When Gregory Reid began his career as a wealth manager at Goldman Sachs over 20 years ago, he didn’t plan to become an expert on master limited partnerships (MLPs). But after investing in them over the years, he became convinced that their combination of high income, strong total returns and tax advantages was hard to beat.

So in 2007 he founded RDG Capital, a Houston-based asset and wealth management firm specializing in this once-dormant corner of the market. One major appeal of these publicly traded limited partnerships—which are typically involved in energy infrastructure businesses such as pipelines, storage and transportation—is their high distribution yields. At midyear, the yield of the Alerian MLP Index stood at 5.29%, well above the 3.75% yield for real estate investment trusts, the 3.7% yield for utilities and the 2% yield for the S&P 500 index.



Reid, whose firm was eventually acquired by Salient Partners, runs more than $4.5 billion in the strategy. About $1.2 billion of that comes from the Salient MLP & Energy Infrastructure Fund II, a two-year-old offering that invests mainly in energy MLPs, as well as energy infrastructure companies that serve as their general partners.

While the latter group’s yields tend to be lower than that of their affiliated MLPs, they typically experience stronger growth. That’s one reason the fund produced an annualized total return of 34% from its inception in September 2012 to the end of June 2014, while the Alerian MLP Index returned 23%.

Although high yields are a powerful draw for investors, Reid prefers to emphasize the “toll road” business models that make them a solid bet on the expansion of energy production in the U.S. Most of the fund’s holdings are in “midstream” companies that have storage and transportation assets, such as pipelines and storage facilities that link oil and gas producers with end user businesses and consumers. “They get paid to bring a product from point A to point B, and those payments are often in the form of long-term contracts linked to inflation,” says Reid. “We think it’s a more predictable business than upstream companies that do exploring or drilling, or downstream companies that sell the products to consumers.”

He points to the “energy renaissance” as a long-term driver that will support growth in payouts to investors. Oil and natural gas production has surged since the mid-2000s, when the extraction method known as “fracking” took hold. This spike has created additional demand for infrastructure investments such as processing and transportation services, the bread and butter of master limited partnership companies.



Reid believes including MLPs in his fund’s energy infrastructure investment mix provides several benefits, including:

Diversification and good risk-adjusted returns. Between June 2006 and the end of last year, the Alerian MLP Index had a correlation of 53% to the S&P 500, 62% to high-yield bonds, 28% to the MSCI U.S. REIT Index and 43% to crude oil. Over the same period, the Alerian MLP Index, with only a slightly higher standard deviation, returned 15.6% annually, while the S&P 500 returned 7.4%.

Inflation protection. As a group, MLPs have grown payouts at a rate averaging 7.8% a year since 2001, over three times the rate of inflation. Many of the businesses themselves have internal inflation hedges, since certain types of pipelines that are regulated by the Federal Energy Regulatory Commission are able to increase tariffs annually.

Tax benefits. Even though these publicly listed securities trade much like common stock, the MLP partnership structure allows investors to defer taxes on distributions, which are treated as a return of capital and taxed at favorable rates. (Since the fund also invests in the stocks of the general partners, which pay traditional dividends, only a portion of its income is treated in that manner.)

But there are also some potential drawbacks, including:

Possible dividend cuts. Three MLPs (none of them in Reid’s fund) slashed distributions this year. One of them, Boardwalk Pipeline Partners (BWP), saw a 46% drop in its stock price in February after it announced a massive payout cut, although it gained back some of that lost ground during the summer. Reid believes that “things look fairly static for now” as far as further cuts are concerned.

Tax uncertainty. One reason MLPs can pay out so much income is that their partnership structure allows them to circumvent federal income tax at the corporate rate. If that were to change, the amount of cash available for distribution would likely fall and shareholders would receive less favorable tax treatment on distributions.

While the tax status of MLPs has not been specifically challenged, they could fall into the crosshairs of legislators seeking to drum up revenue. Reid thinks this is unlikely to happen, though.

“The amount of money that could be raised by taxing MLPs differently wouldn’t be a needle mover,” he says. “And the current administration has been vocal about the need for energy independence and infrastructure. We think MLPs achieve both these goals and create jobs.”

The decision by energy company Kinder Morgan this summer to buy out its affiliated MLP businesses will probably create unexpected tax liabilities for the MLP unit holders, and the same would hold true if other general partners decided to make similar moves. “We don’t necessarily think there is a widespread industry read-through at this point,” notes Reid in reference to whether others will follow Kinder’s lead.

Finally, while the fund aims to generate a large portion of distributions as return of capital from the MLPs in its portfolio, payouts returned in that form can vary. In the first quarter of 2014, the fund reported 81.17% of distributions as return of capital and 18.83% as ordinary income. In the second quarter, the return of capital accounted for 39.43% of distributions, ordinary income 55.94% and capital gains 4.63%.

Rising interest rates. Rising rates could hurt high-yielding MLPs, and to some extent energy infrastructure companies, by making fixed-income investments relatively more attractive. But Reid believes that for now, at least, there’s a decent yield buffer.

“Our research indicates that MLP performance historically has not gone negative until the yield spread between the 10-year U.S. Treasury and MLPs falls below 150 basis points,” he says. “The yield of the MLP index is about 290 basis points higher than 10-year Treasurys’ and 80 basis points higher than investment-grade bonds’. That’s in line with the historical average. So at current spreads, we think MLPs still have some room to run.”

Nonetheless, he believes investors may need to modify expectations. “A 15% to 16% annualized return for MLPs over the last 10 years has been pretty impressive,” he says. “No one knows how markets are going to perform, but based on that historical data, we think a reasonable expectation for the next five to 10 years might be about four percentage points lower, based on current buy-in yield plus annual growth in payouts of 5% to 7%. We think that’s still a relatively solid return, especially on a risk-adjusted basis.” But, he adds, interest rates, commodity prices, equity markets and other factors will ultimately influence how MLPs actually perform.

“There isn’t one risk that drives the entire MLP market,” says Reid. “But if two or three of the risks kick in, we believe it could trigger a 5% to 10% correction. And there are a fair number of trigger events out there now.”

Reid thinks the 30 or so MLPs and energy infrastructure stocks in the portfolio are better prepared than others to keep those risks at bay. To be included in the portfolio, companies must have growing fee-based assets and strong management teams that are best prepared to sustain long-term growth and keep those high payouts coming.

Holdings fitting the bill include Williams Companies (WMB). Based in Tulsa, Okla., the company is one of the largest energy infrastructure providers in North America and has significant business assets tied to the Marcellus Shale. It owns the general partner for two MLPs, Williams Partners and a recently acquired stake in Access Midstream Partners. Another top holding, Targa Resources Corp., (TRGP) is expanding its oil and gas pipelines across multiple shale and natural resource zones and is affiliated with an underlying MLP, Targa Resources Partners. And Plains All American Pipeline (PAA), an MLP that specializes in crude oil and natural gas storage and delivery, has increased its quarterly distribution by 187% since its initial public offering in 1998. The fund also invests in the general partner, Plains GP Holdings (PAGP).