Poor’s, the aggregate market capitalization of energy MLPs rose from $5.6 billion at the end of 1995 to $126.8 billion at the end of 2007. REITs and MLPs are established and formidable means to raise capital for buildings (REITs) and energy infrastructure (MLPs).

Public REITs have emerged as significant managers of institutional private equity. According to real estate industry observer Christopher Vallace, in the industrial REIT and shopping center REIT sectors alone, over the period Jan. 1, 2006, to June 30, 2007, public REITs raised institutional private equity in excess of $11.6 billion, while generating approximately $2.7 billion in REIT common stock offerings. Christopher Vallace’s article, “Public REITs as Managers of Private Equity,” provides an instructive overview of the emergence and evolution of public REITs as significant managers of institutional private equity.

Unlike public REITs, MLPs have not adopted private equity management platforms as part of their growth strategies. Nevertheless energy sector MLPs, according to Wachovia Research, will need to raise $8.5 billion of equity in 2008 to fund organic growth and acquisitions (primarily sponsor drop-downs). For the period 2006-2011, MLPs have announced pipeline projects that will require in excess of $24.5 billion, according to Morgan Stanley Research. While secondary equity offerings and “private investment into public equity” (PIPE) transactions have been meeting these MLP capital needs to date, the capacity of public MLP equity markets to absorb new issues appears less robust than in earlier periods.

Due to recent turmoil in the equity capital markets, MLPs have been largely shut out of equity capital markets. The last MLP equity offering was that of TEPCO Partners LP on Sept. 3, 2008, for gross proceeds of $232 million. As of Oct. 31, 2008, the Wachovia MLP Index was down 27.1% for 2008 (versus a decline of 34.0% for the S&P 500), with a median yield of 10.6%, the highest absolute yield since 2000. MLP access to public equity capital markets could be significantly constrained through at least second quarter of 2009.

A private equity management platform could enable capital funding for MLPs where access to public capital markets, for whatever reason, has become constrained. In addition, non-consolidated private REIT investments have the potential to enhance MLP cash distributions from management fees, incentive fees, and income from carried and contributed interests. Private REIT structures may also provide a means by which MLPs can raise public capital in the Australian-listed property trust (LPT) market.

Evolution of MLPs

The initial public offering for Buckeye Partners LP in 1986 heralded the era of energy infrastructure MLPs. While most publicly-traded partnerships lost favored tax status in 1987, favored status continued for existing and future MLPs provided that 90% or more of their income derived from (i) natural resources/mineral activities and (ii) rents from real property (among other specified sources). The IPO for Northern Borders Partners LP (now named Oneok Partners LP), in September 1993, involving a 70% partnership interest in a major interstate gas pipeline, marked the beginning of a period of sustained growth of energy infrastructure MLPs that has continued to the present.

The Federal Energy Regulatory Commission (FERC) encouraged further growth of energy infrastructure MLPs into the regulated pipeline sector when, following a court’s remand of its 1995 Lakehead Policy, the agency issued a policy statement in which it confirmed the right of an MLP to recover in its regulated rates an allowance for income tax to the extent its holding corporation is subject to tax. The policy statement was affirmed in 2007 on appeal by the same federal court that had earlier overturned the Lakehead Policy.

According to Morgan Stanley Research, the number of pipeline MLPs now exceeds 30, with IPOs for two significant pipeline MLPs in the last 12 months (El Paso Pipeline Partners LP, and Williams Pipeline Partners LP.)

Public REITs began managing private equity in the 1998-2000 timeframe when REIT public equity markets experienced prolonged pricing correction. Private equity management as a strategy, as Christopher Vallace explains, began in response to the pricing correction and the strategy soon evolved:

[T]he rationale shifted from purely capital-driven (obtaining broad access to capital) to the numerous motivations of today’s more established and successful managers of private equity (leveraging human capital/expertise, realizing recurring fee income and incentive-driven promoted economics, and focusing on investor relations and building a track record).

Today’s MLP energy sector seems to have entered a stage that public REITs did in 1998-2000 when the latter embraced private equity management strategies. Developing a comparable strategy for MLPs will enable them to continue to grow through capital market cycles.

REITs and private equity management

Our focus is on the business model of a public REIT with a large funds management business. Christopher Vallace aptly describes:

Public REITs typically focus on a sector-specific strategy and have developed a deep level of specialized expertise that differentiates them from conventional investment managers as [that expertise] relates to product-focused strategies. This is particularly true for select REITs that are generally considered “best of breed” operators, as investors have realized the benefit of “renting” a REIT’s operating platform to satisfy sector-specific objectives.

Managers of MLPs and upper-tier, general partner MLPs have many of the characteristics that have enabled REITs to become successful managers of private equity.

The public REIT Prologis has a particularly robust and successful private equity management platform. Indeed, PLD expanded into public funds management in 2006 with an initial public offering in Europe of a European property fund, ProLogis European Properties.

