Master Limited Partnerships—Lessons from HistoryBy James J. Murchie
A reprinted article from March/April 2008
© 2008 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
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MasterLimitedPartnerships—LessonsfromHistoryBy James J. Murchie
P ubliclytradedmasterlimitedpartnerships(MLPs)intheener-gyindustryareoneofthefastest
growingassetclassesinthestockmar-kettoday.Thisassetclassboastsmorethan70MLPswithacombinedmarketcapitalizationofabout$135billion,upfrom27MLPsin2002withamarketcapof$25billion.From2000through2007,investorsenjoyedacompoundannualreturnof22.7percent(AlerianMLPTotalReturnIndex)versus1.7percentfortheS&P500and16.4per-centfortheAmexEnergySelectIndex(IXE)(source:Bloomberg).TheseMLPscurrentlyyieldover7percent.Thequarterlyper-sharecashdistributionsthatmakeupthisyieldhavegrownabout8percentperyearoverthistime.MLPsponsors(privatecompanies,pri-vateequityfunds,utilities,andoilcom-panies)alsohavedonewell;bringinglegacyenergyassetspublicinanMLPwithahighpayoutratiohasgarneredahighermultiplethaniftheywerefloatedasaconventionalC-corporationwithamoretypical(i.e.,low)payoutratio.Moreover,thegeneralpartnershipinterestretainedbythesponsorhasthepotentialforhighgrowth.
Whileskepticsmayarguethatthissuccessismerefinancialengineeringandvaluationalchemy,forthemostpartrealvalueisbeingcreated.Thisvaluecreationisdrivenprimarilybyonefac-tor:thecapital-spendingdisciplinethatcomeswithahigh-dividendobligation,similartotheleveragedbuyout(LBO)effect.Thehighpayout—whichistax-deferred—hasthebenefitofshiftingalargeportionofthetotalreturntosteadyquarterlycashpayments,loweringthevolatilityandcovarianceofthereturns.Inspiteofthis,MLPshavenotyetat-
tractedsignificantinterestfrominstitu-tionalinvestorsbecausethepartnershipformofMLPscreatestax-filingobliga-tionsforinvestorstoeachstateinwhichtheMLPoperatesandanunrelatedbusi-nesstaxableincome(UBTI)liabilityfornontaxableentitiessuchasfoundationsandpensionfunds.Infact,incomefromMLPswasnonqualifyingincomeformutualfundsuntilthelawwasamendedin2005allowingupto25percentofamutualfund’sportfoliotobeinMLPs.
Atax-deferred7-percentyieldcombinedwithhighsingle-digitgrowth,lowvolatility,andlowcorrelationtootherassetclassesisanattractivesetofcharacteristics.Theseattributeshaveresultedfromyearsoftrialanderror.Areviewofthishistoryiscriticaltoun-derstandingMLPstructureandsuccess.
A Brief History of MLPs
ThefirstMLPwascreatedtoholdoilandgasassetsspunoutofApacheCorporationin1981whenoilpricesfirstreached$40perbarrel,upfromabout$12justafewyearsearlier.Backthen,individualmarginaltaxrateswere70percentandcorporatetaxrateswereabout45percent.High-net-worthinvestorswerepouringmoneyintooilandgasdrillingpartnershipsformedbyinvestmentbanks.Thiswasanerawithnosectorexchange-tradedfunds,fewsectormutualfunds,andonlyahand-fulofsector-specificunitinvestmenttrusts.Partnershipsweremoretaxef-ficientbecausedrillingexpensesandtaxcreditsrelatedtodrillingwerepassedthroughtoinvestorswhocouldusethecreditsandexpensestoshelterotherincome.Thereforefloatingapubliclytradedhigh-payoutoilcompanyintheformofapartnershipthatpaidoutall
availablecashflowmadesense.OtherscopiedApacheandformed
about25energy-relatedMLPsoverthenextfewyears.Othercompaniesinthepetrochemical,refining,paper,andforest-productindustriessoonfollowed.Butwhenlargenon-naturalresourcecompaniessuchasAllianceCapitalandtheBostonCelticsformedasMLPs,Congresswokeuptotherevenuelosspotentialduetoavoidanceofdoubletaxation.Inthe1987TaxReformAct,Congressrestrictedpubliclytradedpartnershipstorealestate,naturalresources,anddividendandinterestincomeandgavenonconformingMLPs10yearstoreverttoacorporatestruc-ture.TodaysomeinvestorsworrythatrecenteliminationofthetaxadvantagesforCanadianincometrusts(topreventmasscorporatetaxrevenueleakage)couldhappentoU.S.MLPs.Arguably,italreadyhappened—20yearsago.
