Master Limited Partnership Portfolio Style

Transcription

1 Master Limited Partnership Portfolio Style Second Quarter 2015 Data through June 30, 2015 Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission.

2 Company Profile Managing client portfolios since 1973 Over $2 billion total assets under management Individuals Institutions Retirement plans Government entities Cash management portfolios Team-based approach with an average of over 25 years of investment experience Clients located throughout the US and abroad Offices Headquartered in Sarasota, Florida Branch office in Vineland, New Jersey Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission. 2

3 MLP Team David R. Kotok cofounded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in economics from The Wharton School of the University of Pennsylvania, an M.S. in organizational dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a masters in philosophy from the University of Pennsylvania. Mr. Kotok s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron's, and other publications. He is a frequent contributor to Bloomberg TV and radio, Fox Business, and other media. Mr. Kotok has served as Program Chairman of the Global Interdependence Center (GIC) ( whose mission is to encourage the expansion of global dialogue and free trade in order to improve cooperation and understanding among nation states, with the goal of reducing international conflicts and improving worldwide living standards. Mr. Kotok chaired its Central Banking Series and organized a five-continent dialogue held in Philadelphia, Paris, Zambia (Livingstone), Hanoi, Singapore, Prague, Cape Town, Shanghai, Hong Kong, Rome, Milan, Tallinn, and Santiago, Chile. He has received the Global Citizen Award from GIC for his efforts. Mr. Kotok is a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE) and served on the Research Advisory Board of BCA Research. Mr. Kotok has served as a Commissioner of the Delaware River Port Authority (DRPA) and on the Treasury Transition Teams for New Jersey Governors Kean and Whitman. He has also served as a board member of the New Jersey Economic Development Authority and as Chairman of the New Jersey Casino Reinvestment Development Authority. He has authored or co-authored four books, including the best selling Second edition of From Bear to Bull with ETFs, now available at Amazon and the soon to be released Adventures in Muniland. Dr. Michael D. McNiven serves as a Managing Director and a Portfolio Manager for Cumberland's International Exchange-Traded Fund (ETF) portfolio style. He is also responsible for Business Development/Sales training and coordination within the firm. He speaks at conferences and other investment fora explaining Cumberland's investment philosophy and portfolio options to individuals, brokers and institutional clients. Dr. McNiven began his career at the Financial Times based in New York where he conducted the North American Market Readership research study as well as the Financial Times research into US university and higher education readership. He then assumed the partnership marketing role to pursue business development opportunities throughout the US and later managed the advertising sales function for US classifieds, art, and residential and commercial real estate advertising. Dr. McNiven joined Cumberland Advisors in April of 2009 as a marketing consultant and then as an Investment Advisor Representative of the firm. Prior to joining Cumberland Advisors, Dr. McNiven was an Assistant Professor at Rowan University in Glassboro, New Jersey teaching strategic marketing communications, research, and advertising courses. He has taught courses and assisted at Rowan University, University of Georgia, Utah Valley University, and Brigham Young University. He is a graduate of Brigham Young University in Provo, Utah for both B.A. and M.A. degrees, and also holds a Ph.D. from the University of Georgia in Athens. Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission. 3

