- Summit Midstream bond prices remain in the tank, elevating going concern talk.
- The Simplification Transaction, while crafty, benefits the GP more than the LP when it comes down to it.
- Given the degrading earnings outlook, I do not expect the current common equity and preferred to survive upcoming maturities. This will, eventually, be a zero.
- This idea was discussed in more depth with members of my private investing community, Energy Income Authority. Get started today »
For those investing in "blue chips", having to deal with reading hundreds of pages in lending documents, analyzing financial covenants, and contemplating lender/borrower game theory was never something that they were used to having to do. Unfortunately, in the pursuit of high dividends and deep value plays in a low yield world, many investors have found themselves involved in companies or partnerships where these discussions matter and are relevant. Summit Midstream (NYSE:SMLP) was not an uncommon high income recommendation in past years, largely because it screened so cheaply versus peers. What many have discovered as the equity has lost more than 90% of its value in the past two =or so years was that discount was there for a reason: poorly-positioned assets with a deceptive valuation created by the deferred purchase price obligation ("DPPO"), essentially an "IOU" to the general partner for assets Summit Midstream counted on its financial statements but had not yet fully paid for. I've covered these issues in the past publicly (" Summit Midstream, Future Concerns Outweigh Near Term Value") and in more detail privately over the past two years. Given some deep misunderstandings on the implications of recently closed simplification transaction and high insolvency risk, I felt it necessary to cover this publicly once again.
The Debt Situation
Corporate debt, at a high level, is pretty simple. Once you make the decision to borrow, you either pay it all off before it comes due or you refinance. For Summit Midstream, the nearest dated unsecured bond maturity (CUSIP 86614WAC0) matures in August of 2022. Those bonds, even after the sketchy simplification transaction outlined further along, trade at 48% yield to maturity. That signals a high level of duress and is a clear signal that the market appetite is not there for a typical rollover of the debt at normal rates (5 - 10% interest rates). Whenever you get these kinds of distressed situations, economically interested parties get concerned - no matter where they stand in the capital structure. Very rarely do bonds "snap back" to prior trading levels absent liquidity shocks, and if they are trading this distressed now after the Federal Reserve sprinkled helicopter money across the bond markets, this means there is a high likelihood that they will not be able to be refinanced on similar terms. That is obviously important, as without a successful refinance - no matter the underlying free cash flow or forward economics - the partnership is destined for bankruptcy.
Summit Midstream finds itself in a more precarious situation than the average distressed energy stock with poor capital market availability. The Secured Revolving Credit Facility at Summit Midstream matures in May of 2022, a few months before the bonds. This is quite typical. Senior lenders want to come due first as it helps them make the most advantaged decision for them, and the senior lenders here have already been keeping the firm on a tight leash. The partnership was already forecast to violate the mandated leverage ratio of 5.5x by the end of this year, which is why they had to suspend common and preferred distributions: $1,424mm of Q1 net debt excluding the DPPO obligation and a $256mm 2020 EBITDA consensus forecast puts leverage above that threshold. The only way to avoid that situation was to direct all available cash to debt paydown. And, while leverage covenants have long been the pain point in recent years when it comes to covenant violations, Summit Midstream also has others that are in play. Most important of these is one that restricts first-lien indebtedness to 3.75x alongside other restrictions on using Revolver capacity to repurchase unsecured, which means that Summit Midstream must not only roll this unsecured bond maturity, it also has to do so in a way that does not compromise the recovery of the Revolver at the top of the capital structure.
- Sell assets: Unfortunately, Summit Midstream started this process last year and was unable to find buyers at attractive prices. Given the current energy market, this is effectively closed.
- Issue common equity: Sometimes, the common has to pay the price, but with a market cap of just $140mm, there just is not enough size and interest there to really address the maturity. Doing so is also incredibly dilutive to near term "per share" valuation metrics.
- Issue preferred stock: Summit Midstream has already gone this path, with $300mm in privately placed preferred stock sitting on the balance sheet. There is no market for issuing more, particularly with the distributions suspended on the existing preferreds.
- Issue second lien debt: This is the only option that Summit Midstream has, potentially rolling the unsecureds to second lien debt that would sit beneath the Revolver. However, given the implied asset recovery on the unsecureds, the second liens would not trade with much cushion. I don't think there is a market for $300mm in second lien secureds, which is reflected in bond prices. If the market felt that this was the likely path, the 2025's would trade at a discount to the 2022's as they would get leapfrogged by new second lien debt.
- Debt exchange: The partnership has to admit it has a debt problem, asking lenders to take a haircut by either lowering the outstanding principal due, cutting interest rates, or both. Of course, bondholders have to agree.
I see only a very narrow path to resolving the 2022 maturity. While some might say "Hey, the Senior Lenders can just ease these covenants. No big deal!", that will not happen here. To explain, put yourself in the shoes of these senior banks. You have done your research. The borrower has consistently missed its projections, including on the DPPO which was supposed to be a growth driver. Its earnings remain at risk, particularly because of its reliance on minimum volume commitment ("MVC") shortfalls. Of Q1 2020 EBITDA, $15mm (or $60mm annual) was collected from shippers on legacy systems where they were unable to meet obligations. Over the next few years, this EBITDA begins to roll off or, in the case of potential bankruptcies in this energy market, might disappear in an instant. You have run your cash flow projections, and they look dismal.
