Kinder Morgan Inc. shocked Wall Street on a sleepy August Sunday with a $71 billion announcement as bold as its size. The energy giant planned to fold into its corporate umbrella the three publicly traded master limited partnerships it manages, and receives revenues from, as general partner, effectively buying out the limited partners with cash and Kinder Morgan stock.

The financial media certainly loved the news. Commentators gleefully obsessed on whether it would start an MLP-industry trend. (So far, no.)

Yet behind the blare lay tax-scarred investors. Like the limited partners in most MLPs, Kinder’s limited partners had received tax-deferred distributions. Alas, the corporate buyout would be their day of reckoning income.

For other investors and their advisors, Kinder Morgan’s eyebrow-raising move gives pause to look again—if not for the first time—at this intriguing investment area. There are many ways to play it.

Master limited partnerships sport LP or LLC acronyms and derive 90% of their income from assets used to explore, develop, produce, refine, transport or market a natural resource such as oil or gas. No rule requires these passive investment vehicles to pay out their income. But it is a tradition in this half-trillion-dollar-market-cap asset class that has drawn institutional attention of late.

“MLPs are equities that historically have had lower correlations to the S&P 500, below-average betas, a higher yield than other equities and today a higher yield than most bonds,” says Ben Niedermeyer, senior partner and chief investment officer at Boston’s NBW Capital (formerly Taylor Investment Counselors). At the end of October, the current yield on the benchmark Alerian MLP Index stood at 5.6%.

“MLPs are typically regulated monopolies that will pre-contract with the end customer before they build, rather than build based on anticipated demand. That reduces risk a lot,” he says.

Nevertheless, it can be a volatile marketplace, owing to thin trading volumes. In a wild week in October, when the S&P 500 index fell 3%, the Alerian MLP Index dropped more than twice that. It finished the month down 5.4%.

Another risk to investors is the potential for an adverse change in the federal tax laws governing publicly traded partnerships.

MLPs are not a play on energy prices, per se. They usually don’t have direct exposure to commodity prices, even if they sometimes get thrown out with the bathwater when energy tanks, says Hinds Howard, head of MLP research at CBRE Clarion Securities in Radnor, Pa. “MLPs are really a bet on activity at various points along the energy value chain.”

To illustrate, suppose the price of oil drops. Cheaper crude could boost demand for refined products. In that case, Howard says, “Midstream MLPs with pipelines from refineries to ports that ship gasoline abroad could see upticks in pipeline traffic”—and therefore revenues. These businesses’ revenues primarily come from charging energy companies tolls to use their pipeline assets.

LP Vs. GP
The Kinder buyout raises a compelling question. Should clients invest as a limited partner by purchasing units of equity in the MLP itself? Or is it better to invest in the managing general partner, which is typically a separate corporation like Kinder Morgan Inc.? Both approaches provide exposure to the same underlying business assets and fundamentals.

Limited partners reap greater tax advantages. Often only about 15% to 30% of the meaty distributions they receive is currently taxable. The rest is tax-deferred and stems from depreciation and other deductions that are passed through to investors from the partnership, which itself does not pay federal income tax. The tax-deferred portion of the client’s distributions gets taxed as ordinary income when the partnership interest is divested. Long-time Kinder partners face ugly tax bills.

When clients aren’t forced out of their positions, a common strategy is to leave the MLP units to heirs. They get a step-up in basis to current value. This effectively converts the client’s tax-deferred income into tax-free income across the generations.

Limited partners also benefit from higher yields. But “the advisor needs to explain to clients that they are likely to do better with a total-return mind set than with a yield-only mind set. Growth needs to be factored into the equation,” says NBW’s Niedermeyer.

General partners typically fare a little better in a merger or acquisition, he says. Furthermore, “a GP’s total return can be higher because of the potential to grow its distribution much more rapidly due to incentive distribution rights,” Niedermeyer says.

With incentive distribution rights, or IDRs, the percentage of the distribution paid to the general partner increases, often up to 50% of incremental cash flows above a predetermined level, when it meets targets for growing the MLP’s distribution. The percentage applies to the aggregate, total-dollar distribution paid out, which benefits the general partner greatly.

 

Niedermeyer explains that because MLPs pay out most of their cash flow, to expand their business they borrow and issue new units of limited-partner equity. If the number of units outstanding increases by 40% to acquire another pipeline or publicly traded MLP, for instance, then the total dollars distributed will likewise increase 40%, assuming the acquisition pays off. “A GP that’s fully into the splits would see an increase in its distribution income of half of that, or 20%,” Niedermeyer says, “even if the limited partners’ distribution-per-unit remains constant.”

