The first quarter’s powerful rebound in US equities was driven by improving prospects of a comprehensive enforceable trade deal with China and a complete reversal of the Federal Reserve’s hawkish fourth-quarter policy and posture. With the markets now pricing in improving global trade prospects and dovish central bank monetary behavior, equities are no longer the bargain they were in late December.

Below is a one-year chart of S&P 500:

The US economy and S&P 500 earnings are at stall speed. The chart composite below shows estimated earnings have flattened as weakness from China and Europe have slowed the synchronous global economic rebound of 2017. If an enforceable and transformative trade deal with China is achieved in the coming weeks global trade tensions should diminish and global economic growth should reaccelerate.

Federal Reserve Model Chart Composite:

The S&P 500 Risk Premium, which compares the S&P 500 earnings yield of 5.85% to the 2.56% yield of the 10-year US Treasury note, shows investors are receiving a 3.21% notional yield premium for investing in stocks over US Treasuries. The Chart Composite above shows the Risk Premium in the middle of its 20-year range. The data chart below shows that since October the 10-year US Treasury Note yield dropped 0.81% from 3.22% to 2.41% (on 3/30) reversing the competition with equities which hampered the stock market in the fourth quarter of 2018 and has helped this year’s equity market rebound.

Market Statistics from Portfolio123

The equity market’s prognosis hinges primarily on the success of the US China trade deal and whether a successful outcome can re-ignite global economic activity with the ensuing reduction in global trade tensions. In the coming weeks and months, we will closely monitor whether a reacceleration in economic activity drives the markets higher or if the global economy weakens, reducing earnings and pushing the equity markets downward.

The AMID Unitholder Tragedy:

In recent letters we have highlighted the unusual 75% distribution cut by American Midstream Partners, LP (AMID) on July 26th and the December 31, 2018 distribution elimination; both of which were followed by bids by ArcLight Capital entities at prices extremely beneficial to ArcLight, and, if permitted, could impose sizable losses on retired investors who had followed AMID CEO Lynn Bourdon’s enthusiastic recommendations when AMID units were trading in the double digit range (pre-distribution cuts) like “Quite frankly folks, this train is leaving the station. I hope as investors, you are as excited as we are about our future….” Further, Bourdon and his team also asserted the supportive role that ArcLight would provide with statements such as “these accomplishments underscore the support that we have had and can expect from our sponsor ArcLight Capital Partners, as we move forward.”

The Art of the Amazing Deal:

American Midstream Partners, LP two-year chart.

Two activists’, as well as our own research, suggest that the bids by ArcLight appear problematically timed, highly profitable and, perhaps, brilliant, if it were not to come at the expense of panicked elderly retail investors’ precious retirement savings. Equally troublesome, AMID’s management had asserted that ArcLight was a “supportive sponsor” and ArcLight is the majority owner of American Midstream GP. Consequently, AMID’s board of directors and their independent directors—the conflict committee—have been forced to resolve a conflict of interest between a leading energy private equity firm and its other unitholders who are primarily retirees.

This is an important test of AMID’s independent directors’ duties of governance, pitting MLP unit holders who have disclaimed some rights under the partnership agreement, and sophisticated insiders with the tools, skills and knowledge of the complex accounting and timing factors surrounding the matter at hand.

Craig W. Thomas, a first-rate equity analyst and former head of research at SAC Advisors, publicly shared some accounting insight into this liquidity “crisis” that created the distribution cuts and the low unit prices that ArcLight stands to capitalize on at the expense of our elderly retired and other AMID unitholders.

The Matter at Hand:

AMID’s Delta House is a key cash generating asset in the Gulf of Mexico.

