MLPs In Play

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.”