The U.S. midstream mergers and acquisitions (M&A) market finally appears to be in a sustained recovery from the market dislocations that began in 2008. In 2010, midstream M&A volume reached a remarkable $51 billion, up 255% from the prior year. Even after excluding the two largest transactions (Enterprise Products Partners/Enterprise GP Holdings and Williams Partners/Williams Pipeline Partners), volume was still $17.5 billion, up 22% from 2009.

In the first four months of 2011, volumes are equally impressive, with nine deals representing an aggregate volume of $4.3 billion. Given assets that are currently on the market or expected to be in the market soon, we believe the volume levels in 2011 could very well exceed $20 billion.

Increasing transaction volume

The increase in transaction volume is, in many respects, attributable to the recovery of financing markets, as the cost and availability of equity and debt capital now rivals pre-2008 levels. The average midstream master limited partnership (MLP) yield is now at 5.98%; MLP equity issuance in 2010 set a record with six initial public offerings and 60 follow-on offerings. The Wells Fargo Midstream MLP Index is up approximately 45% since January 2010.

Recent deals, such as Energy Transfer Partners LP's $717.5 million equity offering (the largest MLP equity offering ever), provides an indication of the liquidity available in the MLP equity markets. Similarly, non-investment-grade BB index yield has tightened significantly —down from more than 7.3% pre-2008 to below 5.8% today.

Digging deeper into the underlying transactions, however, reveals several trends that bode well for a sustained upturn in transaction volume for the sector, beyond the uplift provided by the robust capital markets.

First, transactions have occurred in a balanced manner across all midstream subsectors: pipelines, gathering, processing, storage and terminals, as well as across natural gas, crude oil and refined products assets.

Second, and unlike 2008 and 2009, when a significant portion of the transaction volume consisted of single-asset deals, the past 15 months have seen a wide array of deal types. Transactions have included an increase in the number and size of drop-downs (El Paso, Spectra, Chesapeake), several sales out of private-equity portfolios (Crestwood/Frontier Gas, Regency/Zephyr Gas, and Buckeye/BORCO), a number of larger corporate or platform transactions (Energy Transfer/ Regency/Louis Dreyfus, Crestwood/Quicksilver) and several GP restructurings and acquisitions (Energy Transfer/Regency, Enterprise Products Partners/Enterprise GP Holdings, Inergy LP/Inergy Holdings).

Third, and perhaps most importantly, non-affiliated, third-party transactions now make up the lion's share of transaction volume. This is a critical element of a healthy midstream M&A market. While drop-down-transaction volume has continued to increase, it has become a less significant portion of the overall transaction volume, indicating that the markets have reached a point where uncertainty has diminished and buyer and seller expectations are now in equilibrium.

Recovering valuations

A further sign of health in the M&A market is that valuations have recovered with several recent deals done at low-teens forward EBITDA multiples. This valuation recovery has been led by transactions in the gathering and processing sectors, where multiples reflect the high growth inherent in recent transactions such as Kinder Morgan/Petrohawk, Crestwood/Quicksilver, Enterprise Products/Momentum, and very strong natural gas liquids pricing and frac spreads.

Storage assets are also attracting premium valuations despite weak summer-winter spreads and extrinsic value, which is attributed to a belief in a positive long-term outlook for natural gas in the U.S. These valuation dynamics are also being translated into the drop-down transactions. According to Wells Fargo Securities estimates, the average forward EBITDA multiple for drop-downs was 8.9x so far in 2011, up modestly from 8.6x in 2010, and up significantly from 6.7x in 2009.

One sector where valuations have remained muted is in long-haul natural gas pipelines. Upside to valuations in this sector has been limited by a lack of third-party transactions, a collapse in basis differentials, and uncertainty of gas-flow dynamics, given the emergence of several new shale plays.

Looking forward to the rest of 2011 and beyond, the highest levels of activity will continue to be in the gathering, processing and storage segments. Producers will continue to look to their midstream assets as low-cost sources of capital relative to the equity markets, and several private-equity portfolio companies will likely be ready for an exit in the near future. A number of storage projects currently in development will also reach milestones that will enable them to complete a sale.

These trends, and the continued strength of the financing markets, should facilitate the sustained upturn in midstream M&A activity witnessed in 2010 and 2011 to date.