Don’t Be Seduced By Tax Benefits And High Yield — Beware The MLPs

posted in: Other | 0
Forbes.com, Summer, 2014. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

The $500 billion master-limited-partnership (MLP) sector has attracted many investors with high yields and tax advantages. Since the vehicles can trade on public equity markets, both directly and through funds, not all investors grasp the inherent differences between an MLP and other products traded on the same exchanges.

In particular, many investors don’t understand how MLPs are structured, which economic factors support their growth, how they are valued and what their incentives are. In assuming that MLPs are synonymous with C-corporations, which make up the bulk of the equities markets, an investor may be taking on more risk and complication than he or she intended.

Structure

Created by tax code changes in the late 1980s, MLPs first drew significant investor attention in mid 1990s as tax-advantaged vehicles for holding real assets. Like a REIT, it must be focused on ownership of eligible assets (earning less or nothing from other business operations).

Significantly, unlike C-corporations, there is no stockpiling of earnings as MLPs typically distribute 90% of income to partners. MLPs are also like LLCs in that they are pass-throughs: partners [aka Unit Holders or investors] are taxed on their share of the MLPs income [which can be deferred in certain instances], but there is no tax at the corporate level.

Perhaps the most tangible evidence you’ll get if you invest in an MLP regarding how different it is from a normal stock, is the K1. For taxes, you won’t receive a 1099, you’ll get a K1. This is likely to be taxed very differently and without the benefits of any potential offsetting deductions.

Economic

Today over 75% of MLPs are in the energy industry (up from approximately 30% in 1990). Of those in energy, most are “midstream” (pipelines & storage), or in other words are the middle men/re-handlers between the wellheads (where the energy comes out of the ground) and the refineries.

Economic conditions have favored MLP growth. It’s no coincidence their development has been parallel to that of the fracking boom (which are the gushers of today).

Think of it this way: For decades all the identified oil was in a few well-known locations that had built up significant infrastructure to transport the production. All of a sudden production is coming from totally new places that have no legacy transport to the refinery. Since fracking wells have shorter lifespans than traditional vertical wells, the pipeline/infrastructure needs to be rebuilt over and over.

Also, while interest rates trended downward, financing for these companies remained cheap.

Most experts suggest that a general rise in rates will make it harder to finance infrastructure build-outs, meaning the MLPs might incur higher costs of capital not only to expand their businesses but maintain them.

Valued

MLPs are valued according to their yield. As noted, MLPs are generally required to distribute 90% of income to investors. However, in addition they promise a minimum quarterly distribution (MQD) amount. The imperative for MLPs to maintain distribution levels in the face of income shortfalls is one of their most arcane practices.

This means the MLP promises to pay a quarterly bonus on a yearly income target that hasn’t been met yet. If the target is $80/year and the MQD is $20/quarter, then there is no problem; similarly if the MLP exceeds its target.

But say it misses the target. Where is the money to meet the distribution going to come from? Typically an MLP in this situation would borrow to make the payout. Theoretically it could change the quarterly amount but the custom is not to since investors are looking for tax-deferred income on the schedule they’ve counted on [meaning they can reinvest the pre-tax income for as long as possible before it’s taxed].

When Boardwalk Pipeline Partners recently slashed its distribution by 80% due to setbacks in its natural-gas-pipeline business, its shares collapsed by 46%.

Distributable cash flow — the cash an MLP calculates is available for dividends — is the industry’s preferred earnings metric.  Distributable cash flow, however, is a non-GAAP measure that is calculated based on the MLP’s own financial assumptions.

MLPs typically calculate distributable cash flow by taking net income, adding depreciation, and then subtracting sustaining capital expenditures. What constitutes sustaining versus expansion capex is based on a “good faith” determination by the general partner. That distinction, however, can create an incentive to minimize sustaining capital expenditures, which in turn maximizes the MLP’s distribution coverage ratio (DCF divided by distributions) and its results in a higher distribution to MLP investors and a higher annual incentive payment made to the GP.

One question to ask when examining an MLP is does it use aggressive or conservative assumptions about how much it takes to sustain the company’s business?

Another point which escapes many investors is that a part (sometimes as much as half) of the distribution you receive is actually a return of your own principal – in other words, the actual yield is much lower than promoted.

Third, given the lower “real” yield that is produced, as interest rates rise, the attractiveness of the income potential of MLPs is likely to decline.

Incentives

In addition to the methods MLPs use to determine the MQD, there are other points to consider. Often the MLP’s DCF is wafer thin and provides virtually no cushion for unexpected setbacks (another difference compared to C-Corporations, which can maintain large stock cash piles). You might ask why this is.

Such a financial arrangement is designed to incentivize the general partner to expand the MLP. But it also can create a conflict with the general partner. The GP may decide to grow with little regard for the economics of new deals, since it receives half of the cash flow on new deals. Another point: The GP calls the shots on capital expenditures and acquisitions; MLP investors have little or no say. Many MLPs lack an independent board.

It’s important to note that not all MLPs have a GP. Enterprise Products MLP has no GP so it doesn’t have to share its distributions.

This means, among other things, that it is easier for a company without a GP to make acquisitions. Where there is a GP, in order to try to make acquisitions work financially for the MLP, the GP has to forgo part of the incentive payments known as incentive distribution rights (IDR), to which it is entitled. IDR forgiveness boosts the MLP’s reported distributable cash flow in the near term, and is spun as a sign of the GP’s “supportive” role, but it also demonstrates the inferior position of the MLP.

IDR forgiveness has been characterized as nothing more than a temporary wealth transfer from GP to LP and many analysts deride it as a high-quality form of cash flow. Furthermore, it highlights the longer-term structural friction between LPs and their respective GPs.

Conclusion

Finally, MLPs are expensive based on conventional measures. Kinder Morgan’s MLP for instance trades as high as 33 times 2013 earnings per partnership unit and 16 times estimated 2014 earnings before interest, taxes, depreciation, and amortization, after factoring in payments to the general partner.

That is approximately double the valuation of electric utilities, telecom, and cable TV companies, whose expected annual growth is comparable to or better than the projected 5% growth in Kinder Morgan MLP’s distributable cash flow over the next few years.

As with any investments, MLPs have their merits, and could be suitable for a portion of your portfolio. But you better make sure you understand what you’re buying and where the risks are.

The author holds none of the investments mentioned.

Click here to see the article on Forbes.