Learn About the Intricacies and Risks of MLPs

E*TRADE Capital Management2

During times of low interest rates, investors often consider nontraditional strategies to generate income. Enter the Master Limited Partnership (MLP), a complex investment vehicle known for its potentially high levels of income distribution to investors, but which also has a complex tax treatment and inherent risks. Because of these risks and the MLP’s complex structure, it’s important for investors to look beyond the current yield that MLPs are generating and understand how they work to determine how they may—or may not—fit into their diversified portfolio.

An MLP is a form of partnership whose units combine the liquidity that comes with being publicly traded on a stock exchange with some of the tax benefits of limited partnerships. To qualify as an MLP, the partnership must generate at least 90% of its revenue from what the Internal Revenue Service (IRS) calls “qualifying” sources, which are typically industries that are involved in the extraction, transportation and refining of natural resources.[1] In practice, most MLPs are in the energy sector, primarily in the “midstream” space that involves the transportation and storage of oil and natural gas.

 

A Different Type of Investment

 

Investing in an MLP is different from investing in a traditional publicly held corporation. First, MLPs don’t actually own any of the businesses in which they invest. They provide financing in exchange for a percentage of each company’s cash flow and then pass that revenue through to the partners. Because of that structure, investors don’t buy “shares” in an MLP. They buy “units” that are traded on public exchanges. Second, MLPs have two classes of “unitholders,” general partners and limited partners. General partners oversee the day-to-day operations of the MLP, such as bookkeeping, while limited partners are all of the other investors and have no say in management decisions.

The typical MLP invests in companies that build and operate pipelines and terminals that transport oil and natural gas from an “upstream” driller to a “downstream” refinery or utility. These infrastructure projects are built on a relatively stable revenue stream because they are usually constructed only after long-term supply contracts are signed with downstream customers. Their revenues are not solely dependent on the price of the commodity that moves through them—which tends to be highly variable—but on the volume of that commodity. That said, no revenue stream is ever guaranteed.

The percentage of the revenue received by the MLP from each project is often tied to the rate of inflation, providing investors with inflation protection, notes Jason Stevens, an energy strategist with Morningstar. Typically, MLP managers aim to generate steady and growing cash flows from these projects, which they pass on to their limited partners through quarterly cash distributions that are based on a preset formula outlined in the MLP contract.

 

Tax Considerations

 

This distinctive ownership structure provides specific benefits—and complications—to unitholders because of how they are taxed. One major benefit is that, as partnerships, MLPs don’t have to pay federal or state corporate income tax, which reduces their costs.

The tax obligation is passed through to the investor, and MLP investors are responsible for their portion of the net taxable income, generating complex issues for the unitholders. For example, investors will receive an IRS K-1 tax form every year from the MLP that reports income earned in each state in which the MLP does business. This form is much more complex than a 1099, and investors might have to file tax returns in some of those states if the income is high enough or if the state requires it. That said, most of the distributions to partners are considered return of capital as opposed to interest or dividends, so they are not taxed. Investors should talk to their tax advisors about their individual situations. 

 

Investing in Funds

 

The complex tax structure of MLPs is one factor that has led to the increased popularity of mutual funds and exchange-traded funds (ETFs) that include MLPs as portfolio investments. An MLP mutual fund or ETF may provide broader diversification at a lower cost than direct investment in an MLP, and the tax treatment is greatly simplified. Mutual fund shareholders don’t need to worry about filing K-1 forms to declare MLP partner income.

One caveat, though, is how much each mutual fund or ETF holds in MLPs. Funds holding less than 25% of their assets in MLPs can be classified as regulated investment companies (RICs), which means they are not taxed on their MLP income at the entity (fund) level. Those tax obligations are passed on to investors. If a fund holds 25% or more of its assets in MLPs, it is classified as a C Corp, and is subject to federal, state and local taxes on all distributions that are not a return on capital at the entity level. This is an important differentiation because the tax structure can have a direct impact on yield, says Abi Osanyinjobi, a senior investment strategist with E*TRADE Capital Management, LLC.

