What is a MLP?
Created by Congress in 1986, a master limited partnership (MLP) is a publicly traded partnership, generally a limited partnership (LP) or a limited liability company (LLC), whose interests are typically traded in the form of common units (rather than common shares) on a public exchange (NYSE, NYSE AMEX, NASDAQ), and whose operations are managed by a general partner (GP).
The primary goal of an MLP is to invest in high-quality assets that will increase cash flow generation over time, thus setting the stage for distribution increases to unitholders that translate into higher valuations. As MLPs generally pay out substantially all of their available cash flow in the form of distributions, MLP units trade on a yield-basis rather than a multiple basis. Furthermore, as MLP units are typically traded on the NYSE or NASDAQ, they provide unitholders with liquidity.
Overall, an MLP must derive at least 90% of its income from "qualifying sources". Under subsection D of Section 7704 of the Federal Tax code, qualifying income can come from different sources. These sources include, but are not limited to:
- interest, dividends;
- real property rents;
- gain from the sale or other disposition of real property;
- any gain from the sale or disposition of a capital asset held for the production of income; and
- income and gains from commodities, or futures, forwards, and options with respect to commodities.
- exploration, development, mining, or production;
- gathering and processing, refining, compression, or transportation (including pipelines, ships, and trucks transporting oil, gas, or products thereof); and
- storage and distribution; or
- marketing of any mineral or natural resource (including coal and other minerals, fertilizer, geothermal energy, and timber)
- industrial source carbon dioxide;
- alcohol fuel mixtures and biodiesel mixtures (Code Sections 6426(b) and 6426(c);
- alternative fuels, including liquefied petroleum gas, P Series Fuels, compressed or liquefied natural gas, liquefied hydrogen, liquefied fuel derived from coal through the Fischer-Tropsch process, and liquid fuel derived from biomass (Code Section 6426(e));
- alternative fuel mixtures (Code Section 6426 (e));
- alcohol, including methanol and ethanol, but not including alcohol produced from petroleum, natural gas, or coal, or having a proof of less than 190 (Code Section 6426(b)(4)(A)); and
- biodiesel (Code Section 40A(d)(1)).
Sectors Where MLPs Exist
Today's MLPs are predominately found involved in natural resource activities within the energy sector, as well as the coal and timber sector. However, due to the strong demand for energy infrastructure in the United States, many of today's MLPs have been primarily engaged in the midstream portion of the energy value chain - particularly gathering, processing, refining, storage, marketing and transportation (via pipelines and/or marine vessels) of minerals, oil and natural gas, and/or other natural resources.
Overall, an investment in a midstream MLP is an investment in the build-out of U.S. energy infrastructure.
As with other partnerships, MLPs are comprised of three ownership categories: 1) the sponsor (sometimes referred to as the parent); 2) the general partner (GP); and 3) limited partners (LP).
- The sponsor is usually the entity that creates the MLP and contributes its initial assets, while maintaining a controlling interest.
- The GP, which is typically indirectly owned by the sponsor, is responsible for making managerial decisions, and conducting and directing the activities of the MLP.
- The limited partner ownership is usually represented by two classes of units: "common units" held by individual investors and traded on public exchanges (held mostly by public unitholders and the sponsor, but a portion is also held by the GP in certain MLPs) and "subordinated units" which do not trade publicly (usually held by the sponsor and the GP).
Why Buy MLPs?
Master limited partnership (MLP) units can be best described as a hybrid investment, possessing characteristics of different types of securities. As such, we believe there are several compelling reasons why to buy a MLP, including:
- An Investment that Blends Growth and Income. As MLPs generally pay out substantially all of their available cash flow (roughly 80-100%) in the form of distributions (not dividends) each quarter-end, MLP units were initially viewed as bond surrogates and traded on a yield basis rather than a multiple basis. As of the last decade or so, MLPs have been increasingly viewed as a growth vehicle as they continuously invest in accretive organic projects and acquisitions to grow their distributions over time. As a result, MLPs are now typically evaluated on a yield + growth basis (referred to as total return).
- Tax Advantaged Yields. Like traditional partnerships, MLPs are single tier tax entities (i.e., they do not incur federal taxation at the corporate level). Instead, all taxes (if any) are paid at the unitholder level - thus the MLP avoids double taxation. At the unitholder level, the pass-through of non-cash items (such as depreciation and amortization) generally results in substantial tax deferrals for unitholders, as the cash distributions tend to be greater than a unitholders' allocatable taxable income. As such, an MLP's after-tax yield is greater when compared with other fully taxable investments as a unitholder is taxed on only a portion of the cash distribution received.
