Published by Nick McCullum on June 25th, 2017
Master limited partnerships – or MLPs, for short – are some of the most tax-efficient investment vehicles for investors looking to generate meaningful portfolio income.
Unfortunately, these securities are some of the most misunderstood among the investment community.
Why is this?
Well, one reason is MLP distributions appear to be taxed more heavily than the dividends of common stocks. While the tax on their distributions is higher, MLPs avoid taxation at the organizational level, which leads to higher after-tax income for the investors in these partnerships.
These securities also issue more complicated tax forms each year and carry more leverage than some corporations.
These factors lead many investors to ignore MLPs when constructing their portfolios.
However, this asset class is appealing for a number of reasons and may deserve an allocation in your portfolio. Moreover, there are currently more than 100 publicly traded MLPs, meaning that there is plenty of opportunities to diversify and find attractively valued partnerships.
This article will discuss the advantages and risks of investing in master limited partnerships in great detail.
What Are Master Limited Partnerships?
A master limited partnership is a tax-advantaged corporate structure that primarily exists in the oil & gas sector. To a lesser degree, MLPs also exist in the real estate and finance sector. This is due to regulatory restriction – MLPs are only permitted to operate in these industries.
However, this was not always the case.
MLPs were created in 1981 to allow certain business partnerships to issue publicly traded ownership interests.
The first MLP was Apache Oil Company, which was quickly followed by other energy MLPs, and then real estate MLPs.
The MLP space expanded rapidly until a great many companies from diverse industries operated as MLPs – including the Boston Celtics basketball team.
Below, you can see a diagram showing the change in the sector concentration of MLPs over time.
Source: Master Limited Partnership Association ‘MLP 101’ Presentation, slide 20
One important trend that can be seen in the diagram above is that energy MLPs have gown from being roughly one-third of the total MLP universe to containing the vast majority of these securities.
Moreover, the energy MLP universe has evolved to be focused on midstream energy operations. Midstream partnerships have grown to be roughly half of the total number of energy MLPs.
Source: Master Limited Partnership Association ‘MLP 101’ Presentation, slide 21
MLPs are characterized by their binary ownership structure, composed of a general partner and one or more limited partners.
An MLP’s general partner is a separate corporate entity that controls the operations and decision-making of the MLP. This is primarily because MLPs do not have any employees – instead, they are holding entities that own assets to be operated by employees of their general partner.
The limited partners of an MLP are responsible for providing capital for funding the partnership’s operations.
Limited partners are individuals or corporations that purchase units of the MLP on the stock exchange and hold them for (hopefully) a profit.
It is very common for the general partner of an MLP to also have a limited partner stake, though sometimes the GP’s limited partner stake is very small (~2%).
Typically, an MLP’s general partner is a privately-held entity (though some general partners are publicly traded) while its limited partner units are traded on the stock exchange. The typical structure of an MLP can be seen visually below.
Source: Latham & Watkins LLP
An MLP and its general partner generally have very similar names. For instance, if ‘Sure Dividend Partners LP’ was the name of an MLP, then its GP would likely be called ‘Sure Dividend Holdings’ or ‘Sure Dividend GP Holdings’.
Investors can buy units (not shares) of MLPs exactly as they would for the common shares of a corporation – through their brokerage accounts. Just like stocks, MLP units have a ticker associated with them that are used to place buy and sell orders.
Another distinct characteristic of a master limited partnership is the existence of incentive distribution rights (or IDRs, for short).
Incentive distributions rights are rewarded to the general partners of a master limited partnership because the general partner assumes a disproportionate amount of the partnership’s downside risk at the outset. As a result, the general partner claims a larger proportion of the investment’s upside.
The benefit of incentive distribution rights is that they increase the proportion of cash flow that is distributed to the general partner as the per-unit distributions increase.
IDRs are based on a ‘Minimum Quarterly Distribution’, or MQD, that is specified by the MLP at its inception. The MQD is the initial distribution paid to the limited partners and is the basis for how IDR payments are calculated.
