Private Equity In Midstream - The Bad, The Good And The Unknown

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Includes: AMID, CEQP, CNXM, ETP, NBL, NBLX, NGL, NS, PAA, PSXP, SEMG, SXE, TRGP
by: Alerian

The involvement of private equity (NYSE:PE) firms in the midstream space isn't new, but lately, PE activity has picked up, as there seems to be plenty of private capital looking for opportunities. To give a sense for the amount, PE funds raised $19.8 billion for energy-related investments (not just midstream opportunities) in 1Q 2017 alone. For MLPs, PE's involvement is a bit of a double-edged sword. On one hand, PE adds to the already intense competition in the space, but on the other hand, deep pockets can be helpful when looking to find a joint venture (JV) partner, to raise capital, or to sell assets. In other words, PE investments can set a valuation floor.

The Bad: More Competition and Potential Pressure on Returns

With roughly 100 MLPs already competing for growth opportunities, PE only intensifies the competition. PE firms enjoy some advantages over MLPs. Namely, PE firms have a lower cost of capital, which lowers their hurdle-rate when it comes to project returns. PE also has long-term investors that commit capital for years, allowing PE firms more time to see investments play out; whereas, MLPs must cater to investors that are more likely focused on quarterly results and the next distribution. With a narrowed opportunity set due to many projects from the shale revolution already being completed, increased competition from other MLPs and PE could result in fewer organic growth opportunities for MLPs or lead to more JVs going forward.

On Energy Transfer Partners' (NYSE:ETP) 3Q 2017 earnings call, management said they are routinely losing out on projects to PE, as opposed to their peers. However, management also said that PE is winning projects at rates that they don't think will be profitable in some areas due to PE firms underestimating costs due to less experience. While we doubt anyone is losing sleep over PE profits, there is the potential for the involvement of PE firms to put downward pressure on returns for MLPs' organic growth projects going forward.

The Good: A Willing Buyer, Partner, and Investor

PE's involvement isn't all bad for midstream players. For those companies looking to divest assets to shore up the balance sheet, consolidate their footprint, or raise cash for other purposes, PE firms are well-capitalized, eager buyers. PE can also make good partners - not just for their money, but also because of their connections to energy companies beyond midstream, including producers.

PE's level of involvement can vary from being a financial partner with little involvement in the operation of the assets to directly operating the assets. ETP recently sold a minority stake in the Rover Pipeline to Blackstone Capital Partners and Blackstone Energy Partners for $1.57 billion, indicating that proceeds would be used to pay off debt and fund growth projects. ETP will remain the operator of the pipeline. SemGroup Corporation (NYSE:SEMG) and NGL Energy Partners (NYSE:NGL) each sold their 50% interest in the Glass Mountain Pipeline for $300 million to BlackRock (specifically to an affiliate of BlackRock's Global Energy and Power Infrastructure Fund in partnership with Navigator Energy Services [1]). In this case, PE-backed Navigator Energy Services will operate the asset. Noble Energy (NYSE:NBL), which is an oil and gas producer, announced plans to sell its GP and LP interest in CONE Midstream (CNNX) to a portfolio company of PE firm Quantum Energy Partners.

PE firms are also potential JV partners for midstream companies. Targa Resources (NYSE:TRGP), though not organized as an MLP, sold a 25% JV interest in its Grand Prix NGL pipeline to Blackstone Energy Partners. Concurrently, TRGP inked a deal with EagleClaw Midstream, a recently purchased Blackstone portfolio company, to provide transportation and fractionation services for EagleClaw's NGL volumes. As another example, Crestwood Equity Partners (NYSE:CEQP) has a JV with First Reserve in the Delaware Basin, though the two entities are natural partners given that First Reserve owns the non-economic GP interest in CEQP and 25% of the LP interest. Noble Midstream (NYSE:NBLX) recently formed a JV with Greenfield Midstream, an EnCap Flatrock Midstream portfolio company, to acquire the Saddle Butte crude system in the DJ Basin. Greenfield Midstream will own 45.6% of the JV, and Noble Midstream will operate the asset.

PE has also helped MLPs raise capital through participation in private placements [2]. Examples include Plains All American's (NYSE:PAA) $1.6 billion private placement of convertible preferred units in January 2016 and Phillips 66 Partners' (NYSE:PSXP) private placement in September 2017. Private placements with PE firms can be a helpful alternative to accessing traditional capital markets.

Also Good: Provides Validation and Supports Valuations

In the finance world, PE has a reputation for being "smart" money. That doesn't mean every PE investment is a homerun or that PE firms are perfect operators, but the involvement of PE does lend some credibility to the midstream space. The fact that PE money is being put to work and in large amounts shows confidence in the long-term thesis for US energy infrastructure investment and that PE firms see attractive valuations in the space.

On their 3Q 2017 earnings call, TRGP's management indicated that they are seeing a lot of appetite from private capital. Asked about M&A, PAA's management said on their 3Q 2017 earnings call that there was a lot of capital and a lot of competition in the space. Like with anything, the more potential buyers the better it is for the seller, and PE involvement supports asset valuations - a positive for those MLPs selling assets. On a higher level, PE probably provides some floor to valuations for publicly traded MLPs given the amount of energy-focused PE capital waiting in the wings for opportunities.

The Unknown: What are the Implications of Private Equity Exits?

PE investments tend to be held for a number of years and then exited through a sale or an IPO. As discussed in this Forbes article, median holding periods for buyouts were approximately five years in 2016. Southcross Energy Partners (NYSE:SXE), whose GP is two-thirds [3] owned by PE firms EIG Global Energy Partners and Tailwater Capital, is being acquired by American Midstream Partners (NYSE:AMID), whose sponsor is an affiliate of PE firm ArcLight Capital Partners. Interestingly, the acquisition announcement came almost exactly five years from the date of SXE's IPO. As another example, Medallion Midstream Gathering & Processing, which had Midland Basin crude transportation assets and was 51%-owned by The Energy & Minerals Group, is being purchased by Global Infrastructure Partners, another PE firm. MLPs have also bought assets from PE, namely NuStar Energy (NYSE:NS) purchasing Navigator Energy Service's crude system in the Midland Basin earlier this year.

The PE approach is to exit eventually, so what does that mean for midstream? It could mean that there will be more opportunities in the future for MLPs to buy assets from PE firms, like what NS did earlier this year, perhaps in lieu of organic growth projects. If several assets are on the sales block five or seven years from now, it could put downward pressure on asset valuations and provide a buying opportunity for MLPs. On the other hand, different holding periods, strategies and exit plans may prevent any real noticeable impact from PE exiting. The positive or negative impact from PE's exit is probably premature to really evaluate at this point, but it's worth keeping in mind.

The Bottom Line:

With the opportunity set in midstream somewhat limited, MLPs and PE firms will probably continue to be frenemies of sorts. While management teams may worry about increased competition, the dedicated, smart PE money entering the midstream space with a long-term investment horizon provides a valuation floor and shows confidence in the fundamentals, which could help calm investor nerves about the overall health of the industry.

Footnotes

[1] Navigator Energy Services was backed by First Reserve. BlackRock acquired First Reserve Energy Infrastructure Funds earlier this year.

[2] A private placement is a method of raising capital that involves the sale of debt or equity to a small number of sophisticated investors, as opposed to the general public.

[3] Each PE firm owns one-third of SXE’s GP.

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