Not many asset classes bested the Standard & Poor’s 500 index’s 28.7 percent gain last year, but master limited partnerships did -- and by a wide margin. The Smith Barney MLP composite index reported a 47 percent total return in 2003. For the ten years ended December 31, MLPs posted robust average annual gains of 17.3 percent, versus 10.9 percent for the S&P. They also outpaced ten-year Treasury bonds during that period by an average of 285 basis points a year. Through the end of March, MLPs were up 5.3 percent, compared with a 2.7 percent gain for the S&P 500.
MLPs are publicly traded limited partnerships, most of them tied to the energy industry. Created by Federal tax law to encourage private sector investment in the infrastructure needed to meet America’s growing energy demands, energy MLPs own oil and gas pipelines, terminals and storage facilities.
There’s one catch. Like real estate investment trusts, MLPs generally pay out more than 90 percent of their annual cash flow in distributions to their general and limited partners. Investors, however, can defer paying taxes on most of that money until they sell their shares. That’s because investors are only liable for the net income portion of a distribution. MLPs generally have enough depreciation and depletion credits to allow them to defer taxes on 85 percent of a distribution on average until the units are sold. These days MLPs are yielding about 6.5 percent, compared with a historical average of 7.9 percent.
MLPs boast a total capitalization of $41 billion, up from $27 billion at the end of 2002 and a dramatic increase from $5 billion in 1997, according to Dallas-based consulting firm RBC Capital Markets. The leading MLP: Houston-based Kinder Morgan Energy Partners, with a market cap of $8.4 billion. The No. 2 and No. 3 players are Houston-based Enterprise Product Partners, which has a market cap of $5 billion, and GulfTerra Energy Partners, also in Houston, with a market cap of $2.5 billion. Enterprise and GulfTerra are expected to merge by the end of the third quarter, keeping the Enterprise name.
Investors are attracted to MLPs in part because they have a low correlation to publicly traded equities -- just 0.34 on a scale where 1.0 is perfect and zero means no correlation at all, according to RBC. That compares with a correlation of 0.28 for REITs. MLPs have also outperformed oil stocks; the American Stock Exchange oil index of 13 major companies returned an average annual 8.4 percent for the ten years ended December 31, 2003, versus the MLPs’ 17.3 percent.
“Any time you can put something in your portfolio that has a higher return than equities, less risk and is not correlated, that is something you want,” says Malcom Day, a portfolio manager at Eagle Global Advisors, a Houston firm with $600 million in assets, including MLPs. “People are beginning to recognize MLPs as a separate asset class because of the diversification benefit.”
Adds William Manias, chief financial officer of GulfTerra: “MLPs have provided investors with impressive total returns. They have similar yield characteristics to a bond, but the liquidity and capital appreciation potential of a publicly traded stock.”
Traditionally, MLPs have been a retail product. Most institutional investors have steered clear of them, in part because they are liable for taxes on partnership dividends when the investments generate unrelated business income, which is taxable. Retail investors are not affected by this wrinkle.
In the past few years, MLPs have been growing through acquisitions as major energy producers have shed assets to focus on their main business lines: exploration, refining and distribution. For example, in April 2003, Tulsa, Oklahomabased Magellan Midstream Partners, a $1.5 billion-market-cap MLP, paid $1 billion for the 6,700-mile refined petroleum products pipeline of Williams Cos.
More deals are, well, in the pipeline, says Don Wellendorf, president and chief executive officer of Magellan. “There will be a lot of assets for sale in the coming year or two,” he predicts. “Majors will continue to focus on their core competencies.”
MLPs took off after Congress passed the Tax Reform Act of 1986, which cut the top marginal tax rate for individuals to a level below that paid by corporations. The legislation offered such powerful incentives to create MLPs that many corporations (among them the Boston Celtics and Motel 6) converted to partnerships to qualify for the tax break. To prevent such maneuvers Congress passed the Revenue Act of 1987, which stipulated that only companies in the business of developing natural resources -- oil, gas, timber and minerals -- could claim tax-exempt status. Non-energy MLPs must pay taxes equivalent to 3.5 percent of gross income.
Investors in MLPs must keep an eye on the general partner incentive distribution agreement. The general partner is the company that manages the assets, receiving a fee for its services. On average some 15 to 20 percent of distributions goes to the general partner, with a sliding scale based on the level of payouts. Many MLPs pay out 50 percent above a certain level. Kinder Morgan, for example, paid out $2.63 per unit in distributions in 2003, with about 40 percent going to the general partner. That’s because the MLP has established a particularly generous sliding scale: Above 94 cents per unit, the general partner receives 50 percent.
“I don’t think there is any need for investors to give up half the cash flow to somebody else who buys the properties and manages them,” says Kurt Wulff, a former Institutional Investor All-America Research Team energy analyst, who now runs his own research firm, Boston-based McDep Associates. “It’s a pretty high cut.”
Not every MLP is as generous to its general partner. Enterprise Product Partners caps its distribution to management at 25 percent. General partners receive 25 percent of the cash above $1.23 per unit, and 75 percent goes to the limited partners.
Meanwhile, other MLPs are following suit. Valero announced in March that it would lower its cap from 50 percent to 25 percent. And GulfTerra, which currently pays its partners 49 percent above $1.70 in distribution per unit, will adopt Enterprise’s payout structure if the merger with Enterprise goes through.
“That will allow us to distribute more of the cash flow to the limited partners,” says GulfTerra CFO Manias. And, presumably, sell more partnership shares to potential new investors.
Sticky assets in sticky times
Things could be worse. During the first quarter of this year, scandal-tarred MFS Investment Management, the U.S.'s tenth-largest fund complex, with $79 billion, saw net outflows of $1.2 billion, according to Financial Research Corp., a Boston-based fund industry research firm. A billion dollars is nothing to sneeze at, but it’s far less than the $7.9 billion that poured out of another besmirched fund giant, Putnam Investments, over the same period, or the $6 billion that departed tainted Janus Capital Group.
All three fund companies have recently been key targets of state and federal inquiries into improper trading practices. In February, MFS made a Securities and Exchange Commissionapproved deal with state regulators, including New York State Attorney General Eliot Spitzer, in which the mutual fund company agreed to pay $225 million in penalties and cut its management fees by $125 million over five years to settle charges of improper trading practices. A few months later MFS shelled out an additional $50 million to settle SEC charges related to the company’s use of fund assets -- commissions on mutual fund transactions -- to pay brokerage firms to distribute their funds.
The quarterly fund flows weren’t an aberration. Since the industry’s regulatory problems began last September, MFS’s net outflows have totaled just under $1 billion, compared with $29 billion for Putnam and almost $14 billion for Janus. Of course, other issues, such as performance, affect investors’ decisions to deposit or withdraw money.
Putnam, the country’s sixth-largest fund company with retail assets of $157 billion (it manages another $70 billion in institutional assets), has already settled charges of market timing and late trading with the SEC, and $81 billion-in-retail-assets Janus, the ninth-biggest fund company, recently settled with federal and state regulators over improper trading.
Why is MFS faring better than its two rivals? Says chairman Robert Pozen, “When I went out on the road to meet with the brokers who sell our funds, hundreds would show up at these lunches, and I kept hearing the same thing: ‘We like MFS, we like its culture, so we will give you the benefit of the doubt.’”
Others confirm that MFS is benefiting from long-standing ties to the intermediaries who sell its funds. “MFS for whatever reason is a brand that the intermediaries are standing behind,” says Avi Nachmany of New Yorkbased fund industry research firm Strategic Insight. “Having very good relationships with key gatekeepers is a big part of it."-- Rich Blake
