Friday, 24 February 2017
Last updated 5 min ago
Jan 10 2013 | 9:00am ET
Diversified Trust is a southeast-based wealth management firm with more than $4 billion in assets. Jason Lioon, in the firm's Atlanta office, joined Diversified Trust in 2005 after serving as a financial analyst in Goldman Sachs' private wealth division. These days, Lioon's interest is largely focused on a special corner of the investment universe: master limited partnerships.
Structured as limited partnerships, traded on public exchanges and deriving at least 90% of their returns from real estate, natural resources or commodities, MLPs have long been the purview of high-net-worth investors. But as Lioon told FINalternatives' Senior Reporter Mary Campbell recently, the industry is maturing and institutions are beginning to take an interest.
What do you like about MLPs as an asset class?
The first thing is, we think there's a real secular story to be told here with the growth in energy production in the U.S. There's been a lot in the headlines over the past few weeks and months about the growth in production here in the U.S. Oil production is rising and we may actually surpass production rates of even Saudi Arabia; with natural gas, production is just booming. There's a lot of need for additional infrastructure to be built and the fact is that a lot of that infrastructure needs to be built in non-traditional production areas. So you get the shale gas in the Marcellus Shale which runs through New York, Pennsylvania, Ohio, and the West Virginia area, which is not, at least not in recent history, a big oil and gas producing area, so there's a ton of infrastructure that needs to be built there.
A lot of oil is being produced out in North Dakota and a lot of it is traveling by rail and by truck, which is two, three, four times more expensive than it would be to send it via pipeline. The problem is that it takes a long time for these pipelines to get built—it can take years in some cases—so it's really a long-term, secular growth story that MLPs are nicely situated to take advantage of.
Are you appealing to retail or institutional investors?
The MLP space has traditionally been retail driven. It was a very small area of the market—there are only about 80 of them now and that's a number that has grown a lot over the last 10 years. And so a lot of the investors there had been individuals, especially high-net-worth individuals that were going there for a tax-deferred or tax-advantaged investment vehicle. And you had basically zero institutional investment. It was predominately all individuals who were buying a handful of MLPs outright, holding them for a long period of time and taking advantage of the tax benefits from the structure.
As the MLP space has now grown over the years and the asset class is maturing a little bit more, you're seeing more and more institutional interest. Still, it's a very small area of the market. The total market cap for all of them put together is probably slightly under $300 million. You put the entire MLP sector together and it's not even close to the size of Apple, so that makes it hard for big barrels of money to come into the space without really changing the dynamics of the market. But you're starting to see a lot of the more forward-thinking institutions go in there because they can see beyond it being just some sort of tax deferral strategy and there's real growth potential there, and there's a history that they can look at and get a better understanding for the business model. So, we're starting to see more and more institutional interest.
How do you go about investing in MLPs?
There are three or four structures out there that you can use now to gain access to MLPs. The first one—the easiest one from an implementation standpoint—is that you just can go out and buy the individual MLP holdings. This tends to make the most sense for larger investors since MLPs are publicly traded partnerships, so you have to take into account the fact that you're going to get a K-1 from each of these. There's a little bit of an increased tax-reporting cost so you're probably going to have to pay your accountant something to process each of these individual K-1s. Since this is a fixed cost, the expense declines in percentage terms as the asset size gets larger.
For smaller investors, we tend to favor products that make it easier from a reporting standpoint. So, then you get into mutual funds, ETFs and exchange-traded notes. All of them make the tax reporting much simpler—it's easy diversification if you have less money to put to work—but each of them has a little bit of an issue.
With the exchange-traded notes, you're taking on some credit risk from the issuer, and the biggest issuers out there are JPMorgan and UBS right now, so you're taking on some other risks associated with it and you're also losing out on some of the tax benefits.
Then, on the flip side, because MLPs are partnerships, mutual funds that own strictly MLPs have to be structured as a C-corp and pay taxes at the fund level. You end up paying a full corporate tax rate and losing out on the tax deferral, so we definitely prefer to hold the MLPs outright. But for a smaller investor, the additional tax prep costs and the headache of keeping up with all the K-1s might not be worth it. As a result, we think in some cases owning these other structures can be worthwhile.
How do you evaluate MLPs?
I'll preface this with the fact that we don't actually pick the MLPs ourselves: we hire outside managers to do the analysis of them. But I can tell you that they kind of run the gamut. Basically, in order to be characterized as an MLP, you just have to derive a very significant portion of your revenue, basically 90%, from energy-related activities—storage, gathering, processing, transportation—any of that can qualify.
Traditionally, the MLPs have been focused on what is called the midstream area, basically transporting the oil and gas from point A to point B and maybe doing a little bit of processing to it. They might take the raw natural gas and separate out some of the natural gas liquids from it and put that into a separate pipeline. So, areas where they don't take on any commodity price risk, they don't take ownership of the gas or the oil. We love those businesses, those are the businesses where even during 2008 it didn't matter, commodity prices, the extreme volatility you saw in '08 and '09 where they spiked up and then went way down didn't matter because people still needed to heat their homes, they were still driving their cars. We love those businesses because they were effectively quasi-utility like. It's heavily regulated as well.
