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MANAGEMENT BUY OUT

Meaning

Essentially, a management buy-out (MBO) is the purchase of a business by its existing


management, usually in cooperation with outside financiers. Buy-outs vary in size, scope
and complexity but the key feature is that the managers acquire an equity interest in their
business, sometimes a controlling stake, for a relatively modest personal investment. The
existing owners normally sell most or usually all of their investment to the managers and
their co-investors. Often the group of managers involved establishes a new holding
company, which then effectively purchases the shares of the target company.

How Most Management Buyouts are done


Private equity firms do hundreds of buyouts a year. Their typical approach is to offer to
buy a controlling stake in a company using leverage they obtained from banks based on
the financials of that company. Often times these firms commit very little of their own
money to purchase the business. With little cash invested, these deals create spectacular
returns for the buyout firm.

Buyout firms also collect large fees up front, as well as additional advisory fees while
operating a company they've acquired, and a big share of the investment profits. The
average annual management fee to do business with a private equity firm is about 1.5%
to 2.5%. The average share of profits is about 20%. While buyout firms give
management ownership, it's usually less than 20% of the company. This type of buyout
is the most common and is typically called a Sponsored Leveraged Buyout, where the
equity player is the "Sponsor."
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The Essential Components of an MBO


As illustrated by the previous example, financial investors generally seek companies that
offer the following:
• Organic growth potential. Financial investors generally are more interested in
companies having a sustainable differential advantage in the marketplace and that
operate in a growing industry, as opposed to ‘me too’ types of businesses and those in
declining industries;
• Ability to leverage. By using debt to finance a portion of the purchase price, the
return on equity is higher (as is the risk). The debt capacity of a company is a
function of the nature and quantum of its underlying tangible assets and its ability to
generate cash flows to service debt; and
• Exit strategy opportunities. Financial investors generally have a 3 to 7 year time
horizon. They seek companies that can either be sold to a strategic buyer or are
believed to be good candidates for an initial public offering. These avenues offer
‘exit multiple expansion’, which means that the effective price multiple paid on exit is
expected to be richer than that paid on acquisition.

MBO’s are facilitated where the owner has realistic expectations in terms of the price
that
will be paid for their company. This is not to suggest that financial buyers will not pay a
fair price, but that they are less likely to pay a significant premium as contrasted with
what might be paid by a strategic buyer. The advantage of dealing with a financial buyer
is that they usually will offer a cash deal, whereas other, less attractive, forms of
consideration may be offered by a strategic buyer. It also is helpful where the owner is
prepared to accept a deal structure that facilitates a transaction. For example, where the
owner agrees to retain a partial equity interest in their company, the financing
requirements are reduced and financial buyers generally are encouraged by the owner’s
belief in the exit strategy prospects. Finally, the owner should expect to offer transitional
assistance to the financial investor and management team, where required. For example,
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an owner who was active in the business should expect to remain active for a period of
time following the transaction in order to ensure a smooth transition with employees,
customers and suppliers.
Reasons for Management buy out (MBO)

Common reasons for companies or individuals to consider adopting a MBO strategy


include the following.

1. Non-Core Divestments and Efficiency Improvements:


An organization focusing on efficiency improvements or consolidation of its core
activities will often look to divest business units that are a financial burden or represent a
divergence from a new strategy. In these situations, a MBO can provide a smooth and
efficient transaction that avoids the inconvenience of finding external buyers or the need
to release sensitive organizational data.

2. Management Incentivisation:
Management faces constant pressure to maximise profits and implement new growth
strategies. However, it is often recognised that linking managerial compensation to
substantial direct equity ownership can provide a powerful incentive. A MBO can be an
effective way to implement such an incentive structure.

3. Insolvency :
In the event that the company has become insolvent and a receiver or administrator has
been appointed, current management may represent a viable acquirer for specific
business units. However, appropriate financial backing will often be required in this type
of buy out.

4. Succession :
A MBO can provide a feasible solution to business succession issues such as the
retirement of a key founder or partner. The experience of the current management team
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in running the business alongside the outgoing owner make them an attractive MBO
candidate that will help ensure a smooth transition and minimal disruption to business
growth plans.

5. Regulatory Requirement :
In some circumstances, the Australian Competition & Consumer Commission may force
a company to divest part of its assets, business units, or a portion of a recent acquisition
in the interests of maintaining competition. In this situation, a MBO may offer a cost
effective means of compliance.

