Master Limited Partnerships Present Arbitage Plays

The "pin action" in master limited partnerships (MLPs) was very positive on Monday, and most of it could probably be attributed to an article that appeared in Barron's over the weekend. Specifically, it highlighted four companies that still may have some legs: Energy Transfer Equity (ETE - commentary - Trade Now), Enterprise GP Holdings (EPE - commentary - Trade Now), NuStar GP Holdings (NSH - commentary - Trade Now) and Plains All American Pipelines (PAA - commentary - Trade Now).

Though I'm long three of the four companies and I like the energy sector, after such a strong rebound in prices I have a different idea for investors to consider.

NuStar GP Holdings is one company that I'm long, but against it I'm short NuStar Energy (NS - commentary - Trade Now), its sister company that represents limited partner interests (rather than general partner interests).

My rationale for the trade is as follows:

1. Valuation: General partnerships usually trade at a premium to their limited-partnership companies, and one measure of this valuation disparity can be found in the yield. Currently, the yields are nearly at parity, which suggests NSH is cheap on a relative basis. My expectation is that over time, historical valuations will prevail and the yield spread should naturally widen.
2. Merger possibility: If the valuation gap doesn't close naturally, then I believe we will see more M&A activity. These valuation distortions have not been lost on managements in the sector, as several deals have recently been announced.

   In March, Magellan Midstream Partners (MMP - commentary - Trade Now) agreed to acquire Magellan Midstream Holdings (MGG - commentary - Trade Now) at a 25% premium. By the way, this already-announced deal still has nice arbitrage spreads. By my calculations, based upon trading prices as I write, if the deal closes at the end of the third quarter, the annualized rate of return would be on the order of 35%.

   In another announced deal, Enterprise Products Partners (EPD - commentary - Trade Now) is acquiring TEPPCO Partners (TPP - commentary - Trade Now). Here the common link is that the general partnership of both firms is Enterprise GP Holdings.

   It should be noted, though, that these deals are driven not only by price but by competitiveness. Once the general partnership is eliminated, the cost of capital goes down, because the limited partnership no longer has to pay incentive distribution rights. And the overhead of maintaining a second public company is eliminated.

3. Low opportunity cost: While I'm waiting for something to happen, my opportunity costs are low. Interest rates are near zero, and I'll be taking in nearly as much yield on the long side as I'll be paying out on the short.

For the more momentum oriented, this trade has been working nicely and has produced unrealized gains for me of about 11% over the last month.

I'm also playing the Buckeye complex for same set of reasons. Here, I'm long Buckeye GP Holdings (BGH - commentary - Trade Now) and short Buckeye Partners (BPL - commentary - Trade Now). Again just for some context, over the last roughly 30 days, this pairing has moved slightly against me by about 2%, but I remain steadfast.

At the time of publication, Masino was long ETE, EPE, NSH, MGG, EPD and BGH, and short NS, MMP and BPL.

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Rich Masino is president of Private Investor Research and editor of The Substantial Investor. He is a private investor who manages a family long/short investment portfolio that holds numerous positions across a variety of asset classes.

Before starting Private Investor Research, Mr. Masino co-founded a telecommunications company that grew to 500,000 customers. He sold all of his interests in the company in 1998.

He holds an MBA in finance from St. John's University.