Q&A: Mastering Energy Master-Limited Partnerships

Sep 12 2012 | 1:32pm ET

The energy master-limited partnership universe consists of about 80 companies with collective market capitalization of $300 billion—60% of which is headquartered within 20 miles of Greg Reid’s Houston office. Reid is a managing director of Salient Partners and head of its $1 billion MLP business. Prior to joining Salient he founded and ran RDG Capital, a wealth management firm that also specialized in energy MLPs.

Reid is bullish on the companies—which are structured as limited partnerships, trade on public exchanges and earn 90% of their returns from natural resources—estimating their total annual returns in the double-digits. He discussed the sector, and shared some of his favorite picks, during a recent interview with FINalternatives Senior Reporter Mary Campbell.

Tell me about Salient’s MLP business.

Here in Houston, we manage about $1 billion in our MLP business. I have a nine-person investment team; I’m one of the two portfolio managers. That makes us one of the largest MLP managers in the country.

The fascinating thing about MLPs is there are about 80 companies that comprise about $300 billion, and while only a third of them are headquartered in Houston, over 60% of the market cap is here in Houston, so it really is a Houston-centric type investment.

We have two public, closed-end funds that trade on the New York Stock Exchange. Those are targeted more to retail investors who want a liquid investment, and the beauty of those two funds is they issue 1099s, making it pretty easy to keep track of your taxes and get one 1099.

We also have some separately managed accounts, which means that we would buy individual MLPs for the clients and hold approximately 20 securities with a $100,000 minimum account size. It’s a little more complicated, from a tax standpoint, if you get 15 or 20 K-1s versus one 1099. Then we have some alternative solutions, for qualified investors, where we go long and short to hedge the downside risk for investors.

The energy MLP universe, then, is not a particularly large one?

That’s right, although there are 12 IPOs that are pending and several of those will go public this year, so it’s growing. The reason why it’s small is the MLPs benefit from a favorable tax status—90% of their income has to be qualifying from distribution, transportation or storage of natural resources, so most companies can’t qualify but those that do have a very beneficial tax treatment.

What do you look at when evaluating an MLP?

We evaluate all 80 of the energy MLPs—I say energy because there are some that are not energy; StoneMor is a cemetery MLP. We don’t look at the maybe 20 or so MLPs that don’t fit the energy infrastructure. But of the 80 that qualify, we’re looking for a long-term, sustainable business plan that generates attractive current income, meaning yields of 5% to 8% a year and a long-term growth rate. MLPs are really driven by a total-return formula that is essentially yield plus growth, and today current yields in the index are around 6.2% and growth is around 6.5% or so, even 7%, on a market-cap-weighted basis. That leads us to expected returns of around 12% to 13% a year.

How liquid are MLPs?

They’re all publicly-traded securities and most of them are on the New York Stock Exchange, so they’re very liquid. They’re not quite as liquid as normal stocks because the substantial tax benefits lead investors to be more buy-and-hold oriented; they don’t trade quite as often because most of that 6% income stream is tax-deferred return of capital, which means you don’t pay any tax on it, but when you sell it, you recapture the income, so you really don’t want to turn it over all the time. You want to buy and hold the best companies and let the gains compound without paying taxes.

How long would you plan to hold an MLP?

Our core holdings we’re trying to buy and hold indefinitely, so we never have to pay the tax. But there are some companies that are natural core holdings, others you might have a three-to-four-year investment period. And you could potentially buy something and sell it sooner, but we do try to be long-term investors, we’re not trying to trade to generate profits. It’s really all about the power of compounding with MLPs. A 6% yield and a 6% growth rate is a very powerful return formula, and if it’s working you don’t want to change it.

How many positions do you hold at any one time?

We want to stay focused on our best ideas, and so we typically own between 20 and 25 positions, though it could be as high as 30. We have two public closed-end funds and we tend to be a little bit more diversified in a larger, more public vehicle, whereas a separately managed account might have as few as 20 positions. Somewhere between 20 and 30 out of the 80 are really our best ideas.

And what are some of your best ideas?

One of our favorite companies is Plains All American Pipeline. It yields about 5% today and we expect growth to be in the 5% to 8% a year range. They’re involved in the crude oil transportation, storage and logistics business, which is a high-growth, very profitable part of the MLP industry right now. They also just announced a two-for-one stock split and that’s a good sign that they expect future growth in their cash-flow. And they’re, of course, outperforming this year and have been for a number of years. So that’s one of our top holdings. It’s based here in Houston; it would be a core position and all of our funds would own Plains.

Another large-cap name—these are both pretty recognizable names—Enterprise Products, which is another large Houston company, is the largest company in the industry. It's a similar story as Plains: A diversified business, it’s really the industry leader and has a yield of approximately 5% and we’re expecting at least 6% annual growth.  Enterprise is primarily involved in the natural gas liquid fractionation business, with a number of fractionation facilities here in the Houston area, but they have also other business units that they’re involved with.

In the small- to mid-cap area, one of our favorite ideas is midstream natural gas company Targa. It’s also a Houston company and they actually have two share classes, the limited partnership yields about 6.4% today and trades for about $40 a share, and we’re expecting to see distribution growth of 10% to 15% this year and probably again next year.

Are there any alternative energy sector MLPs?

They're talking about including alternatives as potential qualifying income categories for MLPs, but it’s too early right now. MLPs' business model is built around stable, predictable cash-flows that are paid out to investors. The problem with the alternatives sector is they’re really not profitable, generally, without government subsidies, and they don’t have the cashflow to pay to investors. So even if you could get them to qualify, it’s not clear to me the companies are profitable enough to pay cash distributions to investors and I don’t think it would work to take a company public and not have a yield in the MLP space; that would not be what investors are expecting. Maybe five or 10 years from now, when it’s more proven and more profitable, would be a more appropriate time, but right now, I think it’s a little bit early to be taking a company like that public as an MLP.

Did 2008 change the way MLPs operate?

Well, 2008, of course, was the worst financial crisis this country has seen in 70 years and I think we all learned some great lessons. As a money manager, we certainly learned how to manage risk better. I think the companies themselves learned to maintain more conservative balance sheets, to have a larger margin of safety and lower levels of leverage. I think companies operate a little bit more conservatively today than they did back in 2007.

Back then there was more private investment activity, meaning they were selling some equity to institutional investors and hedge funds in private investments in public equities transactions, and that created a less-stable shareholder base, more concentrated, and some companies learned that’s not the best idea to facilitate growth. Today, most equity is raised in secondary offerings, more broadly distributed across retail investors, so it’s more stable, more public and without as much leverage. Back in 2007, when the hedge funds began to get in the space, they used more leverage than was probably appropriate.

And it’s a growth sector?

It’s definitely going to grow. Currently, we’re running about 8% year-over-year growth in our cash distributions to investors; that’s above the last 10 years' average growth rate. That means there’s an abundance of capital expenditure opportunities to invest capital at a profitable rate of return and that will lead to more growth, and growth is what fuels the unit prices to go higher. 

The MLP industry today yields about 6.25%, which is close to the  historical average yield, so if the yield is growing at an 8% annual rate, that essentially means prices should be up about 8% in the next 12 months. And that will increase the market cap.

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