Increasing IDR payments are delivered to the general partner based on the MLPs ability to grow its per-unit distribution above the initial MQD. To get a sense of how IDRs are implemented, consider the following example:
Source: Master Limited Partnership Association ‘MLP 101’ Presentation, slide 38
So, as the MLP’s distribution increases, the proportion of its cash flow that moves from the MLP to the general partner increases from 0% to 50%, giving the GP incentive to help drive the MLP’s growth.
There are a number of requirements that a partnership must meet to retain its status as an MLP.
Most importantly, it must distribute at least 90% of its qualifying income (defined as the income from relevant business activities such as midstream energy transportation, real estate, or financing) to its partners.
The requirement of distributing the vast majority of its cash flow means that MLPs can have a hard time driving organic growth.
As a result, these partnerships often seek capital markets financing (both debt and equity) to acquire new assets and increase their distributable cash flow.
When the economy – particularly the oil economy – is booming, this is not an issue because MLP unit prices are high and issuing shares is a good way to raise capital.
It is during recessions that this growth strategy can be problematic. Issuing undervalued MLP units to acquire assets is a surefire way to destroy shareholder value.
Investors should also note that master limited partnerships make ample use of non-GAAP financial metric to paint a better picture of their financial situations. There are two main non-GAAP financial metrics that potential MLPs investors should familiarize themselves with.
The first is distributable cash flow. Distributable cash flow is used to assess how much cash per quarter is available to fund an MLP’s distribution. It is a very important metric used to assess the safety of an MLP’s distribution.
Distributable cash flow is derived from net income, after adding back depreciation and amortization and adjusting for other particular charges. We can see the differences between net income and distributable cash flow by looking at the financial reports of various publicly-traded MLPs.
One of the headline companies in the MLP space is Enterprise Products Partners (EPD), the largest MLP by market capitalization and also one of the most well-capitalized.
Here’s how Enterprise Products Partners defines their distributable cash flow.
“Distributable cash flow. We define distributable cash flow as net income or loss attributable to partners adjusted for: (1) the addition of depreciation, amortization and accretion expense; (2) the addition of operating lease expenses for which we do not have the payment obligation; (3) the addition of cash distributions received from unconsolidated affiliates less equity earnings from unconsolidated affiliates; (4) the subtraction of sustaining capital expenditures and cash payments to settle asset retirement obligations; (5) the addition of losses or subtraction of gains from asset sales and related transactions; (6) the addition of cash proceeds from asset sales or related transactions; (7) the return of an investment in an unconsolidated affiliate or related transactions (if any); (8) the addition of losses or subtraction of gains on the monetization of derivative instruments recorded in accumulated other comprehensive income (loss); (9) the addition of net income attributable to the noncontrolling interest associated with the former public unitholders of Duncan Energy Partners L.P. (“Duncan”), less related cash distributions paid to such unitholders; and (10) the addition or subtraction of other miscellaneous non-cash amounts (as applicable) that affect net income or loss for the period.”
Looking at the financial reconciliation between net income and distributable cash flow will help to further understand the meaning of distributable cash flow. We can look at another leading MLP’s financial statement for an example.
One candidate for this is Energy Transfer Equity (ETE), another very well-known MLP which is the parent company of the Energy Transfer family of oil & gas entities. The Energy Transfer family includes Energy Transfer Partners (ETP) and Sunoco LP (SUN), as well as other private entities.
Below, you can see the reconciliation between Energy Transfer Equity’s net income and distributable cash flow for the three months ended March 31, 2017.
The second major non-GAAP financial metric that is used by MLPs is the distribution coverage ratio.
This is a non-GAAP metric that portrays the sustainability of a partnership’s dividend and is calculated by dividing distributable cash flow by total distributions paid.
The higher a distribution coverage ratio, the better.
Because the net income of MLPs is so low thanks to depreciation and amortization charges, the traditional payout ratio (dividends divided by net income) is not useful, which is why the distribution coverage ratio is used.
Note that Energy Transfer Equity reported a distribution coverage ratio of 0.86x in the quarter, which means that – for this quarter – the MLP was paying an unsustainable dividend.
Before investing in an MLP, investors should take note of the regulatory risks of investing in these securities.
MLPs – particularly oil & gas MLPs – operate in a highly regulated industry, and depend heavily on approvals from agencies like the Federal Energy Regulatory Commission (FERC).
