Publicly traded limited partnerships - MLPs in US

United States: A New Structure for MLP Roll Ups?
21 February 2007
Article by Keith Martin

A structure that a manager of private equity and hedge funds plans to use to take the company public may open the door to "roll ups" of wind farms, ethanol plants, solar facilities and other projects that have had trouble using master limited partnership structures
A master limited partnership is a limited liability company or partnership with units that are traded on a stock exchange or over-the-counter market.

A business structured as an MLP has several advantages over other forms of business.

First, its earnings are subject to only one level of income tax.In contrast, income earned by a corporation is taxed twice: once to the corporation and again to shareholders when the earnings are distributed as dividends. Second, unlike other partnerships, MLP units are liquid and can be sold more easily. This allows businesses organized as MLPs to raise equity more cheaply. Investors are willing to pay extra for the ability to exit the business freely. Third, an MLP has a currency — MLP units that can be sold on a stock exchange — that it can use to make acquisitions.

MLPs have been used to "roll up" or acquire multiple gas pipelines, coal reserves, propane distributors and other energy-related businesses.

However, the difficulty using an MLP is that partnerships whose interests are publicly traded are ordinarily taxed like corporations unless they can fit in one of several exceptions in the US tax code or IRS regulations. The term "MLP" refers to a publicly-traded partnership that fits in one of these exceptions.

Key to MLP Status
One exception is for partnerships that receive almost entirely eligible income. The types of eligible income are mostly various forms of passive income. Examples are dividends, interest, rents from leasing out real property and capital gains from the sale of income-producing capital assets and real property. At least 90% of the gross income that such a partnership earns each year must be from eligible sources.

Another type of eligible income — in addition to passive income — is income from natural resource businesses.This category is at the core of most energy MLPs. Eligible income includes:

income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy and timber).

The key is an MLP must do something to a "mineral or natural resource."

Geothermal energy, fertilizer and timber are considered natural resources, but Congress said that "fishing, farming . . . [and] hydroelectric, solar, wind, or nuclear power production" are not activities that deal in minerals or natural resources. Inexhaustible resources, even if natural resources, do not qualify. Examples of inexhaustible resources are soil, sod, turf,water, air and minerals from sea water.

Alternatively, a partnership can avoid being taxed like a corporation if it allows only limited trading in partnership interests.The interests could not be listed on a stock exchange or NASDAQ. Restricting trading may not be a satisfactory approach since the company will not benefit fully from the higher multiples for publicly-traded shares. In general, shares are considered publicly traded if they are listed on a stock exchange or are "readily tradable on a secondary market (or the substantial equivalent thereof)."Congress said shares are not considered "readily tradable" on a secondary market unless the share prices are regularly quoted by someone who is making a market in the shares. Also, the time frame to complete a trade must be comparable to trading on an established exchange.Thus, units are not readily tradable where one can find a quote on a computer system, but the interests cannot be sold within the same time frame as on an over-the-counter market.

Fortress Offering
Fortress Investment Group is a manager of 17 private equity and hedge funds and two other investment vehicles. The company has $29.7 billion under management. The management company is owned currently by five individuals. It earns three kinds of income: fees of 1% to 2% a year of the funds under management, incentive fees that are a percentage of the returns earned by the various investment funds, and a return as an investor on $500 million of its own money that it has either invested in or committed to the various funds.
Fortress plans to sell 13.5% of the management company to Nomura for $888 million in a private sale followed by a sale of another 10% to the public. The management company will be restructured as an MLP in connection with the transactions. Fortress filed a registration statement with the US Securities and Exchange Commission on November 8 and updated it on December 21.The sale of units is still pending.The company hopes to raise as much as $750 million from the public sale, which suggests the company is worth as much as $7.5 billion. Units will be listed on the New York Stock Exchange.

The structure Fortress proposes to use suggests a way to use MLPs for roll ups of energy projects that do not fit neatly under MLPs because they generate active income and are not considered natural resource businesses.

Fortress manages the 19 funds and investment vehicles currently through 19 separate management companies, each of which is a limited partnership. Each of these limited partnerships is currently a partnership among the five principals who own the business.

Fortress plans to form a master LLC that it intends to treat as a master limited partnership for tax purposes.The master LLC will have two subsidiaries: one is a Delaware corporation and the other is a Delaware LLC that will be treated as "disregarded," meaning that it will be treated for income tax purposes as if it does not exist.

The master LLC will have two classes of units. The A units will be sold to Nomura and the public. Unitholders will be entitled to all the economic returns, but only a 23.5% vote in master LLC affairs. The five principals will retain the B units. B units carry no economic rights, but have 76.5% of the votes. That will let the principals retain control over the business.

The principals will also retain 76.5% of the interests in the 19 existing management partnerships directly. The other 23.5% of the interests in the management partnerships will be put under the corporation or the disregarded entity depending on whether they produce eligible income for the 90% gross income test for MLP qualification. Entities that produce eligible income will go under the disregarded entity. Those that generate ineligible income will be put under the corporation. That way, the ineligible income will be converted into eligible income — by converting it into dividends — by the time it is received by the master LLC.

Fortress hopes to raise as much as $750 million in the public offering. The Fortress group has $600 million in outstanding debt currently. Roughly $250 million of the proceeds from the offering will be used to repay $250 million in debt that was borrowed in order to make distributions to the five principals. The remaining $500 million in proceeds from the public sale will be contributed by the master LLC to the corporation and disregarded entity in a ratio to be determined. However, the disregarded entity plans to lend at least part of the capital it is contributed to the corporation and take back a demand note that pays interest and can be called at any time. Some of the $888 million paid by Nomura may follow the same path.

The note is another way of converting ineligible income received by the corporation into eligible income — since some earnings will move from the corporation to the disregarded entity in the form of interest.However, it also reduces the amount of taxable income the corporation has to report. Fortress hopes that the corporation will be able to deduct the earnings it transfers to the disregarded entity as interest.The effect is to convert some portion of the ineligible income into eligible income while subjecting it to only one level of tax.

Connecting Dots
The same structure could be used to roll up businesses that do not qualify easily for MLPs.The part of the business that generates eligible income can be owned by the disregarded entity.The rest can be put under the corporation. All of the income would be converted into eligible income. Some of it would be taxed twice and some only once to the extent of the annual "earnings stripping" achieved through the intercompany note and to the extent of income that is received by the disregarded entity from operating businesses directly.

Fortress is the first fund manager in the US to try to go public. Fortress said it hopes to gain a currency it can use to make acquisitions and reward other fund employees. It also wants a source of permanent capital. Its funds have only 650 investors in total. Institutional money in private equity and hedge funds can be nimble. It wants access to another source of capital through the public markets.
The five principals in Fortress retain ownership of 76.5% of the business directly with only one level of tax.They keep their 76.5% ownership in the operating partnerships directly.

They have the option of converting their B shares in the operating companies into A shares in the MLP in the future at a one-for-one exchange. However, there is a risk that such a future exchange would trigger a tax to each principal to the extent the A shares he receives are worth more than the "tax basis" that the principal has in the B shares he exchanges. If such a tax were triggered, the MLP could benefit from a step up in the value of the various fund assets.The corporation and disregarded entity will sign a "tax receivable agreement" with the principals promising to pay them 85% of the cash value of any such step up to the MLP (including any step up that occurs as a result of the private sale to Nomura). The cash value is the ability to recover the step up through depreciation deductions over time.