The advantages and disadvantages of master limited partnerships as an investment tool
Over the past few years, financial advisors, estate planners and investors seeking a source of regular income have become increasingly aware of the benefits of master limited partnerships (MLPs). MLPs are limited partnerships that are traded on exchanges similar to corporate stock, that is, limited partnerships that are publicly traded. They are becoming widely known as an investment that can offer tax advantages as well as offset price risk through a high yield provided by quarterly cash distributions.
MLPs, however, have faced some challenges in attracting investors. First, they're a small and, until recently, relatively unknown, sector of the market. Second, they bring with them a level of tax complexity that many investors and even their accountants may find daunting. Moreover, they can be problematic when owned through tax-exempt institutions or retirement accounts, which for many investors is the best source of investment capital.
Over the past year or so, there have been some noteworthy developments in the MLP world that have helped address some of these issues and provided investors interested in MLPs with some new choices. They include: (1) the resumption of MLP initial public offerings (IPOs) after an almost two-year hiatus, adding to the choices for those wishing to invest directly in MLPs; (2) “simplification” transactions in which several MLP general partners and their incentive distribution rights have been folded into the underlying MLPs, simplifying the structure and allowing more cash to go out to the unitholder; and (3) the growth of a variety of MLP-oriented funds, providing investors a way to access the MLP market with fewer tax complications.
A share in an MLP is called a “unit,” and its shareholders are referred to as “unitholders.” As limited partnerships, MLPs have a general partner (GP) that manages the MLP, and limited partners (LPs) (unitholders) who contribute capital and play no role in management. Those that are limited liability companies (LLCs) have no GP, and their unitholders have voting rights more like corporate shareholders.
The most important distinction between MLPs and corporations is the way that they and their investors are taxed. Like all partnerships, an MLP doesn't pay corporate income tax because it's not considered to be a separate taxable entity. Instead it's treated as the collective enterprise of all its partners. Thus, the MLP's income, gains, deductions, losses and other taxable items are allocated for tax purposes among all the unitholders, each of whom pays tax on his share of net income. This basic fact is the foundation of both the benefits and the challenges of MLP ownership.
Benefits and Challenges
There are a number of benefits associated with investing in MLPs. They include:
- More earnings distributed
Because the MLP itself doesn't pay tax, more of its earnings are available to distribute to investors — and it's the policy of most MLPs to distribute all earnings not needed for current operations, debt service and maintenance of assets on a quarterly basis.
- Taxable income reduced
While investors are responsible for paying tax on their proportionate share of the partnership's income, they're also allocated a proportionate share of the partnership's deductions (such as depreciation) and losses, substantially reducing the amount of income on which they must pay tax. Moreover, the distributions are considered a return of capital, which lowers the investor's cost basis in his partnership units and thus aren't taxed until the partnership units are sold.
- Heirs receive untaxed distributions
When the normal estate tax and related rules are in place (in 2011), publicly traded partnership (PTP) units, like other securities, may be bequeathed to the owner's heirs, and the heirs' basis in the units will be stepped up to the units' market value at the owner's death. In this case, the original owner's distributions are never taxed.
MLP investing also presents some challenges, which unfortunately have deterred many individuals who could benefit from adding MLPs to their portfolios.
- Added tax complexity
Owning MLPs can add considerable complexity to the process of filing a tax return. Instead of the familiar 1099, investors receive a K-1 detailing their share of the MLP's income, deductions, gains, losses and credits. The investor must then enter the amounts in the appropriate places on their own tax return. Also, the investor's basis in the units fluctuates, adjusted upwards for taxable income and downwards for cash distributions. MLPs work hard to get tax information to investors in an accessible format. Many MLPs now allow investors to access their K-1s through their websites and download them into tax software.
- More state taxes
Investors in MLPs may be subject to tax in more than one state. Because they're allocated and taxed on a share of the MLP's income, investors are subject to state tax wherever the MLP earns that income. By the time MLP income (and deductions) are allocated among its states of operation and its unitholders, the net income for one investor in one state is likely to be too small for any tax to be owed; it may even be negative in some states. However, investors, especially those with large holdings, are advised to be aware of each state's filing requirements.
- UBIT incurred
MLPs may not be appropriate as a direct investment for retirement funds and tax-exempt institutions. When a tax-exempt entity is an LP, its allocated share of MLP income (not the distributions) is considered unrelated business income as if the entity had earned it directly, and subjects the entity to unrelated business income tax (UBIT) on amounts over $1,000. This doesn't necessarily preclude investors from putting MLPs in retirement accounts as a few MLPs earn income such as royalties, which are excluded from UBIT. Some analysts believe that the high yield makes the investment worthwhile even if the account does incur UBIT — but it's another complication that gives some investors pause.
Despite all this, the benefits of MLP ownership have been substantial enough for a large number of investors to deal with its limitations and complexities. And recent developments in the MLP world, combined with the current interest in income-oriented investments, should help attract even more investors to the fold.