  • Delta House’s 2018 EBITDA was artificially low because it was under repair. Delta House’s operation is ramping back up – Q3’s volume increased to 90k BPD from Q2’s 60k BPD.  Eighteen months ago, Delta House volumes were 123k BPD.
  • MLPs own hard assets, like Delta House, which produce recurring revenue streams much like real estate. When a recurring revenue hard asset’s income is temporarily impaired, the asset itself should not drop 50% or 75%, though simple cash flow modelling might suggest such a myopic conclusion. Likewise, when cash flows are restored, a 100% or 200% would be forecast by cash flow modelling.
  • In the AMID unit holder situation retired investors likely concluded from the deafening silence following the July 26th, 2018 75% distribution cut and the December 31 distribution elimination due to a “covenant renegotiation”, that their investment had been permanently impaired and their retirement investment was in serious trouble. Since most retired investors cannot afford to lose their precious retirement assets or income, in the absence of a thoughtfully stated explanation which typically emanates from conference calls and their Q&As, all, but the most astute investors and insiders, would have been shaken out of their position. This means that ArcLight could accumulate shares in the open market and then secure a voting majority.
  • The AMID accounting is quite complex. Delta House pays a distribution to AMID on a lagged basis. Consequently, Delta House’s Q1’s cash flows will be credited to AMID’s Q2’s earnings. Hence, real-time operating improvements will lag reported earnings by about 6 months.
  • ArcLight entered into a “Capital Contribution Agreement” with AMID in order to offset the expected shortfall when Delta House was not at its full capacity. 
  • AMID’s 2018 Q1 and Q2 adjusted EBITDA were stable at $52.4mil and $51.2mil.
  • Look below at the Distributable Cash Flow and Adjusted EBITDA reconciliation sections from AMID 10Qs for 2018 Q2 and Q3. When you compare the Q3’s to Q2’s, ArcLight’s contribution is notably absent – line item (“General Partner contribution”).

Q2 2018 Reconciliation Section:

Q3 Reconciliation Section:

In the financials above “distributable cash flow was $4.5 million for the three months ended September 30, 2018, compared to $22.1 million for the same period in 2017.” This 80% decline was highlighted in AMID’s November 8, 2018 Q3 earnings release. Why was the Q3 GP contribution missing? Did the General Partner withhold it? Were conditions at Delta House improving so rapidly that the Capital Contribution unnecessary?

Normally conference calls follow earnings releases and a Q&A between analysts and management occurs. Analysts typically ask management, during Q&As, to reconcile accounting irregularities or operating items which might arise from such a sharp drop in a key operating metric such as distributable cash flow. Had the historically effusive CEO, who the preceding year was telling unit holders “this train is leaving the station”, addressed why the General Partnership contribution was not there, the impact of the timing issues and status on Delta House, the 80% DCF decline might not appear so disastrous and lift AMID unit prices.

Recall that AMID cut its distribution by 75% on July 26th, 2018 and then ArcLight bid for AMID at $6.10 on September 28th, the last day of the quarter following the distribution cut. In fact, in the initial aftermath of the $6.10 bid, AMID units traded at a premium.

Last month, we recommended buying AMID units. We forecasted that AMID could issue a distribution of $1/unit by year end. We estimated “AMID could earn $208mm in EBITDA. At a 10x multiple less debt, preferreds and other obligations, we estimate $707mm in equity value. Divide that by 54mm shares and AMID is worth $13.09/unit.”

Not So Hard To Resolve:

Had the Board of Directors delayed the bid by ArcLight and/or held an auction as both Save Unitholders and Income Growth Advisors, LLC had independently recommended, a price far closer to the $13.09/unit range could have resulted. To not have other institutions invited to bid in an auction so a fair market value could be established would resolve the conflicts and valuation debate. Alternatively, to simply wait until the cash flows from normalized Delta House volumes are reflected in the reported earnings is almost costless and effortless and far more rewarding to the other shareholders.  See the Board’s response to my October letter, received by Federal Express.