The mutual fund or ETF structure may also make it easier for investors to strategically allocate a portion of their portfolio to MLPs, Osanyinjobi says. MLPs have a somewhat modest to low positive correlation with both stocks and bonds, which means that they don’t always move in sync with other investments through typical market cycles. That may help diversify a to portfolio, he adds. It’s important to note, though, that during economic downturns such as the one experienced in 2008, MLPs tend to have a higher correlation to stocks and commodities.

Because of MLPs diversification benefits and due to the complexity and risk, investors may want to consider investing a small portion, usually 5% or less, of their total portfolio into MLP funds or ETFs, Osanyinjobi says. “Investors should consider their total asset allocation in energy and infrastructure assets when deciding whether or not to invest in an MLP,” he adds.

Investors should also note that as MLPs have grown in popularity, a new breed of “nontraditional” MLPs has emerged that invests in upstream assets such as drilling rigs. These investments may offer greater yields today but also come with higher risk because their performance is more tied to commodity energy prices than traditional MLPs. Some of these new MLPs also offer “variable-rate distribution,” which means their payment will go up and down with their cash flow.

 

Don’t Forget About Risk

 

While it’s hard to resist MLPs’ potential to generate possible yield for income, investors should also be aware of the risks inherent in the MLP structure. First, despite its relatively recent rapid growth, the MLP sector is still very small when compared to other investment sectors. That means liquidity may be limited, especially during market downturns, leading to higher volatility than other major asset classes. The sector’s small size also means its assets are concentrated among just a handful of major companies that control a significant portion of the market.

Another consideration is that MLPs are highly regulated, and their tax benefits could be reduced or eliminated by legislative or regulatory changes. They are also susceptible to commodity risk. Drops in energy prices could impact MLP revenue.  MLP prices can become highly tied to the oil market as was witnessed in the recent collapse of oil prices from mid-2014 to early-2016. However, over the long term MLPs may have a generally low correlation to commodities. Finally, MLP growth is largely driven by debt so any tightening in the capital markets could have a negative effect on the industry.

Like Real Estate Investment Trusts (or REITs), MLPs potentially provide both income (through required cash distributions) and capital appreciation (through being traded on an exchange). When deployed effectively in a diversified portfolio, MLPs can provide income as well as exposure to a very specialized subsector of the energy market for investors who are comfortable with the potential high volatility.

 

 

 

 

 

Article Disclaimer

Alternative investment strategies are not for everyone and entail risks that are different from more traditional investments. Alternative investments are intended for sophisticated investors and involve a high degree of risk, including the potential for loss of some or all principal. An investment in an alternative investment product or strategy is speculative and should not constitute a complete investment program.  For additional information, please read the guidelines provided by FINRA at: http://www.finra.org/Newsroom/NewsReleases/2013/P278031

Master limited partnerships (MLPs) are complex investments that have unique tax characteristics and significant risks. As a result, MLPs may not be suitable for all clients.

Most MLPs typically have concentrated investments in assets characterized as alternatives and most operate largely in the energy and natural resources sectors. A downturn in these sectors could have an adverse impact on the fund and as a result, its performance may lag the performance of other sectors or the broader market as a whole.

Before investing in MLPs, it is important to understand the structure and terms of the security, along with potential risks such as concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy and political risk, operating, economic and market risk.  When considering purchase in a primary offering, you should obtain and carefully read the prospectus. If buying in the secondary market, you should review the issuer’s publicly available financial and other information (such as recent annual, quarterly and current reports).

MLPs are not proxies for bonds or fixed income securities and investors who are looking at higher yielding alternatives should be fully aware of the complexities of MLPs, including the possibility the investment will not continue to pay income. Investors should consider their individual income needs and portfolio constraints, and consult their tax advisors regarding the complex tax treatment, prior to investing in any MLP or MLP fund.

  1. Qualified natural resources include crude oil, natural gas, petroleum products, coal, other minerals, timber and any other resource that can be depleted as defined in Section 613 of the US Internal Revenue Code. Section 7704 was amended in 2008 to include industrial source carbon dioxide, ethanol, biodiesel and other alternative fuels. Other sources of qualifying income were defined to include interest, dividends, real property rents, income from the sales of property, gains from the sale of assets, income from the sale of stock, gains from commodities and commodity-related futures/options. Retail operations are generally excluded except in the propane sector.

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