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By Anthony Reale A Master Limited Partnership (MLP) is a publicly traded entity that is listed on the major U.S. stock exchanges and is subject to the same accounting, reporting and regulations as a publicly traded corporation. MLP’s are significant owners of America’s energy infrastructure, controlling substantial assets involved in the transportation, processing, refining, marketing and storage of the nation’s energy resources. These assets include major pipeline systems that deliver products such as natural gas, crude oil and refined fuels to end markets. History The first MLP was launched in 1981. Early MLPs operated in a variety of cyclical and sometimes volatile industries including oil and natural gas exploration and production, restaurants, sports teams and other consumer activities. The MLP structure was redefined through the Tax Reform Act of 1986 and the Revenue Act of 1987. The legislation stated that the established structure would apply to limited partnerships only if at least 90% of their revenues came from natural resource activities including, but not limited to, exploration, development, mining and production, real estate, commodity investments and specific capital gains and losses related to these sectors. In the late 1980s, MLPs became entities that generally owned midstream assets used to transport, process and store energy products. These partnerships historically had limited exposure to commodity price risk and primarily consisted of mature assets that generated stable cash flows for their unit-holders. MLPs have varying degrees of risk. For example, lower risk MLPs are involved in businesses that act as an intermediary between energy producers and users. Medium risk MLPs are engaged in activities such as the acquisition and development of oil and natural gas properties while higher risk MLPs transport energy via tankers and barges. Business Structure of MLPs Most, but not all MLPs can be described as publicly traded partnerships. MLPs consist of a General Partner (“GP”) and Limited Partners (“LPs”). GPs typically hold a 2% ownership and are responsible for managing the operations of the MLP. The General Partner runs the company’s operations and holds all of the voting power, while the Limited Partners provide the capital and realize the benefits of the distribution payments. The entity is obligated under law to distribute profits to the partners accordingly, making up a vast majority of their earnings. The General Partner is paid via a management fee and additionally may incur up to a 50% fee for increasing the distribution to the Limited Partners. LPs benefit from quarterly cash flow distributions and capital appreciation of MLP interests. The MLP “shares”, called units, make up the majority of the partnership and represent the limited partner’s stake in the entity. The strong returns that many MLP investors have historically enjoyed are based on two primary factors — yield and growth. MLP distribution yields have generated 6-7%, and over the past twenty years, capital growth has totaled approximately 8% annually. Exhibit A: MLP Structure Source: J.P. Morgan
MLP’s have followed an evolutionary path comparable to real estate investment trusts (REIT’s). Similar to REIT’s, which are now considered to be a staple of most institutional portfolios, MLP’s are adhering to slow acceptance by the institutional investment community. However, with market capitalization hovering around the $200 billion mark, there is more acceptance of MLP’s as a legitimate asset class. Historical PerformanceMLPs have outperformed the S&P500 for the last decade and a half, reaching cumulative gains of 650% versus 130% for the broader market. This comes with the exception of a lag for MLPs in 1998-99 due to the tech boom, where investors sought out high-growth energy companies and were willing to pay premium dollar. As a result, there was a sharp sell-off of MLPs in 2008, decreasing returns significantly as evident in Exhibit B. Since then, MLPs continue to see an increase in historical returns, though it is unknown whether such returns will continue. Expectedly, MLPs experience increased correlation to other asset classes when the markets are down. Specifically Y2K and the tech boom have had the greatest overall impact on the correlation of MLPs to the broader market. Generally speaking, MLPs do not have a strong correlation to other asset classes, making them an attractive investment to many. The performance of MLP investments is driven primarily by income distribution and the anticipated change which exists in such. When the dollar amount of the distribution grows, market demand for the MLP increases, leading to price appreciation. Some anticipate that MLPs which currently have a 6% distribution and are likely to increase distributions by 4-6% annually, have the potential to offer investors low double-digit returns. Institutional Participation in the MLP Market While institutional ownership of MLPs has increased over the years, individual investors hold the majority of outstanding MLP interests. MLP distributions are typically subject to the Unrelated Business Taxable Income (“UBTI”) rules which state that if a tax exempt entity receives UBTI in excess of $1,000 per year, the investor may be liable for tax on that income. As a result, MLPs may become less attractive investment vehicles in tax deferred retirement accounts. A number of closed-end funds focusing on MLP investments were introduced in the mid-2000’s. These new funds offered diversification and allowed investors to avoid filing K-1’s for individual MLP’s, both of which are attractive qualities for the institutional marketplace. In addition, hedge funds were introduced to the expanding MLP marketplace, as well as mutual fund product offerings by MLP managers. These products were intended to offer added liquidity and transparency, as well as consolidated tax reporting. The implications which exist in adding the aforementioned funds are the additional fees and capital gain related tax issues which can negatively impact performance. Potential Investment Advantages The following are some positive attributes of MLPs which have made them appropriate investment vehicles for certain individuals and institutional investors:
Exhibit B: MLP vs. Russell 2000
While MLPs have attractive features, there are potential risks which should be considered prior to considering this investment:
Other potential issues include changes in the regulatory climate for energy-related activities, tax law changes, supply disruptions, environmental accidents and terrorism. Interest rate risk may increase the potential cost of financing projects and affect the demand for MLP investments; this translates into lower valuations. Outlook Since MLP’s are by law mandated to receive at least 90% of their revenues from natural resource activities, they may be in a position to benefit as the United States develops its energy infrastructure. Some forecasts put the amount of infrastructure investment in the hundreds of billions of dollars range over the next decade. MLP’s may also be purchasers of multiple midstream energy infrastructure assets currently owned by both private and public corporate entities. The MLP market is poised to potentially receive vast additional assets in new forms of energy infrastructure introduced by technological advancements. These assets include liquefied natural gas terminals, gas-to-liquids technology, bio-fuel assets, renewable energy assets, and coal gasification projects. Conclusion Master Limited Partnerships are still a relatively small, narrowly defined, and concentrated asset class. Accordingly, it is unrealistic to conclude that MLPs will continue to deliver the outsized returns of the last ten years; however, continued investment in energy infrastructure may result in further expansion and accessibility to these investments. Generally low historical correlations to other asset classes could make them an effective vehicle to improve a portfolio’s diversification and risk profile. This in turn may result in the increased usage of MLP’s as a part of an alternative investment allocation in a qualified investor’s portfolio. References: |
