Master Limited Partnerships—Lessons from HistoryBy James J. Murchie

A reprinted article from March/April 2008

© 2008 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.

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MasterLimitedPartnerships—LessonsfromHistoryBy James J. Murchie

P ubliclytradedmasterlimitedpartnerships(MLPs)intheener-gyindustryareoneofthefastest

growingassetclassesinthestockmar-kettoday.Thisassetclassboastsmorethan70MLPswithacombinedmarketcapitalizationofabout$135billion,upfrom27MLPsin2002withamarketcapof$25billion.From2000through2007,investorsenjoyedacompoundannualreturnof22.7percent(AlerianMLPTotalReturnIndex)versus1.7percentfortheS&P500and16.4per-centfortheAmexEnergySelectIndex(IXE)(source:Bloomberg).TheseMLPscurrentlyyieldover7percent.Thequarterlyper-sharecashdistributionsthatmakeupthisyieldhavegrownabout8percentperyearoverthistime.MLPsponsors(privatecompanies,pri-vateequityfunds,utilities,andoilcom-panies)alsohavedonewell;bringinglegacyenergyassetspublicinanMLPwithahighpayoutratiohasgarneredahighermultiplethaniftheywerefloatedasaconventionalC-corporationwithamoretypical(i.e.,low)payoutratio.Moreover,thegeneralpartnershipinterestretainedbythesponsorhasthepotentialforhighgrowth.

Whileskepticsmayarguethatthissuccessismerefinancialengineeringandvaluationalchemy,forthemostpartrealvalueisbeingcreated.Thisvaluecreationisdrivenprimarilybyonefac-tor:thecapital-spendingdisciplinethatcomeswithahigh-dividendobligation,similartotheleveragedbuyout(LBO)effect.Thehighpayout—whichistax-deferred—hasthebenefitofshiftingalargeportionofthetotalreturntosteadyquarterlycashpayments,loweringthevolatilityandcovarianceofthereturns.Inspiteofthis,MLPshavenotyetat-

tractedsignificantinterestfrominstitu-tionalinvestorsbecausethepartnershipformofMLPscreatestax-filingobliga-tionsforinvestorstoeachstateinwhichtheMLPoperatesandanunrelatedbusi-nesstaxableincome(UBTI)liabilityfornontaxableentitiessuchasfoundationsandpensionfunds.Infact,incomefromMLPswasnonqualifyingincomeformutualfundsuntilthelawwasamendedin2005allowingupto25percentofamutualfund’sportfoliotobeinMLPs.

Atax-deferred7-percentyieldcombinedwithhighsingle-digitgrowth,lowvolatility,andlowcorrelationtootherassetclassesisanattractivesetofcharacteristics.Theseattributeshaveresultedfromyearsoftrialanderror.Areviewofthishistoryiscriticaltoun-derstandingMLPstructureandsuccess.

A Brief History of MLPs

ThefirstMLPwascreatedtoholdoilandgasassetsspunoutofApacheCorporationin1981whenoilpricesfirstreached$40perbarrel,upfromabout$12justafewyearsearlier.Backthen,individualmarginaltaxrateswere70percentandcorporatetaxrateswereabout45percent.High-net-worthinvestorswerepouringmoneyintooilandgasdrillingpartnershipsformedbyinvestmentbanks.Thiswasanerawithnosectorexchange-tradedfunds,fewsectormutualfunds,andonlyahand-fulofsector-specificunitinvestmenttrusts.Partnershipsweremoretaxef-ficientbecausedrillingexpensesandtaxcreditsrelatedtodrillingwerepassedthroughtoinvestorswhocouldusethecreditsandexpensestoshelterotherincome.Thereforefloatingapubliclytradedhigh-payoutoilcompanyintheformofapartnershipthatpaidoutall

availablecashflowmadesense.OtherscopiedApacheandformed

about25energy-relatedMLPsoverthenextfewyears.Othercompaniesinthepetrochemical,refining,paper,andforest-productindustriessoonfollowed.Butwhenlargenon-naturalresourcecompaniessuchasAllianceCapitalandtheBostonCelticsformedasMLPs,Congresswokeuptotherevenuelosspotentialduetoavoidanceofdoubletaxation.Inthe1987TaxReformAct,Congressrestrictedpubliclytradedpartnershipstorealestate,naturalresources,anddividendandinterestincomeandgavenonconformingMLPs10yearstoreverttoacorporatestruc-ture.TodaysomeinvestorsworrythatrecenteliminationofthetaxadvantagesforCanadianincometrusts(topreventmasscorporatetaxrevenueleakage)couldhappentoU.S.MLPs.Arguably,italreadyhappened—20yearsago.

