What are MLPs?
Written by Rick Welch
Much like REITs which we covered in our column last month, Master Limited Partnerships (MLPs) have the status of pass-through entities under the Internal Revenue code which means that their earnings are not subject to income tax at the corporate or partnership level so long as the entity restricts its operations to certain qualifying activities. The two-tiered economic structure of an MLP, which structure often consists of a corporate general partner and one or more limited partners (in this case investors), is unique in that it revolves around cash flow. When MLPs are traded it is based on a multiple of cash flow and not net income. Investors buy units of the partnership, rather than shares of stock, as their ownership interest is in a publicly traded partnership and technically is not common equity. Previously, MLPs were limited to just a few closed-end funds, however, growing investor interest has resulted in the establishment of over 100 mutual funds and exchange traded funds which cover this alternative asset class.
Investors can now purchase units (not shares) of MLPs in the same manner that they would purchase shares of a publicly traded company. Just like stocks, MLP units have a ticker (symbol) associated with them that is used to place buy and sell orders. All investors or unit-holders receive quarterly distributions (instead of dividends) which include a share of partnership income and a return of capital. MLPs typically own midstream energy assets which can include mining, process, transportation (marine, pipeline and road) and distribution activities. Over 80% of all MLPs are found in the oil and gas sector, which includes qualifying products like gasoline, kerosene, refined lubricating oils, diesel fuel, methane, butane and propane. The transportation of these products is considered qualifying so long as the delivery point is a bulk distribution center or a public power generation utility. In contrast, transportation to a retail outlet is not a qualifying activity. Publicly traded MLPs found outside of the oil and gas sector include StoneMor Partners (cemeteries and funeral homes) and Cedar Fair Entertainment Company (amusement parks).
We view MLPs as an instrument from which the investor can earn a strong quarterly yield-based return and also retain the potential for capital appreciation. There are three main reasons why an investor should consider an investment in MLPs: strong distribution yield, diversification and tax advantages. The current yield of the Alerian MLP Index, which tracks midstream energy firms, is 7.60% compared to 2.20% for the benchmark 10-year US Treasury Bond and 1.85% for the S&P 500. Aside from the rich distribution yield, another benefit of investing in MLPs is their low correlation with US Large Cap stocks (0.45) and the Barclays US Aggregate Bond Index (0.01). The most common way of looking at diversification is the correlation between asset classes. When two investment assets have low correlation we expect that when one asset goes up the other will go down. Low correlated assets provide the opportunity to get higher risk adjusted returns and to improve diversification within an investment portfolio. The most important difference between investing in corporate common shares and investing in an MLP is the tax implications of their distributions which allow a greater share of every $1 of corporate revenue to be distributed to unit-holders on an after-tax basis. The tax efficiencies provided by MLPs suggest that they are best suited for taxable investment accounts, rather than your retirement account.