MLP 101: What Investors Need to Know About Master Limited Partnerships

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1 April 2014 Private Wealth Advisory MLP 101: What Investors Need to Know About Master Limited Partnerships

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3 Master limited partnerships (MLPs) can be an attractive source of income and diversification for investors. MLPs also generate a lot of questions from investors given the asset class s unique ownership structure and tax consequences. This paper is designed to help investors understand the fundamentals of how MLP investing works, as well as the return opportunities and risks associated with this alternative asset class. What Is a Master Limited Partnership? A master limited partnership is an entity that is structured as a pass-through partnership whose investment units are publicly traded on U.S. securities exchanges, like common stock of a public company. Unlike a C-corporation, which is taxed at the corporate level and separate from its owners, any profits earned by the MLP are taxed at the level of the unitholders at their individual tax rates. As a result, an MLP combines the benefits of a limited partnership structure with the liquidity of a common stock. To qualify as an MLP, per the Tax Reform Act of 1986, an entity must earn at least 90% of its income through qualified sources and/or activities relating to: Natural resources (exploration, mining, production, processing, refining, transportation, storage, and marketing of natural resources) Interest Dividends Real property rents Gain from sale or other disposition of real estate The disclosures of an MLP are regulated by the Securities and Exchange Commission, and an MLP must file 10-Ks, 10-Qs, and notices of material changes similar to any publicly traded corporation. An MLP must also comply with the record keeping and disclosure requirements of the Sarbanes-Oxley Act. It is important to note that a limited liability corporation (LLC) is similar to an MLP and maintains the same tax advantages, including no taxes at the corporate level and tax deferral for limited partners. LLCs and MLPs, however, differ in terms of operational control. Specifically, an LLC generally does not have a general partner managing the operations of the business and therefore does not issue incentive distribution rights (discussed adjacent). Instead, stakeholders of an LLC typically possess some form of control through voting rights, which limited partnership unitholders of an MLP do not have. Private Wealth Advisory MLP 101 April

4 Background: How the MLP Market Became Dominated by Energy Companies The first MLP, Apache Oil Company, was launched in Other oil and gas MLPs as well as real estate MLPs soon followed. The original intent was to raise capital from individual investors by offering them a partnership investment in more affordable and liquid securities. During the 1980s, the number of MLPs grew rapidly, and MLPs were created for a variety of businesses purposes, including hotels, restaurants, and even sports franchises, such as the NBA s Boston Celtics, presumably to avoid double taxation. Conscious of this trend, Congress stepped forward with the Tax Reform Act of 1986 and passed legislation that continues to serve as the framework for publicly traded partnerships today. During the late 1980s and throughout the 1990s, the highly cyclical nature of many of these types of businesses proved ill-suited for an entity that is required to distribute large amounts of its cash flows. Consequently, many of the original oil and gas exploration MLPs left the space, as they were unable to maintain distributions when oil and gas prices plummeted. In addition, most of the original real estate MLPs converted to real estate investment trusts (REITs). Integrated energy companies sold or spun off midstream assets (the parts of the business involved in gathering, processing, pipelines, Investment Structure MLP C-Corp LLC Entity level Taxation No Yes No GP/LP Structure Yes No No Incentive Distribution Rights Yes No No Tax Reporting K K-1 Tax Deferral on Distributions Yes No Yes Voting Rights No Yes Yes and distribution) to MLPs so the company could focus on its core business. These energy spinoffs became the core of the modern MLP universe. Today there are more than 130 MLPs, about 110 of which are energy-related, meaning they are engaged in the transportation, storage, processing, refining, marketing, exploration, production, and mining of minerals and natural resources. More than half of today s 110 energy MLPs are involved in midstream assets (split almost equally between natural gas and oil infrastructure), with an additional 17 in upstream assets (exploration and production) and nine in Size of the MLP Market After the Tax Reform Act of 1986 redefined what types of businesses could qualify as an MLP, the MLP market has become dominated by energy-related businesses. Today, 110 of the 134 total MLPs are businesses that provide a service to the energy industry. $ $ $500 $ $ $ $ $ $ $ $ $102 $145 $ $0 $2 $4 $5 $7 $11 $15 $26 $29 $45 $56 $69 $90 $ Aug 13 Source: HarvestFund Advisors Private Wealth Advisory MLP 101 April