Now, because of this MLP boom, you've seen a lot more IPOs of companies that are on the extremes, that are on either end—that are more involved in the retail distribution of the commodities. There's a company that's called Hi Crush Partners and it makes sand and other proppants that they inject into these wells when they're doing hydraulic fracturing. Basically, businesses like this are dependent upon continued volume growth in fracking. And so, you're heavily leveraged to production there, and to a very specific type of production. With those businesses, you're generally getting compensated with higher yields but the volatility is much, much greater; much more like what you would see from a traditional small-cap exploration and production company. There's nothing necessarily wrong with that but the thing that we really like about MLPs is their stability. During '08-'09, when you saw massive draw-downs in the stock price just because of what was happening in the broader world, these companies continued their distributions and even grew their distributions, which you can't say about very many areas in the investing world.
What kind of returns can an investor expect from MLPs?
Well, again, it kind of depends on where you're looking...I'd say out of [those] 80 [MLPs], maybe 50-55 of them are midstream focused. Kinder Morgan is probably the most high profile one, the other big one is Enterprise Products Partners. Those two are hands down the largest by a wide margin. Those are companies that have huge installed pipeline bases. They own massive, I like to think of them as trunk lines—for example, a line that runs from refineries down in Texas and Louisiana running up the east coast to New York City. These are things that cost several billion dollars to construct, they have no competition, it's a great commodity but, again, the law of large numbers factors into play here and it's harder for them to grow rapidly...I view those as quasi-utilities with some growth potential to them. Then as you get into smaller and smaller names, there's more risk but more potential for returns.
Taken as a whole, if you look at the Alerian MLP index, which is the main MLP index out there...you're getting your coupon return, which is the distributions out of MLPs right now, the yield is a little bit north of 6%, so we're looking at clipping that plus seeing some modest growth. Over the next few years we can probably average out to total returns around 10 [%], which I think is a reasonable expectation and something that hopefully is achievable without too much variability. There are risks, obviously, with the stock price component but we think the risk to the cash flow component is actually pretty low.
What impact could growing concerns about the environmental impacts of fracking and of fossil fuels in general have on the MLP sector? And can you imagine the structure lending itself to the promotion of green energy?
I think it would be a great boon for the sector if green energy companies were allowed to have the MLP designation. It would be a win/win. Bringing everybody into the fold would really be helpful for allowing MLPs to maintain their attractive tax structure.
That said, the two biggest risks we really see to MLPs are the tax side, if the tax structure changes and...if there is environmental regulation change or fracking suddenly goes away, that would have a massive impact on the sector, a massive negative impact.
MLP investing is certainly not without risks, but the thing we like about them while constructing a broader portfolio is that their risks are totally different from what you would see from most other investments; these are very specific risks that hopefully should allow us to get some sort of diversification benefit in that, if something bad were to impact MLPs the things that would negatively impact MLPs would probably have no impact on the outside portfolio and vice versa.
What are the tax advantages of MLPs?
We could have our own 30-minute conversation about the tax side of things.... The biggest reason, I would say, we don't see more interest in this sector is because the tax structure is complex. It is a partnership. Each of these entities that you invest in is its own partnership with its own K-1...[T]he benefit that you get is that, because they are a partnership, the MLPs can offset the income, the cash flow they generate, with depreciation expense on their assets.
So, as you might imagine, a pipeline company especially is going to have massive capital expenditure every year and with the tax laws the way they are you can accelerate that depreciation and take more of it in nearer term as you're building new pipelines. So, if you're a taxable investor, almost all of the income you receive is offset by depreciation expense. Much of the yield that you're getting now is not going to be taxed currently, it's going to be deferred...until you sell the position. Theoretically, if you were to hold the MLP for 10 or 15 years you may not have to pay that tax until you actually sell the position.
There's no guarantee that that depreciation pass-through will always be covering 100% or 90% of your distribution—it will fall over time, as a lot of these projects come on line—but in the short run it's a very attractive tax position. For some of our clients who are older, it can be very attractive from an estate-planning perspective in that they can buy the MLPs, get a very attractive tax-deferred income now, and then either gift the appreciated stock positions to charity or hold them until they pass away and then their heirs would receive the asset with a basis stepped up to the value at the date of the investor’s death. So we really like it from that standpoint too.
Will the MLP universe expand in the next few years?
It's tough to say, I think it will depend a lot on the capital markets and how well the stock market continues to do. There are more companies out there that are wanting to take advantage of this increasing interest in MLPs. The mutual funds that are out there now didn't exist a couple of years ago, so there's more demand for MLP shares, [and] usually supply comes to meet demand, so as long as demand is robust, there are smaller companies out there that could file IPOs.
What you've seen a lot of, actually, is larger energy companies or utilities spinning out MLPs to take advantage of the tax structure. It's become something of a proven concept and more widely accepted—there's more easily acquired capital there. I would gather that there's probably still room for modest growth but I think most of the growth you're going to see is probably going to be from the existing players. All of the big names of any consequence, really, are already there. You might see some additional spin-offs. Most really big oil and gas producers have already made their spin-offs and what you're likely to see is them then buying assets, either from the parent company that spun them out or buying assets from other utilities that don't want to go through the process of creating their own MLP.