Seth Appel and Roger Weiss
MLV & Co LLC.
On June 12, 2013, Vanguard Natural Resources (NASDAQ:VNR) became the first energy Master Limited Partnership (MLP) to issue non-convertible perpetual preferred equity, leading the way for these types of MLPs to tap the capital markets without diluting existing investors, at a potentially lower cost than traditional capital markets products.
Since 2010, energy MLPs have raised $82 billion in equity and $83 billion in debt. This doesn’t tell the whole story as these MLPs are also looking for alternative sources of capital to help sustain the rapid growth in the sector as well as ways to lower their cost of capital.
When you combine the MLP sector’s almost insatiable demand for capital with investors actively searching for yield, one can expect more MLPs to take advantage of this new form of equity capital. By issuing a preferred, MLPs can tap into a new pool of both retail and institutional capital.
For the retail investor, in an ultra-low interest rate environment, the ability to buy higher yielding preferred shares is very appealing. Investment grade and high yield bonds (with a typical $1,000 par and traded off-exchange) are difficult, if not impossible, for retail investors to purchase. Contrast that with preferred shares, which are investor-friendly with a $25 par value and traded on a national exchange just like common stock.
One of the main benefits of issuing a non-convertible perpetual preferred is that the issuer can structure the security to attract institutional investors. Due to the inherent tax timing differences associated with an MLP K-1, these investors have, up until this point, been precluded from investing in energy MLPs. With a non-convertible perpetual preferred, an MLP issues a simplified K-1 that mimics a 1099.
These institutional investors, many of which are open and closed-ended mutual funds, have a mandate to invest in preferred and income securities. To date, Real Estate Investment Trusts (REITs) and financials have predominantly issued the bulk of preferreds in the market. The opportunity to diversify into energy is very appealing to these portfolio managers.
Some might argue that a preferred will compete for the same investment dollars as an MLPs common units. The Vanguard example demonstrates this is false. When Vanguard issued its preferred with a yield of 7.875%, its common units had a dividend yield of 8.95%. Why would a retail investor buy the preferred yielding 1.075% less than the common? For retail investors, the preferred is not a proxy for the common units, but rather a way for them to invest in a yield security of Vanguard. It is difficult for a retail investor to buy Vanguard’s April 2020 bonds which trade in the institutional market. The preferred gives these investors an easy way to play “high yield”. Interestingly, many institutions are prohibited from buying non investment grade debt, but are allowed to buy unrated preferred. Vanguard pricing of its preferred less than 90 bps higher than where its 2020 senior notes trade shows that pent-up demand exists for MLP non-convertible preferred paper. More importantly, investors will pay a first-mover premium for this paper.
Here are the basics:
- Non-convertible perpetual preferred shares are a non-dilutive form of equity capital that locks in a company’s dividend for perpetuity.
- Shares are treated as equity for GAAP and IFRS.
- Shares are typically callable at liquidation value after five years at the company’s discretion, effectively giving the company an option on future interest rates.
- The investor typically cannot put the shares back to the company.
- There are no covenants and the shares typically receive between 25% and 50% equity treatment from the rating agencies.
- Shares are never convertible into the underlying common units of the MLP, so there is no arbitrage or shorting of the common units typically associated with a convertible preferred offering.
- Shares trade on a national exchange such as the NYSE or NYSE MKT and provide an ongoing financing vehicle that can be accessed for future capital requirements.
As noted above, energy MLPs are continually looking for less expensive, more flexible sources of equity capital. They need it to sustain their robust growth. Preferred shares deliver these benefits without diluting unit holders, requiring covenants, or cross-defaulting debt securities in the event of a failure to pay a dividend. Meanwhile, institutional investors focused on yield are constantly looking for ways to diversify their income investments away from financials into high quality companies in the industrial sector. Similarly, retail investors are looking for stable fixed rate investments. MLP preferred are a uniquely situated security that fulfills a capital raising need for MLPs while providing institutional and retail investors a quality yield producing product.
About the authors
Seth Appel is a managing director and is the head of Energy Capital Markets and Roger Weiss is a managing director of Institutional Sales at MLV & Co LLC. MLV & Co. LLC is a full-service investment bank with an energy and MLP focus, with offices in New York, Houston, New Orleans, Denver, and San Francisco.