August 16, 2002;
Supply and Fees May Weigh on Partnership Securities
A preliminary registration statement has been filed with the Securities and Exchange Commission covering the proposed offering of $600 million of partnership securities. A new entity, El Paso Energy Management LLC, would issue shares primarily to institutional buyers. Management is a misnomer, as the entity would manage nothing. A more descriptive name would be El Paso Institutional Derivatives. The new entity would own limited partner units in El Paso Energy Partners, L.P. The hope, apparently, is that the new entity would attract institutional capital that would not otherwise want the tax consequences of a limited partnership.
The contemplated offering would be made in a market that may be saturated with similar derivative securities. Kinder Morgan initiated the derivative more than a year ago with a billion dollar offering. Then investors started to look more closely. A follow-on offering was completed recently more than six months late and 70% short of expectations. Enbridge has also filed for an offering of similar derivative units.
The high fees charged by the general partner may be giving new investors pause. There is good reason why we label the partnerships as high greed. We have further likened them to Ponzi schemes and pyramid frauds. The tendency to pay existing unitholders in part with the proceeds of new offerings reminds us of Carlo Ponzi. Apparently Mr. Ponzi changed his name to Charles as he is more commonly remembered (see Walsh, James, “You Can’t Cheat an Honest Man – How Ponzi Schemes and Pyramid Frauds Work”).
The fee structure of high greed partnerships looks like that of a pyramid fraud (see Table). The general partner creates a new entity with a conservative payout and charges the initial limited partners 2%. Then the payout is boosted to what may be less conservative levels. The unit price hopefully goes up with the payout. The general partner charges 15%. New money is raised at the higher unit price and the proceeds used to acquire additional assets carefully selected for early cash returns to support another increase in payout. The unit price hopefully goes up again. The general partner now charges 25%. New money is raised at the higher unit price and the proceeds used to acquire additional assets carefully selected for early cash returns to support another increase in payout. The unit price hopefully goes up again. The general partner now charges 50%.
We list the pyramid levels for well-known schemes. It is immediately apparent that El Paso has reached the fourth level of the pyramid as its current quarterly distribution exceeds the pyramid level at which the general partner extracts 50% of distributions incrementally. Moreover, the acquisitions that El Paso is jamming into its partnership are likely to be used to justify raising the average 29% fee asymptotically to 50%.
Another implication is that high greed partnerships do fail. Bankruptcy of the general partner, Enron, contributed to limited partner loss in EOTT. Genesis failed even before advancing beyond the first pyramid level. No problem, a new general partner was installed and the pyramid levels were reset at vastly easier levels to achieve. Limited partners lost some 80% of their value in the first failure of Genesis and seem destined to lose the rest in the new form.
New Investors Enter
At The Top Pyramid Level
Perhaps it is telling that El Paso has turned to institutional investors for incremental funding. If individuals have many choices to enter other partnerships at lower pyramid levels, why should they enter at a high level? Instead EP, the general partner of EPN, is asking institutional investors to pay an immediate fee of 29% on average and 50% incrementally of all income and principal distributed. Yet, we ask, do workers want their pension fund managers making such investments? Do mutual fund investors want their fund managers making such commitments?
The counter argument is mainly that the pyramid can keep going. The most vociferous voices making that argument are likely limited partners that got in early or general partners and investors in general partners that are on the other side of those fees. General partners are likely to downplay their greed and to make hypocritical claims that their interests are aligned with unitholders.
We like fees, too, but there has to be a limit to what responsible professionals would charge. In the end that limit is the marketplace. Limited partners need to think independently and to be wary of the propaganda from high greed general partners like El Paso. The best protection that limited partners have is to sell while there is still a lot of support for unit price. Thus, because we have concerns about the investment value in El Paso Energy Partners, it is hard for us to be confident about the investment value in El Paso Corporation.