4 MLP Team John Mousseau, CFA joined Cumberland Advisors in September He is currently an Executive Vice President and the Director of Fixed Income, as well as a portfolio manager for municipal bond investments. In this capacity, Mr. Mousseau and his team manage portfolio construction, management, analysis, trading, and research for both tax-free and taxable bond accounts. Mr. Mousseau has over 30 years of investment management experience. Prior to Cumberland, he was the Director of Municipal Bond Investments for Lord Abbett & Company. He also worked previously for Shearson Lehman Brothers and its predecessor firm, E.F. Hutton. His comments and analyses have appeared in The Bond Buyer, Barron s, the Wall Street Journal, Bloomberg, Forbes, the New York Times, the San Francisco Chronicle, and the Newark Star-Ledger. In addition, he has appeared on Bloomberg Radio and Television, Reuters, and CNBC for commentary on fixed-income markets. He has also been a speaker at various industry conferences, and a guest lecturer at Florida International University. Mr. Mousseau holds an A.B. degree in economics from Georgetown University and a M.A. degree in economics from Brown University; and he is a holder of the Chartered Financial Analyst (CFA) designation. He is a member of the Philadelphia Council for Business Economists (PCBE), the National Federation of Municipal Analysts (NFMA), the National Association of Business Economics (NABE), the Washington Area Money Managers (WAMM), and the National Economists Club (NEC). He is also a member of the New York Society of Securities Analysts, where he served on the Society s High Net Worth Investors Committee. He is a past chair of the Municipal Bond Buyers Conference and is still a current active member. In addition, he has served as an instructor at the New York Institute of Finance and Bond Market Association. Mr. Mousseau resides in Sarasota, Florida. He is a member of the Tampa Bay CFA Society and the Sarasota South Side Rotary Club. He is also active in alumni affairs at Georgetown University. Prior to moving to Sarasota, he was involved with the Rotary and YMCA in Maplewood, New Jersey and still has ties to those associations. DonnaMarie Valles joined Cumberland in 2008 and serves as a Portfolio Manager and ETF Analyst. She is also an Investment Advisor Representative for Cumberland Advisors. Her responsibilities include portfolio management for equity accounts, researching and filtering all ETFs, assisting in the creation and execution of equity trades, evaluating equity portfolio asset allocations, and handling issuer relationships. She holds a bachelor of arts degree in finance from the University of South Florida and is currently studying to sit for the Certified Financial Planner exam. Richard Daskin CFA, CFP became the research and valuation sub advisor for the MLP strategy at Cumberland in In addition he is the CIO for RSD Advisors, LLC a registered investment advisor based in New York City. As part of his RIA practice he has been researching and investing in higher yield assets, including Master Limited Partnerships for clients. Mr. Daskin has over 30 years experience on both the "buy" and "sell" side of Wall Street in fixed income and investment management and has been a research analyst, trader, portfolio manager, and salesperson. Prior to Cumberland Advisors, Mr. Daskin worked at the Goldstein Capital hedge fund. Previously he worked at First Albany, DLJ, Alex Brown, and Lazard Frères. He recently wrote a chapter for the book, "Investing in the High Yield Municipal Market: How to Profit from the Current Credit Crisis and earn Attractive Tax Exempt Interest Income". Mr. Daskin has a B.A. in Economics from the University at Albany. He is a holder of a Chartered Financial Analyst, CFA designation and is a member of the New York Society of Securities Analysts. He has also obtained a Certified Financial Planner, CFP designation and a life and health insurance brokers license. He has been an instructor at the New York Institute of Finance. Mr. Daskin resides in Park Slope Brooklyn and Peconic, New York and is actively involved in Civic Affairs in both places and serves as a Vice President in his cooperative residence. Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission. 4

5 Master Limited Partnerships Consistent approach that balances risks and returns Blend of top-down and bottom-up focus on value creation on the total portfolio and each partnership We believe the best approach is to diversify by sources of risk and along the energy value chain Disciplined sell process in the event of market changes or credit difficulties for a partnership We Seek to Create Alpha Balancing credit risk versus growth Selecting sustainable business models and analyzing each partnership Constantly reviewing factors that drive returns in the MLP and energy markets Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission. 5

6 Portfolio Style Investment Objective To provide our clients Attractive and growing cash flow that is largely tax deferred Total returns that approximate the benchmark (Alerian Index) Preservation of capital Superior diversification to an acceptable level of volatility Investment Philosophy Macro fundamentals peculiar to energy partnerships are often counterintuitive. These factors must be followed closely to manage risk and enhance returns. Cross correlations are an important factor in managing risk in the energy MLP market Investment Approach Blend of top-down and bottom-up focus on value creation on the total portfolio through diversification Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission. 6

7 5-Stage Model Process 1. Starting Universe 2. Fundamental Investment Discipline 3. Primary Screening 4. Fundamental Assessments 5. Portfolio Construction/Sell Discipline Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission. 7

8 1. Starting Universe Energy Partnerships Upstream, Midstream, Downstream Core Holdings Younger and Smaller Partnerships Approximately 100 energy partnerships currently outstanding Select from upstream, midstream, and downstream energy partnerships Emphasis on larger and more established MLPs for core holdings Younger and smaller partnerships with more risk are considered for a smaller share of the portfolio to provide additional growth or enhance income Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission. 8

9 2. Fundamental Investment Discipline Evaluate underlying businesses Review capital structures and compare to business requirements Evaluate partnership structure Estimate risk factors for each partnership Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission. 9

10 3. Primary Screening Upstream, downstream, and midstream energy partnerships Current focus oil, gas, and natural gas liquid related business Partnerships or LLC that provide K-1 tax statements only, no C corps for tax deferred income Fixed distribution partnerships not variable distribution partnerships (traditional MLPs) Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission. 10

11 4. Fundamental Assessments Macro environment Interest rate cycle and Fed policy Geopolitical environment impact Domestic and international energy fundamentals Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission. 11

12 5. Portfolio Construction/Sell Discipline Portfolio Construction Portfolio core of larger more established partnerships Consider other partnerships that add either incremental income or distribution growth Add partnerships that may improve underlying business mix of the portfolio Credit surveillance and surveillance including business or market changes that affect each partnership Generally 20 to 30 partnerships in a portfolio to provide sufficient diversification Focus on at least 5 distinct business models for diversification Sell Discipline Credit difficulties affecting an individual partnership Monitor for large negative change likely in a particular sector followed Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission. 12

