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Mastering the MLP Domain

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MLPs have handily trounced both the Dow Jones Industrial Average and S&P 500 Index since the start of the millennium. But there's a hornet's nest of hidden costs the investor has to consider.

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By purchasing an MLP unit, the investor effectively becomes a limited partner in its business. By paying its owners "quarterly required distributions" (different from a dividend per se), MLPs are able to avoid corporate taxes. Such a set-up allows for about 80% of their distribution to be tax-deferred, the earnings instead subject to taxes only at the partnership level. Broadly analogous to real estate investment trusts (REITs), the generous pay-out ratios of MLPs result from a legal stipulation that most of their available income gets "passed on" to owners of the unit.

Child of the '80s

The master limited partnership arrived on the scene in 1981, when Texas oil and gas outfit Apache Corp. (APA) came onstream. Although MLPs are found in fields from finance (Blackstone Group (BX)) to fairgrounds (Cedar Fair (FUN)) to funeral homes (StoneMor Partners (STON)) the overwhelming majority -- around 80% -- are in the energy industry. In particular, many are pipeline plays involved in its transportation.

The Tax Reform Act of 1986 ushered in several new entrants to the sector. "MVP," not "MLP," was the chant from Boston Celtics fans that season, as Larry Bird lead the team to a national basketball championship. But ask any investor of the era more concerned with net profits, and they will tell you the iconic sports organization was among many to adopt the structure that same year. Not long after, Congress limited the range of business able to take advantage of the preferential tax treatment offered by MLPs, although a grandfather clause exempted non-energy firms from the law and a select few still survive.

Current Landscape

From being viewed as a fringe investment as recently as the 1990s -- only six energy MLPs existed in 1994 -- the sector started to take off in earnest about a dozen years ago just as the broader market was beginning its spectacular collapse. Over 100 MLPs operate today.

Since 2010, there has been an explosion in both broad industry ETFs and a concurrent boom in stock specific IPOs. (Please see MLP IPOs Continue to Shine.) Equity issuance in September has already set a monthly record for the space, and several MLPs like Sunoco Logistics (SXL) have attained all-time highs this week alone.

Enterprise Products Partners (EPD) is the largest master limited partnership and can boast 31 consecutive quarters of distribution increases. Other key industry participants include Magellan Midstream Partners (MMP) and Plains All American (PAA), both set to split 2:1 in October. Investors looking to focus on specific niches have options including Alliance Resource Partners (ARLP) for coal, propane provider Inergy (NRGY), and Williams Partners (WPZ) and Copano Energy (CPNO) offering exposure to the Marcellus and Eagle Ford Shales, respectively. Meanwhile Hi-Crush Partners (HCLP), a US producer of monocrystalline sand, went public in August and promptly received several adulatory analyst recommendations. It is among the new breed of somewhat riskier MLPs focusing on hydraulic fracturing, viewed as a key if contentious source of America's future energy needs.

Just the Tax, Man

A key consideration when investing in MLPs (and one reason why they remain the dark side of the moon for many individual investors and anathema to most large institutions) is their often onerous tax implications.

In contrast to other publicly traded entities, MLPs are not taxed at the corporate level. Instead, the IRS treats payouts as ordinary income subject to the holder's regular rate, which can of course run as high as 39.6%. Their distributions, amounting to approximately 20% of the total, are a return on investment and hence subject to higher taxes than the capital gains threshold of only 15% currently enjoyed by payers of pure dividends.
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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