Here comes this borrower into your office. It wants that traditional three-to-five-year secured credit extension, putting the maturity of the Revolver ahead of its August 2022 ($300mm outstanding) and April 2025 ($500mm outstanding) unsecured notes, the first of which is just months away. What happens if you relax covenants? Unsecured noteholder problems now become your problem as that debt gets rolled onto your facility. While you might feel comfortable making full recovery in either Chapter 7 or 11 given your current position, you likely do not feel the same way absorbing several hundred million more in obligations in a few months. Besides, who knows what the market will look like in the future. These lenders will take their chances in bankruptcy, likely making full or partial recovery while the unsecured bonds get a significant haircut or are just issued new equity. Preferred and the common get nothing. Banks are going to balk at that extension, and that is why the unsecured notes continue to trade so poorly.
On May 03, Summit Midstream Partners agreed to acquire Summit Midstream Investments, the general partner, for just $35mm in cash plus warrants with capped value. In exchange, it received 45.3mm common units, the general partner interest, and the deferred purchase price obligation ("DPPO") receivable of $181mm related to assets that it dropped down but had not yet fully paid for. How the company would pay for the DPPO has long been a point of contention, with the exact same issues facing it as the 2022 bond roll-over: it cannot borrow more money via debt and it cannot issue common or preferred stock. This solved that problem - buy the receivable and you control its fate.
In order to fund this transaction - because as stated above Summit Midstream Partners has no capital markets access - the seller (Energy Capital Partners II or "ECR") loaned the $35mm it received back to Summit Midstream as a first-lien loan that matures in March of next year. While there was accompanying bad news (common and preferred distribution suspension, EBITDA guidance cut), the market had no reaction until the transaction closed a few days ago. Why? This part of the press release:
Through its ownership in SMP Holdings, SMLP now indirectly owns and controls the $180.75 million DPPO receivable which we intend to address in a manner that maximizes value for SMLP's stakeholders.
What does this mean? Pretty simple. Summit Midstream Investments also came with debt: an existing $158mm term loan which matures in May of 2022, secured by 34.6mm common units and the general partner interest. When Summit Midstream Partners got this Term Loan from the banks, it was written to be non-recourse to Summit Midstream Partners with no change of control provisions. While that might seem odd, it is understandable, because at the time the collateral of the pledged assets (34.6mm in shares, GP interest) had implied values well in excess of the Term Loan. In addition, the expected DPPO receivable was much larger. At one time, the DPPO was valued at north of $500mm, but has since been adjusted down because it had pricing adjustments based on EBITDA earnings. Banks felt that they had the coverage necessary, and did not protect themselves fully.
That is, of course, no longer the case. Today, the pledged assets are worth just $50mm, a fraction of the Term Loan. That is not a lot to give up to make this go away. This move, in my opinion, indicates that Summit Midstream Partners is going to default on this obligation. They cannot pay the DPPO, and to act in the best interest of their stakeholders, Summit Midstream Partners will default on that Term Loan. This eliminates the DPPO, but it does mean that Summit Midstream Partners will give up control of 34.6mm common units and the GP interest to the bank. For a firm already teetering on bankruptcy, that's a tough pill to swallow but does create value for Summit Midstream stakeholders. For those wondering why ECR sold, this is it. Even though the implied value they received on the DPPO was small, that is better than zero. Summit Midstream Partners actually gets screwed here, because if this comes to pass, all they got for their $35mm (plus interest) and warrants was 16.6mm units, worth far less than what they paid.
In keeping with confusing metrics, this does have implications for the equity. The transaction means that the partnership will be reporting inaccurate past per information if this does come to pass, primarily in the form of higher "per unit" metrics:
In addition, the remaining 34.6 million SMLP common units that are pledged as collateral under the SMP Holdings term loan will not be considered "outstanding" units under the Fourth Amended and Restated Agreement of Limited Partnership of SMLP (the "Amended Partnership Agreement"), so long as they are held by SMLP or one of its subsidiaries.
Those 34.6mm units are going to be excluded from DCF per unit and other such calculations - at least until the likely default on the Term Loan occurs. So, don't be fooled into turning bullish based on better-reported results. Outside of a miracle of paying off the DPPO or some new agreement with the Term Loan lenders, those units will eventually come back into the pool, now in the hands of the lending group which will have total control over the partnership (limited partner stake, general partner control).
That creates significant uncertainty in overall strategic direction. Banks and hedge funds rarely make good general partners, and it has been a reason that many partnerships have been sold indiscriminately in the past, such as with EnLink Midstream (ENLC) and its trials and tribulations with Global Infrastructure Partners.
While the resolution of the DPPO in this way eliminates a large overhang on Summit Midstream, it still has not spurred much of a rally in bond prices. That is concerning, and it appears the stage is set for a strategic default for this partnership over the next twelve months, likely ending up in a debt exchange offer which has become all too commonplace in recent months in the energy space. While these can be theoretically value creative for equity (debtholders take a cut, improving implied equity value for unitholders), I'm deeply suspicious that any bank will want to continue to be involved here, and will likely just look for a pre-pack bankruptcy that gives the unsecured bondholders equity in the "NewCo" that they can sell into the market to get this off their books. Units of this partnership remain a strong avoid.
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This article was written by
I have a decade of experience in both the investment advisory and investment banking spaces, with stints in portfolio management, residential mortgage-backed securities, derivatives, and internal audit at various firms. Today, I am a full-time investor and "independent analyst for hire" here on Seeking Alpha.
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