13 Portfolio Summary Type of Investment Structure Individual Account (not a pooled instrument) Portfolio Objective Match or beat benchmark with less volatility in returns Returns Short-term and long-term capital gains Rebalancing Frequency Monthly and opportunistic Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission. 13

14 Disclosures Performance Standards: Cumberland Advisors has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS ). Definition of a Firm: For purposes of complying with Global Investment Performance Standards (GIPS ), the firm has been defined as an Investment Advisor, established in 1973 and registered with the United States Securities and Exchange Commission. Cumberland Advisors manages a variety of equity, taxable and tax-free fixed-income and balanced assets for primarily U.S. clients. Selection Criteria: All accounts with the investment objective listed are included in the composite regardless of size or tax status. Effective 1/1/2012, accounts are included in the composite 30 days following funding. For example, an account opened and funded on January 28th would be entered into a composite on February 28th. Terminated accounts are removed from a composite at the end of the last full month under management. For example, an account that is terminated August 15th will be included through July 31st. Prior to 1/1/2012, accounts were included the first day of the first full month after funding. Calculation Methodology: Cumberland Advisors relies on performance numbers computed from Advent s APX portfolio reporting system. Our portfolio accounting system calculates a time-weighted portfolio return using the Modified Dietz Method. Performance figures reflect the time-weighted performance of Cumberland Advisors managed accounts with the total return investment objectives listed. These are size-weighted composites (dollar-weighted). This composite was created April 30, All performance data is calculated in US dollars. Quarterly and year to date time-weighted returns are calculated by linking monthly returns. Accounts do not use leverage. Returns consider interest income only on an accrual basis; dividends are considered on a cash basis. All calculations are based on trade date. Securities traded on a national exchange are valued based on closing prices on the exchange; data is provided by major pricing services. Stocks traded on the over the counter market are valued based upon prices provided by major pricing services. Fixed income securities that do not trade on a national exchange are valued based upon estimates provided by a variety of services including major pricing services. The above figures do not represent any single or model portfolio. Accounts may at times include cash equivalents. Performance is on a total return basis. Internal dispersion is calculated using the dollar-weighted standard deviation of all portfolios that were included in the composite for the entire period. Selected Definitions: Composite dispersion (standard deviation) measures the consistency of a firm s gross composite performance results with respect to the individual portfolio returns within a composite. 3-Year Ex-Post Standard Deviation of Composite: this calculation uses monthly returns to calculate the three-year annualized standard deviation. Benchmark: The Alerian Total Return Index is a composite of the 50 most prominent energy Master Limited Partnerships (MLPs) that provides investors with an unbiased, comprehensive benchmark for this emerging asset class. The index, which is calculated using a float-adjusted, capitalization-weighted methodology, is disseminated real-time on a price-return basis (NYSE: AMZ) and on a total-return basis (NYSE: AMZX). Composites: Additional information regarding policies for calculating and reporting returns and/or a complete list and description of Cumberland Advisors composites and/or a presentation that complies with the GIPS standards, is available by contacting your account executive at (856) , or write to Cumberland Advisors, One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL Past Performance: Past performance is not an indication or guarantee of future performance. No alterations of the composite as presented here has occurred because of changes in personnel or other reasons at any time. Master Limited Partnership (MLP) Portfolios Fees: Performance is presented Net of all fees. We will no longer publish Gross performance since we are unable to (On an annual basis) break-out and deduct transaction costs on WRAP accounts as required by GIPs. Gross number net of transactions Minimum account size in each investment style: $500,000 costs, except in the case of WRAP accounts, is available upon specific request as supplemental information only. All fees (management, custodial, WRAP, transactions costs, etc.) have been deducted from NET Performance. WRAP First $500,000 - $1,000, basis points (0.50 of 1%) fees include transaction costs, management fees and custodial fees. Composites may include accounts with wrap fee arrangements and non-fee paying accounts. Fees may vary as to type and size and can affect compounded, annualized Next $1,000,001 - $3,000, basis points (0.45 of 1%) returns. Clients returns will be reduced by the investment advisory fees and any other expenses as they may incur in the management of the investment advisory account. Cumberland Advisors reserves the right to waive the minimum account Next $3,000,001 - $5,000, basis points (0.40 of 1%) size or impose a higher account size. Next $5,000,001 - $10,000, basis points (0.35 of 1%) Negotiated fee rate on market value in excess of $10,000,000 Minimum Household Investment Size: $1,000,000 Copyright 2015 Cumberland Advisors. Further distribution prohibited without prior permission. 16