5 downstream assets (refining, marketing, and distribution). The rest cover the spectrum of the energy value chain, including propane, marine transportation, coal, and royalty trusts. The majority of MLPs receive a fee or toll for delivering a customer s product across their infrastructure systems, resulting in relatively stable cash flows. The MLP, in most cases, does not own the commodity, essentially eliminating commodity price exposure and thereby smoothing out its cash flows. Natural gas pipelines receive stable income in the form of rental fees from pipeline capacity reservations, independent of actual throughput and largely through take-or-pay contracts. Other product pipeline revenues typically depend on throughput, but are protected by inflation escalators that act as a hedge. Other midstream assets have similar fee-based contracts that vary in risk depending on their position in the energy value chain. While it is not legally required to do so, an MLP typically pays a substantial portion (70% to 100%) of its cash flow from operations to unitholders in tax-deferred distribution, which are not dividends. To accomplish this, the MLP usually engages in businesses that provide robust, stable, and predictable cash flows. Investors typically seek partnerships that can grow distributions over time, and an MLP accomplishes this partly by growing its asset base through organic projects, asset purchases from its parent known as dropdowns, or third-party acquisitions. Ownership: General Partner and Limited Partners An MLP generally has two main classes of owners: the general partner (GP) and limited partner (LP). The general partner typically owns 1% to 2% of the partnership and is responsible for managing the daily operations of the MLP. In return, the GP receives its pro rata share of the MLP s available cash flows through distributions, which are generally paid out on a quarterly basis, similar to dividends on common stock. Distributable cash flow is calculated as net income plus depreciation and other noncash items, less maintenance capital expenditures. These distributions from the MLP are at the discretion of the GP and in accordance with the partnership s documents. Limited partners usually own the remaining interest in the partnership in the form of publicly traded common units. While LPs receive quarterly cash distributions in exchange for contributing all of the capital to the partnership, they have no role in daily operations nor do they have any voting rights. Additionally, liability is limited to the amount of capital invested. MLPs combine the pass-through tax benefits of a limited partnership structure with the liquidity of common stock Incentive Distribution Rights In return for managing the business, the GP also owns incentive distribution rights (IDRs), which specify the GP s share of the total cash distributions. The GP s share typically increases, as a percentage, as distributions exceed certain thresholds. IDRs motivate the GP to operate and grow the business in a manner that maximizes cash distributions to the unitholders. They are generally agreed to between the partnership and the GP at the creation of the MLP and typically start with the GP receiving 2% of the cash distributions. A GP s IDRs can reach as high as 50% and this is referred to as high splits. High splits can stifle the growth of an MLP as projects and/ or acquisitions will require more cash flow generation to compensate for the higher distribution flows to the GP. Different IDR split structures have a material impact on total distribution paid to LPs. Percentage of Distributions The general partner s share of the total cash distributions, known as the incentive distribution rights (IDRs), typically increases above pretermined thresholds. It is important for potential limited partnership investors to understand how the IDR schedule can influence the operations of the business. Tier Annual Distribution per LP Unit LP Interest Tax Environment and Implications for Investors GP Interest 1 Up to $ % 2% 2 Above $1.16 up to $ % 15% 3 Above $1.31 up to $ % 25% 4 Above $ % 50% Classified as a partnership rather than a corporation, an MLP is not subject to corporate-level federal income taxes, eliminating double taxation at the unitholder level. Private Wealth Advisory MLP 101 April