6. Bundled Businesses :
In some circumstances a company may acquire a bundle of businesses, but may have no
intention of operating all aspects of each business. A MBO strategy can be adopted for
the divestment of the undesirable components of a bundled acquisition.

7. Aspiration Divergence :
At a given point in a company’s life cycle, current managers and owners may hold
different opinions as to the future direction the business. A properly planned and
executed MBO can therefore offer a viable resolution to major business disagreements.

The process Management buy out (MBO)


Depending on the size and complexity of the transaction, a properly structured and
implemented MBO strategy can ordinarily take between two to eight months. A
successful MBO process will often include the following.

1. Business Plan Development :


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It is vital that the MBO team has a clear understanding of what it aims to achieve and
how it intends to achieve it. The development of a comprehensive business plan should
include the company’s financial projections, the strategy the team will implement to
achieve these projections, the level of capital investment required to implement the
strategy and a clear definition of success. It is also important that the buy out team have a
thorough understanding of the market forces and economic variables that may influences
future business prosperity. An estimated timeframe for the purchase negotiations and
completion of the buy out should also be established.

2. Selection of a Financial Supporter :


The individual managers involved in a buy out will often lack the financial capacity
to fund the transaction on their own. Frequently, the buy out team will seek backing from
an equity partner such as a private equity firm. Careful planning and selection of an
appropriate equity partner is critical to the success of any MBO team.

3. Conducting Due Diligence :


While a MBO team will have greater knowledge of a business than an external
acquirer, it is still important that a proper due diligence is undertaken. The individual
managers involved in the MBO will already have access to certain types of confidential
information. However, it is important that any buy out team has access to all relevant
information and can assess the full situation to ensure the validity of estimates and plans.

4. Debt Funding :
Identifying the types of debt funding required and securing the debt is an important
next step in the buy out process. The most common form of debt funding for a MBO is
Senior Debt, however a combination of Mezzanine Funding and possibly Hybrid Capital
can be arranged in conjunction with Senior Debt.
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5. Documentation :
The final step of the MBO process is to create and sign off on the legal
documentation between the parties, which outlines the relationship between all
shareholders of the restructured entity. This process ordinarily commences around the
time of the Due Diligence process although the final contracts will reflect all information
discovered during Due Diligence.

LEVERAGED BUY OUT

In the realm of increased globalized economy, mergers and acquisitions have assumed
significant importance both within the country as well as across the boarders. Such
acquisitions need huge amount of finance to be provided. In search of an ideal
mechanism to finance an acquisition, the concept of leveraged buy out (LBO) has
emerged. LBO is a financing technique of purchasing a private company with the help of
borrowed or debt capital. The leveraged buy outs are cash transactions in nature where
cash is borrowed by the acquiring firm and the debt financing represents 50% or more of
the purchase price. Generally the tangible assets of the target company are used as the
collateral security for the loans borrowed by acquiring firm in order to finance the
acquisition. Some times, a proportionate amount of the long term financing is secured
with the fixed assets of the firm and in order to raise the balance amount of the total
purchase price, unrated or low rated debt known as junk bond financing is utilized. The
primary objective of an LBO is to ensure that the balance sheet of the acquiring firm
does not suffer due to the additional funding costs of such acquisition. At the same time,
the acquiring firm would be benefited from the acquisition of the brand of the target
company. Moreover, the acquiring company can expand its business horizon in the
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international market without making any huge outlay of wealth from the internal
resources.

SOURCES OF LBO FINANCING

There are a number of types of financing which can be used in an LBO. These include,
for example, the following (in order of their risk):

1. Senior debt
This is the debt which ranks ahead of all other debt and equity capital in the
business. Bank loans are typically structured in up to three trenches: ‘A’, ‘B’ and ‘C’.
The debt is usually secured on specific assets of the company, which means the
lender can automatically acquire these assets if the company breaches its obligations
under the relevant loan agreement; therefore it has the lowest cost of debt. These
obligations are usually quite stringent. The bank loans are usually held by a syndicate
of banks and specialized funds. Typically, the terms of senior debt in an LBO will
require repayment of the debt in equal annual installments over a period of
approximately 7 years.