15 Master Limited Partnership Research This is a copy of a presentation for research purposes made to Cumberland Advisors by Sub-Advisor Richard Daskin. For questions regarding MLP investing, contact David R. Kotok, Chairman & CIO. Part 1: A brief summary of the market and what we will cover in this discussion 1. What is an MLP? It is a vernacular term for a publicly traded partnership. An investor owns units instead of shares and receives distributions rather than dividends. A related company structure, also covered under this umbrella, are entities structured as limited liability companies (LLCs). We will use the term MLP to cover both unless specified. 2. How is an MLP formed? It is often spun out of an existing corporation or entity with some existing assets. 3. Why is it advantageous for a sponsor to form an MLP? It is a pass-through entity for tax purposes and pays no corporate-level taxes. It is capital-intensive and so has tax advantages for investors. It therefore has a lower cost of capital. The creation of an MLP also allows a company sponsor the ability to control slower-growing, steady cash-flow assets that are necessary to its business in a separately capitalized entity. 4. What are the advantages for investors of owning partnership units? Yield: Alerian Index distribution yield is typically 2-4% higher than the 10-year US Treasury bond (index yield is approximately 6% at present). Distribution Growth: Partnerships can achieve an annual distribution growth of 2-10% with fairly steady operating results. Somewhat distinct asset class, for diversification Tax shield Estate tax planning tool Participate in the rapidly growing US domestic energy business 5. What are some of the disadvantages? Tax complications Mostly smaller entities, so trading may be less liquid Complicated business structures and changing markets makes them difficult for individuals or brokers to analyze. Governance practices vary and do not usually offer the same legal protections for unit holders that shareholders of corporations enjoy. Copyright 2014 Cumberland Advisors (800) One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL E. Landis Avenue, Vineland, NJ Cumberland Advisors is an SEC registered investment adviser.

16 6. Explanation and discussion of types of businesses Due to tax law passed in 1987, about 90% of the MLPs and assets in the space are energy related. Most MLPs, not energy, were grandfathered in by the 1987 law. Our focus is on the energy business. See attached Alerian MLP Index 7. How to value MLPs and LLCs 8. How to construct portfolios/portfolio philosophy Part 2: Detailed discussion 1. Traditional MLP entity structure: Exhibit 6: Typical MLP Structure Source: Company data, Credit Suisse estimates 2. Explanation of the role and motivation of each entity Sponsor: the company that creates the MLP and usually owns the General Partner General Partner: owns 2% of the partnership. Owns subordinated units at formation. May eventually be sold by the sponsor to the public or another entity. Owns incentive distribution rights (IDRs). Copyright 2014 Cumberland Advisors (800) One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL E. Landis Avenue, Vineland, NJ Cumberland Advisors is an SEC registered investment adviser. 2

17 3. Subordinated units When an MLP is created, the general partner (GP) invests in subordinated units to insure that public limited partners get paid their minimum qualified distribution. This structure was adopted after the MLP energy business ran into difficulty in the late 80s to early 90s. Subordinated units usually get converted to limited partnership (LP) units in 3-5 years according to the partnership agreements, once distribution tests are met for the public limited partners using performance tests. 4. Minimum qualified distributions (MQD) Set at MLP formation as the initial distribution rate Later used as a metric to determine the breakpoints to increase distributions for general partners. MQD levels and consistency are used to determine when GP s subordinated units can get converted to regular LP units per the partnership agreements. 5. Incentive distribution rights (IDRs) Owned by general partners to compensate them for earlier subordinated units and managing the business When MQDs are paid and distributions increase, the amount of distributions to general partners increases. Example: Partnership pays MQD to partners LP gets 98%, GP gets 2% When distribution increases to 1.15 x MQD, LP gets 85% of incremental revenue and GP gets 15%. When distribution increases to 1.25 x MQD, LP gets 75% of incremental revenue and GP gets 25%. When distribution increases to 1.5 x MQD, LP gets 50% of incremental revenue and GP gets 50% ( high splits ). IDRs align the GP s interest with LP, but when the partnership matures it can increase the equity cost of capital to the partnership. It can also raise the cost of debt due tot he complicated capital structure. Sometimes LPs will buy out GPs or give GPs more LP units to reduce or change the splits. 6. LP entity or MLP (public unit holders) Factors to consider when investing in LP units, such as legal structure, sponsor, and GP characteristics 7. What are limited liability companies (LLCs)? LLCs are a newer type of legal structure in the MLP universe. They are also pass-through entities that receive K-1 partnership distributions. LLCs can be created at formation. LLCs can also be created when an LP buys out its GP. Some LPs can operate similarly to an LLC in many respects but do not adopt the LLC legal structure. Governance structure of LLCs is simpler than a traditional MLP structure. Unit holders often enjoy similar rights to a shareholder in a corporation. An LLC is a standalone entity. There is no GP or payments of any IDRs. Because of the simpler structure with no overriding payments of IDRs, over time the cost of equity capital is frequently lower than for the traditional MLP. Copyright 2014 Cumberland Advisors (800) One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL E. Landis Avenue, Vineland, NJ Cumberland Advisors is an SEC registered investment adviser. 3