6 This effectively provides an MLP with a cost advantage over its incorporated peers when pursuing growth or expansion projects. The tax liability of the entity is passed on to its unitholders, and the GP and LPs are required to pay taxes on their allocable share of the partnership s net income at the investor s individual ordinary income tax rate. The Schedule K-1 (Form 1065) The K-1 is the tax statement that an MLP investor receives each year from the partnership which outlines the investor s share of the partnership s income, gains, losses, credits, and deductions, including accelerated depreciation and amortization deductions. It is typically distributed in February of each year and is similar to a Form 1099 that an investor receives from a corporation. If the partnership reports a net loss after deductions, it is considered a passive loss under the tax code. While passive losses may not be used to offset income from active sources, they may be carried forward and used to offset future income from the same MLP or other passive sources. The amount of taxes an LP pays is determined by several factors, including the unitholder s ownership percentage, the timing of the investment, and the cost basis. Typically, the K-1 allocates partnership income and loss items to each state in which the partnership conducts business or owns property. Thus, a potential complication with direct investing in an MLP is that an LP may be required to file state and local income tax returns in some or all of the various jurisdictions, regardless of the investor s residence. As a result, many investors are often discouraged from allocating capital to this asset class due to the onerous tax filings. Tax Deferral MLPs can generate two distinct sources of income each year for investors: 1. An allocable share of an MLP s net income for tax purposes 2. Quarterly cash distributions This distinction is important because the two income sources are taxed differently. While the investor s allocable share of net income is taxable on an annual basis, the amount tends to be very small relative to the annual cash distribution. This is because an MLP typically generates significant noncash deductions, such as depreciation expenses, that substantially offset the allocated income and greatly reduce the amount of taxable income. These noncash deductions do not affect the quarterly cash distributions. Indeed, the allocable share of net income typically accounts for only 10% to 20% of an LP s total income received in a given year. In other words, an investor receives a tax shield equivalent to 80% to 90% of its cash distributions in a given year until the investor sells the LP units. At the time of the sale, however, there is depreciation recapture and the net income that was shielded by the deductions becomes deferred taxable income and is taxed as ordinary income. Unlike stock dividends, the quarterly cash distributions are not taxed in the year received and are 100% taxdeferred. These distributions are treated as reductions in the investment s cost basis, or a return of capital, and create a deferred tax liability. There are two primary events that can trigger the end of the tax-deferred status of the distributions: 1. Monetization: Once the investor sells his or her units, the deferred portion of the distributions becomes taxed at the investor s personal income rate (capital gains above the purchase price are taxed at the capital gains tax rate). 2. Basis reaches zero: Each year, the portion of the distributions that the net income allocation does not offset goes toward decreasing the original cost basis of the investment. If the sum of these offsets increases beyond the original purchase price of the units, then the future distributions lose their tax-deferred status. MLPs are a unique estate planning tool for tax-efficient wealth transfer. When an heir receives the units, the cost basis is reset at the new price. Therefore, there are no taxes on the prior deferred distributions. An investor s basis is calculated by taking the initial basis plus allocated income less depreciation and less the cash distribution. In general, tax-exempt vehicles such as pension accounts, 401(k)s, IRAs, and endowment funds are encouraged not to directly invest in MLPs because the partnerships generate unrelated business taxable income (UBTI). If a tax-exempt entity receives UBTI in excess of $1,000 per year, the investor would be required to file IRS form 990-T and may be liable for tax on the UBTI. MLP Investors Historically, MLPs have been mostly owned by individual investors rather than institutions. In 2000, individual ownership approximated 90% of total MLP units, with limited institutional participation. Private Wealth Advisory MLP 101 April

7 Before 2004, institutional investors such as mutual funds and other registered investment companies were restricted from investing in MLPs because distributions and allocated income from publicly traded partnerships were considered nonqualifying income. To retain their special tax status as regulated investment companies (RICs), mutual funds and other registered investment companies were required to receive at least 90% of their income from qualifying sources. Since the passage of the American Jobs Creation Act in October 2004, however, it is now incrementally easier for RICs to own MLPs. Still, the current parameters specify that no more than 25% of a fund s asset value may be invested in MLPs and a fund may not own more than 10% of any single MLP. So any fund with an MLP focus would easily exceed these thresholds and would no longer be eligible to file as a RIC. As a result, the fund would likely file as a C-corporation, which is subject to income taxes at the corporate level, negating the taxation benefits of the MLP structure. Investment Vehicles As previously mentioned, the most tax-efficient means to invest in MLPs is through direct ownership of the securities by either buying them in a brokerage account or in a separately-managed account. However, direct owners receive K-1s which can require tax filings in multiple states. Various investment vehicles have been created to consolidate tax reporting, and each have their own pros and cons. Limited Partnerships Accredited investors and qualified purchasers can obtain MLP exposure through limited partnerships that pool investor capital. While these vehicles provide a single consolidated K-1, they tend to have high minimums and liquidity constraints. Unlike other vehicles, limited partnerships may not protect against the generation of UBTI, which can make them restrictive for tax-exempt accounts. Open-End Mutual Funds Mutual funds replace the burden of multiple K-1s for investors with a single 1099 and provide professional management. However, the MLP investment parameters of the American Jobs Creation Act restrict a RIC s investments in LP structures to 25%. While mutual funds will include the GP portion of MLPs, or invest in other creative structures to increase exposure to the LPs, they are not considered pure plays on the MLP space. If an open-ended mutual fund elects to concentrate in MLPs and file as a C-corporation instead of a RIC, the fund is not only subject to double taxation but it must also reduce its net asset value (NAV) to reflect withholding for the future tax liability on deferred income and distributions. For these reasons, many critics question whether mutual funds can adequately track the performance of MLP indices. At the time of this writing, there were 12 open-ended funds. Closed-End Funds (CEFs) For MLP-dedicated funds, the closed-end structure has been preferred over the open-ended one, and today there are 23 distinct options. However, many closed-end funds are structured as C-corporations because of the aforementioned RIC limitations on owning MLPs. Therefore CEFs are subject to corporate level taxes. While CEFs offer intraday liquidity, they may trade at a price that differs from NAV, creating a price discount or premium. MLP Investment Options Separate Account Limited Partnership Open-end Mutual Fund Closed-end Mutual Fund ETF ETN Pros Cons Professional management Tax deferral Wealth transfer benefits Professional management Consolidated K-1 Professional management Consolidated 1099 Professional management Consolidated 1099 Consolidated 1099 Consolidated 1099 K-1 for each MLP High minimum investment Lock ups High minimum investment Corporate tax if fund does not qualify as a RIC Corporate tax if fund does not qualify as a RIC Leverage Tracking error No professional management Corporate tax if fund does not qualify as a RIC No professional management No tax deferral Credit risk Private Wealth Advisory MLP 101 April