And if the limited partners’ per-unit distribution does increase at its typical above-inflation rate, the general partner effectively gets a piece of that, too. In sum, “the GP benefits from both asset growth and distribution growth, whereas an LP investor benefits only from distribution growth,” says David Chiaro, co-advisor of the Eagle MLP Strategy Fund. “You don’t want to invest as a limited partner if you’d be giving up a lot to the general partner.”

In the Kinder family, general partner Kinder Morgan Inc. was taking about half of the cash from its underlying MLPs. The situation is similar at other partnerships. The problem is that a high payout to the general partner raises the MLP’s cost of capital (translation: it increases the hurdle rate of return on proposed projects), hindering its ability to compete and grow.

But this concern is not universal. Some general partners don’t have incentive rights. “So 100% of the distribution growth stays with the limited partners,” Chiaro says. As examples, he cites Enterprise Products Partners LP, Magellan Midstream Partners, L.P. and Buckeye Partners, L.P. Still other MLPs have eliminated their general partner altogether, such as MarkWest Energy Partners LP.

Incentive distribution rights don’t seem to be going away, Howard observes. When Dominion Midstream Partners LP went public in October, “it had IDRs with the goal of getting to the top tier as fast as possible. And it’s a trade-off. The IDRs encourage the general partner to grow the MLP as fast as possible, but at some point those IDRs are going to hurt the limited partners. It’s something to monitor in the MLPs you pick,” Howard says.

A Tax Reporting Issue
Most general partners are regular C corporations. Accordingly, investing in their shares in a taxable account gets the client Form 1099-DIV at tax time. It will typically show that a generous portion of the dividends received are qualified dividends taxed at long-term capital gains rates.

MLP partners, on the other hand, receive Schedule K-1. This is a complicated form that can increase tax-preparation fees.

Moreover, limited partners’ distributions can consist of unrelated business taxable income—the dreaded UBTI—if the partnership units are owned inside a retirement account. When UBTI tops one grand for the year, a tax return must be filed for the account.

These tax issues can be averted by investing in an open-end mutual fund, closed-end fund or exchange-traded fund. Besides providing investors with a 1099 and shielding them from UBTI, funds offer diversification, professional management, modest investment minimums and some tax-deferred distributions. These features come at a price, though.

The Internal Revenue Code says that if more than 25% of a fund’s investments are in MLPs that issue K-1s, then the fund must pay income tax. Status as a regulated investment company is lost.

Some funds therefore strive to stay under the 25% threshold. The rest of their portfolio is usually dedicated to the stock of corporate GPs, a combination that may appeal to some investors, but not all.

Other funds, including pure MLP plays, blow right through the 25% limitation and endure tax at the fund level. These funds must reserve money for taxes. This double-edged practice makes it difficult for ETFs to track their indexes well, but it also makes an ETF less volatile than its index and gives it a greater yield, Howard says.

Exchange-traded notes don’t suffer this. “The ETNs track better. If you’re willing to take on the fees and credit risk, ETNs offer some of the best passive exposure in the MLP space,” Howard says.

But some experts recommend avoiding the JP Morgan Alerian MLP Index ETN (AMJ). This popular product has sometimes traded at a premium to net asset value since J.P. Morgan stopped creating new notes in 2010.

Current Holdings And Outlook
Presently, Chiaro is favoring general partners in his Eagle MLP Strategy Fund. “We have found that in an environment of growth such as this where there is a lot of opportunity to build and buy assets, the GP typically provides a better total return because it benefits from asset growth,” Chiaro says.

The opposite view prevails elsewhere. “Right now, we don’t have any general partners in the Meritage Yield-Focus Equity Fund. Our view is that the value of the LP is stronger,” says Mark E. Eveans, chief investment officer and senior portfolio manager at Meritage Portfolio Management in Overland Park, Kan. Currently, about 12% of the 1-year-old fund is invested in LP units.

That’s on the low end of the 10% to 20% exposure the shop has maintained in clients’ separately managed accounts over the last decade. The firm believes some MLPs are currently overvalued, even if the industry’s long-term prospects appear favorable. “We think energy independence is a huge theme for the next 10 to 20 years,” Eveans says.

There are no general partners in the Alerian MLP Index. As of this writing, it includes two of the Kinder MLPs, which account for about 12% of the index. Howard says, “With them coming out of the index post-consolidation, and all the ETF money that owns the index coming out of them, other large MLPs should benefit as that money gets invested in them, depending on how their weights in the index are adjusted.”