2. Subordinated debt
This debt ranks behind senior debt in order of priority on any liquidation.
The terms of the subordinated debt are usually less stringent than senior debt.
Repayment is usually required in one ‘bullet’ payment at the end of the term. Since
subordinated debt gives the lender less security than senior debt, lending costs are
typically higher. An increasingly important form of subordinated debt is the high
yield bond, often listed on Indian markets. High yield bonds can either be senior or
subordinated securities that are publicly placed with institutional investors. They are
fixed rate, publicly traded, long term securities with a looser covenant package than
senior debt though they are subject to stringent reporting requirements.
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3. Mezzanine finance:
This is usually high risk subordinated debt and is regarded as a type of
intermediate financing between debt and equity and an alternative to high yield
bonds. An enhanced return is made available to lenders by the grant of an ‘equity
kicker’ (e.g. warrants, options and shares), which crystallizes upon an exit. A form of
this is called a PIK, which reflects interest ‘Paid In Kind’, or rolled up into the
principal, and generally includes an attached equity warrant (for larger financings)

4. Loan Stock:
This can be a form of equity financing if it is convertible into equity capital.
The question of whether loan stock is tax deductible should be investigated
thoroughly with the company’s advisers

5. Preference Share:
This forms part of a company’s share capital and usually gives preference
shareholders a fixed dividend and fixed share of the company’s equity (subject to
there being sufficient available profits)

6. Ordinary Shares:
This is the riskiest part of a LBOs capital structure. However, ordinary
shareholders will enjoy majority of the upside if the company is successful.

VALUE GENERATION THROUGH LBO

Every restructuring programme must generate some additional values for the
business, owners, shareholders etc. So an LBO exercise also creates certain
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additional values for various groups involved in such an operation. The sources of
value generated are as follows:

(a) Reduction in agency cost is the most important sources of value in an LBO. An
LBO refers to take a public corporation to private. In case of a public corporation,
the management is different from owners. In practice, however, the management
sometimes takes some suboptimal decisions without the prior approval of its
owners, which are proved to be costly and detrimental to the growth of the firm
and beneficial to the management. On the contrary, when a public corporation
goes private, the owners and management are the same and in all cases, the
management takes decisions which are not only cost effective, but also for the
growth of the organization. Agency cost refers to the difference of the firm value
when management and owners are the same than that of the firm value when
different groups function as owners and managers. An LBO exercise tries to
eliminate such agency cost that is considered as value gain for a restructured
firm.
(b) The second source of value gain is associated with efficiency. It is argued that a
private firm is much more efficient in taking decisions relating to a changing
environment than that of a public corporation, where every decision is not
required to be ratified by the general body before implementation. Thus, action
can be taken more speedily since major new programmes do not have to be
justified by detailed studies and reports to the board of directors. It is this
efficiency in decision –making that creates value for an LBO.
(c) Another source of value gain in case of an LBO is tax benefits as in such an
operation; the interest obligation of the private firm is expected to certain tax
benefits. The concept of stepping up of assets for depreciation as an ingredient of
LBO calls for additional tax advantages.
(d) Finally, it is understood that management or investors in an LBO deal have more
information on the value of the firm, than the ordinary shareholders. Because of
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this information, a buy out proposal gives indication to the market that the post-
buy out scenario would certainly provide more operating incomes than
previously expected or that the firm is less risky than perceived by the public at
present. It is this asymmetric information, which adds value to an LBO and
because of this value; the buy out investors do not mind paying large premiums
on such deals.
The value so created through an LBO exercise are exclusively meant for
shareholders of restructured firm and partly for the specialists engaged in such an
operation. Basically, this is considered as a ‘wealth transfer’ mechanism in a sense
that because of the financial leverage, the gain achieved by the shareholders came at
the expense of the firm’s debt holders.

STAGES OF LBO OPERATION

Four distinct but related stages are envisaged for the proper implementation of an LBO
programs, which are described below.

1st Stage:

Arrangement of Finance:

The first stage of the operation consists raising the cash required for the buy outs and
working out a management incentive system. The equity base of the new firm consists of
around 10 percent of cash put up by the company's top management or buy out
specialists. Outside Investors like merchant bankers, venture capitalists and commercial
banks then arrange to provide the remaining equity. Usually 50 per cent of the cash is
raised by borrowings against company's assets in secured bank acquisition loans from
commercial banks. Rest of the cash is obtained by issuing certain debts in a private
placement, usually with pension funds, insurance companies, venture capital firms or
public offerings through high-risk high-yield junk bonds. Private placements and and
junk bonds are subordinated forms of debts (often referred to as mezzanine money') and
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they secure a place in between the secured debts from banks and risky residual claims
of share holders.