8 Exchange-Traded Funds (ETFs) An MLP ETF holds units in a diversified basket of MLPs, with the benefits of providing a single 1099 and intra-day liquidity. While ETFs are generally less expensive than funds, they are structured as C-corporations, making all income and capital appreciation subject to the corporate tax rate of 35%. Therefore, ETFs must adjust their NAV for any deferred tax liability, which may lead to substantial tracking error. Distributions from the ETF, however, do retain the characteristics of the underlying MLPs. As such, most of the distributions from MLP ETFs to date have been treated as a return of capital, though this could change as the ETFs turn over their underlying positions. The first of now six MLP ETFs, the Alerian MLP ETF (AMLP), was launched in August Exchange-Traded Notes (ETNs) An exchange-traded note operates as an index-linked bond that provides access to an index, such as the Alerian MLP Index (a market-cap weighted, float-adjusted index created to provide a comprehensive benchmark for investors to track the performance of the energy MLP sector.) The unsecured note pays coupons linked to the distributions of MLPs tracked in the underlying index less fees. Because the payment is a coupon, income distributions are treated as ordinary income and there is no deferral mechanism. ETNs typically track the index better than ETFs because they are not constrained by proportion of ownership of the securities in the index. In this structure, the sponsor essentially guarantees that funds will be available to replicate the value of the index holdings at the date of maturity. This makes credit risk a concern with ETNs, as a decline in credit rating or bankruptcy of the note-issuing bank can erode the value of the securities. Highlighting this risk is that the first MLP ETN was started in 2007 by Bear Stearns, which failed in Many institutions have constraints that prohibit them from taking on significant credit exposure from a single issuer, so investments in ETNs may be limited. At the time of this writing, there were six ETNs listed for trading. Investment Risks Investing in MLPs involves risks that differ from investments in common stock. These risks include those related to cash flow risk, interest rate risk, the ability to access capital markets, taxation risk, regulatory risk, and industry-specific risk. Cash Flow Risk Distribution yields and their growth serve as an essential driver of MLP performance. MLPs typically pay out a large proportion of their excess cash flows through quarterly distributions to unitholders. The distribution yield is typically inversely related to expected distribution growth because investors are willing to forego current yield in return for future distribution growth. Historically, those MLPs with the fastest distribution growth tended to outperform those with little or no distribution growth. Thus, any reduction in an MLP s distribution yield and/or distribution growth will likely be met with falling prices. Tax-efficient Investing in MLPs While mutual funds, ETFs, and other investment vehicles can provide exposure to MLPs in retirement accounts without generating unrelated business taxable income, the most tax-efficient way to invest in MLPs is through direct ownership. Investment Structures for MLPs Double Taxation Tax Deferral Tax Reporting Direct Investing No Yes K-1 Seperately Managed Accounts No Yes K-1 Open-End Mutual Fund - RIC No Yes 1099 Open-End Mutual Fund - Corporation Yes Yes/No* 1099 Closed-End Mutual Fund - Corporation Yes Yes/No* 1099 Exchange Traded Fund (ETF) - Corporation Yes Yes/No* 1099 Exchange Traded Note (ETN) No No 1099 * NAV will reflect 35% withholding for future tax liability Private Wealth Advisory MLP 101 April