ThecombinationofthechangeinlegislationanddecliningcommoditymarketstookatollontheMLPassetclass.MLPsdependentoncyclicalcashflowsgothurtbythefallinthepriceofcommodities(crudeoilfellfrom$40in1981to$10in1986)andbythelate1980svirtuallyallearlyMLPsinvolvedincyclicalcommoditybusinessescutdividends,suffereddramaticdropsinvaluations,andde-listed.ThefirstphaseofMLPhistory—let’scallitthe“pioneeringera”—wasending.

Thenextphase—let’scallit“nuclearwinter”—wascharacterizedbyinvestordistrustofanythingMLP.Survivorsofthisshakeoutwerehigher-qualityandconservativeMLPswhosecashflowsdidnotdependoncyclicalbusinesses.Com-paniessuchasTeppcoPartners,BuckeyePipeline,andLakeheadPartners(now

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EnbridgeEnergyPartners)dominatedthenext10years,untilthemid-1990s.Thesecompanieswerebasedonslow-growing,stablecashflowsthatescalatedwithinflationcomingfrompipelinesandstorageterminalsratherthanoilandgasproduction.TheprimaryholdersofMLPswereretailinvestorswhosawthemasbondsubstitutes.ThenRichKindercamealong.

KinderwasaregulatorylawyerwhorosetobecomepresidentandchiefoperatingofficerofEnron.Helostthebattletobecomechiefexecutiveofficer,soheleftthecompany.KinderandBillMorgancobbledtogethersomeinvestors.In1997theyboughtEnron’sinterestinanMLPcalledEnronLiquidPipelineCompanyandrenameditKinderMorganEnergyPartners(KMP).KinderlikedtheMLPstructurebecauseitranlikeaprivatepartnership,payingoutallcashflowtopartnersonaregularbasis.Andhelikedthatthequarterlycash-distributionobligationwasbackedbynoncyclicalfee-basedcash-flowbusinesseswithlowsustaining-capi-talrequirementsandmodestgrowth.Further,hetookadifferentapproachtorunningtheassetsthatEnronsawasacostcentertosupportitstradingdesk.Heranthemlikeabusiness.Hesawnu-merousde-bottleneckingopportunitiesthatEnronhadneglectedas“toolow-return.”Overthenext10years,Kindergrewthecompanybybuyingothersimilarlyneglectedenergyinfrastructureassets.Fromearly1997totoday,KinderMorgan’smarketcaphasgrownfrom$260millionto$17billionandquarterlycashdistributionshavegrownfrom16centsto88cents,acompoundannualgrowthrateof18.8percent.RichKinderusheredinthethirdphaseofMLPhisto-ry:the“growthMLP”era.Otherscopiedhisbusinessmodelandtodaythesecompaniesrepresentthehigher-qualitymembersoftheMLPassetclass.

Todaythetypesofbusinessescom-ingintoMLPsarefarmorevariedthaninthepast,andsomehavemorerisk.We’llvisitrisklater.Nowlet’stalkabout

whatmakesMLPsdifferentfromotherassetclasses.