Because of the complexities of administration and the limitations imposed by the Internal Revenue Code, the number of MLPs has always been somewhat limited. However, there have been periods of growth and retrenchment over the years. During this time, the number of new MLP IPOs alternately exceeded or failed to replace MLPs that ceased public trading because of mergers and changes in structure.
For most of the 2000s, MLPs were in growth mode, with numerous IPOs and a steadily increasing number of MLPs actively trading. This trend peaked in 2006 and 2007, with 18 IPOs in each of those years. This period saw expansion of MLPs into new (or in one case, a revived) areas. MLPs engaged in oil and gas production returned for the first time since the 1980s. GPs of 10 MLPs became MLPs themselves. And the financial world, most notoriously the Blackstone Group, took interest in the structure. (See “MLPs 2000-2010,” WMRG, p. 52.)
Momentum slowed somewhat during 2008 — and then, when the financial crisis hit, halted completely. Like other companies, many MLPs were affected by the plunge in stock prices, investor fears and the extreme difficulty of raising capital and obtaining debt financing. The IPO of Western Gas Partners (WES) in May 2008 was the last IPO of that year. In 2009 there were no IPOs at all, while several existing MLPs went off the market because of mergers or restructurings.
In April 2010, after almost two years, the freeze on MLP IPOs lifted with the arrival of PAA Natural Gas Storage, L.P. formed by Plains All American Pipeline, L.P. to operate its gas storage assets. It has been followed by three new MLPs, one in natural gas storage and two in coal. In addition, the KKR MLP, although technically not an IPO because it had been trading on the Amsterdam market, began trading on the New York Stock Exchange on July 15, 2010, bringing the number to five.
These additions mean more choices for investors who want to explore MLPs and, it's to be hoped, are a harbinger of increased growth bringing additional choices to the market.
Over the past year, a number of restructured GP-LP arrangements have been announced or completed. These have had the effect of simplifying the partnership structure and changing previously established incentive distribution rights (IDRs). IDRs are a share of the quarterly cash distributions that are paid to most MLPs' GP.
IDRs are intended as compensation for management of the MLP as well as for the frequent practice of subordinating units held by the GP to those held by the LP. They also serve as an incentive for the GP to manage operations effectively and grow the business to achieve increased distributions.
One response during the growth years of 2005 and 2006 was to create GPs that were MLPs themselves. These entities, whose sole assets were their interests in the underlying MLPs (GP interests, IDRs and occasionally LP interests), allowed MLP managers to raise large amounts of new equity capital without diluting the equity of existing unitholders while allowing investors access to the benefits of IDRs. During these two years, 10 existing MLPs took GPs public, raising some $2.7 billion in new equity capital.1
Now, some five years after the GP MLPs first appeared, they have begun to leave the scene. Two of the 10 are gone, and four more have announced “simplification” transactions in which they'll be merged back into the original MLP. In the simplification transactions, as effected by Magellan Midstream Partners in September 2009 and planned by several others, the GP's IDRs are terminated, any other interests are acquired by the MLP and unitholders in the GP receive proportionate shares in the original MLP in exchange for their GP units. Eagle Rock Energy Partners (EROC) underwent a similar process this year in which it terminated IDRs and acquired its non-publicly traded GP, and some GPs have simply eliminated or reduced their IDRs.
Why is this being done? One important reason is that IDRs, whether paid to GP unitholders or a non-traded GP, increase the MLP's cost of equity capital, which includes the return paid to all equity holders. As the GP percentage of distributions increases, so does the cost of paying equity holders their expected return relative to total capitalization. This means that less of any equity capital raised is available for growth opportunities. The releases announcing the simplification transactions cite a lower cost of capital and resulting increased opportunity for growth as primary expected benefits.
The MLP also benefits from a more simple and streamlined structure without the additional administrative costs created by a second traded entity. These benefits adhere to the unitholders as well, by increasing their share of distributable cash (though existing MLP unitholders experience some initial dilution as new units are issued to the former GP unitholders), by enhancing the prospects of growth which will lead to more cash to distribute in the future, by making the MLP's governance structure more apparent and by increased liquidity as the GP's unitholders become unitholders of the MLP.
As interest in MLPs has grown in recent months, the choices for would-be MLP investors have broadened considerably. Since 2004, investors have been able to invest in MLPs through one of several closed-end mutual funds. These are funds with a fixed number of shares, which are bought and sold on stock exchanges. MLP-oriented closed-end funds began to come on the market early in 2004 with Tortoise Energy Infrastructure Corp. (TYG), and several more followed from then until 2007 from Tortoise Capital, Kayne Anderson, and other fund advisors. (See “MLP-Oriented Mutual Funds,” WMRG, p. 54.)
As with everything else financial, there was somewhat of a hiatus in the formation of funds during the market downturn. Two new funds appeared in 2010, however; including one by a new player in the market: Legg Mason, which sponsored the ClearBridge Energy MLP Fund (CEM). Today there are about a dozen closed-end funds, which invest primarily in portfolios of energy MLPs.