9 Interest Rate Risk Investors are often attracted to MLPs because of the relatively high current yield the securities offer. Interest rates represent an important driver of MLP performance as MLP yields are compared with government bond yields. As government bond yields fall, MLP prices may rise, as they become more desirable alternatives for income-producing securities; but the reverse is also true: as government bond yields rise, MLP prices may fall, as they become less desirable alternatives. Rising interest rates could also raise an MLP s cost of capital, which may drive investors into other investment opportunities. Most MLPs have become public since 2000, a period in which the United States was in a declining interest rate environment. There have been intermittent periods of rising rates within the broader declining rate environment and, during these periods, MLPs lagged the S&P 500, but tended to outperform utilities and REITs. According to a Credit Suisse analysis, there were 11 instances when 10-year Treasury rates increased from trough to peak. Out of those instances, the Alerian MLP Index underperformed the S&P 500 seven times but mostly outperformed utilities and REIT indices. This data suggests that while rising interest rates may force MLPs to lag the broader equity markets, they may hold up better than other yield-oriented securities. In addition, rising interest rates may increase an MLP s debt costs, which would further reduce the available capital for the general and limited partners. MLPs involve a distinct set of risks for investors relative to the risks of investing in common stock. Access to Capital Markets The success of MLP partnerships depends on their ability to effectively manage projects as well as to execute profitable acquisitions. Because MLPs pay out the majority of their cash flow as distributions, MLPs rely heavily on access to capital markets to issue debt and equity to finance growth projects and acquisitions. Limited access to financing would negatively affect MLPs that require significant capital resources to continue producing strong returns. The financing mix for these projects averages around 50% equity and 50% debt. Following the credit crisis in 2008, the capital markets have continued to improve and remain accessible today. In 2013, MLPs completed about 70 deals including IPOs and secondary offerings to raise a total of more than $20 billion, according to RBC Capital Markets. Legislative Risk MLPs do not pay U.S. federal income tax at the partnership level. Rather, each partner is allocated a share of the partnership s income, gains, losses, deductions, and expenses. A change in current tax law by Congress, or a Annual Equity Issuance - IPOs and Follow-ons Access to capital markets is vital to the growth and success of MLPs. Since the credit crisis, capital markets have been relatively open to MLPs. ANNUAL MLP EQUITY ISSURANCE (IPO & FO) $BN IPOs Follow-ons 36 $3.6 $ $ $3.1 $4.0 $8.3 $3.4 $6.4 $0.9 $1.8 $2.7 $3.6 $ $12.9 $13.9 $18.2 $16.3 Source: RBC Capital Markets Private Wealth Advisory MLP 101 April

10 change in the underlying business mix of a given MLP, could result in an MLP being treated as a corporation for U.S. federal income tax purposes. Further, the classification of an MLP as a corporation for U.S. federal income tax purposes would have the effect of reducing the amount of cash available for distribution by the MLP. Regulatory Risk The IRS has called an internal working committee to evaluate REIT qualification principles in response to a growing list of companies with nontraditional real estate assets seeking conversion. Primarily, the committee is looking at the definition of real property, the framework for determining rents versus service revenues, and tax-free spin-offs of REITs from a C-corporation. While the IRS has yet to establish an internal working group to evaluate current principles used to determine qualification for MLP status, a modification of the tax code could be a negative event. Industry-Specific Risk Energy infrastructure companies also are subject to risks specific to the industry they serve, including: Reduced volumes of natural gas or other energy commodities available for transporting, processing, storing, or distributing Sustained reduction in demand for crude oil, natural gas, and refined petroleum products resulting from a recession, an increase in market price, or higher taxes Depletion of the natural gas reserves or other commodities if not replaced New construction risks and acquisition risk that can limit growth potential Changes in the regulatory environment, and Extreme weather, such as warm winters or natural disasters This information has been prepared solely for informational purposes and is not intended to provide or should not be relied upon for legal, tax, accounting, or investment advice. We recommend that you consult your attorney, tax advisor, investment or other professional advisor about your particular situation. This material is provided for information purposes only and is not intended as investment advice nor is it a recommendation to buy or sell any particular security. Any discussion of particular topics is not meant to be comprehensive and may be subject to change. Data shown does not represent the performance or characteristics of any William Blair & Company, L.L.C. product or strategy. Any investment or strategy mentioned herein may not be suitable for every investor. Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness, or interpretation cannot be guaranteed. Opinions expressed are those of the author and do not necessarily reflect the opinions of William Blair & Company, L.L.C. Information is current as of the date appearing in this material only and subject to change without notice. This document and its contents are proprietary to William Blair & Company, L.L.C., and no part of this document or its subject matter should be reproduced, disseminated, or disclosed without the written consent of William Blair & Company, L.L.C. Any unauthorized use is prohibited. William Blair is a registered trademark of William Blair & Company, L.L.C. Private Wealth Advisory MLP 101 April

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12 William Blair & Company is a global investment banking and asset management firm. We are committed to building enduring relationships with our clients and providing expertise and solutions to meet their evolving needs. An independent and employee-owned firm, William Blair is based in Chicago, with office locations in 12 cities across five continents. For more information, please visit williamblair.com tel 222 West Adams Street Chicago, Illinois 60606