Delta House is Alive and Well:

AMID’s ownership in Delta House increased to 35.7% in 2018 from 20%. Consequently, an improvement in Delta House volumes would materially improve AMID’s operating financials. For example, if Delta House was producing 120k BPD and with AMID’s increased ownership of 35.7%, Delta House would contribute $22mil EBITDA per quarter or $88mil annualized EBITDA. This is a material jump from the estimated $35mil annualized EBITDA for last year.

Below is Segment Financial and Operating Data for Q4 and 2018:

Somebody Didn’t Get the Memo:

A January 14, 2019 operational update from LLOG Exploration the operator of Delta House.

LLOG’s CEO Phillip LeJeune stated, “At our Delta House FPS, our continued discoveries and new well productivity has exceeded our expectations, resulting in our Delta House platform currently operating at maximum capacity.”  As indicated by AMID’s CEO on the two most recent conference calls, “full capacity” is approximately 135,000 barrels per day. 

A Two-Year Perspective on Volumes and Adjusted EBITDA

If the AMID deal closes at $5.25/unit, the banker writing a Fairness Opinion and others will be challenged on this point should class action attorneys take on this case. If a class action lawsuit occurs and prevails, unit shareholders could collect meaningful compensation–perhaps a few dollars per unit–if they hold their unit position into the proposed acquisition. 

For a $22 billion dollar private equity firm, even after paying a couple of dollars a share to minority shareholders, this will be a great business decision. These assets will help serve the growing US Natural Gas export market. The field is enjoying good volume growth and major new discoveries like BPs 1 billion barrel Thunder Horse find in January. This opportunity was not lost on MLP giant Enterprise Products Partners, LP, who announced its JV with AMID in late August.

Great assets. Great partners. Great demand. Great price. What is not to like?

Reconciling the Irreconcilable:

It is breathtaking that ArcLight wrote the independent board on January 2, 2019 asserting that business was impaired “As you are aware, since the date of the Original Non-Binding Offer, the U.S. financial and M&A markets and the commodity markets have all experienced a significant decline, which have negatively impacted AMID’s business and leverage situation,” and used AMID’s Unit price–in the wake of the December 31, 2018 distribution elimination–to justify its $4.5/unit bid “as evidenced by the significant collapse in the trading price of AMID Common Units materially below the price set forth in the Original Non-Binding Offer.” With LLOG discrediting ArcLight statement of business conditions at Delta House combined with ArcLight’s circular logic for its reduced bid is stupefying to me.  

Here We Go Again:

The independent board members Mr. Peter A. Fassulo, Mr. Donald R. Kendall Jr., and Mr. Gerald A. Tywoniuk did not accept the $4.5 bid by ArcLight which expired on January 31. Consequently, we hold out hope that these independents will demonstrate bold and serious governance.

However, the operating financials to be released through its regular 10-K on March 18, were not released. Instead, on March 18, 2019 American Midstream Partners, LP announced it would be bought for $5.25 “that it has entered into a definitive agreement and plan of merger” by “an affiliate (the “Purchaser”) of ArcLight Energy Partners Fund V, L.P. (“ArcLight”)”. And since “Affiliates of ArcLight own approximately 51% of such voting power…. As such, the merger has been approved by the limited partners of the Partnership, and the Partnership will not hold a meeting of its unitholders to approve the merger.”

It is not surprising that a meeting will not be held. It seems when information could have been most helpful, the management has not had conference calls when one would expect them to. Even when they had calls they stopped having Q&As. Without a shareholder meeting and management pushing towards a closing, it appears there will not be a fairness opinion. Does that sound fair?

Ray Dalio’s Social Justice Quest and Lori Loughlin’s Ironic Educational Quest:

Ray Dalio, the brilliant hedge fund billionaire, is publicly addressing the historically established fact that vast economic disparities in society lead to social instability and terrible societal outcomes. “These unacceptable outcomes aren’t due to either a) evil rich people doing bad things to poor people or b) lazy poor people and bureaucratic inefficiencies, as much as they are due to how the capitalist system is now working,” Dalio says.