Also in May 2010, the first open-end MLP mutual funds appeared in the form of three funds created by SteelPath Capital Management, which split off from Alerian earlier in the year. Another open-end fund, from the Cushing fund family, came out in October. The open-end funds offer advantages and disadvantages similar to those of the closed-end funds. One advantage open-end funds offer is that shares are priced at their net asset value (NAV), while closed-end fund shares may trade at a discount to NAV. On the other hand, closed-end fund shares may be bought and sold on the stock market, whereas open-end fund shares must be purchased from the fund.
For investors hesitant about direct investment in MLPs, investing in the sector through mutual funds have several advantages:
Rather than trying to choose among several dozen MLPs, the investor has a broad portfolio pre-selected by experts.
- Reduced tax complexity
Because the funds, rather than the individual investors, are the MLP's LPs, they take on the responsibility of dealing with K-1s and state taxation. The funds are structured as corporations and pass through the MLP's distributions as dividends, so investors receive the familiar 1099 during tax season.
- Retention of tax deferral
A substantial percentage of the dividends paid to a shareholder in an MLP fund, like the distributions from a direct MLP investment, will be treated as tax-deferred return of capital, lowering the investor's basis in his fund shares.
- No UBIT issues
Because the investor receives only dividends and not the allocation of MLP income, there's no unrelated business income issue for retirement plans and tax-exempt organizations.
There are considerations on the other side, however, and investors should consider the disadvantages carefully before deciding whether to invest directly or through a fund. The disadvantages include:
Reduced tax advantage: The MLP funds make things simpler for the investor by their structure as corporations so that their payouts take the form of dividends. Unlike many mutual funds, however, they don't qualify as regulated investment companies because of their concentration in MLPs,2 and must pay corporate tax on their income. Thus, to the extent they're allocated net taxable income by the MLPs, they'll pay tax, reducing the amount available for dividends. The direct investor must also pay tax on his share of taxable MLP income but receives the full distribution and may have a lower marginal rate than the fund.
- Extra costs: Investors who invest through a fund will also lose some return to administrative fees and other costs. These vary among the funds, and it's important to compare them in deciding whether to invest directly and which fund to choose.
- Missed opportunities: By letting the fund managers select the investor's MLP portfolio, the investor may miss out on investment opportunities from which he might have benefited if making the selection himself.
Some of these factors tend to diminish total return from an MLP fund investment compared to the return from direct investment, and should be weighed against the cost of tax compliance in a direct investment and the value to the investor of the convenience that the funds offer.
Although MLPs have been around since the 1980s, they're currently enjoying an unprecedented wave of popularity stoked by investors' desire for income-oriented investments that will continue performing during price downturns, as well as the possibility of future tax increases and the desirability of investing in energy infrastructure. This increased popularity is fortunately occurring at a time when there are (once again) new MLPs coming on the market to widen the possibilities and attract investors.
In addition, a number of MLPs are planning to or have undertaken changes to their overall structure. These changes should benefit both MLPs and investors by lowering the cost of capital and facilitating growth, thereby allowing MLPs to provide what investors are looking for: reliable and increasing cash distributions.
- And an eleventh, Crosstex Energy, L.P., took its general partner interests public as a corporation in 2004.
- Internal Revenue Code Section 851(b) allows regulated investment companies to have no more than 25 percent of their assets invested in master limited parterships.
Mary S. Lyman is the executive director at the National Association of Publicly Traded Partnerships in Alexandria, Va.
MLP-Oriented Mutual Funds
Companies owning closed-end and open-end mutual funds as an alternative method of MLP investment
|ClearBridge Energy MLP Fund||NYSE/CEM||7/6/2010|
|Cushing MLP Total Return Fund||NYSE/SRV||8/27/2007|
|Fiduciary/Claymore MLP Opportunity Fund||NYSE/FMO||12/22/2004|
|Fiduciary Energy Income and Growth Fund||AMEX/FEN||6/24/2004|
|Kayne Anderson MLP Investment Company||NYSE/KYN||9/30/2004|
|Kayne Anderson Energy Total Return Fund||NYSE/KYE||6/28/2005|
|Kayne Anderson Energy Development Company||NYSE/KED||9/20/2006|
|Tortoise Energy Infrastructure Corp.||NYSE/TYG||2/27/2004|
|Tortoise Energy Capital Corp.||NYSE/TYY||5/31/2005|
|Tortoise North American Energy Corp.||NYSE/TYN||10/31/2005|
|Tortoise Capital Resources Corp.||NYSE/TTO||2/2/2007|
|Tortoise MLP Fund||NYSE/NTG||7/28/2010|
|SteelPath MLP Alpha Fund||NYSE/MLPAX, MLPOX||3/31/2010|
|SteelPath MLP Income Fund||NYSE/MLPDX, MLPZX||3/31/2010|
|SteelPath MLP Select 40 Fund||NYSE/MLPFX, MLPTX||3/31/2010|
|Cushing MLP Premier Fund||NYSE/CSHAX, CSHCX, CSHZX||10/10/2010|
Note: The various ticker symbols for each fund are for different classes of shares.
— Mary S. Lyman