LPs Hit the Legal Wall
Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Limited Partnership (LP) Linn Energy made a big splash when it announced plans to buy Berry Petroleum (NYSE: BRY). Linn highlighted the tax benefits of the LP structure as part of the reason for it buying a regular tax paying company like Berry. Not surprisingly, the government wants to take a look. This could have implications for all LPs.
The SEC is in Town
After repeated articles questioning Linn's accounting in Barron's, the Securities and Exchange Commission has opened a private review of the company. According to Linn, the SEC has “requested the preservation of documents and communications that are potentially relevant to, among other things, LinnCo's proposed merger with Berry Petroleum Company, and LINN and LinnCo's use of non-GAAP financial measures and hedging strategy.”
Bad News Bears
Unsurprisingly, Linn shares sold off dramatically on the news. So, too, did the shares of Berry. Although the damage has probably been done, investors are better off taking the loss and moving on to new names. In the case of Berry, this is an example of why it is often best to take profits in an acquisition target. There's no telling what could go wrong with a deal and when deals collapse, investors jump ship quickly.
However, the longer-term problem this poses for the LP industry is the bigger issue. There are already concerns about the use of the LP structure by finance companies and other non-energy related entities. If the scrutiny starts to include energy-related LPs or increases on acquisitions, the entire industry could experience a CanRoy moment.
Similar but Different
Canadian Royalty Trusts (CanRoys) were similar pass through entities in Canada until too many regular corporations chose to convert to the structure. Essentially, becoming a CanRoy allowed companies to avoid corporate level taxes. When the government effectively outlawed the structure, the entire sector fell in unison.
While Linn buying Berry isn't exactly the same, it could be viewed as a way for a tax paying company to back into the LP structure. The SEC is likely to take a very close look at the situation. However, companies like Blackstone Group LP (NYSE: BX) and Carlyle Group LP (NASDAQ: CG) could increasingly see scrutiny as well, since they have nothing at all to do with energy and are already raising questions with regard to their use of the carried interest tax loophole.
In fact, earlier in the year, Bloomberg noted that “The nonpartisan Joint Committee on Taxation quadrupled its cost estimate for exempting the fast-growing 'master limited partnerships' from corporate income tax in the year ended in September to $1.2 billion from $300 million.”
No Problems, for Now
Unfortunately, Linn needs the Berry deal to keep its top line and distribution growing. So there's more at risk than just this one deal for shareholders. That said, there probably won't be any major problems for companies like Enterprise Products Partners and Kinder Morgan so long as they stay away from buying notable tax paying entities.
Blackstone and Carlyle may not be so lucky, however, it scrutiny kicks up of non-energy LPs. The top-lines at both companies have been heading higher since the end of the 2007 to 2009 recession. Since both are massive asset management firms, that trend makes complete sense. So long as the markets head higher, or at least don't tank, both should be able to provide solid top-line results and pay unit holders decent distributions.
Blackstone's recent yield is around 5.5% and Carlyle's is around 2.4%. Of the pair, Blackstone is probably the better option for those willing to take on the political and tax risks inherent to the LP structure right now based on its massive size and higher yield.
More to Watch
Investors should also watch companies like amusement park owner Cedar Fair (NYSE: FUN) and cemetery operator StoneMor (NYSE: STON). Cedar Fair recently bought a large competitor that basically doubled its size overnight. It also loaded the company up with debt just as the capital markets were starting to get tight during the recession. It had to cut its distribution, a no-no for an LP. That said, it has since gotten back on the right foot, and the distribution is growing again. However, the big purchase has overtones of the Berry deal.
StoneMor, meanwhile, is actively consolidating the cemetery industry. That could be viewed as a way to dodge taxes. To make matters worse, despite solid top-line growth and a rising dividend, the complicated accounting issues surrounding cemeteries make the business hard to understand, at best. Either issue could set the company up for a government review.
Renewables to the Rescue
The one saving grace for energy related LPs today is that there are calls in the government for expanding the structure to include renewable energy companies. That means that energy LPs aren't likely to go away. However, those that stray a little too far from the intended goal, like Blackstone, Carlyle, Cedar Fair, and StoneMor, could find themselves facing a Linn moment. Unitholders need to consider this risk when investing in this quartet. And LPs buying taxpaying companies looks like it's out for now.
Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends StoneMor Partners. The Motley Fool owns shares of StoneMor Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!