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Mastering the MLP Domain


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.

MINYANVILLE ORIGINAL It's the exceptionally rare person ever associated with Enron who emerges with their reputation intact, much less enhanced, but Richard Kinder has proved a profitable exception. As Kenneth Lay's college buddy, Kinder was the ill-fated firm's president for six years before leaving to found Kinder Morgan Energy Partners (KMP) in 1997. While other Enron alums including Jeffrey Skilling serve jail time, Kinder's company has served up annual returns of approximately 25%.

Mr. Kinder is considered a founding father of the master limited partnership (or MLP), an often obscure asset class that is attracting ever more investor attention. MLPs have handily trounced both the Dow Jones Industrial Average (^DJI) and S&P 500 Index (^GSPC) since the start of the millennium.

With the Fed committing last week to keeping interest rates at record low levels at least through mid-2015, the frantic search for yield shows no signs of abating. 10-year Treasuries (^AXTEN), while off their record low of 1.379% reached on July 25, remain utterly unenticing. In other countries, investors are being forced to pay for the dubious privilege of owning debt.

Master limited partnerships -- where yields of 6% are common and 8% not unheard of -- have hence become increasingly attractive in a rock-bottom rate environment where other options are so scarce. For those who believe demography is destiny, MLPs also have a generational tide on their side. 10,000 baby boomers become eligible for Social Security each day, and are increasingly risk averse as retirement nears. Having seen life savings evaporate in the Great Recession, they crave income opportunities, but are hardly about to jump headlong into junk bonds or speculative emerging market debt.

The defensive characteristics many MLPs offer, then, provide huge appeal in a period of ongoing market turmoil. Often hiding in plain sight, either unloved and misunderstood, MLPs have much to recommend them, but as we shall see there are downsides, too.

ABCs of MLPs

To qualify as an master limited partnership, the entity in question must derive a minimum of 90% of its income from sources deemed to be "qualifying" by the Internal Revenue Service. In practice, this entails activities related to the extraction, storage, and transportation of energy commodities, natural resources, minerals, or real estate.

An MLP comprises both general and limited partners, with the former a decision-making member of management, and the latter a passive investor that provide capital.

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.

The relevant paperwork, not plain vanilla 1099s but instead a form called K-1, clocks in at a deceptively simple two pages, but that hides a hornet's nest of ensuing complications. (Under "Other information, number 20, subsection D, did you duly list all "qualified rehabilitation expenditures" per the partner's instructions? Not including rental real estate, of course.)

Moreover, as myriad MLPs have pipelines crisscrossing several states, tax liabilities can be incurred all over the map irrespective of where the owner actually resides. Hence when it actually comes time to sell, specialist advisers must invariably be brought on board to decipher arcane issues including passive loss carryovers and flow-through accounting. When each costs up to $500, the cost of such experts can quickly mitigate many potential profits.

It also bears mentioning that master limited partnerships, much of whose income is already tax deferred, are by definition unsuitable in retirement products such as IRAs and 401 (k )s. Indeed, owning an MLP in such an account can also subject the holder subject to dreaded Unrelated Business Taxable Income (UBTI), a levy that often amounts to over $1,000 annually.

Enter the ETF

In recent times, a rebellion against the sheer volume of tax paperwork involved in owning individual MLPs has seen an exponential growth in industry exchange traded funds, exchange traded notes, and closed end funds. Examples include ALPS Alerian MLP ETF (AMLP), JPMorgan Alerian MLP Index ETN (AMJ), and Credit Suisse Cushing 30 MLP Index ETN (MLPN).

By buying a basket of MLPs as opposed to specific names, investors can at a stroke eliminate the burdensome K-1 issue, as Uncle Sam simply treats these distributions as regular dividends. After the parent fund company pays the piper at the corporate level, a single 1099 is all individual stakeholders need concern themselves with. As an added benefit, such investments are also allowed in tax-deferred retirement vehicles.

Of course, as with anything in the MLP arena that may appear too good to be true, the reward carries a risk, in this case fund fees of up to 200 basis points that can quickly erode portfolio value.

Bull case

Proponents of MLPs have plenty to point to. In the popular industry parlance, assets are often likened to turnpikes or toll roads, in that they provide a relatively safe and steady income stream derived from fixed fees. Indeed, about 65% of industry revenue comes from such long-term contracts. Stable cash flow, recurring revenue, and consistent payouts offer an attractive safe haven appeal, especially in the current turbulent investing climate.

Moreover, MLPs typically exhibit less volatility than many other assets and also tend to be less correlated with other market sectors, an important factor for investors in search of diversification. The opportunity to accrue tax deferred income is another advantage, especially with the "fiscal cliff" looming ever closer. America is also currently experiencing an unprecedented energy boom, with outfight independence no longer a pipe dream.

Master limited partnerships provide method of participating in new forms of extraction including shale and natural gas. Renewable sources such as sun and wind will soon be added to the mix if Democrat Senator Chris Coons, of Delaware, has his way. In June, Coons introduced the MLP Parity Act, a bipartisan bill aimed at amending a tax code quirk that currently prohibits the industry from investing in such "inexhaustible" energy assets.

Buyer Beware

These positives aside, MLP investing is now an increasingly crowded trade and performance has suffered of late after several stellar years. Investors shouldn't be blind to risk while chasing rewards. In particular, many of the new higher-yielding MLPs are less tied to traditional assets, and have many market mavens espying a bubble about to burst. While interest rates currently stand at once-in-a-lifetime lows, the law of gravity hasn't been entirely upended and they are destined to increase eventually. In these scenarios, yield-based investments inevitably suffer.

Asset depletion always needs to be taken into account when natural resources are involved. Also, the partnership structure leaves individual holders somewhat exposed should any issues arise at the parent company. Volatile capital markets, which represent a key source of funding, could dry up, as investors in 2008 painfully learned.

Acts of both God (a Katrina-style hurricane) and government (more fiddling from Congress on the Keystone Pipeline) are other considerations for investors to keep in mind.

While MLPs often employ hedging strategies to counter constantly shifting commodity prices, these techniques aren't infallible. For instance, 2012 has seen natural gas prices plunge to 10-year troughs, dimming prospects at companies exposed to the sector -- although with industry rig counts having subsequently fallen to their lowest level since 1989, a rebound may already be at hand.

Perhaps the biggest issue overhanging MLPs are future changes to the tax status they currently enjoy. Blame Canada. The October 31, 2006 decision of our northern neighbors to tax their similarly high yielding income trusts -- known ever after as the "Halloween Massacre" -- remains a spooky specter stateside some six years later.

Faced with structural deficits as far as the eye can see, Capitol Hill continues to mull an overhaul of the tax code including ending the present preferential treatment enjoyed by "pass-through" entities like MLPs. The likelihood remains that legislators will act gingerly if at all, especially in an election year and up against army of AARP retirees unwilling to accept any threat to their fixed income.

Still, the mere possibility of revamping current "carried interest" legislation had Blackstone head Stephen Schwarzman threatening to emigrate to France and comparing Obama to Adolf Hitler. Regardless of who wins in November, we likely haven't heard the last of this issue.

The Master

This weekend, The Master, a movie called "confounding" by one critic and centering on a mysterious cult-like organization, broke box office revenue records for a film in limited release. Master limited partnerships can appear equally impenetrable from the outside, yet offer a similar shot at big bucks. Investors must make sure they perform ample due diligence and are aware of all risks.
No positions in stocks mentioned.
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