- Stable Cash Flows. Little or no commodity price exposure, depending on contract mix which can include fee-based only (has no direct commodity risk), or a combination with fee-based, percentage of proceeds and keep-whole (both percentage-of-proceeds and keep-whole contracts incur direct commodity risk), and long-lived assets provide stable cash flows for the majority of the MLP asset class. In addition, substantial internal growth projects continue to supplement acquisition opportunities.
- Lower Risk Profile than Overall Market. Because of the income oriented nature of MLPs and the defensive qualities of the energy sector (where most MLPs are found), in general, the MLP sector has historically proven to have a low correlation with the broader markets as it tends to perform strongly in uncertain market environments.
- Strong Historical Performance. From 1996-2010, the Alerian MLP Index has generated total returns of 926.0%, compared with the S&P 500 Index total returns of 166.9%. In addition, MLP yields have loosely tracked the 10-year Treasury. From 1996-2010, spreads to the 10-year Treasury Bond have averaged 309 basis points for the Alerian MLP Index.
- Still an Emerging Asset Class. While the MLP space outperformed the broader market for several years (prior to 2008), the group is still predominately held by individual retail investors. In our opinion, having a shareholder base that is predominately one-sided presents an opportunity as other investors, i.e., institutional investors and the broader market, become more educated about the MLP sector and increase their shareholder interests within the space as MLPs continue to grow their asset base and distributable cash flow.
- At the Forefront of Energy Infrastructure Boom. With the enactment of the Tax Reform Act of 1986, which imposed a qualifying income test in order to be classified as a partnership for income tax purposes, today's MLPs are well positioned to undertake the growing demand for natural resources and the need for additional infrastructure (including pipelines, fractionation, storage, transportation) to support the growing demand. Given capital expenditures of roughly $17.3 billion in 2010, and preliminary capital expenditure estimates of $16.9 billion for 2011, $12.4 billion for 2012, and $11.1 billion for 2013, we believe industry fundamentals (supply and demand forces) will produce more growth opportunities within the MLP sector.
Typical Investors Who Buy MLPs?
Historically, the MLP investor base consisted solely of individual (retail) investors looking for a source of regular income payments and/or seeking a combination of income and growth.
However, MLPs typically would not be held in tax-exempt accounts, such as IRAs, Keoghs, 401ks, or other retirement plans due to their tax advantaged status. As a result of MLP income being classified as unrelated business taxable income (UBTI), MLP income may be taxable in tax-exempt accounts. Thus, MLPs have not historically attracted much institutional interest as tax-exempt institutions would be required to pay taxes on UBTI.
Yet over the past several years, the MLP investor base has been evolving as MLPs have garnered increasing interest from institutional players - including closed-end funds, private equity funds, dedicated MLP funds, and hedge funds - as favorable legislation has been passed (such as the American Jobs Creation Act of 2004 which made MLP income "qualifying" for mutual funds).
An Alternative Way To Own MLPs - Closed End MLP Funds
For investors who otherwise cannot own MLPs directly, an alternative way to invest in MLPs is through a dedicated closed-end MLP fund.
As in the case of an investor looking for a source of regular income payments and/or seeking a combination of income and growth via MLPs and their affiliates, the same strategy can be achieved via the dedicated closed-end MLP fund.
A closed-end fund is a professionally-managed investment company that is registered under the Investment Company Act of 1940. The fund, through its investment management team, invests in securities that it believes will help it achieve its stated investment objective. Historically, most closed-end funds have specialized in either fixed income or equity securities and follow a pre-determined investment objective, such as current income or capital appreciation or both.
Income received by tax-exempt investors directly from MLPs is generally treated as unrelated business taxable income (UBTI). However, dedicated closed-end MLP funds do not generate any UBTI, and as a result, can be held in tax-exempt accounts such as IRAs, Keoghs, 401ks, or other retirement plans despite their tax advantaged status.
Furthermore, a portion of the distributions received from a dedicated closed-end MLP fund is generally tax-deferred (return of capital) and the remaining portion is generally dividend income and treated as qualified dividends for income tax purposes.
Lastly, while direct MLP investors receive a Schedule K-1, closed-end fund investors receive a Form 1099 as the fund is a taxable entity (generally a C-Corp for tax purposes).
On top of normal economic and market risk factors that impact most all equities, in general, we believe that MLPs in general are uniquely at risk to, but not limited to, the following: capital markets appetite for new debt and equity; interest rate risk; adverse regulatory environment; economic downturn / decline in demand for natural gas, oil, and NGLs; dependence on a single geographic region for all of its natural gas supply; loss of a key customer / supply side disruptions; commodity price sensitivity (direct or indirect); if obtaining new supplies of natural gas and NGLs proves difficult, growth potentially dependent on acquisitions; integration risk; conflicts of interest; and tax law changes.
Unit holders may be required to file taxes in states where the partnership conducts business and should consult a tax advisor for further counsel.
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