A Pipeline to Growth (Simpson Thatcher & Bartlett LLP)
Within the next five years, the United States is projected to become the world’s top oil producer.1 Driven largely by the shale revolution and technological advancements in the extraction of tight oil, the United States has experienced the fastest growth in oil production since the Saudi Arabian boom of the 1960s.2 The Permian Basin, which straddles West Texas and Eastern New Mexico, accounts for about 55% of all operating oil rigs in the United States and is expected to increase production by approximately 60% in less than fifteen years.3 While U.S. oil production is near its prior peak,4 adequate midstream infrastructure— e.g., pipelines and storage—does not exist to support the current level of production,5 and additional midstream infrastructure is needed to sustain anticipated future growth.6 The preferred source of capital for the midstream business has historically been obtained via publicly traded master limited partnerships (“MLPs”),7 but challenges with the MLP financing model has some businesses seeking alternative sources of capital. Given the structuring flexibility and long-term investment horizon of private equity, private fund structures may be uniquely situated to supplant MLPs as a source of capital for the midstream energy and infrastructure industry.
The inability to transport production from wellhead to market is a principal risk of the U.S. shale industry.8 Recently, a lack of pipeline capacity in the Permian has caused double digit price differentials for a barrel of oil between delivery points in Midland, Texas and those in Houston.9 Flaring—the burning of associated natural gas resulting from oil extraction—while decreasing globally,10 has increased in the United States as pipelines lack sufficient capacity to transport gas to market.11 Other critical midstream infrastructure associated with production activities, such as wastewater and other byproducts of fracking may also be insufficient.12 As the United States becomes an increasingly dominant force in global oil and energy markets,13 significant midstream infrastructure investment will be needed not merely to address these deficiencies, but to also increase storage capacity and to make port upgrades on the Gulf Coast in order to facilitate access to global markets for U.S. energy products.
Master Limited Partnerships
MLPs are the dominant source of capital for midstream infrastructure, representing approximately 56% of midstream market capitalization.15 As publicly traded limited partnerships, MLPs offer investors the liquidity of public markets as well as certain tax advantages, including those of pass-through entities. While MLPs have no tax or regulatory obligation to make annual cash distributions to unitholders, they have historically paid out distributions between 80% and 100% of annual cash flows per year.16 Given the dominance of cash-on-cash yield in determining market value, MLPs do not typically maintain cash reserves necessary to pursue large, multiyear development projects. Instead, they have historically raised new equity or debt in the capital markets,17 with the former having a dilutive effect on existing unitholders and the latter resulting in significant leverage. When oil prices collapsed in early-2016, transportation and processing volumes dropped18 and some MLPs were strapped for cash. Although many midstream-focused MLPs have since moved to curtail distributions in order to retain cash to finance future growth, the sector is now comparatively less appealing vis-à-vis other cash yielding investment strategies in light of the risk-return profile of midstream investments and the rising interest rate environment.19 Consequently, the cost of equity for MLPs has increased and other sources of capital may be needed to replace MLP money that has historically supported the midstream market.20
Private equity and private funds may offer a compelling alternative (or partner) to MLPs for midstream energy and infrastructure investments. As compared to MLPs, private funds typically have more flexibility to retain current income for reserves and to recycle capital from realizations. These features of the private fund toolkit give sponsors optionality to utilize cash flow for future investment or to distribute income as yield to investors. The MLP market is dominated by retail investors,21 and has faced challenges in attracting institutional capital due in part to the significant dilution risk posed by the sector’s historical reliance on cycles of equity fundraisings. By contrast, private fund sponsors are likely to be more effective in this respect in light of their strong relationship with institutional investors and their ability to offer exposure to regulated energy infrastructure without the dilutive risks of MLPs. Given the reduced volatility of private funds vis-àvis equity raised in the public markets, private equity may also be more focused on long-term capital appreciation versus the short-term cash yield pressures faced by MLPs.
Private funds also lend themselves to a degree of customization not available for products traded in public markets. The bespoke nature of private fund structures enables sponsors to develop midstream-focused energy or infrastructure products that can attract institutional capital focused on cumulative return or cash-on-cash yield. In that regard, energy and infrastructure funds have employed the full range of potential fund structures:
- Closed-end funds: Represent the traditional fund structure utilizing a fixed term (8-12 years) and investment period (4-6 years). Closed-end funds remain the most common private equity fund structure for illiquid energy and infrastructure investments. • Evergreen funds: A median between closed-end and open-ended funds (described below).
- Evergreen funds include rolling commitment periods (typically 3-5 years) and a “series” concept, with subscriptions accepted within an initial marketing period and subsequent periodic subscription windows. Each series typically stands on its own for investment and economic purposes. At the end of each commitment period, investors may choose to continue their participation at their current level, increase their commitment or cancel their remaining commitment altogether. Evergreen funds can represent an efficient on-going fundraising tool, particularly among a smaller group of investors.
- Open-ended funds: A recent trend in the private funds space. Open-ended funds are a move from the more commonplace closed-end fund model towards longer-term products, which may pair well with the long lived, physical nature of most midstream assets. Open-ended funds typically follow a modified hedge fund format, include a perpetual term and employ economics and valuation principles based on a mark-to-market approach (i.e., incentive allocation and management fees based on net asset value and unrealized values). Usually, these open-ended funds offer some manner of liquidity/withdrawal rights for investors after an initial lock-up period.
- Club funds: Can represent an opportunity for a newer energy and infrastructure fund sponsor (or existing sponsor entering the space for the first time) in order to establish a track record outside of a large, blind-pool fund. A club fund is a commingled fund product comprised of typically a small number of investors, where each investor may elect to participate in investments on a deal-by-deal basis. On the heels of a successful club fund, a sponsor may then seek to market a blind-pool product, where the sponsor retains full investment discretion.
- Separately managed accounts: Investment arrangement with a single investor. Separately managed accounts are highly customized products, representing an opportunity for creating a structure to meet the needs of sponsors and investors in an efficient manner. Separately managed accounts can take on a wide variety of terms, forms or functions, such as to further a long-term partnership, operate a multi-strategy program, or accelerate new product development.
The broad nature of the private equity structuring toolkit allows sponsors to fit their products closely to target energy and infrastructure investments, as well as to accommodate investor need.
By 2035, approximately $791 billion is projected to be invested in new oil and gas infrastructure in the United States, including about 41,000 miles of pipeline.23 As the midstream sector expands its search for capital beyond MLPs, private funds and private equity are attractive alternatives to fill-the-gap. Not surprisingly, Texas, the Energy Capital of the World, received more private equity investment in 2017 than any other state in the United States.24 Advisors to private funds will therefore need to be increasingly attune to the unique challenges posed by sponsors active in the midstream space, including those related to leverage, extended hold arrangements, environmental, social, and governance considerations, and the national security implications of certain infrastructure investments. The U.S. shale industry has matured and so has its capital needs. As a consequence, the flexibility of private fund structures should ensure that private equity has a role to play in expanding and maintaining U.S. infrastructure, and in particular the midstream infrastructure necessary to cope with the expected “colossal” growth of U.S. oil output.25