The fourth-largest investor in oil pipeline operator Magellan Midstream Partners LP plans to vote against a merger with gas company Oneok Inc. in an $18.8 billion stock and cash deal, mostly because the premium would not make up for taxes on long-time Magellan holders.

"We believe the taxes paid by our funds and investors will exceed the premium offered by Oneok and any potential benefits from the merger," asset manager Energy Income Partners LLC (EIP) co-founder and CEO James Murchie said in a June 8 letter to Magellan's board of directors. "Moreover, we want to see Magellan remain as a stand-alone entity whose returns on invested capital are far superior to Oneok."

At the end of the first quarter, EIP owned a 3% stake in Magellan with a value of $394.8 million, according to S&P Global Market Intelligence data.

Murchie estimated that long-term holders of 202 million outstanding units of Magellan, a master limited partnership (MLP), would owe $2 billion in taxes when the deal closes, while Oneok will get a tax benefit of $1.5 billion from the Magellan assets it will now be able to depreciate and amortize.

"This deal represents an enormous transfer of value from Magellan unitholders to the Internal Revenue Service and Oneok shareholders," Murchie said.

The potential value from adding Magellan's oil and refined product pipelines and storage to Oneok's natural gas pipelines and processing units was another selling point raised by the deal participants. Murchie, however, noted that if Magellan shareholders wanted exposure to Oneok's gas operations and finances, they could just buy Oneok shares.

EIP not alone in raising objections

Announced by the companies late May 14, the deal valued Magellan at $67.50 per unit, a 22% premium for Magellan unitholders based on May 12 closing prices. It would create a midstream company with an enterprise value of $60 billion and a 25,000-mile network of oil and gas midstream infrastructure stretching from North Dakota's Bakken Shale to the Gulf Coast. Oneok said the deal was scheduled to close in the third quarter.

There are other upset investors in the Magellan MLP, CreditSights' senior analyst Charles Johnston told clients June 8. Johnston had doubts that the deal would get the votes it needs.

"Based on the pushback we heard at the recent MLP conference, and the fourth-largest holder's public opposition to the deal, we see real risk of this getting voted down," Johnston told clients. "We have also heard of opposition from the seventh-largest holder and believe many of the 'less than 25%' of 10-year plus holders aren't likely to support the merger."

Magellan's seventh-largest investor is midstream specialist Tortoise Capital Advisors LLC. Rob Thummel, Tortoise managing director and senior portfolio manager, agreed with Murchie's criticisms but said "we want to review the proxy materials before reaching our final conclusion on the deal."

"The prospectus is the most articulate, better way to make it clear about how businesses will be much better and have more value added for shareholders," Thummel said in an interview.

Thummel said Oneok management did not make a compelling case for the combination when it was announced, and he hoped that the prospectus for the deal would state more clearly how Oneok intends to add value for Magellan unitholders. For now, he agreed with EIP that Magellan is undervalued in the deal.

Magellan Vice President for Government and Media Affairs Bruce Heine responded to the criticisms by saying the deal includes cash to take care of the tax bill and gives unitholders a chance to benefit from the combined company's increase in value. "We remain focused on completing the transaction with Oneok and delivering on the many compelling benefits of this combination," Heine said in a June 9 email.

Long-term unitholders, retail investors

The biggest issue boiled down to the taxes that long-term unitholders would have to pay, since their holdings will lose their tax-advantaged status after the Magellan MLP disappears at the deal's close, CreditSights' Johnston said.

"Long-term unitholders have a very low-cost basis due to distributions being treated as a return of capital," Johnston said. "They most likely intended to hold until they passed away, [with their heirs] benefiting from the free [basis] step-up at that time."

Another potential stumbling block for the deal will be getting unitholders to vote, Johnston said. Magellan's bylaws require that a majority of unitholders vote in favor of the deal, but Johnston estimated that 60% of Magellan's unitholders were retail investors and this could be an obstacle.

"It can be challenging to get enough unitholders to even cast a vote, and other management teams with much stronger insider ownership noted past difficulty in getting above the threshold given how few retail holders typically vote," Johnston said.

S&P Global Commodity Insights produces content for distribution on S&P Capital IQ Pro.