2nd Stage:

Going Private:

In this stage, the organising or sponsoring group purchases all the outstanding shares of
the target company and takes it private through stock purchases format or purchase all
assets through asset purchasing format. For the latter case, the purchasing group forms
another new, privately held corporation. To reduce the debt by paying off a part of bank
loans, the new owners sometimes sell off part of the corporation and may begin
disposing of the inventory.

3rd Stage:

Restructuring:

In this stage, the new management would try to enhance the generation of profit and cash
flows by reducing certain operating costs and changing the marketing strategy. For this
operation, it may adopt any or all of the below given policies: viz.

(i) Consolidation and reorganisation of existing production facilities;

(ii) Changing the product mix (thereby changing the quality of the product)and changing
the policy relating to customer services and pricing.

(iii) Trimming employment through attrition;

(iv) Phasing out employees in turn and reduction on spending on research and
development, new plants and equipments, etc., so long as there is a need toredeem the
fresh acquired debts;

(v) Extraction and implementation of better terms from various suppliers.


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However, while undertaking the above stated restructuring activities due attention should
be given for the approval of genuine capital expenditure programs for the growth of the
firm, otherwise, the long term growth of the firm would hamper.

4th stage:

Reverse LBO:

Under this stage, the investor group may take the company to public again, if the already
restructured company emerges stronger and the goals set by theLBO groups have already
been achieved. This is known as the process of 'Reverse LBO' or the process of 'Going
Public', where the process it effected through public equity offerings. The sole purpose
of this exercise is to create liquidity for existing shareholders. This type of reversa LBO
is executed mostly by ex-post successful LBO companies.

THE ADVANTAGES

Certain important advantages can be obtained from LBO programme. These are:

 With the help of LBO strategy, the acquiring company can be benefited from the
acquisition of international brand without having significant impact of the
additional funding costs on the Balance Sheet of the firm. In other words, the
acquiring company can expand its business network in the international market
based on leveraged capital i.e., without occurring huge amount of outlay from the
internal resources of the firm

 Since in the LBO system, a new company is created to procure the debt capital as
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well as other sources of finance required for the acquisition, the volatility of
earnings of that new created company, popularly known as special purpose
vehicle does not affect the business of the acquiring company. After the passage
of certain years, when debts are fully repaid, the parent acquiring company gets
merged with its SPV which was created purposefully. As a result, the parent
acquiring company can enjoy the benefits of entire acquisition without
confronting the adverse business as well as financial risk arising out of such
acquisition

 Moreover, the newly created company can enjoy tax benefits in operating the
business for a considerable time period of five to six years. Due to the existence
of high amount of leveraged or debt capital, in the capital structure of the
company, tax benefits can be achieved in respect of payment of interests.
Moreover, higher amount of assets setup will provide greater amount of tax
savings in the form of depreciation expense.

 The LBO system helps stimulating the cross border acquisition since; this system
ensures the supply of required amount of capital needed for large acquisition .As
a result, a firm can enlarge its business network not only in the domestic market,
but also in the international markets as well.

 High gearing tends to be a discipline on management, since a company's cash


flow is usually quite tight due to the necessary pay-down of interest and debt.
Management is therefore likely to focus on driving down costs and controlling
capital expenditure.
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 In a highly leveraged company, a relatively small increase in the company's


enterprise value can lead to a substantial increase in the value of its equity. In a
bull market, the attractiveness of an LBO will therefore increase. Of course, the
gearing effect also means that high gearing increases an equity investor's risk,
since a relatively small decline in enterprise value could severely impact the
value of the equity investment. Moreover, high interest charges increase the risk
of default by the company.

 Low capital or cash requirement for the acquiring entity.

 Synergy gains. By expanding operations outside own industry or business.

 Efficiency gains. By eliminating the value-destroying effects of excessive


diversification.

