Energy master limited partnerships have been in the news lately for all the wrong reasons. Involved in the transportation and storage of fossil fuels, these companies plummeted in value over the past year, in part because of lower oil prices. In 2015, the Alerian MLP Index slumped more than 30%.
Although the companies were sold to investors as being immune to commodity price gyrations—they only get paid to move the fuel along, after all—it turns out they do have some sensitivity to the underlying commodity price. Analyst Jason Kephart at Morningstar says around 25% of pipeline companies’ revenues are tied to the price of oil.
Additionally, analysts have called MLPs’ coverage ratios, accounting practices and (in some cases) their business models into question. Brian Nelson of Valuentum Securities thinks it’s difficult to tell what free cash flow many companies are generating. He doubts the companies have been paying distributions with operating cash flow (less capital expenditures). Instead, they have been borrowing or financially engineering distribution payments, which can only last so long. Nelson sounded the alarms about Kinder Morgan (no longer organized as an MLP) to Barron’s in June 2015, just before the stock began its steep descent.
Owning these oddball companies in a closed-end fund structure presents additional complications. To understand the issues of owning the MLPs in a closed-end format, let’s examine the MLP structure first.
Pass-Through Companies
MLPs are not seen as separate entities from their owners. This feature allows them to pass through income to unit holders (not “shareholders,” since the companies are not C corporations or separate entities) without being taxed at the corporate level. In this way, they are similar to (but not exactly like) REITs, which have to pay out 90% of their net income to shareholders as dividends to retain their tax-free status at the corporate level.
In the world of MLPs, the distribution to unit holders is called a “return of capital,” and it reduces the unit holder’s cost basis. Unit holders only pay tax on most of these distributions when they sell their MLP units. So the distributions are effectively tax-deferred. Also, the unit holder only pays taxes on the taxable part of a distribution, and this is often only a small portion of it.
MLPs own expensive assets that need upkeep but also depreciate over time. As with REITs, MLPs report net income that’s often less than the distributable cash they generate because of the depreciation charge. However, unlike REITs, MLPs can use depreciation to reduce a unit holder’s taxable income.
Here’s how it works, according to former Morningstar analyst Abby Woodham in an interview she gave to ThinkAdvisor in 2014: A $5 distribution on a $100 stake in an MLP might mean that a unit holder pays tax only on $1, while $4 is treated as a return of capital, which lowers the cost basis of the units.
If you hold the MLPs directly, you would just pay your ordinary income tax rate on the $1. You wait until you finally sell your shares to pay your ordinary income rate on the $4, which represents the recapture of past depreciation deductions. That gives an investor the benefit of tax deferment, which becomes increasingly attractive as years pass.
The structure promotes long-term investing, because if you owned the MLP for just a year, you would pay the ordinary rate on your distributions (without depreciation), which is more than the rate you’d pay on qualified dividend income from stocks.
Investors who own MLPs individually get K-1 tax forms detailing their distributions and indicating whether these represent profit or a return of capital. This makes for complications at tax time, and investors must keep careful records of cost basis and how much it’s been reduced by the subsequent returns of capital.
The Problems Of The Fund Format
Investing in a mutual or closed-end fund that in turn invests in MLPs can help investors avoid the tax filings. A fund can take care of the individual K-1 forms and pass distributions on to shareholders via a single 1099 form.
There’s a major catch, though: Tax law doesn’t allow funds to be characterized as regulated investment companies (RICs) if they have more than 25% of their portfolios in MLPs. A fund that does must undergo reclassification as a C corporation.
As such, the fund must accrue the future tax liabilities of unrealized gains in its portfolio. It deducts the amount of the accrual from its shares’ net asset value on a daily basis. According to Woodham, a fund investor usually gives up nearly 40% of the total return to the accrued tax liability. So although a fund is easier to own from an administrative standpoint, an investor trades a considerable amount of total return for administrative ease.
The result is that the funds’ returns are muted when MLPs are both surging and declining, according to Sam Lee of Severian Asset Management in Chicago, who spoke with Financial Advisor. Shareholders don’t get all the gains in up years, but also don’t get all the losses in down years. For this reason the fund format is not ideal for owning MLPs. Instead, analysts prefer exchange-traded notes (ETNs), a vehicle that doesn’t own MLP units directly but instead owns a derivative, albeit with some extra counterparty risk since a bank stands behind the ETN.
Nevertheless, for those who want to wade into the closed-end fund waters, there are some advantages. First, closed-end funds often use leverage to magnify their bets. While this can hurt during declines, it can boost returns in market surges. Unfortunately, Lee has observed that the funds don’t use the maximum leverage or borrowing power available to them when their assets have dropped in value. In other words, they tend to be highly levered when their prices peak, guaranteeing a magnified loss when prices drop, and only lightly levered after they’ve dropped, guaranteeing a muted bounce-back. On top of that, closed-end funds are just plain expensive, Lee says.
Closed-End Fund Features: Leverage And Discounts
Closed-end funds make greater use of leverage than mutual funds because they issue a fixed amount of shares in an IPO. After they raise capital and issue the shares, the funds close in the sense that they do not redeem shares from holders who want to sell them or create new shares for those who want to buy. After the IPO period, shareholders trade a fixed number of outstanding shares among themselves on the open market, making the assets in the fund essentially “captive.” Since the funds themselves don’t redeem shareholders who want to sell, they can use meaningful amounts of leverage.