The proliferation of midstream master limited partnerships (MLP) and their pursuit of gathering, processing, pipeline and storage have driven asset valuations to exceptional heights and made compelling deals harder to find.

“Today, given the presence of several multi-billion dollar midstream entities, each highly motivated to expand, the valuations required for winning acquisition bids should result in diminishing returns on capital,” wrote Standard & Poor’s analyst Charles LaPorta in a Thursday note.

Consequently, many midstream MLPs have turned to organic growth, putting away their checkbooks and building new or expanding existing projects instead. While the MLP structure worked like a charm for buying that were throwing off a lot of cash for unitholders, it makes organic growth a little tricky, wrote LaPorta.

“While MLPs were an ideal currency for acquiring existing midstream assets and rationalizing the industry, this income-focused security appears ill-suited for financing new, organic expansion projects,” LaPorta wrote.

“Thus, many midstream energy MLPs are increasingly demanding a way to raise capital that allows them to curtail future cash outlays to security holders and lets them retain cash for the build-out phase of their projects, while minimizing the potentially negative balance-sheet consequences. These unique demands have contributed to the creation of hybrids — securities that have characteristics associated with both equity and debt.”

Hybrid securities will give MLPs greater access to capital markets, LaPorta wrote. Institutional investors, pension plans in particular, were discouraged from investing in MLPs because of the MLPs’ unique tax reporting requirements. “These new types of securities with equity characteristics and without onerous tax implications would provide an attractive avenue for institutional investors to gain equity exposure to the energy infrastructure sector,” LaPorta wrote.

Further, hybrid securities can help balance MLPs’ need to retain cash for build-outs of infrastructure without alienating their income-hungry investor base “and causing significant credit deterioration that may result from issuing securities with substantial cash outflows,” LaPorta wrote.

Still, investors need to be aware that as spending by MLPs on greenfield projects grows, so does project risk, wrote S&P analyst Plana Lee in a separate Thursday note.

“The sheer magnitude of capital being deployed for organic projects by the midstream players makes the quick receipt of cash flow important for credit quality,” Lee wrote. “We would expect companies to be mindful of extensive project delays and costs overruns, which could lead to creeping leverage, weaker financial metrics and a deteriorating credit profile.”

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