MLP Distinguishing CharacteristicsPartnership Form

MLPsarepubliclytradedpartnerships.Theytrade,settle,andclearjustlikeotherC-corporationstocks.EnergyMLPstodayhaveacombinedtradingvolumeofabout$250millionperday(source:Bloomberg).AnMLPinvestorreceivesaK-1eachyearandmayhavestatetax-filingrequirementsinallofthestatesthattheMLPoperatesin.Thepartnershipstructurehasbeenanentrybarrierforlargeinstitutionalnontax-ablebuyersbecauseitgeneratesUBTIandstatetax-returnrequirementsthatdetermanywould-beMLPinvestors.Solutionstothistaxhavearisen,buttheytoohavedrawbacks.Forexample,somefundmanagerssetup“blocker”corporationsthatkeepstatetaxorUBTIobligationsfrompassingthrough.How-ever,thisapproachaddsalayeroftax.TheMLPclosed-endfundslaunchedin2004aremutualfundsthatpaytax.Inanotherapproach,offshoreinvestorsinvestinMLP-focusedhedgefundsthatholdMLPsintotal-returnswaps.Funds-of-fundshaveembracedthisapproach,butsomeinstitutionalinvestorsareun-comfortablenowthattheIRShasdisal-lowedswapsonassetsheldforoffshoreaccountsthatitdeemsaresetupsolelytoavoidwithholdingtax.Onefundthatwemanage,bycontrast,hassetuparegisteredinvestmentcompany(RIC)asablockerthatdoesn’taddalayeroftax.Mosthedgefundmanagersdon’twanttolivewiththeconstraintsofaRIC,butthoseconstraints,suchaslimitsonleverageandtheneedtoretainaninde-pendentboardoftrustees,areexactlywhatmanyinstitutionalinvestorsseektoensurepreservationofcapital.

High Payout Ratio Means Capital-Spending Discipline

ThemostattractivecharacteristicofMLPsistheirhighpayoutratio.Allthelimitedpartnershipagreementsstate

thatcompanieswillpayoutallavail-ablecasheveryquarterlessareservethatmanagementdeemsappropriatetomaintaintheassets.Thishastwosignificantbenefits.First,capital-spend-ingdisciplinecomesfrompayingoutsuchalargeportionoffreecashflow,similartotheLBOeffect.Thesecond,discussedbelow,isthatyieldmakesupalargeportionoftotalreturn,reducingbothvolatilityandcovarianceoftheshares’totalreturn.

Matureindustriessuchastheenergyindustrygrowabout1percentto2percentperyear,yettheyearnreturnsoncapitalinthehighsingledigits.Toomanycompaniesreinvestallcashflowgeneratedbythesereturnsinthemistakenbeliefthattheycangrow8percentto10percentperyeareventhoughtheindustryisgrowingonly1percentto2percent.Historyshowsusthatmostofthesecompanieswilldisap-pointandthatthewinnersarecompa-niessuchasExxon,whichhavepaidoutanaverageofmorethan50percentofearningsindividendsandsharebuy-backs,andMLPsandroyaltytruststhathaveamandatetopayoutallavailablecasheveryquarter.AstheoilanalystatSanfordBernsteinintheearly1990s,Ipublishedareportonthisrelationshipandfoundacorrelationofabout85percentbetweentheportionoftop-linecashflowreinvestedandunleveredre-turnoncapitalemployed forthemajorintegratedoilcompanies.Updatingtheanalysis10yearslaterfortheAMEXOilIndexhadthesameresults.Inmature,capital-intensiveindustries,wherecom-paniesdotheirbestprojectsfirstandtheirworstprojectslast,itmakessensethatthehigherthereinvestmentrate,thelowertherelativereturns.

ButhowhaveMLPsgrownper-sharedistributionsiftheypayoutalltheircash?Theansweristhattheymustraisenewcapital.Sowhenthecom-panyseesanopportunitytomakeanaccretiveacquisitionorinvestinalargeaccretive-growthprojectsuchasapipe-lineextension,thecompanycanissue

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newstockandnewdebt.Thisgivesthecapitalmarketsachanceto“approve”theproject.ItwouldbedifficultforanMLPtoraisecapitalfromitsyield-hun-gryretireesforadilutiveacquisitionthatwouldcausethequarterlydistribu-tiontobecutonthepromiseofrisinginthefuture.Inmaturenoncyclicalindustries,ifabusinessisnotprofitablenow,whenwillitbe?

Energy Infrastructure

Basedonthemarketvalueofassetsem-beddedinmidstreamMLPs,IestimatethevalueofenergyinfrastructureassetsinNorthAmericaatbetween$500bil-lionand$1trillion.ApipelinemapofNorthAmericalookslikeahighwayandrailroadmapthatincludeslocalroadsinhydrocarbonproductionareassuchasTexas,Louisiana,andOklahoma.Thesepipelinesoperateliketollways,collect-ingtariffsonthemovementofcrudeoil,gasoline,dieselfuel,propane,natu-ralgas,etc.frompointsofproductionorimporttopointsofconsumption.Storageandterminalingareassociatedwithallthesemovements.Withfewexceptions,theseservicesareprovidedforafeethatisbasedontheoperatingandcapitalcostsofserviceandnotonthecommodityprice.Forinterstatepipelines,thesereturnsareregulatedandoftenhaveaninflationescalator.

