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.

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