ThecombinationofthechangeinlegislationanddecliningcommoditymarketstookatollontheMLPassetclass.MLPsdependentoncyclicalcashflowsgothurtbythefallinthepriceofcommodities(crudeoilfellfrom$40in1981to$10in1986)andbythelate1980svirtuallyallearlyMLPsinvolvedincyclicalcommoditybusinessescutdividends,suffereddramaticdropsinvaluations,andde-listed.ThefirstphaseofMLPhistory—let’scallitthe“pioneeringera”—wasending.
Thenextphase—let’scallit“nuclearwinter”—wascharacterizedbyinvestordistrustofanythingMLP.Survivorsofthisshakeoutwerehigher-qualityandconservativeMLPswhosecashflowsdidnotdependoncyclicalbusinesses.Com-paniessuchasTeppcoPartners,BuckeyePipeline,andLakeheadPartners(now
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EnbridgeEnergyPartners)dominatedthenext10years,untilthemid-1990s.Thesecompanieswerebasedonslow-growing,stablecashflowsthatescalatedwithinflationcomingfrompipelinesandstorageterminalsratherthanoilandgasproduction.TheprimaryholdersofMLPswereretailinvestorswhosawthemasbondsubstitutes.ThenRichKindercamealong.
KinderwasaregulatorylawyerwhorosetobecomepresidentandchiefoperatingofficerofEnron.Helostthebattletobecomechiefexecutiveofficer,soheleftthecompany.KinderandBillMorgancobbledtogethersomeinvestors.In1997theyboughtEnron’sinterestinanMLPcalledEnronLiquidPipelineCompanyandrenameditKinderMorganEnergyPartners(KMP).KinderlikedtheMLPstructurebecauseitranlikeaprivatepartnership,payingoutallcashflowtopartnersonaregularbasis.Andhelikedthatthequarterlycash-distributionobligationwasbackedbynoncyclicalfee-basedcash-flowbusinesseswithlowsustaining-capi-talrequirementsandmodestgrowth.Further,hetookadifferentapproachtorunningtheassetsthatEnronsawasacostcentertosupportitstradingdesk.Heranthemlikeabusiness.Hesawnu-merousde-bottleneckingopportunitiesthatEnronhadneglectedas“toolow-return.”Overthenext10years,Kindergrewthecompanybybuyingothersimilarlyneglectedenergyinfrastructureassets.Fromearly1997totoday,KinderMorgan’smarketcaphasgrownfrom$260millionto$17billionandquarterlycashdistributionshavegrownfrom16centsto88cents,acompoundannualgrowthrateof18.8percent.RichKinderusheredinthethirdphaseofMLPhisto-ry:the“growthMLP”era.Otherscopiedhisbusinessmodelandtodaythesecompaniesrepresentthehigher-qualitymembersoftheMLPassetclass.
Todaythetypesofbusinessescom-ingintoMLPsarefarmorevariedthaninthepast,andsomehavemorerisk.We’llvisitrisklater.Nowlet’stalkabout
whatmakesMLPsdifferentfromotherassetclasses.
MLP Distinguishing CharacteristicsPartnership Form
MLPsarepubliclytradedpartnerships.Theytrade,settle,andclearjustlikeotherC-corporationstocks.EnergyMLPstodayhaveacombinedtradingvolumeofabout$250millionperday(source:Bloomberg).AnMLPinvestorreceivesaK-1eachyearandmayhavestatetax-filingrequirementsinallofthestatesthattheMLPoperatesin.Thepartnershipstructurehasbeenanentrybarrierforlargeinstitutionalnontax-ablebuyersbecauseitgeneratesUBTIandstatetax-returnrequirementsthatdetermanywould-beMLPinvestors.Solutionstothistaxhavearisen,buttheytoohavedrawbacks.Forexample,somefundmanagerssetup“blocker”corporationsthatkeepstatetaxorUBTIobligationsfrompassingthrough.How-ever,thisapproachaddsalayeroftax.TheMLPclosed-endfundslaunchedin2004aremutualfundsthatpaytax.Inanotherapproach,offshoreinvestorsinvestinMLP-focusedhedgefundsthatholdMLPsintotal-returnswaps.Funds-of-fundshaveembracedthisapproach,butsomeinstitutionalinvestorsareun-comfortablenowthattheIRShasdisal-lowedswapsonassetsheldforoffshoreaccountsthatitdeemsaresetupsolelytoavoidwithholdingtax.Onefundthatwemanage,bycontrast,hassetuparegisteredinvestmentcompany(RIC)asablockerthatdoesn’taddalayeroftax.Mosthedgefundmanagersdon’twanttolivewiththeconstraintsofaRIC,butthoseconstraints,suchaslimitsonleverageandtheneedtoretainaninde-pendentboardoftrustees,areexactlywhatmanyinstitutionalinvestorsseektoensurepreservationofcapital.
