HITE Hedge Asset Management LLC:
To Ms. Lara E. Washington and Mr. Michael A. Bryson, members of the EQT Midstream Partners LP Conflicts Committee:
On November 30, 2018, Equitrans Midstream Corporation (ticker: ETRN) made an offer to its controlled subsidiary EQT Midstream Partners LP (ticker: EQM) to sell its Incentive Distribution Rights (IDRs) in EQM in exchange for 95 million newly issued EQM units. This represents a shockingly bad deal for EQM unit holders that both dilutes cash flows for the foreseeable future by >15% and values EQM’s IDRs at a 30% premium to market precedent. With no unit holder vote, it is up to the Conflicts Committee to reject this offer and negotiate an attractive deal for EQM unit holders. If an attractive deal is not possible, EQM’s Conflicts Committee should walk away from the negotiation and wait until such time as ETRN is able to acquire EQM at a premium of at least a thirty percent to its current trade, consistent with the relative MLP vs. IDR valuation present in prior transactions.
Summary
1. ETRN offer to sell its IDRs to EQM is valued 30% above where the IDRs were valued in comparable IDR-for-LP unit transactions over the past two years
2. This transaction, if consummated, would dilute EQM’s cash flow per unit by greater than 15% for the foreseeable future while most comparable transactions allow cash flow accretion by year three
3. The proposed transaction fails to address the weak governance at EQM that prevents a unit holder vote for transformative, destructive, and self-dealing transactions such as this one
4. The Conflicts Committee has an ethical and likely legal obligation to ensure EQM unitholders receive a reasonable deal, one in-line with precedent and with a pathway to cash flow accretion
5. This implies retiring EQM’s IDRs in exchange for at most 72 million EQM units, not the 95 million units in ETRN’s self-dealing proposal. This level would still value the IDRs above the average of comparable transaction, but at least would allow EQM reach cash flow to break even in 2020
6. If ETRN refuses to accept a deal within these parameters clearly set by market precedent, the Conflicts Committee must walk away from the process and await a more favorable transaction
Why is this a bad deal for EQM unitholders?
Simply put, this deal is substantially cash flow dilutive to EQM units for the foreseeable future and as such is dramatically more onerous than all other recent comparable transactions:
Cash flow per unit accretion (dilution) to LP in year following transaction: | ||||||||||
Deal | 1 | 2 | 3 | 4 | 5 | |||||
| ETRN proposal to EQM | -15% | -21% | -19% | -17% | -16% | |||||
| Average of comparable transactions* | -5% | -1% | 3% | 5% | 8% | |||||
| * See “Comparable transaction detail” | ||||||||||
It is difficult to fathom why ETRN should expect the EQM Conflicts Committee to take such a permanently dilutive offer seriously when most comparable transactions offered cash flow accretion by year three if not sooner. We also wonder, would ETRN would ever consider using its own currency to execute a permanently dilutive transaction?
Note that we cannot let the potential use of paid-in-kind (“PIK”) units confuse us. Whether distributions are paid in cash or equity, it dilutes existing unit holders just the same. The use of this financial slight-of-hand to sell a bad deal is particularly disappointing in the context of a broader MLP market moving away from this sort of device.
How does the valuation of EQM’s IDRs compare with recent transactions?
The valuation for EQM’s IDRs in the ETRN proposal is about 30% higher than comparable transactions.
When valuing the transaction, the Conflicts Committee and its financial advisors must avoid the fallacy of looking at comparable IDR multiples in isolation. The intrinsic value of IDR cash flow is unique in each case and is directly mathematically related to the value of the underlying MLP. For instance, MPLX bought-in its IDRs at a value of about 16.5X one-year forward IDR cash flow estimates, a two-turn premium to the proposed EQM transaction. However, MPLX traded at 14X its annualized one-year forward distribution at its deal price, compared with less than 10X for EQM at the time of announcement, a four-turn discount. Since IDRs are a levered play on the MLP’s distribution, the MPLX IDR multiple would need to be adjusted down by more than four turns – a 5.5 to 6.0 turn discount would be reasonable – to account for the difference in LP valuation.
A simpler way to relate the valuation of IDR cash flows to the MLP valuation is to look at how much more cashflow (or less) the GP receives each year on account of the IDR-for-LP unit exchange versus the status quo – this is the cash flow premium (or discount). This analysis makes clear that the ETRN proposal is far above market regardless of the year used to set the exchange ratio:
Cash flow premium (discount) paid for IDRs in year following transaction: | ||||||||||
Year after transaction: | 1 | 2 | 3 | 4 | 5 | |||||
| ETRN proposal to EQM | 37% | 31% | 25% | 21% | 18% | |||||
| Average of comparable transactions* | 5% | -1% | -6% | -9% | -12% | |||||
| * See “Comparable transaction detail” | ||||||||||
Clearly, paying a material premium on cash flow beyond year one is unacceptable. Moreover, the ETRN proposal is so far above market precedent that it cannot even be taken seriously as a starting point for negotiation.