While the FERC has generally been quite supportive of oil & gas MLPs and these investment vehicles have not been meaningfully impaired by regulatory problems, any change on this front could have a significant and uncontrollable effect on the cash flows of oil & gas MLPs.
With that said, oil & gas MLPs tend to operate in the midstream subsector of the energy industry, meaning that they are in the business of transporting energy products from Point A to Point B.
Generally, midstream oil businesses are paid based on the volume of product transported, not on the price of the underlying commodity.
This creates an insulating effect and means that the financial performance oil & gas MLPs are generally less sensitive to changes in oil prices, though a prolonged downturn in commodity prices could impact their business as transportation volumes eventually decline.
Why Invest in MLPs?
There are three main reasons why an investor would invest in MLPs:
- Tax Advantages
Yield and diversification are discussed in this section while the tax implications of master limited partnerships have their own section below.
MLPs may be useful investments for investors looking to generate above-average dividend income because of their exceptionally high dividend yields.
For instance, the Alerian MLP ETF has paid the following distributions over the past twelve months:
Adding these distributions together ($0.92) and dividing by the ETF’s current price of $11.06 gives a TTM dividend yield of 8.3%.
For context, the S&P 500 has a current average dividend yield of 1.9%, meaning that the Alerian ETF has a dividend yield more than four times as high as the average yield in the S&P 500.
This is not an isolated phenomenon. The Alerian MLP ETF has consistently had a higher dividend yield than the S&P 500 over long periods of time.
As with any high yield securities, investors should perform careful due diligence to ensure that MLP distributions are sustainable. Chasing yield without studying payout ratios is one of the few surefire ways to destroy capital in dividend investing.
The safety’s of an MLP’s distribution can seen by looking at a partnership’s distribution coverage ratio, which – as mentioned earlier – is defined as the ratio between an MLP’s distributable cash flow and its total distributions paid.
A distribution coverage ratio above 1.0x means that the company is paying out less than its total distributable cash flow. These distributions are sustainable.
A distribution coverage ratio of exactly 1.0x means that a partnership is paying out precisely all of its distributable cash flow. These distributions are sustainable but should be watched closely.
Similarly, a distribution coverage ratio below 1.0x indicates that an MLP’s distribution is unsustainable. These distributions are not sustainable and should be watched very closely.
Sometimes, a company can experience a temporary downturn in its distribution coverage ratio without cutting its dividend. Qualitatively assessing the company’s financial reports and management conference calls can help determine the true danger of a distribution coverage ratio below 1.0x.
Distribution coverage ratios are often reported with the company’s quarterly financial release, but if not, are easy to calculate manually.
The high dividend yields of master limited partnerships have contributed to their strong total returns in recent years. Over ten and twenty year periods, MLPs have outperformed the other main U.S. asset classes (stocks, bonds, and Treasuries).
Note that in the above diagram, the longest-dated performance comparison starts in 1996, which is actually 15 years after the inception of the first MLP in 1981.
If we look at the performance of MLPs over a much longer time horizon, back to their inception in 1981, the performance of this asset class has not been as strong. If fact, MLPs actually trailed other asset classes that had much less inherent volatility.
The performance of MLPs from 1981 to 2013 can be seen below.
Over the entire time period of 1981 to 2013, energy MLPs only slightly outperformed U.S. bonds, delivering 8.5% annualized returns compared to 8.4% for domestic bonds. MLPs also underperformed U.S. stocks, with equities returning 11.2% per year and MLPs returning 8.5% per year.
This is largely due to a ‘lost decade-and-a-half’ that MLPs experienced between 1981 and 1995, a period that saw a prolonged energy slump that drove many MLPs out of existence.
Case-in-point: Of the 49 energy MLPs that were formed in the 1980s, only 4 exist in their original form today. 34 of these entities went bankrupt or were liquidated, merged, or restructured within ten years of their inception. Further, during the 1981-1995 time period in the table above, MLPs returned only 1.1% per year to their investors – a rate of return that was surely lower than the pace of inflation during that time.
The key takeaway here is that while MLPs have been a very good asset class to own over the past decade or so, this was not always the case and these securities are prone to poor performance over some time periods (just like all asset classes).