 Improved leadership and management. Sometimes managers run companies in


ways that improve their authority (control and compensation) at the expense of
the companies' owners, shareholders, and long-term strength. Takeovers can
weed out and discipline such managers. Large interest and principal payments
can force management to improve performance and operating efficiency. This
"discipline of debt" can force management to focus on certain initiatives such as
divesting non-core businesses, downsizing, costcutting or investing in
technological upgrades that might otherwise be postponed or rejected outright.
Note: in this manner, the use of debt serves not just as a financing technique, but
also as a tool to force changes in managerial behavior.

 Leveraging. As the debt ratio increases, the equity portion of the acquisition
financing shrinks to a level at which a private equity firm can acquire a company
by putting up 20-40% of the total purchase price.

THE LIMITATIONS
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Even though value so created through an LBO exercise, it cannot be claimed to be from
criticism. The most important drawbacks of the LBO system are:

(a) The LBO programme is subject to high degree of financial risk since; it is mostly
based of borrowed capital. On the other hand, if the degree of operating risk of the LBO
candidate is also high, it may be difficult for the firm to service the debt properly which,
in turn, may lead to the firm into bankruptcy in near future. In addition to that, the
fluctuation in interest rate is another important point to be considered here. The rise in
interest rate may create genuine problem for firm that has more variable debt rate. In
order to meet all these categories of risk, a strong and stable cash flow is quite essential.
The lack of such secure and stable cash flows may raise meaningful questions about the
existence of the concerned firm.

(b) In order to implement the LBO programme, a LBO candidate should have strong
asset base that can be used as collateral for financing the acquisition. Moreover an
experienced as well as efficient team of management is also important. Thus, a firm that
lacks these requirements may not be able to finance its acquisition plan.

(c)Finally, if the firm cannot afford the interest burden to be boned by it due to any
reason, the ultimate liability of repayment of the huge amount of loans will confer onto
the shoulder of that firm. Naturally, the acquiring firm should always remain aware
regarding the fact that, the LBO programme is subject to high degree of risk.

Critics of the Leveraged Buy-out mechanism indicated that bidding firms successfully
squeezed additional cash flow out of the target's operations by expropriating the wealth
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from third parties. For example the federal government. Acquired companies pay less
taxes because interest payments on debt are tax-deductible while dividend payments to
shareholders are not. Furthermore, the obvious risk associated with a Leveraged Buy-out
is that of financial distress, and unforeseen events such as recession, litigation, or
changes in the regulatory environment. These can cause: difficulties in paying scheduled
interest payments, technical default (the violation of the terms of a debt covenant) or
outright liquidation. Weak management at the target company, or misalignment of
incentives between management and shareholders, can also pose threats to the ultimate
success of an Leveraged Buy-out

MASTER LIMITED PARTNERSHIP

Introduction
Master limited partnership (MLP) is a limited partnership that is publicly traded on a
securities exchange. It combines the tax benefits of a limited partnership with the
liquidity of publicly traded securities. The limited partnership interest are divided into
units which are traded as shares of common stock. Share of ownership are referred to the
units.

MLPs as an asset class originated in the 1980s through laws passed by


Congress designed to encourage investment in energy and natural resources. Early
partnerships that took advantage of these laws had mixed results. Many partnerships
were taking advantage of tax avoidance to extend their scopes beyond those originally
envisioned. In response to this, Congress strengthened regulations to ensure that an MLP
must generate at least 90% of its income from qualified sources, most of which pertain to
natural resources. As a result, the majority of MLPs in existence today operate in the
energy infrastructure industry, although recent issues have included companies operating
in a variety of different industries. This asset class has grown rapidly in recent years,
with the number of listed energy MLPs roughly tripling since 2000.
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The majority of MLP business is in the following areas:

• Gathering, marketing, transporting and storing natural gas, crude oil and refined
products.

• Transportation in wholesale/retail operations in propane and heating oil.

• Coal production and royalty interest ownership.

• Shipping liquid and bulk commodities.

Eg: Some private equity management companies such as Blackstone Group (NYSE: BX)
and Fortress Investment Group (NYSE: FIG) are structured as MLPs
Types of partners

1. General partners:
The general partner (GP) oversees and manages the MLP’s operations and receives
compensation that is tied to the performance of the MLP. Generally, the GP receives a
minimum of 2% of the LP distribution. General partners are the party responsible for
managing business and bears unlimited liability. Received the compensation on the basis
of performance of the venture. A general partner receives compensation that is linked to
the performance of the venture and is responsible for the operation of the company; and
in most cases is liable for the partnership debt.