18 Exhibit 11: Major Differences Between MLPs, LLCs, and Corporations Characteristic MLP LLC Corporation Taxable at entity level No No Yes Tax items flow through Yes Yes No Tax deferral on distributions Yes Yes No Tax reporting K-1 K-1 DIV-1099 General partner Yes No No Incentive distribution rights (IDRs) Yes No No Investor voting rights No Yes Yes Source: National Association of Publicly Traded Partnerships (NAPTP) 8. Alerian Index description The Alerian Index is created by and named for Alerian, an index provider, and is the most widely used and quoted index for MLP returns. Alerian has some more specialized MLP indexes as well. There are several other indexes that are less widely used. The Alerian index is cap and float weighted, and there are some very large entities such as Enterprise Products that make the index somewhat concentrated at the top. Pipelines and gatherers and processors are most of the capitalization in the index. As a result, one must be mindful when comparing portfolios to the Alerian Index. 9. MLP distribution growth MLP growth in distributions comes from: More efficient operations and volume growth leading to wider operating margins and increasing prices Organic growth of existing operations Acquisition of assets, other MLPs, or companies. Acquisition can be from Sponsor/GP ( dropdown ). Since 2003 a subset of MLPs, midstream companies, have grown unit distributions by 3-14% with an average of about 9%, for example. A realistic assumption for the next 5 years of distribution growth, depending on the type of partnership, would be 2-8%, with an average of perhaps 4%. If you assume an approximate 4% distribution growth rate and an approximate 4-5% distribution rate, then after deducting investment management fees and expenses, you could realistically estimate a return of 6-8% as a long-run estimate of average returns for MLPs. Copyright 2014 Cumberland Advisors (800) One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL E. Landis Avenue, Vineland, NJ Cumberland Advisors is an SEC registered investment adviser. 4

19 Exhibit 3: MLPs Dist Growth Has Exceeded Inflation Exhibit 4: Growth Capex Drives Distribution Growth Source: FactSet, Bureau of Labor Statistics, Credit Suisse estimates Source: FactSet, Credit Suisse estimates; Dist growth excludes GPs 10. Different or distinct asset class? Energy partnerships own real assets, many with distinct economic moats. MLPs tend to own assets in the energy space that offer steadier but lower average returns than some of the more risky energy assets. The traditional model uses hedges to reduce some of the operating and commodity price risk. The assets have low but positive correlation to energy prices. There is a stronger correlation to high-yield bonds, but MLPs grow distributions with comparable cash returns. It is not proper to portray MLPs as a bond investment. They are a form of equity. LPs may be compared to common stock of a corporation but slightly higher up the capital structure than common stock. In common with other assets that continuously need to raise capital, such as REITs, MLPs depend on being able to access capital markets. Judging whether an MLP s capital structure makes sense versus its business requirements is important. In a credit crunch, MLPs can suffer in the same manner as a highyield bond issuer with a need to raise capital. 11. Tax Shield MLPs or LLCs are not taxed at the corporate level. Deduction and distributions are passed directly to unit holders. Most MLPs are capital-intensive. Depreciation and amortization can defer typically 80% of taxation on the distributions. There is a recapture and reduced tax basis for return of capital due to deductions when units are sold. A unit holder may owe state tax - rules vary by state. Many have a minimum threshold for reporting income. MLPs may not be suitable for retirement accounts due to UBTI (passive income rules). In common with other tax-advantaged investments such as municipal bonds, there can be tax legislative risk. When/if basis reaches zero, distributions are taxed at the capital gains rate. Tax treatment can be complicated depending on an individual s tax situation - this is only a basic summary. Copyright 2014 Cumberland Advisors (800) One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL E. Landis Avenue, Vineland, NJ Cumberland Advisors is an SEC registered investment adviser. 5