It is also important to realize that just because MLPs have high dividend yields does not mean that they will have high total returns.
More generally, the highest yielding dividend stocks are not necessarily the best-performing dividend stocks from a total return perspective.
In fact, over very long periods of time, the fourth quintile of dividend stocks (those with dividend yields in the 60th-80th percentile) have outperformed the fifth quintile of dividend stocks (those with the very highest dividend yields).
This trend can be seen below.
This data suggests that investing in only the highest-yielding master limited partnerships may be detrimental to overall portfolio performance.
Aside from their outstanding dividend yields, another unique characteristic of master limited partnerships is their low correlations to other, more traditional asset classes. This makes them an ideal source of meaningful portfolio diversification for individual investors.
Data on correlations between energy MLPs and other asset classes can be seen below.
There are three main takeaways from this correlation data.
First of all, MLPs have remarkably low correlations to low-risk securities such as U.S. bonds and U.S. Treasury bonds.
This makes sense. Energy MLPs distribute the vast majority of their distributable cash flow, leaving a very small margin for error if operations experience any sort of temporary trouble. In fact, it is common for energy MLPs to experience a temporary decline in their distribution coverage ratio to below 1.0x.
Accordingly, MLPs are seen as more of a ‘risk-on’ investment and move in sharp contrast to safe haven investments like bonds.
Secondly, MLPs have a relatively low (.28) correlation with the price of crude oil.
Given that roughly half of energy MLPs are in the midstream subsector which is relatively isolated to the price of the crude, this is not so surprising.
Thus, midstream MLPs (and midstream companies more generally) are an attractive way to gain exposure to the energy industry without assuming commodity risk.
Thirdly, the highest correlation between MLPs and any other asset class is seen with energy stocks. This is very unsurprising.
Within the energy sector, MLPs are the most highly correlated to Oil & Gas Storage & Transporation companies. This is shown below.
The next section discusses the tax advantages of investing in MLPs – which is one of the most compelling reasons to consider these securities.
Tax Implications of Master Limited Partnerships
The most important difference between investing in corporate common shares and investing in master limited partnerships is the tax implications of their dividends (or distributions, as they are called for MLPs).
Master limited partnerships are taxed in a way that is quite similar to privately-held limited partnerships, but MLPs trade on stock exchanges just like the common shares of well-known corporations like Johnson & Johnson (JNJ), Coca-Cola (KO), or Procter & Gamble (PG).
This means that MLPs do not pay tax at the organizational level.
Instead, the partnership’s taxes ‘flow through’ to the owners of their publicly-traded securities. MLPs also have different tax reporting documents. Some of the main tax differences between MLPs and corporations can be seen below.
Source: Master Limited Partnership Association ‘MLP 101’ Presentation, slide 42
Since MLP taxes ‘flow through’ to their unitholders, this avoids the double taxation that happens on traditional corporate dividends (paying corporate tax, and then paying personal tax on corporate dividends).
This, in turn, reduces the overall tax burden on both companies when taken together and allows for higher after-tax income.
For evidence of this, consider the following example of an MLP and a corporation that both have gross income per share/unit of $10.00 and corporate expenses of $7.50.
While more personal tax is paid on the MLP distribution ($.83 compared to $.31), less total tax (personal + corporate) is paid, which results in higher after-tax income for the same operating entity.
While this is a somewhat simplified example, it illustrates the main benefit of MLP investing – for every $1 of corporate revenue, more money is distributed to shareholders on an after-tax basis for entities that are operating as MLPs rather than corporations.
The downside to this superior passive income is the complications of MLPs come tax-time.
As mentioned, the cash payouts of master limited partnerships are not technically called dividends. Instead, they are known as distributions. Distributions are composed of various items which can be bucketed into two categories: returns of capital and net income.
Investors only pay current tax on the portion of an MLP’s distribution that represents its per-unit net income.
Since MLP’s incur significant non-cash amortization and depreciation charges lower GAAP net income, the partnership’s earnings-per-share is typically much lower than its distributions per share.
Around 20% of the typical MLP distribution is composed of net income.
