Oneok Inc (OKE) surprised sell-side analysts with their Mother’s Day acquisition announcement of Magellan Midstream, LP (MMP) at a 22% premium. Anticipated synergies of $200MM aren’t that big for the $18.8BN transaction value. Management expects that to reach $400MM+ but nobody can ever tell after the fact whether it happened or not. And given the merged entity’s $60BN enterprise value, it’s insignificant.
By resetting the cost basis of MMP’s infrastructure assets, OKE expects to realize tax deferrals with an NPV of $1.5BN. Critics assert that taxes are the chief motivation with few visible benefits from synergies. Moreover, the tax benefits are coming from long-time MMP unitholders, for whom the transaction is defined as a sale of their MMP holdings.
MLP investors enjoy tax-deferred distributions, because the K-1s allow them to include their proportional share of the business’s depreciation in their tax returns. Eventually this tax has to be paid, usually when the investor decides to sell. Making a charitable donation of MLP units is one way to avoid the recapture of deferred taxes. Another is to never sell, instead leaving the investment to one’s heirs who acquire the units with a current cost basis.
The least attractive way to deal with the deferred taxes is to be forced to pay them when the company decides to sell. This is what MMP has done. Tax impacts vary by length of ownership. The longer your ownership the bigger your tax recapture. Recent MMP buyers aren’t much impacted by this. Your blogger, a long-time MMP investor, is at the less pleasant end of this range.
MMP is treating its investors in a similar way to Kinder Morgan when they rolled up Kinder Morgan Partners (KMP) into the parent c-corp in 2014. As well as a tax bill at a time of management’s choosing, KMP investors were also stuck with a reduced dividend. Nine years later former KMP holders remain bitter.
MMP can calculate the recapture liability for all their unitholders. On Monday’s call to discuss the deal, management noted that the $25 per MMP unit cash component was based on the aggregate tax liability of MMP unitholders. Assuming they use the cash portion of the deal to pay taxes generated by the transaction, Wells Fargo calculates that the average MMP investor will suffer a 38% distribution cut. Long-time investors will do even worse, because they’ll have a bigger than average tax liability. MLP investors are highly attuned to taxes, which is why they tolerate the K-1s. A significant percentage of MMP holders will face a tax liability in excess of the cash component. They won’t be happy.
Many investors own both companies. OKE likes the diversification provided by MMP refined products pipelines, but investors already had that as separate entities. By Tuesday’s close, the 22% premium had shrunk to 13% because OKE dropped 11% since the announcement. This increases the proportion of MMP unitholders who are net worse off from the transaction after calculating the tax recapture. An investor who holds both names in proportion to their market cap has lost more on OKE’s slump than she’s gained from MMP’s rise. And that’s before adding in the cost of the recapture of taxes deferred on prior MMP distributions. The market regards this as a value-destroying transaction. It’s not even clearly good for MMP investors alone because of the recapture.
A simple way to think of the transaction is to imagine that you owned 100% of both companies. Would you borrow $5.1BN, like OKE, to pay deferred MMP taxes in exchange for a tax shield from the stepped-up cost basis? Few of us would take on debt to pay taxes sooner rather than later. Moreover, MMP investors are there for the tax deferral and have lost it. By contrast, OKE investors care more about the increased leverage than the tax shield offered by acquiring MMP assets, as shown by the weakness in OKE since the deal was announced.
Small MLPs initially performed strongly on the news, because MLP-dedicated funds like the Alerian MLP ETF (AMLP) will have to rebalance away from MMP by investing in the ever-diminishing pool of MLPs. For example, Crestwood LP (CEQP) rose 8.5% on Monday as traders anticipated this inflow of index-constrained buying. Energy Transfer LP (ET) didn’t react the same way because it’s already at its position limit in AMLP’s index.
There’s nothing about the OKE/MMP transaction that is intrinsically bullish for CEQP or other MLPs. Traders are positioning ahead of a rebalancing. The MLP structure is out of favor compared with the more conventional c-corp because of its limited investor base. Most institutional equity investors are tax exempt and face onerous taxes if they invest in partnerships. Retail investors dislike the tax complexity of K-1s.
This leaves US taxable, K-1 tolerant buyers – wealthy individuals and taxable institutions. This includes the poorly structured AMLP, which will have to accrue for taxes once more when market appreciation turns its unrealized losses into gains. So it’s hard to interpret one more MLP going away as a reason to own a concentrated portfolio of MLPs, even though MLP-dedicated funds did receive a performance bump on Monday.
The combination looks unattractive all round. SMA managers will be explaining to clients for whom they own MMP why a strategy designed to defer taxes has instead presented an unwelcome tax bill. It tarnishes the entire MLP structure, because being a long-term investor brings increased exposure to another MMP deal with sudden tax recapture. It’s unclear why investors in either company should vote to approve. We own both OKE and MMP. That will give us two chances to vote no.