Master Limited Partnerships: An Energy Alternative

Since the credit crisis of 2008, interest rates on traditional fixed income investments (bonds, CD's, savings, money markets...) have been at record lows.  On the other hand, there has been a boom in the natural gas industry as the extracting method of "fracking" has become accepted.  These two trends, combined with the fiscal cliff's tax increases scheduled for January 1st, are making Master Limited Partnerships (MLPs) attractive investments.

Like hedge funds, MLPs have grown dramatically over the last 15 years.  Including a dip in 2008, they have grown from $8 billion to $241 billion in market capitalization and trade volume has increased from $6 million to $600 million.  But it is still tiny compare to the S&P 500.  Initially, retail investors were the primary buyers but the institutional share has grown to more than 30%.  There are about 100 partnerships trading in "units" on the NYSE and NASDAQ.  They are managed by a General Partner (GP) who runs the partnership for the Limited Partners (LPs), much like a private equity fund.  Also, the GP is invested in the MLP and can earn a performance fee called Incentive Distribution Rights.

MLPs have a number of attractive characteristics for investors:

• They have a higher yield than bonds except for high yield
• Annualized returns for the standard index - Alerian MLP Index - are higher and have less volatility than the S&P 500, Russell 2000, GSCI Commodity and FTSE NAREIT Equity REIT indices
• Favorable tax treatment

On the negative side, investor must watch for:

• MLPs may be as volatile as equities and commodities
• Limited liquidity because of small market capitalization and the tax treatment attracts buy and hold investors
• High concentration of product.  The 10 largest MLPs make up 60% of the total market capitalization.
• Has a small correlation with equities than increases during a crisis
• Has regulatory and legislative risk on the tax exempt status
• As MLPs pass through their income to LPs, they can only raise money from the capital markets to grow their company
• Conflicts in interest between GP and LPs
• When all is said and done, this is an investment in the energy sector

The energy sector represents about 77% of public partnerships.  The remainder are in real estate or financial businesses.  To qualify for an MLP status, 90% of its income must be derived from either energy, real estate, natural resources or minerals sectors.  According to Greg Reid of Salient Partners, there are 80 energy MLPs with a total market capitalization of $300 billion.  Reid runs two publicly-traded closed end funds and is a Managing Director in charge of $1 billion.  MLPs' average yield is 6.2% and have a projected growth rate of 6.5%.  The high yield is paid quarterly, like a dividend.  It is accomplished because a high percentage of income (about 90%) is distributed to the LPs and because the MLP has favorable tax status.  It is exempt from corporate taxes.  Additionally, taxes on 80% of the distributions are deferred until the units are sold;  the other 20% is taxed as income.  A higher yield is given to the investor in exchange for passing the corporate taxes to them.

Some MLPs favored by investors are Plains All American Pipeline, Enterprise Products and Targa (Reid).  Jason Stevens, energy analyst at Morningstar, likes Enterprise Products and Energy Transfer Products.  John Tysseland of Citigroup likes Enterprise Products, Atlas Pipeline Partners, Genesis Energy, Magellan Midstream Partners and Western Gas Partners.  Stephen Massocca, chief investment officer of Wedbush Securities, likes Memorial Production and BreitBurn Energy Partners.

The sources for this article can be accessed at FINalternatives.com, the New York Times and an NEPC research report authored by Andrew Brett, CAIA, Senior Research Analyst and Tim Bruce, Senior Research Consultant.