20 Exhibit 8: MLP XYZ Tax Example Purchase Price $20.00 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Distribution per unit $2.00 $2.00 $2.00 $2.00 $2.00 Income per unit $2.00 $2.00 $2.00 $2.00 $2.00 Depreciation expense $1.60 $1.60 $1.60 $1.60 $1.60 Cost basis $20.00 $18.40 $16.80 $15.20 $13.60 $12.00 Sales price $22.00 Taxes: Earnings per unit $0.40 $0.40 $0.40 $0.40 $0.40 Depreciation recapture $8.00 Amt subject to ordinary tax rates $0.40 $0.40 $0.40 $0.40 $8.40 Ordinary tax rate 35% 35% 35% 35% 35% Taxes owed at ordinary rates $0.14 $0.14 $0.14 $0.14 $2.94 Amt subject to LT capital gains rates $2.00 LT capital gains rate 15% Taxes Owed at ordinary rates $0.30 Total taxes owed $0.14 $0.14 $0.14 $0.14 $3.24 Source: Credit Suisse estimates 12. Estate planning tool Tax basis goes down annually, assuming there are deferred or sheltered distributions. Estate tax law provides for a step-up of tax basis for assets on date of death. As a result, for an investor who buys and holds MLPs, deferred taxes can effectively become tax-free with the estate tax step-up to the individual s heirs. 13. Disadvantages Taxes K-1 filings can delay filing and make taxes more expensive to file. May have to file state tax returns, as MLPs usually operate in different jurisdictions. State tax laws vary. Can make tax planning a little more complicated. Selling units can generate ordinary income. Illiquid MLPs are still a small asset class. Many of the entities have small capitalizations and low turnover. As a result, bid/ask spreads can be high and trading costly. Complicated, nuanced, and hard to invest efficiently in mutual funds These are not simple investments. Corporate structure varies, and business environment by type is not uniform. The entities are not extensively covered or very easily understood. Following the space is time consuming. It is not easy to understand how they are valued or traded. ETFs, ETNs, mutual funds, and closed-end funds have distinct performance and tax drawbacks for many investors, and they have high fees. Governance LPs have little say in the management of the MLP. The GP and sponsor control the entity. Per exchange rules, there are a few independent directors elected. There can be conflicts of interest between GP/sponsor and LP. This bears watching. Copyright 2014 Cumberland Advisors (800) One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL E. Landis Avenue, Vineland, NJ Cumberland Advisors is an SEC registered investment adviser.

21 14. Business Types Traditionally, MLP structure emphasizes business models that produce steady cash flow to LPs. This can work along the energy value chain, depending on how operators structure the business. Many on Wall Street emphasize the toll road model. Very few MLPs are actually close to toll roads. This is an exaggeration that can distort investment portfolio decisions. A better comparison in many cases is to a specialized real estate or infrastructure investment. Risk management and attention to correlations can help reduce portfolio risk. We believe there is a diversification benefit to owning these entities along the energy value chain. 15. Upstream assets Upstream refers to exploration and production of oil, gas and natural gas liquids. These assets are suitable for MLP ownership provided that: Management seeks mainly producing assets to lower risk. Commodity risk is mitigated by hedging. Acquisition strategy is sound and the MLP at least replaces production declines. Leverage rates and cash flow should be watched carefully. If owned, appropriate amounts can provide a natural business hedge to midstream assets. Typically, upstream MLPs have a higher yield but slower distribution growth than most MLP businesses. Upstream MLPs are usually structured with little or no payment of IDRs, because it is felt that far higher returns could be generated by commodity price increases than by the skill of GPs. At present, due to lack of cash flow visibility in the MLP E&P space, we do not own any upstream E&P MLPs in our strategy. This may or may not change in the future. 16. Coal Mining Currently, this business is under pressure due to low prices for competing natural gas in the USA. Implementation of pending EPA regulations is causing electric utilities to switch from coal, thereby reducing demand for thermal coal. As of the third quarter 2014, we believe thermal coal mining represents a reasonable opportunity for MLP portfolios as we think that the business is bottoming. We will consider selective investments in coal oriented MLPs. This represents a change in our views from our prior research. 17. Midstream assets The largest category of MLP companies is related to fixed assets to transport energy and related products. Long-distance pipelines for oil, refined products, natural gas liquids, natural gas, CO2, ammonia Gatherers and processors of gas, natural gas liquids, and oil Compressor service companies Oil and gas midstream businesses differ by business model and geographic footprint. There is a diverse customer base for both suppliers and consumers. Sometimes cited as toll roads although the risk is often more complex than this. Although we categorize MLPs in our portfolio management system as one type of midstream company, MLPs often have operations in several categories by product and service. Copyright 2014 Cumberland Advisors (800) One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL E. Landis Avenue, Vineland, NJ Cumberland Advisors is an SEC registered investment adviser. 7