What action should the Conflicts Committee take?
The
first and most clear step is to reject the current offer outright. This
deal permanently dilutes EQM unitholders, damages its financial position
and is too far away from market to constitute a serious offer. This deal
is so bad for EQM and so
far out of line with market precedent that we suspect voting in favor
would open the Conflicts Committee to legitimate legal risks and any
financial advisors it retains to the appearance of malpractice.
The simplest solution for both parties is to value the IDRs such that the deal becomes neutral to EQM cash flow per unit in 2020 consistent with market precedent. This would translate to an exchange of at most 72 million EQM units for 100% of the IDRs and GP interest. This level should not be viewed as an opening counter-offer, but rather as a reasonable compromise versus holding out for large-premium buy-in of EQM by ETRN once that option becomes available.
If ETRN refuses to accept a reasonable market price for its IDRs, then no deal is far better than this transaction and the Conflicts Committee should walk away from the process.
Conclusion
Since poor
governance at EQM prevents unit holders from voting on this
transformative and highly destructive proposal, the Conflicts Committee
is the sole hope of achieving a more balanced offer. Fortunately, there
is strong precedent from other conflicts committees negotiating
reasonable deals for their respective MLPs. This includes committees
representing EEP, EEQ, SEP, TLP, CQH, all of which received a better
deal after initial announcement. HITE Hedge seeks the opportunity to
share our analysis with you and work with you on behalf of all unit
holders to achieve a better deal.
ETRN, as primarily a holder of the general partner, also has little to gain by rejecting a fairer deal. The Conflicts Committee should make it clear that any deal close to the current proposal will never be acceptable, and ultimately simplifying the entities will be in the interest of both ETRN and EQM. Deferring the inevitable has little value.
In the end, we fully expect EQM to receive a better deal. While ETRN’s proposal is insulting even as an opening bid, there is strong precedent for conflicts committees negotiating substantial improvements in IDR-related deals. and we expect no less in this case.
Sincerely,
Matt Niblack and James Jampel
HITE Hedge Asset
Management
Appendix: Comparable transaction detail | ||||||||||
Cash flow accretion (dilution) to LP in year: | ||||||||||
1 | 2 | 3 | 4 | 5 | ||||||
| WES – proposed acquisition by WGP | +11% | +13% | +15% | +17% | +19% | |||||
| ENLK – proposed acquisition by ENLC | (1)% | +1% | +3% | +5% | +7% | |||||
| AM – proposed acquisition by AMGP | (1)% | +4% | +9% | +15% | +21% | |||||
| ETP – acquisition by ETE * | (18)% | (12)% | (7)% | (7)% | (5)% | |||||
| HEP – IDR buyout** | 0% | 0% | (1)% | (5)% | (5)% | |||||
| MPLX – IDR buyout plus dropdown** | (15)% | (13)% | (9)% | (6)% | (3)% | |||||
| ANDX – IDR buyout plus dropdown | (8)% | +1% | +3% | +4% | +7% | |||||
| OKS – acquisition by OKE | (5)% | (1)% | +8% | +17% | +19% | |||||
Cash flow premium (discount) paid for IDRs in year: | ||||||||||
1 | 2 | 3 | 4 | 5 | ||||||
| WES | (15)% | (17)% | (21)% | (24)% | (27)% | |||||
| ENLK | +3% | 0% | (5)% | (9)% | (13)% | |||||
| AM | +6% | (9)% | (16)% | (21)% | (23)% | |||||
| ETP* | +22% | +14% | +8% | +7% | +6% | |||||
| HEP** | +5% | +3% | +2% | 0% | (1)% | |||||
| MPLX** | +23% | +14% | +3% | (4)% | (8)% | |||||
| ANDX | +6% | +2% | (3)% | (7)% | (10)% | |||||
| OKS | (7)% | (11)% | (13)% | (15)% | (17)% | |||||
* ETP is the only transaction with an implied cash flow premium for the IDRs beyond year four, but ETP unitholders, in receiving ETE units in the transaction, also received significant option value in the form of the Lake Charles LNG terminal. No other transaction had a meaningful cash flow premium beyond year two
** MPLX and HEP, two of the three least favorable transactions, were situations where the MLP’s largest customer was a party to the transaction. In such a cases, you might expect a parent to extract more value in exchange for an ongoing special relationship. Removing these transactions to make the comparison set even more comparable to the ETRN-EQM situation, would make the stated comparable averages materially more favorable to the LP and the ETRN proposal even more out of line with market
Note: all estimates are based on sell side estimates or management guidance in an effort to most accurately capture the economics expected by the transaction participants at the time each transaction was announced
View source version on businesswire.com: https://www.businesswire.com/news/home/20181212005636/en/
Contacts:
Portfolio Manager
HITE Hedge Asset Management
mniblack@hitehedge.com