1. Limited partners:

The limited partner (LP) provides capital to the MLP and receives periodic income
distributions from the MLP’s cash flow. A limited partner is the person or group that
provides the capital to the MLP and receives periodic income distribution from the
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MLP’s cash flows. If the partnership does not pay the taxes from the profit. The money
is only taxed when unit holders receives distribution, this eliminate double taxation.

Characteristics of Master Limited Partnerships


1. Tax Treatment
Since MLPs are structured as partnerships they do not pay corporate income taxes. Taxes
are only paid when distributions are received, thus avoiding the double taxation faced by
investors in corporations.

2. Consistent Distributions
MLPs face stringent provisions including the requirement to pay minimum quarterly
distributions to limited partners, by contract. Thus, the distributions of MLPs are very
predictable.

3. Energy Infrastructure
The majority of MLPs operate in the energy sector, particularly in energy infrastructure
industries such as pipelines, which provide stable income streams. The performance of
companies in the energy infrastructure industry is not highly correlated with the price of
oil and other types of energy, but rather with the demand for energy. The demand for
energy is far less volatile than commodity energy prices and
generally increases steadily over time, resulting in steady, predictable cash flows for
companies in these industries.

4. Unlimited life
The life of the MLP is unlimited nature. MLPs typically specify a limited life of
100 years more or less.
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The internal revenue service has focused on in distinguish between a corporation and
master limited partnership are limited liability, centralized management, and
transferability.

Types of Master Limited Partnership

1. Roll up MLP’s
Formed by the combination of two or more partnership into one publically traded
partnership. Roll ups were the first type of MLP’s organized. The Roll- ups began
with combining limited partnerships formed to invest in programs in the oil
industry.

2. Liquidation MLP’s
Formed by a complete liquidation of corporation into Master Limited
Partnership.

3. Acquisition MLP’s
Formed by an offering of MLP interest to the public with the proceeds used to
purchase assets.
4. Roll out MLP’s
Formed by a corporation contribution of operating asset in exchange for general
and limited partnership interestin MLP, followed by a public offerings of limited
interest by the corporation of the MLP or both.

5. Start up MLP’s
Formed by partnership that is initially privately held but later offers its
interest to the public in order to finance internal growth.
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ADVANTAGES OF INVESTING IN MASTER LIMITED PARTNERSHIPS


The main advantage of the MLP is the tax advantage, the idea that the MLP is taxed as
partnership and therefore avoids the double taxation to which corporate dividends are
subject. The partnership structure of Master Limited Partnerships results in favourable
tax treatment due to the avoidance of double taxation.
The nature of the advantage to the use of an MLP is shown under table.
Pre Tax Reform Act Post Tax Reform Act
PARTICULARS 1986 1986
Corporations MLP Corporations MLP
Company income $100 $100 $100 $100
Company Tax 46 0 34 0
After tax income 54 100 66 100
Retained income 20 20 20 20
Personal tax 17 15 13 28
Investor after tax income 17 30 33 52

Under the old tax law, the marginal corporate rate of 46 percent was below the marginal
personal rate of 50 percent. It is assumed that for the same $100 of income, the same $20
is required under either form of reinvestment in the operating activity. The investor
would receive $30 under th MLP as compare with $17 under the corporation. This is 76
percent more income.
Under the new tax law, the top marginal corporate rate of 34 percent is now higher then
the top marginal personal rate of 28 percent. Under the same assumptions as before, the
after tax income to the investor is $33 under the corporation and $52 under the MLP. The
investor receives 58 percent more income under the MLP then under the corporation.
The differential under the old tax law was $13: the differential under the new tax law is
$19. Thus the absolute dollar value of benefit is greater under the new tax law. The
percentage depends on patterns of numbers assumed. Also the comparison depends
critically on the amount of retained earnings. This is because the partners pay tax
whether the income is retained or not. Also the degree to which there is double taxation
depends on the payouts; the higher the payout, the more double taxation, so it is difficult
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to generalize. This also illustrates that MLP is likely to be more attractive in industries
where reinvestment rates are relatively low. This implies high payout rates, and when
payout rates are high, the advantage of avoiding double taxation is greater.

