Since we last wrote a commentary piece on energy master limited partnerships (MLPs), much has changed. Several general partners have gone public, allowing investors to participate in the upside of incentive distribution payments. Tax laws that restricted MLP ownership by mutual funds have been rolled back, increasing the pool of potential MLP investors. In the quest for growth, MLPs have paid ever-higher prices to acquire assets or other companies. But in the biggest change, several exploration and production (E&P) companies have gone public under the MLP umbrella, and many more have announced plans to do so.
The biggest reason for a company to organize in the MLP structure is tax avoidance. While shareholders in a corporation face double taxation--paying taxes first at the corporate level, and then at the personal level when those earnings are received as dividends--owners of a partnership are taxed only once, at the individual level. There is no partnership equivalent of corporate income tax.
Not just any company can qualify for MLP status. According to the National Association of Publicly Traded Partnerships, the MLP structure is limited to companies that receive 90% or more of their income from interest, dividends, real estate rents, gain from the sale or disposition of real property, income and gain from commodities or commodity futures, and income and gain from mineral or natural resources activities. While there are a few exceptions, the vast majority of MLPs operate in the energy industry.
Historically, companies that have used the MLP structure tend to operate in very stable, slow-growing parts of the energy industry, such as pipelines and storage terminals. These assets produce steady cash flows but don't offer the rapid growth prospects of other industries. Growth typically comes from acquisitions or the construction of new pipelines and other facilities. The stability of the midstream business often means below-average risk for investors.
How MLPs Differ from Corporations
There are some important differences between buying shares of a corporation and buying a stake in an MLP. With MLPs, investors buy units of the partnership rather than shares and are referred to as "unitholders." There are two classes of MLP owner: general partners and limited partners.
General partners manage the day-to-day operations of the partnership. An MLP technically has no employees, so all services, from management to bookkeeping, are provided by the general partner. All other investors are limited partners, and have no involvement in the partnership's operations. The general partner stake is often 2% of the partnership, though the general partner can also own limited-partner units to increase its percentage of ownership.
The most important difference between general and limited partner interests from an investor's standpoint is the way the cash pie is divided between the two groups. In most cases, the general partner is paid on a sliding scale, receiving a greater share of each dollar distributed as the limited partners' cash distributions rise. This type of incentive distribution scheme gives the general partner extra motivation to increase limited-partner distributions.
To illustrate, take the case of Enterprise Products Partners (EPD). Enterprise Product's general partner is owned by Enterprise GP Holdings EPE, which receives 2% of quarterly distributions up to $0.253 per unit, 15% if the distributions are $0.254 to $0.3085, and 25% if the distributions are above $0.3085. Because Enterprise Product's current quarterly distribution exceeds $0.3085, Enterprise GP receives 25% of every incremental dollar that comes in the door. In some scales, the general partner's take can reach as high as 50% of distributions, which can really cut into the cash available to limited partners.
This illustration shows why we like general partners--any business where you can receive 25% to 50% of the company's incremental cash flow for a 2% equity stake seems like a good business. This payment scheme does make the general partner somewhat riskier, though--any cut in the distribution to limited partners would have an amplified effect on general partners. It may be helpful to think of general partners as "super equity" stakes with higher returns and growth. Meanwhile, think of limited partner units as akin to participating preferred debt, with lower returns and upside participation than the general partner, but higher yield and meaningful downside protection. Fortunately for general partners and limited partners alike, midstream assets tend to be safe enough to minimize the risk of a dramatic reduction in cash flows.
Yields and Taxes
Most MLPs offer very attractive yields, generally falling in the 5%-7% range for limited partnerships and 3%-4% for general partnerships, and unitholders often receive favorable tax treatment on their partnership income. Cash distributions usually exceed the partnership's taxable income, and when they do, the difference is counted as a return of capital to the limited partner and taxed as ordinary income when the unitholder sells. Because of this deferral, unitholders often pay an effective tax rate of under 10% of annual distributions. This rate can fall as low as zero in some cases.
However, investing in an MLP does have its drawbacks, with personal tax complexity being the biggest concern. Each unitholder is responsible for paying his or her share of the partnership's income taxes. The complexity ramps up for larger unitholders, who are more likely to reach the thresholds that would require an investor to file tax returns in the various states in which the partnership operates. Moreover, limited partners might owe taxes on partnership income even if the units are held in a tax-free account, like an IRA.
The pool of potential MLP investors is limited since institutional investors, such as pension funds, are not allowed to hold MLP units without subjecting themselves to taxation. Preferring to avoid taxes, institutions largely shy away. These large investors represent a huge portion of investor dollars in the market; and eliminating them reduces the potential demand for MLP units.
To get around this restriction, two companies, Enbridge (ENB) and Kinder Morgan Energy Partners KMP, have set up separate share classes that pay dividends in the form of partnership units rather than cash, allowing institutions to participate. Shares of Enbridge Energy Management (EEQ) and Kinder Morgan Management KMR also hold allure for individual investors--because they are organized as corporations, investors don't have to deal with the tax-filing headaches of a traditional MLP. Mutual funds are now allowed to buy MLP units, but to date, funds have expressed relatively little interest.
The most recent development in the MLP marketplace has been the reintroduction of E&P MLPs. Many E&P MLPs went bust in the 1980s, and since that time the MLP space has been dominated by midstream companies. The new generation of E&P MLPs aims to create pipeline-like cash flows by investing in oil and gas fields with long remaining lives and using hedging to minimize the impact of fluctuations in commodity prices.
We remain skeptical of this strategy for two main reasons. Production volumes can be difficult to project, and hedging allows a company to lock in prices only for five years as of today. However, the tax benefits of the MLP structure will likely lead to a significant number of companies to set up MLPs over the next few years. The potential market size for these companies is huge--estimates suggest that around $250 billion in E&P assets would be appropriate for MLPs, while only $7 billion are held by MLPs currently.
Through the many changes in the marketplace, we continue to think that MLPs make solid choices for income-oriented investors. Not all MLPs are created equal, with some offering stability and less risk and others promising faster growth and higher risk. Investors should carefully consider the pros and cons of investing in a particular MLP, then consult a tax advisor to help determine the tax implications of such an investment.
Michael Cumming, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.