I disagree with “These unacceptable outcomes aren’t due to either a) evil rich people are doing bad things to people” or b) “…bureaucratic inefficiencies.”

A) Facebook, High Frequency Traders and AMID ArcLight. Mark Zuckerberg has been overreaching and apologizing for years. From taking the photos of girls at Harvard and creating a voting algorithm to offering a free social network and selling your data without clearly asking, does feel like the rich systemically exploiting the unaware (the other 99%). High Frequency Traders place their servers closer to major exchanges and use algorithms to scalp pennies from the public every day, leaving the top 1% benefitting at the expense of the other 99%. AMID ArcLight feels like the top 1% capitalizing on trusting retirees who have little recourse or capacity to recover their financial loss.

B) Bureaucratic inefficiencies. The SEC is a typical large governmental organization. It is filled with great people, but as Harry Markopoulos testified after his numerous letters to the agency about Bernard Madoff fell on deaf ears, “If I took the SEC to Fenwick Park they could not find first base.” Several investment professionals have confided in me that they are a bit surprised by the audacity of the behavior in the ArcLight AMID situation. I could see a far more efficient regulatory organization and believe that by removing inefficiencies—which can hurts investors—the capital markets would operate more efficiently.

Is there a Solution? Better corporate governance could go a long way to making for better corporate behavior which in turn would help reduce the exploitation of the other 99% by the top 1%. There is a big push for ESG, it would be nice to see corporate governance to have real consequence and be implemented through more responsive transparent oversight.

Lori Loughlin Ironic Quest.

Reports that Lori Loughlin and her husband may get upwards of 40 years jailtime for paying $500,000 to William “Rick” Singer, the college cheating mastermind, seems unmeasured. Maybe I am missing something, but I did not think USC was considered one of America’s the great academic institution–worth a $500,000 payoff. Dartmouth, that’s another thing. Ivy League. Dartmouth’s Tuck Business School, that is in the same stratosphere as Harvard Business School or Yale Law School. I could see an economic argument for paying that kind of money to get degrees from top schools like those.

Don’t get me wrong, Lori and Mossimo broke the law, and serious laws at that. However, conceptually the number people whose lives have been changed by Olivia Jade and Isabella Rose displacing their seats at USC, seems disproportionate to the threatened jail time.

New Approaches and Ideas:

Perhaps colleges should allow the super-rich to pay unlimited amounts to get their kids into a particular college and use that money to fund college scholarships.

But what are we getting from college today and is it really worth it? Olivia Jade was on her way to make millions with her massive Instagram following and cosmetic giant Sephora contract, before all this…. While there is no doubt that a disproportionate number of business successes come from name brand schools, the majority business giants succeed without the name brand degree. Rather, hard work, perspicacity, and persistence combined with academic resources produce success. In fact, Malcom Gladwell’s book “David and Goliath” would argue that your chances for success are probably better if you come from a poor immigrant family and had to support yourself and your family while getting your education from an inauspicious institution.

Is the best all that great? Ironically, in reading about ArcLight I discovered its Managing Partner Dan Revers had given millions to Dartmouth’s Tuck School of Business and the Revers Center for Energy is named after him. Even more ironic, David Kendall, one of the independent directors and conflict committee members, approving this legal transaction ArcLight AMID merger is a member of the Board of Trustees of Tuck along with Dan Revers. While I am confident that nothing wrong occurred in the ArcLight AMID transaction, is Tuck’s Board of Trustees the rule or the exception among top business schools?

Maybe the CFA program with its Code of Ethics and Standards of Professional Conduct is a better alternative at $1500/year versus the cost of a top business school and ignoring the huge opportunity cost differential. Perhaps the CFA Institute could be a template for other industries to reduce the dizzying educational debt burden feedback loop which is exacerbating economic inequality and sowing the seeds of our demise?

We welcome all questions whether on the markets, AMID or ideas on business ethics and wealth inequality.

Sincerely,

Tyson Halsey, CFA