As an investor of a Master Limited Partnership, the catalyst for high CAGR distribution growth is often by way of the Drop Down. This asset transfer at an EBITDA multiple enables the MLP to expand distributable cash flow and project future distribution growth. Having a view on the drop down impact to short- and long-term distribution growth will help investors calibrate their total return expectations. In many cases, the SEC Form 8-K filing of an "Entry into a Material Definitive Agreement" provides enough information to calculate the accretive impact on future distributable cash flow, the forward distribution yield and the potential unit price reaction.
Anatomy of a Drop Down
A drop down is an asset sale between the GP Sponsor and LP. The two partners agree to an acquisition price determined by an independent financial advisor, who renders a fairness opinion often set as a multiple of the annual EBITDA the asset is expected to generate. The purchase will be financed by the LP using some combination of cash, credit revolver, debt or equity issuance of new units. LPs which manage to get high distribution coverage will often be able to finance the acquisition partially with cash.
Benefits for the MLP: In most cases, the EBITDA cash flow and financing structure of the drop down will allow the acquisition to be immediately accretive to DCF. The cash generated by the new asset will increase the distributable cash flow per unit, which will enables the LP to increase the distribution rate to unitholders, assuming the coverage ratios are maintained. All of the costs to build the asset and obtain long-term contracts from customers to generate revenue were paid by the parent company. The ability to access the inventory of drop downs from a Sponsor is a critical catalyst for distribution growth with clear transparency and limited execution risk.
Benefits for the Parent/GP: Dropping down assets to a controlled MLP allows the parent company to monetize assets in which a significant amount of capital may be tied up, or in which the EBITDA multiples are not fully valued within their capital structure. The GP is able to sell the asset to the LP at a fair value multiple. Frequently, the company is in the upstream or downstream sector of the energy business and has built or accumulated midstream assets to support the primary business. Drop downs separate out the non-core assets from the parent's core business focus. Often, the parent has retained a large portion of the LP units as well as the GP stake - usually equal to 2% of the MLP's value - so the company receives a steady and growing revenue stream from its stake in the MLP to which the assets have been transferred. With a GP incentive distribution rights structure, drop downs will help the MLP increase the distributions to move into the higher IDR splits. The GP can receive up to 50% of the accretive cash flow back by way of the IDRs. For those without IDRs, the GP may benefit from their LP ownership and participate equally with the LP unitholders to receive distribution growth.
Evaluating the DCF Increase From a Drop Down
The details of a drop down transaction can be used to calculate the estimated DCF benefit per unit. For example, with its fourth-quarter earnings conference call, Summit Midstream Partners, LP (NYSE:SMLP) announced a $305 million acquisition of Red Rock Gathering Company, LLC from Summit Investments. The purchase price is at 8.7 times adjusted EBITDA for the next 12 months, including expected capex.
To calculate the DCF increase, the 8.7 times results in expected EBITDA of $35 million. The drop down will be financed with a $110 million draw on SMLP's revolving line of credit, with the balance funded from the proceeds of a recently announced equity offering. Using a spreadsheet set up to calculate finance costs, the revolver loan interest will be $8.3 million for a year (assuming it will be converted to notes) and the distributions on the additional units come to $10.2 million at the current distribution rate. Subtracting these costs leaves $16.6 million of incremental DCF from the drop down. Applying the prevailing 1.1x coverage ratio and a 25% IDR split, the $17 million of added DCF would increase the annual per unit distribution rate by 10% to $2.11 from the current $1.92.
Predicting Future DCF and Distribution Growth
The timing and size of a potential drop down acquisition makes it difficult for an MLP to accurately predict distribution growth within the fiscal year, but the DCF calculation exercise can be used to make sure an MLP company is on track to meet its guidance. Summit Midstream Partners announced the drop down with its fourth-quarter earnings report, and at the same time, increased the 2014 distribution growth guidance to 15% to 20%, up from the previous guidance of 10% to 12%. The calculation completed above shows that the drop down will go a long way to help SMLP meet the guidance.
Probably of the most current interest concerning drop downs is the date, size and timing of the first drop down to Valero Energy Partners, LP (NYSE:VLP) from Valero Energy Corp. (NYSE:VLO). VLP was spun off in December 2013. Barclays Capital has forecast the first drop down to occur in the third quarter. Barclays expects that Valero Energy Partners will grow the distribution rate by more than 20% per year through 2017 as assets move down from VLO. VLP has $375 million in cash from the IPO and a $300 million line of credit to finance any drop downs without diluting unitholders with equity issuance. PSXP surprised the market with its $700MM drop announced on 2/13/14 and has moved 14% higher, and the market has been trading VLP higher 4.38%+ with similar expectations.
Drop downs are a critical driver to MLPs' total return appreciation. Assessing the accretive impact of the drop down will position investors for higher returns.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.