The remainder of an MLP’s distribution is composed of return of capital, which lowers the cost basis of the MLP in an investor’s brokerage account. This means that no taxes are paid on return of capital distributions until the MLP units are sold.
To understand the effect of returns of capital on an investor’s cost basis as well as how much tax is paid on this portion of MLP distributions, consider the following example of an MLP that distributes $1.00 per unit (of which $0.20 is composed of net income and $.80 return of capital).
Note that for the sake of conservatism, the assumes the highest possible tax rate for both ordinary income (39.6%, before state tax) and long-term capital gains (20%).
$0.24 of taxes were paid on $1.00 in distributions. This tax is quite reasonable but would be much superior if the MLP was held for a longer period of time. This is due to the tax-deferred nature of taxes on return of capital distributions.
Investors should note that any meaningful change to the United States tax code could negatively effect the after-tax performance of master limited partnerships. Anyone with a significant stake in these entities should closely monitor tax changes, as any negative changes would likely result in a meaningful selloff in MLP securities.
In What Accounts Should I Hold MLPs?
MLPs are very tax-effective investments even when held in a normal, taxable investment account.
This leads many investors to have confusion about the best place to hold their MLP investments.
Unlike most investments, the best place to invest in a master limited partnership is in a taxable account.
Said another way, the existing tax advantages of investing in MLPs mean that there is minimal additional benefit to holding MLPs in a retirement account. There is far more benefit in using your retirement account to hold more traditional investments, such as dividend-paying common shares.
MLPs are also not subject to the normal tax favorability of being held in a retirement account.
When retirement plans conduct or invest in a business activity (including the ownership of an MLP), they must file separate tax forms to report Unrelated Business Income (UBI), and may owe Unrelated Business Taxable Income (UBTI). UBTI tax brackets go up to 39.6% (the top personal rate). UBTI can sometimes be generated from MLP investments.
MLPs issue K-1 forms for tax reporting. K-1s report business income, expense, and loss to owners. Therefore, MLPs held in retirement accounts may still qualify for taxes.
If UBI for all holdings in your retirement account is over $1,000, you must have your retirement account provider (typically, your brokerage) file Form 990-T. You will want to file form 990-T as well if you have a UBI loss to get a loss carryforward for subsequent tax years.
Failure to file form 990-T and pay UBTI can lead to severe penalties. Fortunately, UBIs are often negative. It is a fairly rare occurrence to owe taxes on UBI.
The bottom line is this: MLPs are tax-advantaged vehicles that are suited for investors looking for current income.
It is fine to hold them in either taxable or non-taxable (retirement) accounts. Since retirement accounts are already tax-deferred, holding MLPs in taxable accounts allows you to ‘get credit’ for the full effects of their unique structure and use your precious retirement account dollars for less tax-advantageous investments. Thus, non-taxable accounts are likely the best place to hold MLPs, although retirement accounts suffice.
Analysis of Master Limited Partnerships
The MLP Excel document at the beginning of this article provides a comprehensive list of publicly traded MLPs.
If you’re interested in more detailed analysis on individual MLPs, the following articles will be useful:
- The 10 Best MLPs for High Income
- Energy Transfer Equity: Undervalued MLP With A 7% Yield
- Buckeye Partners: Dividend Achiever Pumping Out A Secure 7.4% Yield
- Enticing But Unsustainable 14.1% Dividend Yield From This Energy MLP
- ONEOK Partners: Dividend Achiever MLP With A 6% Yield
- Holly Energy Partners: Dividend Achiever Pumping Out A 7.4% Yield
- TC Pipelines: 17 Consecutive Years of Distribution Growth And A 6.4% Yield
- By How Much Will Genesis Energy Raise Its Distribution In 2017?
- TransMontaigne Partners: High-Quality Dividend Achiever With A Secure 7.3% Dividend Yield
- Brookfield Renewable Partners: 6% Yield and Growth From Renewable Energy
- Spectra Energy Partners: 6% Yield and 38 Consecutive Quarterly Dividend Increases
- Should Income Investors Buy Into Alliance Resource Partners’ 7.8% Yield?
- EnLink Midstream Partners: 9% Dividend Yield And Potential For Dividend Growth in 2018