High Payout Ratio Means Capital-Spending Discipline
ThemostattractivecharacteristicofMLPsistheirhighpayoutratio.Allthelimitedpartnershipagreementsstate
thatcompanieswillpayoutallavail-ablecasheveryquarterlessareservethatmanagementdeemsappropriatetomaintaintheassets.Thishastwosignificantbenefits.First,capital-spend-ingdisciplinecomesfrompayingoutsuchalargeportionoffreecashflow,similartotheLBOeffect.Thesecond,discussedbelow,isthatyieldmakesupalargeportionoftotalreturn,reducingbothvolatilityandcovarianceoftheshares’totalreturn.
Matureindustriessuchastheenergyindustrygrowabout1percentto2percentperyear,yettheyearnreturnsoncapitalinthehighsingledigits.Toomanycompaniesreinvestallcashflowgeneratedbythesereturnsinthemistakenbeliefthattheycangrow8percentto10percentperyeareventhoughtheindustryisgrowingonly1percentto2percent.Historyshowsusthatmostofthesecompanieswilldisap-pointandthatthewinnersarecompa-niessuchasExxon,whichhavepaidoutanaverageofmorethan50percentofearningsindividendsandsharebuy-backs,andMLPsandroyaltytruststhathaveamandatetopayoutallavailablecasheveryquarter.AstheoilanalystatSanfordBernsteinintheearly1990s,Ipublishedareportonthisrelationshipandfoundacorrelationofabout85percentbetweentheportionoftop-linecashflowreinvestedandunleveredre-turnoncapitalemployed forthemajorintegratedoilcompanies.Updatingtheanalysis10yearslaterfortheAMEXOilIndexhadthesameresults.Inmature,capital-intensiveindustries,wherecom-paniesdotheirbestprojectsfirstandtheirworstprojectslast,itmakessensethatthehigherthereinvestmentrate,thelowertherelativereturns.
ButhowhaveMLPsgrownper-sharedistributionsiftheypayoutalltheircash?Theansweristhattheymustraisenewcapital.Sowhenthecom-panyseesanopportunitytomakeanaccretiveacquisitionorinvestinalargeaccretive-growthprojectsuchasapipe-lineextension,thecompanycanissue
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newstockandnewdebt.Thisgivesthecapitalmarketsachanceto“approve”theproject.ItwouldbedifficultforanMLPtoraisecapitalfromitsyield-hun-gryretireesforadilutiveacquisitionthatwouldcausethequarterlydistribu-tiontobecutonthepromiseofrisinginthefuture.Inmaturenoncyclicalindustries,ifabusinessisnotprofitablenow,whenwillitbe?
Energy Infrastructure
Basedonthemarketvalueofassetsem-beddedinmidstreamMLPs,IestimatethevalueofenergyinfrastructureassetsinNorthAmericaatbetween$500bil-lionand$1trillion.ApipelinemapofNorthAmericalookslikeahighwayandrailroadmapthatincludeslocalroadsinhydrocarbonproductionareassuchasTexas,Louisiana,andOklahoma.Thesepipelinesoperateliketollways,collect-ingtariffsonthemovementofcrudeoil,gasoline,dieselfuel,propane,natu-ralgas,etc.frompointsofproductionorimporttopointsofconsumption.Storageandterminalingareassociatedwithallthesemovements.Withfewexceptions,theseservicesareprovidedforafeethatisbasedontheoperatingandcapitalcostsofserviceandnotonthecommodityprice.Forinterstatepipelines,thesereturnsareregulatedandoftenhaveaninflationescalator.
TheMLPassetclasshasgrownthroughtheacquisitionoftheseassetsfromoilcompanies,pipelinecom-panies,utilities,andprivateowners.Recently,however,theneedtoinvestinnewinfrastructurehasbeguntodominatemidstreamMLPs’investmentactivities.Thisneedcomesafteralongperiodofunderinvestment.Petroleumdemanddeclinedforfiveyearsstraightfromits1978peakduetorecession,conservation,andsubstitution.Growthresumedin1984buttheoldhigh-wa-termarkofdemand(about20millionbarrelsperday)stooduntil2003–2004,usheringintheneedfornewinvest-ment.Inaddition,thematurationofhydrocarbon-productionareassuchas
theshallow-waterGulfofMexico,andtheirreplacementbyonshoreresourceplayssuchastheBarnettShaleintheFortWorthBasin,theRockyMoun-tains,andtheCanadianOilSands,hastriggeredtheneedformassiveinvest-mentinnewpipelines,storagefacilities,andterminalstodeliversupplyfromnewproductionareas.