22 18. Long-Distance pipelines Expensive to build and hard to permit give them an economic moat If the pipeline is interstate, rates are regulated by FERC. Intrastate pipelines are regulated by the states. Pipelines can be repurposed by product, and flow direction can be reversed if demand changes. One large risk is basis risk (price differentials) based on geographic differences in supply and demand. High differentials are generally good for pipeline companies. Larger systems of pipelines have the ability to increase value via the network effect. Certain types of contracts have volumetric risk indirectly related to price of commodity and overall demand. Other types of contracts are in effect leases on pipeline space and are lower-risk (the toll road model ). Duration of pipeline contracts is important, as leasing rates can fluctuate over time. There are operational risks such as leaks, spillage, and possible environmental impacts. Hydraulic fracturing, tight oil, Canadian oil sands, and shale gas deposits are increasing demand to move commodities that are in different places than most of the existing infrastructure. Oil pipelines must be batched to take into account different grades of oil. Pipelines need to be dedicated by product - for instance, crude-oil versus refined-petrol products Companies have diversified into trucking and rail to complement/supplement pipelines. 19. Gatherers and processors Natural gas industry operates tertiary pipes to get gas from well to processing facility. The gas is processed to remove impurities and moisture that can damage pipelines. The gas is fractionated to refine it into methane plus natural gas liquids such as ethane, butane, isobutene, propane, and natural gasoline (pentanes), which are used for industrial applications. Gatherers and processors convey products to large pipelines to be transported long distances and distributed to end users. Contracts with producers vary from fixed-fee (least risk, least upside) to percentage of price, percentage of index, percentage of liquids, and keep-whole contracts. Fixed-fee contracts have no commodity exposure, and the processor does not own the gas. Other contracts often have commodity exposure and ownership risks. Oil industry gatherers transport oil via smaller pipelines, rail, barge, tankers, and trucks to either larger pipelines for further transport or directly to terminals for eventual transit to refiners. Gas often needs a compressor to raise the pressure at the wellhead or in the various stages of the supply chain. There are a few specialized compressor MLPs that provide this service on a fee basis. 20. Storage and terminal assets These are distinct assets but are often attached to pipeline companies or gathering and processing companies as part of the overall transportation picture. Some MLPs have segregated these assets into separate but co-managed MLPs. 21. Propane distributors This is a mature business with low or no growth, but the business is fragmented. Larger MLPs can moderately grow distributions by consolidating and improving costs. Tend to be higher-yielding to compensate for slow growth and risk Demand is seasonal and is influenced by winter heating needs. Useful as a possible hedge vs. gas gatherers and processors, as propane distributors are end-use clients We currently follow two larger propane companies. Copyright 2014 Cumberland Advisors (800) One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL E. Landis Avenue, Vineland, NJ Cumberland Advisors is an SEC registered investment adviser. 8

23 22. Shipping Many companies are foreign domiciled and have elected to be taxed as regular corporations. We are following one with a typical MLP tax structure for now, but it is not a focus for us. 23. Variable-rate MLPs Relatively new type Created expressly to market high-yield entities that are not steady payers, such as fertilizer producers We do not advocate this sector now but could readdress in the future if deemed attractive. 24. Valuations of MLPs Distribution yield combined with distributable cash flow (DCF) coverage Necessary but not sufficient tool Distributable cash flow not GAAP and is measured and disclosed differently by each MLP DCF somewhat equivalent to free cash flow for corporations We believe this is the best model if you additionally factor in overall risk including balance sheet and liquidity and factor in growth upside of a partnership as well. 25. Distribution discount model Estimate distributions for the next 3-5 years and terminal growth rate. Factor in a discounting interest rate for the type and risk of business. Nice conceptually but requires a very clear crystal ball 26. Price to distributable cash flow Reasonable method but must factor in presence of IDRs and differing business models DCF is an estimate and not GAAP measure and is measured and disclosed differently by each MLP. 27. Enterprise value to adjusted EBITDA Analyst community likes this metric. We prefer to more closely track cash distribution and credit risk. Good for historical comparison of a single MLP or comparison between two similar MLPs 28. For valuation of MLPs as a broad asset class it is useful to compare yield spreads to high-yield or highgrade bond indexes. 29. Constructing a portfolio Diversification by type of business and business model helps. Investors that tout that they only buy toll road models are likely to be too concentrated and not diversified along the energy value chain. Higher yields in the space can mean more risk, less risk, or different risk. In this slightly to slowergrowth E&Ps and propane companies may add diversification benefits to an MLP portfolio. Their high yield can indicate risk but also indicate that their businesses have slower growth potential. Sometimes, depending on high growth for returns entails more risk as well. Volumetric, regulatory, tax, and execution risk are present even in the biggest MLPs. Basis risk via geography and by product is a factor and can be difficult to diversify away. The energy business constantly evolves and changes, so an investor needs to be nimble. MLPs act as competitors, partners, and counter-parties; in short there are a lot of interconnections. Copyright 2014 Cumberland Advisors (800) One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL E. Landis Avenue, Vineland, NJ Cumberland Advisors is an SEC registered investment adviser. 9