An S&P 500 index member since July of 2003, PLD owns, operates, and develops (directly or through unconsolidated investments) industrial distribution properties in North America, Europe, and Asia. PLD’s business is: (i) property operations; (ii) investment management; and (iii) corporate distribution facilities services (CDFS). Property operations represent PLD’s direct long-term ownership of industrial distribution and retail properties. The investment management segment represents the long-term investment management of property funds and the properties they own. The CDFS business segment comprises PLD’s development or acquisition of real estate contributed to a property fund in which PLD has an ownership interest (typically 20%) and acts as manager, or which are sold to third parties.

Over time, cash flows from PLD’s operations and fund management businesses have been sizeable. As of Sept. 30, 2008, total assets under fund management (from unconsolidated investees) were $23.2 billion (leveraged with an aggregate $12.7 billion in third-party, non-PLD provided debt). PLD earned $35.5 million in fees and incentives from property funds for the third quarter of 2008.

Publicly available material for a state public school employee’s retirement fund provides a perspective on the system’s rationale for investing in a PLD fund. In committing $200 million to the Prologis North American Industrial Fund, the retirement fund stressed several factors: exclusive access to PLD’s development pipeline in the United States and Canada; 20% co-investment by PLD; PLD’s extensive track record in institutional fund management; and the fact that investment through a fund structure should reduce the potential volatility present in public security positions while maintaining a degree of liquidity.

Similar to PLD, an energy infrastructure fund managed by an MLP or its sponsor (with co-investment by the MLP) seems well-positioned to respond to the alternative investment goals of institutional private equity.

Natural Gas Pipeline Company of America

In late March 2007, Kinder Morgan Inc. (now Knight Inc.), the sponsor of Kinder Morgan Energy Partners LP, completed its going-private transaction. Less than a year later, Knight sold an 80% interest in its Natural Gas Pipeline of America (NGPL) to three investors: an externally advised publicly traded Australian infrastructure fund, a Canadian pension fund for public employees, and a Dutch pension plan for employees in the Dutch healthcare and social work sector.

In addition to the 20% interest retained by Knight, Knight retained the right to operate, maintain, and further develop the natural gas pipeline system and related facilities on behalf of NGPL under a 15-year operating agreement. While the genesis of the transaction is not known, its end result is noteworthy. In addition to the management role over its sponsored MLP, Knight secured a significant role in managing a $2.1 billion investment by a public infrastructure fund and two private equity investors.

The NGPL transaction is a good example of how an MLP (here, the sponsor of an MLP) can reposition itself vis-à-vis its assets by transitioning from an ownership role to a funds management/co-investment role. The NGPL transaction did not include any United States private equity investors. As will be explained below, a private REIT structure provides a means by which United States private equity investors (particularly, those who are tax-exempt investors) can participate investment transactions like the NGPL transaction.

Unrelated business income tax considerations

Central to any private equity management strategy is attracting investment from entities whose income is exempt from US federal taxation: public and private pension funds, university and college endowments, 401(k) plans, private foundations and the like. Most (but not all) tax-exempt investors are subject to unrelated business income tax (UBIT) on certain sources of income.

State pension funds (such as California Public Employees’ Retirement System and Teacher Retirement System of Texas) are not subject to UBIT. State college and university endowments, however, are subject to UBIT. Registered investment companies (mutual funds) are also subject to UBIT but since 2004 can invest in publicly traded partnerships subject to certain limitations. The prospects for success of private equity management strategy will be enhanced by an effective and efficient means to avoid UBIT.

Income derived from the leasing of personal property (beyond a relatively modest level) is subject to UBIT, while generally real property rents are not subject to UBIT. The Tax Code’s UBIT provisions categorize virtually all energy infrastructure assets as personal property for UBIT purposes even though the assets may be inherently permanent and thus real property for other purposes of the Tax Code (for example, the Tax Code’s REIT provisions).

For UBIT purposes (but not REIT purposes), personal property includes inherently permanent non-building structures and fixtures where used “as an integral part of manufacturing, production or extraction or of furnishing, transportation, communications, electrical energy, gas, water, or sewage disposal services” (including facilities for the bulk storage of fungible commodities).

Except in certain circumstances, REIT dividend payments are not subject to UBIT. Even where the source of the dividend stream is solely personal property for UBIT purposes, if the REIT qualifies as a REIT, then its dividend payments to tax-exempt investors are not subject to UBIT. For a number of years, there was a publicly-traded REIT, Global Signal Inc., whose assets were predominately communications towers, assets that were all personal property for UBIT purposes. A REIT (unlike an MLP) has the ability to cleanse UBIT whether it is a publicly-traded or privately-held REIT. (Private REITs will be discussed in Part Two of this article in the March issue of OGFJ.)

REIT structures have two additional significant advantages over partnership structures (whether an MLP or a private partnership). First, a REIT reports its dividends on Form 1099 rather than the more cumbersome partnership K-1s. Second, holders of REIT common stock are required to file income tax returns in states only in which they would ordinarily file. In contrast, holders of partnership interests may be required to file income tax returns in each state in which the partnership generates income, which deters private equity investment in partnerships owning classes of energy infrastructure, such as pipelines, that pass through numerous states.

About the authors

Dan Watkiss is a partner in the Washington DC, office of Bracewell & Giuliani LLP. He has written and spoken on the topic of the federal regulatory implications of employing REIT structures for FERC-regulated energy infrastructure.