Readers who have followed PLEXUS’ activities over the past months, either through personal contact, during our regular Backstage Events or under altii, may have noticed that we are trying to think outside-the-box and are persuaded by the belief that more “exotic” asset classes do not necessarily mean more risk.
In this edition we intend to shoot some light into the equity-like asset of Master Limited Partnerships (“MLPs”), a nowadays well-established asset class in the US with quite some remarkable features. From recent conversations with various institutional investors, particularly across German-speaking countries, it seems that many investors are not really aware of this instrument and do not cover this type of securities in continental Europe. Therefore, MLPs are usually excluded when investors think about the universe of attractive high income opportunities.
Comparable to the last edition on private debt we divide this posting into two parts: We start off with providing some information about the basics of MLPs and explain the performance attributes. In the second part of the article we will explain how MLPs can be purchased, will pinpoint to the inherent risk factors and will provide an outlook for the asset class.
What makes MLPs unique?
In the US, MLPs were introduced in the early 1980s as a tax efficient vehicle for companies that are, broadly speaking, involved in the commodity complex. In order to be able to create an MLP the underlying business has to derive at least 90% of their income from natural resource activities. In fact, MLPs can be categorized into 10 sub-sectors within the commodity spectrum that can benefit from beneficial tax treatment. The activities include the exploration, development, mining, production, processing, refining, transportation, or marketing of any mineral or natural resource. Most MLP companies belong to the gas and oil industry, particularly to the midstream segment that reflects the processing, storing, gathering and transportation of crude oil, natural gas and natural gas liquids.
In contrast to corporations, MLPs are structured like a listed Private Equity vehicle with a General Partner (“GP”) and Limited Partners (“LP”), but with the feature of being traded on public exchanges such as the NYSE, NASDAQ and AMEX. They are therefore regulated by the Securities and Exchange Commission (SEC). The parent company acts as GP and thus has operational control over the MLP; the LPs are the equity-like unitholders. The other essential difference to common stocks is that MLPs are eligible for special tax treatment as they are being exempt from corporate taxes which makes it possible for MLPs to pass on a high degree of income directly to the LPs. Thus, MLPs are passed through entities, meaning that payouts are distributed to the partners as a distribution (defined under the US taxation law as return of capital) rather than as a dividend which is the other benefit for the LPs. However, the distributions for individual investors are not completely tax free, rather the taxation of the received ordinary income is deferred until the LPs are selling their units which creates an attractive yield compounding effect. Special tax treatment may apply to foreign investors.
Historically, MLPs have been primarily owned by high net worth and retail investors, partly due to the tax benefits, but also due to a lag of diverse universe and little market capitalization. Over the years, the universe expanded slowly but steadily and MLPs have started gaining traction over the past few years among institutional investors who seek alternative sources of yield in today’s low-yield world. Like with other asset classes Hedge Funds were the first group of institutions to discover MLPs for their investable universe. The low correlation across other asset classes and the strong return profile was quite appealing. It took until 2002 to have more than 30 MLPs listed with an estimated total market capitalization of little more than USD 25bn; in 2007, 75 MLPs were listed with the first time reaching more than USD 100bn of market cap. As of end of April 2014, there were 116 energy MLPs totaling 485bn in market cap (source: Alerian Capital Management, May 2014).
What is the payout profile of MLPs?
MLPs have demonstrated strong performance as these assets have exhibited a history of a combination of prolonged high current yield, growth in distributions and capital gains. Based on calculations of the index provider Alerian the yield as well as distribution growth has comprised of approx. 7% of the return, and the balance of the total return came from multiple expansion. With these components MLPs have outperformed all major asset classes over the past 10 years until end of April 2014: Based on the Alerian MLP TR index (Bloomberg ticker: AMZX) MLPs have generated 358%, while REITs achieved 164%, the S&P 500 109% and 60% for Bonds based on 10Y Treasuries. With regard to annualized performance MLPs performed 16%, REITS 10%, the S&P 500 8% and Bonds 5%. Other metrics also compare favorably to the S&P 500 such as standard deviation of 14.7 (S&P 500 16.3 for the same period May 2004-April 2014), correlation (0.49), beta (0.44), and Sharpe Ratio of 1 and current yield of 6.1%.
While MLPs have a history of more than 10 years, as mentioned earlier, statistical evidence has just started with more than 30 underlying MLPs in the Index since 2002, not just dominated by a few large ones. However, MLPs have not only proven their potential to deliver significant income to a portfolio over longer period, but have remained substantially uncorrelated to the broader markets. The quick drawdown recoveries are another differentiating observation, particularly exhibited in the steepest V-shaped recovery after the meltdown of 2008 that was fueled by the investors searching for yield and safety.
The recent analysis by Alerian demonstrates that the Alerian MLP Index weighted average annual distribution growth was positive over the full timeframe 2004-2013, with no year of flat or even reduced payout. Thus, as the distribution yield was never less than 6% and the distribution growth was positive, the effect of multiple expansion was and continues to be the only fluctuating factor.
Potential investors may ask whether the yield and distribution growth is sustainable and could be an indication for future behavior. Without already disclosing the outlook for the MLP segment, it can be stated that as of today average yields remain around 6% and weighted average distribution growth is still nearly 6%. Going forward, due to the need for substantial energy infrastructure in the future, expectations for MLPs yields remain reasonable at around 5%-6% and distribution growth is anticipated in the broader band of 4%-8%.
As mentioned earlier the second Part will be published in a few weeks. However, in the meantime we are open for a more detailed discussion on this topic and welcome to get in contact with us.