A Crisis In Ponzi-Land (The "Drop-Down")

February 25, 2016 1:21 AM

As I dig through the toxic debris of collapsed Ponzi-Land MLP vehicles, I keep having this recurring question; why do all these MLPs continue to have sponsors that are so aggressive in supporting the LP distributions? I’ve seen everything from; purchases of preferreds at below market interest rates, to sponsors agreeing to forgo subordinated distributions, to support agreements where they are literally gifting the MLP cash to offset its SG&A expense and maintain enough cash flow to cover its 1.0 Distributable Cash Flow (DCF) to LPs. I’m all for charity, but since when do PE funds gift public shareholders cash that they can then receive in distributions? This doesn’t seem like finance as I know it—the stock market exists to screw suckers, not enrich them. Finally, it all came together for me—these bastards have been greedy twice and they’re still screwing the LPs while trying to look generous.

I’ve already gone over the twisted incentives of IDRs—now let’s talk about the “drop-down.” The premise of a "drop-down" is that a stabilized asset is sold by the sponsor to the MLP and due to differences in yield expectations, the sponsor is willing to cash out at a higher yield than the current cost of debt  at the MLP, leading to accretion to LPs. It’s simple cap-rate arbitrage and since public vehicles often carry higher leverage ratios, it lets more leverage be employed to increase returns.

Previously, the “drop-down” always seemed like it was the true scam, designed to feed the IDR math and de-risk the return for the sponsor as the increased financial leverage was now at the LP instead of GP level. Then I realized; the gain on sale might actually be leading the whole process at MLPs. It’s easy to look at some of the drilling sponsors, see what they paid for the rig, what they dropped it down for and have a good chuckle—crafty Norwegians—they understand financial engineering with the best of them. Most transactions don’t leave such an obvious paper trail, yet as I’ve discovered, the stated ROA is the give-away that something is indeed fishy.

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Take a midstream gathering asset. It costs $50 million to build and produces $15 million in annual DCF or a 30% return—not bad. At a 10% disposition yield, it is worth $150 million. Sell it to the MLP for $150 million and voila, you have a $100 million gain on sale. The MLP borrows $150 million on the revolver at 5% and then has $7.5 million in incremental DCF with no dilution. Talk about successful financial engineering. At the LP level, it looks like the sponsor has done the LPs a favor by creating extra DCF and the press release can brag that there has been NO DILUTION, only an increase in the distribution—which makes shareholders happy—even if a good chunk of that goes back to the sponsor through the IDR.

Now look beneath the numbers a bit, the sponsor has taken all the real gains and the MLP has taken all the risk. The sponsor got a $100 million gain on sale along with an increase in the IDR. The MLP got an incremental $7.5 million of DCF with leakage through the IDR and now has $150 million of additional debt. That’s a very un-equal bargain. Meanwhile, in the 20 years that it takes to pay off the debt through DCF, the energy field has probably been depleted to the point that the midstream asset is stranded and practically worthless. It’s Ponzi-finance at its apex.  

As I search through dozens of these companies, I’m amazed at just how many of their assets seem to be earning better than 20% ROA with a massive offsetting dose of goodwill—effectively equaling the profits to the sponsors. In addition, depending on how the purchase accounting was resolved, this may also explain the huge mismatch between depreciation and DCF. In the end, the MLP is often the dumping ground for overpriced assets which are increasingly becoming stranded uncompetitive assets as volumes trail off and competing infrastructure is built. At 20% un-leveraged returns, you would expect a lot of competition and rapid margin compression—it just takes a few years to show up. It would seem that the sponsors keep the MLP lights on because there is no other way to extract huge gain on sale profits on rapidly depreciating assets—except to dump them on sucker MLP investors. They can’t even sell them to other MLPs because those MLPs have their own backlog of sponsor assets to “drop down.”

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In the 2014 vintage of MLP presentations, I repeatedly see this slide presenting future distribution growth in the form of an inventory of “future drop-downs from the sponsor.” The basic premise was that the distribution can grow forever because the sponsor has more assets that they’ll sell you. Back in 2014, that slide got the MLPs a growth multiple—today it is all quite hilarious. They were making so much money looting the LPs that they even had the gumption to brag about all the crap they were going to plug them with.

In 1998-2001 an epic glut of fiber optics was laid that bankrupted everyone who funded it. Over the past few years, the same thing has been repeated with midstream gathering assets. Much like fiber optics, the assets have value, just nowhere near what people were tricked into thinking they did. The big difference is that since the tech bubble, the promoters have matured and developed new and creative ways to screw investors.

Despite dropping 90%, many of these MLPs are not cheap. Rather, they're going to zero—in the meantime, sponsors are going to do everything possible to keep the game alive—it isn’t altruism that is supporting these companies.

Be VERY skeptical.

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