Thestabilityofcashflowsandthelowsustaining-capitalrequirementsofthepipelineandstoragebusinessesmakethemanidealfitwiththeMLPassetclass.Butthereisanotherat-tributeoftheinfrastructurebusiness:it’salsolikesellingpickaxestominers.EveryoneknowsaboutLeviStrausssellingbluejeanstotheforty-ninersandHowardHughessellingdrillbitstowildcatters.Minersareoptimistsholdingoutforhomeruns.Theythinkpipelinetransportationoperatorsandotherserviceprovidersaresuckersforacceptingpaltry10-percentto12-per-centreturnsoncapital.Butwiththeadditionofconservativeleverage,an11-percentreturnonassetscanbea15-percentreturnonequity(assuming50-percentdebt-to-capitalanda7-percentborrowingcost).Well,signmeuptobea15-percentsucker.
Partnership Structure: Limited Part-ners and the General Partner
MLPsarecreatedfromexistingassetsownedpubliclyorprivately.Usually,thesponsoractsasthegeneralpartnerandusuallyretainsabout20percentto50percentoftheshares.Afterthepioneeringeraanditsmanyfailures,newMLPinitialpublicofferingsmetwithskepticismregardingthesafetyofquarterlycashdistributions.Inresponse,
sponsorssubordinatedtheirunitstothepubliclyheldcommonunitswithrespecttoreceivingquarterlydistributions.ThusforanewMLPinwhichthesponsorretaineda50-percentstake,cashflowscoulddropbyhalfbeforedistributionsofthepubliclyheldcommonunitswouldbeatrisk.Asthesubordinationstructurefoundsuccessinaskepticalmarket,generalpartnersbegangettingagrowthincentiveinreturn,knownasincentivedistributionrights(IDRs).IDRsarearisingprofitshareonincrementalper-sharedistributions.Atfirst,thegeneralpartners’profitshareisjust2percentwithnoIDRs,butasper-sharedistribu-tionsriseby15percent,25percent,and50percent,theIDRsriseaccordinglyuptoa50-percentprofitsplit.
Manywouldarguethata50-percentsharingofincrementalfreecashflowisexcessiveandactsasalargetaxongrowth.Whilethiscriticismhasmerit,theIDRshaveactedasapowerfulincen-tivethathasrewardedthelimitedunitholderswithhighsingle-digitgrowthinadditiontotheiryield.Also,inresponse,afewMLPshavecappedIDRprofitsplitsat25percent.OthershavecomepublicwithouttheIDRsbutalsohaveeliminatedthesubordinationfeature.Whilenoonelikespayinganexcessiveshareofprofitstomanagementjustfordoingitsjob,MLPinvestorsnowhavenumerousopportunitiestoreceivethesepaymentsthemselves:Thegeneral-part-nerinterestsof10MLPsarepubliclytradedasseparateentities.Theseentitieshaveextraordinarygrowthcharacteris-ticsduetothearithmeticofa2-percentaverageinterestinprofitgrowingbya50-percentincrementalinterestinprofitgrowthintheunderlyingMLP.Bymy
“ Thestabil i tyof cashf lowsandthelow
sustaining-capital requirementsof thepipe-
l ineandstoragebusinessesmaketheman
ideal f i t with theMLPasset class.”
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estimate,general-partnerinterestsaregrowingper-shareflowsatabout2.4timesthegrowthrateoftheirrespectiveMLPunits.
Tax Efficiency
Partnershipsdonotpaytax,sodoubletaxationofprofitspaidoutindividendsisavoided.Butjustasimportant,MLPquarterlypaymentsaretreatedasdistri-butionsofcashoutofthepartnership.Thesecashdistributionsarenottaxableperse.Instead,theylowerthetaxcostbasisofaninvestor’sunits.Forexample,imagineaninvestorpays$40foranMLPwitha65-centquarterlydistribu-tion($2.60peryear).Mostofthisdivi-dendwillbedeemedreturnofcapital.If$2.00ofthe$2.60isreturnofcapital,thecostbasiswillgofrom$40to$38inthefirstyear,to$36inthesecondyear,andsoon.Theinvestorwillowetaxonthedifferencebetweenthislowerbasisandhiscost(calledrecapturetax),butthattaxisdueonlywhensharesaresold.Forlong-terminvestors,thepres-entvalueofthattaxliabilityissmall.