OTHER ADVANTAGES
• High, consistent distributions make MLPs an attractive asset class for investors looking
for high yielding securities. Average yields have recently been in the 8% range.
• Historically, MLPs have been able to steadily increase their cash flows and, thus,
distributions over time. High distribution growth provides MLPs an advantage over other
high-yielding assets.
• MLPs have returns that have low correlations to both stocks and bonds. This makes
them good for diversification in a stock/bond portfolio.
• Cash flows and distributions are relatively stable and immune to the business cycle.

ELIGIBALITY CRIETERIA TO BECOME MLP


According to the National Association of Publicly Traded Partnerships, the MLP
structure is limited to companies that receive 90% or more of their income from interest,
dividends, real estate rents, gain from the sale or disposition of real property, income and
gain from commodities or commodity futures, and income and gain from mineral or
natural resources activities. While there are a few exceptions, the vast majority of MLPs
operate in the energy industry.

Historically, companies that have used the MLP structure tend to operate in very stable,
slow-growing parts of the energy industry, such as pipelines and storage terminals. These
assets produce steady cash flows but don’t offer the rapid growth prospects of other
industries. Growth typically comes from acquisitions or the construction of new
pipelines and other facilities. The stability of the midstream business often means below-
average risk for investors.
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RISKS OF INVESTING IN MASTER LIMITED PARTNERSHIPS


• REGULATORY RISK - One of the most attractive characteristics of MLPs is the tax
treatment of this asset class. If MLPs were no longer able to pass through taxes to limited
partners a large benefit of investing in MLPs would be removed. Also, the fees that
pipelines are able to charge are highly regulated by the government resulting in
additional regulatory risk.

• INTEREST RATE RISK - As with high-yielding equities, MLPs are often more
appealing to investors at times of low interest rates, as this results in higher yields for
MLPs relative to bonds and money market instruments. Increasing interest rates would
result in lower relative yields versus other alternative assets.

SIMILARITIES BETWEEN MLP’S AND LLC


• In general, MLPs and LLCs are considered as belonging to the same asset class. Both
MLPs and LLCs enjoy the same tax treatment. They are non-taxable entities with a tax
shield on distributions, thus avoiding the double taxation of corporate profits.

• There are two types of partners in an MLP structure, general partners and limited
partners. The MLP is managed by the general partner. On the other hand, an LLC does
not have a separate general partner. Limited partners have voting rights in an LLC but
not in an MLP.

• The general partner in an MLP has what are called Incentive Distribution Rights
(IDRs). IDRs are terms defined in the MLP partnership, which allow for the general
partner to claim a higher proportion of incremental amounts of the distribution payments
as these payments grow over specified levels. This is designed to provide general
partners with a strong incentive to increase distributions, further enhancing the appeal of
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MLPs based on large, growing distributions. On the other hand, it raises the cost of
equity for the MLP and can dilute the ownership claim of limited partners.

RECENT DEVELOPMENTS OF MLP’S


The most recent development in the MLP marketplace has been the reintroduction of
E&P MLPs. Many E&P MLPs went bust in the 1980s, and since that time the MLP
space has been dominated by midstream companies. The new generation of E&P MLPs
aims to create pipeline-like cash flows by investing in oil and gas fields with long
remaining lives and using hedging to minimize the impact of fluctuations in commodity
prices.
We remain skeptical of this strategy for two main reasons. Production volumes can be
difficult to project, and hedging allows a company to lock in prices only for five years as
of today. However, the tax benefits of the MLP structure will likely lead to a significant
number of companies to set up MLPs over the next few years. The potential market size
for these companies is huge--estimates suggest that around $250 billion in E&P assets
would be appropriate for MLPs, while only $7 billion are held by MLPs currently.
Through the many changes in the marketplace, we continue to think that MLPs make
solid choices for income-oriented investors. Not all MLPs are created equal, with some
offering stability and less risk and others promising faster growth and higher risk.
Investors should carefully consider the pros and cons of investing in a particular MLP,
then consult a tax advisor to help determine the tax implications of such an investment.

BIBLIOGRAPHY
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• Link: http://www.12manage.com/methods_leveraged_buy-out.html

• Link:http://www.referenceforbusiness.com/management/Int-Loc/Leveraged-
Buyouts.html

Bhagaban Das, Debdas Raskhit, Sathya Swaroop Debasish, Corporate restructuring,


Himalaya Publishing House, first edition 2009.

• Howard E. Johnson, FCMA is President of Veracap Corporate Finance


(www.veracap.com), which specializes in shareholder value enhancement
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