Until early this summer, certain promoters seemed to believe that they could do a magic trick that no one would catch. A larger entity would “drop down” an asset at twice what it cost to purchase or build, add a bit more leverage and call it a “yield vehicle” that would then be sold to retail investors. Adding hubris to this whole charade of financial engineering, the “sponsor” would keep an IDR so that in addition to a huge gain-on-sale, it would also get a healthy chunk of the cash flow from this “yield vehicle.” Is it any wonder that in a market starved for yield, these vehicles frequently traded with dividend yields of 8%-10%? Even retail investors weren’t totally fooled. However, the yield was the inducement to allow these vehicles to continue raising equity (see Part I).
Six months later and there are no fools left. Many of these MLPs now trade with yields well over 20%. At 8%, an investor gets intrigued—at 10%, it gets more interesting. When it pushes into the 20% range, it is no longer interesting—it is scary. Even if the numbers check out, you ask yourself, “What am I missing?” The yield was the inducement to lure in retail investors, now the yield is pushing them further away. Before, it brought in more equity capital, now it is simply bleeding capital that will be needed in the future. When you are leveraged by 4 or more times EBITDA, even a small decline in revenue can create a major solvency issue—especially when your customers are in the energy sector. Yet instead of paying down debt, these companies continue to fund ridiculous dividend yields.
The lynchpin of this conundrum are the Incentive Distribution Rights (IDRs) that are held by the “sponsor” GP. These IDRs produce huge cash flows for the people who were crafty enough to build “yield vehicles” in the first place. No one wants to give up on the IDR, especially if the cash flow from the IDR is needed to service GP level debt or the GP is partially public. (I think it’s particularly ingenious that sponsors were able to borrow and sell equity against future siphoning from “yield vehicles”).
Exclusive: York Capital to wind down European funds, spin out Asian funds
York Capital Management has decided to focus on longer-duration assets like private equity, private debt and collateralized loan obligations. The firm also plans to wind down its European hedge funds and spin out its Asian fund. Q3 2020 hedge fund letters, conferences and more York announces structural and operational changes York Chairman and CEO Jamie Read More
In any good host-parasite relationship, the parasite is careful not to kill off the host. At this point in the cycle, the IDR is killing off the host. Much like in nature, I think that the GP will have to relent a bit, but the GP will also come out ahead long-term. Wouldn’t it be better for everyone if the MLP pays no dividends for a few years and instead engages in aggressive buybacks of shares and bonds that often trade at huge discounts to par? In that case, the host will de-lever the balance sheet and very accretively reduce the share count as most of these things trade at obscenely low EBITDA multiples. The GP will get crushed in the short term, but the GP then benefits substantially in the future as there will be much more cash flow per share, leading to much higher potential payouts through the IDR. Alternatively, the IDR can be merged with the MLP as we’ve seen on a number of occasions by promoters who realize that the game is over and they ought to salvage something of IDR value before it is too late.
Now, I’m sure that some of these MLPs really can support the current dividends—but that has stopped mattering as yields go past the teens. Besides, why pay out a double digit yield when you can do something very accretive for everyone involved?If nothing else, reducing leverage and retaining capital will de-risk things and set you up to buy out failing MLPs who refused to cut.
The smart players will realize this next step in financial engineering and the greedy ones will bankrupt both the IDR and MLP. When you trade at over 20% yields, it is time to cut the dividend—watch for the companies that do this. There are huge bargains to be had in the debris of Ponzi-Land, starting with the MLPs today and the GPs with IDRs a few years into the future. Let’s just say that I haven’t slept much in 3 weeks. For the first time in ages, there are some pretty stunning bargains to be had and I’m getting educated fast and scooping them up.
The toxic debris of Ponzi-Land will be a recurring topic for quite some time. Interestingly, the trade will be pretty straight-forward—don’t buy until the day that the dividend is cut dramatically enough to spook the last few yield guys, then get greedy if it’s cheap. If they’ve already collapsed the GP into the MLP, overweight the position.