Performance, Volatility, and Covariance
Aspreviouslymentioned,returnsforMLPshavebeenveryattractiveonaverage.Assumingnomajorchangeinyield,MLPshaveexpectedfuturetotalreturnsapproximatingyieldplusgrowthinquarterlycashdistributions.Thisannualgrowthhasaveragedabout7percenthistorically,drivenbyvolumegains,returnsoninvestmentfromnewprojects,andaccretiveacquisitions.Recentgrowthhasbeenashighas13percentannually,butItendtothinkthat6-percentto7-percentannualgrowthismoresustainable.
AnnualizedmonthlyvolatilityofmidstreamMLPs(asmeasuredbytheWachoviaMidstreamMLPIndex)overthepast10yearshasbeen14.1percent.Overthisperiod,theS&P500monthlyvolatilitywas14.7percent,thePhiladel-phiaUtilityIndexwas17.1percent,andtheAMEXOilIndexwas20.1percent.
TheMidstreamMLPIndexhas31membersnow,but10yearsagotherewerefewerthanninenames,whichwouldhaveincreasedthevolatility.
Table1illustratesthecovarianceofenergy-relatedMLPswithotherassetclassesfrom1990to2003(recessiontorecession).
ThenearlynonexistentrelationshipbetweenMLPsandinterestrates(asmeasuredbythe10-yearbenchmark)issurprisingtomanywhoassumethat,asabondsubstitute,MLPswouldmovewithinterestrates.Buttwofactorsdrivethisnoncorrelationandareinstruc-tiveinunderstandingcovariancewithallotherassetclasses.First,interestratesoftencanmoveoppositeofcreditspreadsandtheresultinginvestorap-petiteforstocksversusTreasuries.Indeed,thishasbeenthecaseoverthepastsixmonthsandwasthecasefrommid-2003tomid-2007,wheninter-estratesrosefromunder3.5percenttoabout5percentyetcreditspreadsnarrowedasinvestorsmovedmoneyfromsafehavensintoriskierassetssuchasequities.Second,thecorrela-tionsaboverepresentthecovarianceoftotalreturns.BecausethebulkoftotalreturnsfrombondsandabouthalfthetotalreturnsfromMLPsaremadeupofsteadycashpayments,whichhaveacorrelationtoanythingofalmostzero,theresultingcovarianceofactualtotalreturnsislow.SomeMLPfundmanag-ers,however,hedgeexposuretointerestratesbyshorting10-yearbondsorbondfutures,despitecostandlackofbenefit.
A Final Thought
Survivorshipbiasisacommonprobleminanalyzinghistoricaldata.Butwhosurvivesandthrivesandwhodoesn’t
isanessentiallesson.Naturalselec-tioncreatesagroupofcompaniesthatbenefitedfrommistakesofthepast.ThisselectionprocesshascreatedanddemonstratedthesuccessofMLPsthatarenoncyclicalinfrastructurebusiness-eswithlowsustaining-capitalrequire-mentsandacorporatestructurethatpaysoutmostoralloffreecashfloweveryquarter.
Yetinthepasttwoyears,24newMLPshavegonepublic,14inoilandgasproduction,refining,oilservice,orshipping—allcyclicalbusinesses.Butcyclicalityisn’ttheonlyconcern;soissustainingcapital,andsustainingcapitalisabignumberforoilandgasproducers.Oilandgasproductionisthebusinessofdrainingnaturalreservoirs.It’sdifficulttomatchupalong-termdividendobligationwithadecliningas-setembeddedinacompanythatwilldonoexplorationdrilling.
ThesenewMLPs,ofcourse,havenonegativeimpactonthelegacyMLPs,theyjustincreasetherisktoan“index”buyer.Anindexbuyerwillmistakeas-cribingsuccesstotheentireassetclassratherthanthebusinessmodel.JustbecauseanenergycompanyisanMLPdoesnotmakeitagoodcompany.Onlygoodmanagementcanmakeagoodcompany.Agoodinvestmentisagoodcompanyintherightassetclass.
James J. Murchie is founder and chief executive off icer of Energy Income Partners , LLC, which manages funds that invest in energy master limited partnerships , income trusts , and other energy-related securities . He earned a B . A. f rom Rice University and an M. A. from Harvard University. Con-tact him at [email protected].
TABLE 1: COVARIANCE Of ENERGy-RELATED MLPs wITh OThER ASSET CLASSES, 1990–2003
Asset Class Beta R-squared
10-year u.S. Treasury 11% 4%
S&P 500 22% 3%
S&P Oil and Gas Producers 38% 9%
© 2008 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
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