In a move hinted at last month, Tallgrass Energy GP (NYSE:TGE) has agreed to acquire its high-yielding MLP Tallgrass Energy Partners (NYSE: TEP) in an all-stock deal. The transaction will create one public entity, Tallgrass Energy LP. The merger accomplishes several things for the franchise, including reducing complexity and costs, while at the same time preserving the lucrative income stream.

Drilling down into the deal

Under the terms of the agreement, investors in Tallgrass Energy Partners will receive two shares of the new Tallgrass Energy LP for each unit of the MLP they currently hold. The new entity will be a C corporation for tax purposes, which is the most commonly used corporate structure. That said, it doesn't expect to pay any federal income taxes for at least the next decade.

Bright sun obscuring the outdoor backdrop with a pipeline in and out of camera's focus

Image source: Getty Images.

It does, however, expect to continue paying out lucrative dividends, and has already announced an increase to $1.95 per share, up 32.7% from the prior rate. At the 1-for-2 exchange rate, investors of Tallgrass Energy Partners will receive $3.90 in dividends for each unit they currently hold, about 1% higher than last quarter's rate. That payout should continue increasing this year, with Tallgrass Energy expecting current holders to receive 5% to 8% more income by year-end even as the combined company maintains a comfortable dividend coverage ratio of more than 1.2 this year.

Going with a proven winner

This "non-dilutive combination differentiates our transaction from most other recent combinations in the MLP universe," according to Tallgrass Energy CEO David Deheamers. That's because several resulted in the MLP issuing a boatload of new units to its parent company in exchange for eliminating the incentive distribution rights (IDRs), which are costly management fees MLPs pay to their parent companies. Williams Companies (NYSE:WMB) and Williams Partners (NYSE: WPZ) took that approach last year. In their financial repositioning transaction, Williams Partners issued 289 million units to Williams Companies in exchange for eliminating the IDRs, giving Williams a 72% stake in its MLP. As a result of that dilution, Williams Partners reduced its payout 29%, while Williams boosted its dividend 50%.

Tallgrass aims to avoid that dilution and the added complexity of having two publicly traded entities by going with a more simplified and streamlined model that follows the blueprint ONEOK laid out last year when it acquired its MLP. That deal has worked out well for investors so far, since the company has delivered a total return approaching 13% over the past year. For comparison's sake, the total return of both Williams Companies and Williams Partners is a negative 7% over that time frame. In following ONEOK's lead, Tallgrass is striving to deliver similar outperformance over rivals choosing other paths in the coming years.

In addition to avoiding the added dilution, this chosen transaction structure also helps eliminate some of the redundancy in the MLP space, where there is often more than one publicly traded entity representing the same franchise. That's not only confusing to investors but has added too much supply to the market at a time when investors' appetite for MLPs has waned, which has weighed on valuations in recent years.

A better vehicle for what's ahead

Tallgrass Energy becomes the latest pipeline company to abandon the MLP vehicle. While the company created significant value for investors with it since coming public in 2013, delivering a more-than-125% total return versus just 78% for the S&P 500, the MLP structure has become more challenging to use in recent years due to higher costs and other issues. As a result, Tallgrass is changing vehicles to better navigate the road ahead, so it can continue paying a growing income stream and creating more value for investors in the coming years.

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