24 Counter-party risk should not be underestimated as a risk factor. Strong sponsors or GPs can greatly enhance the value of an MLP. Other things being equal, larger, longer-existing, and better-capitalized MLPs are less risky. Credit is extremely important in constructing a portfolio - we don t advocate blindly reaching for a yield. We diversify by name, underlying business, geographic footprint, and growth characteristics. We advocate taking advantage of cross-correlations to reduce risk. We focus on businesses that have particular advantages and economic moats. Copyright 2014 Cumberland Advisors (800) One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL E. Landis Avenue, Vineland, NJ Cumberland Advisors is an SEC registered investment adviser. 10

25 Master Limited Partnerships (MLPs) Taxation 101 Carla Plush Smith, CPA/PFS, CFP, CLU, ChFC Plush Smith PA 2 N Tamiami Trail, Suite 506 Sarasota, FL This is a copy of a presentation for research purposes, made to Cumberland Advisors by Plush Smith, PA. For questions regarding how MLPs and the filing of K1s might effect your own personal situation, please contact your own tax advisor/accountant. Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in the communication including attachments, was not written to be used and cannot be used for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. If you would like a written opinion upon which you can rely for the purpose of avoiding penalties, please contact us.

26 Tax? What Tax? No tax at company level Tax liability passed on to unitholders(limited partners) Form 1099-DIV vs. K-1 Cash distributions do not equal net income similar to free cash flow 2

27 Business Entity Comparison Corporation Separate entity Personal asset protection Paystax on income Double taxation Shareholder Dividends Limited Partnership Aggregate of partners GP exposed / LP protected No taxat entity level Single taxation Limited partner / unitholder Cash distributions 3

28 Partnership Tax: Income Unitholder earns a share of the MLP s income. Each unitholderis allocated on papera proportionate share of the MLP s income, gain, deductions, losses, and credits. Each item is entered on a unitholder stax return and tax is paid at the unitholder sown tax rate. Tax is owed whether or not the unitholder receives cash distributions. 4

29 Partnership Tax: Losses Net loss cannot be used to offset unitholder s other income Net loss carried forward and used against future income from same MLP At sale of entire MLP interest, any remaining loss from that MLP is deducted against other income. 5

30 Partnership Tax: Distributions Quarterly cash distributions not the same as the MLP s income. Return of capital not taxed when received Basis in partnership lowered by amount of distribution, so gain on sale is increased Often you will hear someone say 80% of the MLP s distribution is tax-deferred. What they mean is that your share of taxable income (on K- 1) is about 20% of distributions. 6

31 Basis Adjustments Basis is used to determine gain/loss on sale of units. Initial basis is price paid for units. Cash distributions adjust basis downward. Taxable income adjusts basis upward. Your share of deductions such as depreciation adjust it downward. 7

32 Simplified Example Year 1: 1,000 units $30.00 basis is: $30,000 Investor receives total cash distributions of $2.50/unit -$2,500 Investor is allocated and pays tax on net taxable income of $.50/unit, Including $2.00 of income and $1.50 of depreciation +$ 500 Adjusted basis $28,000 Year 2: All units $32.00 $32,000 Gain per unit: $ $28.00 = $4.00 $4,000 Depreciation recapture taxed at ordinary income rates $1,500 Taxed at capital gain rates $2,500 8

33 Basis Adjustments As long as basis is above zero, tax on distributions is deferred until sale of units. Once basis reaches zero, future cash distributions are taxed as capital gain in the year received. If unitholder dies and units pass to heirs, basis is reset to fair market value on date of death, and prior distributions are not taxed. 9

34 Gain and Recapture When MLP units are sold, taxable gain is the difference between sales price and adjusted basis. Not all gain is taxed at capital gain rates: Gain resulting from basis reductions due to depreciation is taxed at ordinary income rates this is called recapture. Reported with K-1 for year of sale 10

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37 Who Should (And Should Not) Own Tax-exempt funds may be subject to tax from owning MLPs, because the taxable income is considered unrelated business taxable income (UBTI) income that is unrelated to the activity that gives the fund tax-exempt status Examples: Pensions, endowments, 401(k) plans Also true for individuals holding MLPs in an IRA account 13

38 Strengths Potentially higher yield Relatively inexpensive and liquid compared to private limited partnerships Reduced cost of capital for partnership Limited liability for limited partners 14

39 Trade-Offs High fees may apply. General partners share of cash may increase over time. Limited partners have no participation in management and aren t fully shielded from liability. Potential tax complexity state tax compliance May not be suitable for all types of accounts Can be sensitive to interest rate changes and commodity prices 15

40 Tax Considerations MLPs may be taxed as corporations. Tax preparation complexity results in additional cost of compliance. Subject to passive loss limitation rules IRAs & tax-exempt entities have exposure to UBIT Don t donate depleted MLPs to charity. Distributions cannot create negative basis. Death of unitholder results in basis step-up to FMV at date of death. 16

41 To receive a copy of our newsletter, please carlasmith@plushsmith.com 17