TheMLPassetclasshasgrownthroughtheacquisitionoftheseassetsfromoilcompanies,pipelinecom-panies,utilities,andprivateowners.Recently,however,theneedtoinvestinnewinfrastructurehasbeguntodominatemidstreamMLPs’investmentactivities.Thisneedcomesafteralongperiodofunderinvestment.Petroleumdemanddeclinedforfiveyearsstraightfromits1978peakduetorecession,conservation,andsubstitution.Growthresumedin1984buttheoldhigh-wa-termarkofdemand(about20millionbarrelsperday)stooduntil2003–2004,usheringintheneedfornewinvest-ment.Inaddition,thematurationofhydrocarbon-productionareassuchas

theshallow-waterGulfofMexico,andtheirreplacementbyonshoreresourceplayssuchastheBarnettShaleintheFortWorthBasin,theRockyMoun-tains,andtheCanadianOilSands,hastriggeredtheneedformassiveinvest-mentinnewpipelines,storagefacilities,andterminalstodeliversupplyfromnewproductionareas.

Thestabilityofcashflowsandthelowsustaining-capitalrequirementsofthepipelineandstoragebusinessesmakethemanidealfitwiththeMLPassetclass.Butthereisanotherat-tributeoftheinfrastructurebusiness:it’salsolikesellingpickaxestominers.EveryoneknowsaboutLeviStrausssellingbluejeanstotheforty-ninersandHowardHughessellingdrillbitstowildcatters.Minersareoptimistsholdingoutforhomeruns.Theythinkpipelinetransportationoperatorsandotherserviceprovidersaresuckersforacceptingpaltry10-percentto12-per-centreturnsoncapital.Butwiththeadditionofconservativeleverage,an11-percentreturnonassetscanbea15-percentreturnonequity(assuming50-percentdebt-to-capitalanda7-percentborrowingcost).Well,signmeuptobea15-percentsucker.

Partnership Structure: Limited Part-ners and the General Partner

MLPsarecreatedfromexistingassetsownedpubliclyorprivately.Usually,thesponsoractsasthegeneralpartnerandusuallyretainsabout20percentto50percentoftheshares.Afterthepioneeringeraanditsmanyfailures,newMLPinitialpublicofferingsmetwithskepticismregardingthesafetyofquarterlycashdistributions.Inresponse,

sponsorssubordinatedtheirunitstothepubliclyheldcommonunitswithrespecttoreceivingquarterlydistributions.ThusforanewMLPinwhichthesponsorretaineda50-percentstake,cashflowscoulddropbyhalfbeforedistributionsofthepubliclyheldcommonunitswouldbeatrisk.Asthesubordinationstructurefoundsuccessinaskepticalmarket,generalpartnersbegangettingagrowthincentiveinreturn,knownasincentivedistributionrights(IDRs).IDRsarearisingprofitshareonincrementalper-sharedistributions.Atfirst,thegeneralpartners’profitshareisjust2percentwithnoIDRs,butasper-sharedistribu-tionsriseby15percent,25percent,and50percent,theIDRsriseaccordinglyuptoa50-percentprofitsplit.

Manywouldarguethata50-percentsharingofincrementalfreecashflowisexcessiveandactsasalargetaxongrowth.Whilethiscriticismhasmerit,theIDRshaveactedasapowerfulincen-tivethathasrewardedthelimitedunitholderswithhighsingle-digitgrowthinadditiontotheiryield.Also,inresponse,afewMLPshavecappedIDRprofitsplitsat25percent.OthershavecomepublicwithouttheIDRsbutalsohaveeliminatedthesubordinationfeature.Whilenoonelikespayinganexcessiveshareofprofitstomanagementjustfordoingitsjob,MLPinvestorsnowhavenumerousopportunitiestoreceivethesepaymentsthemselves:Thegeneral-part-nerinterestsof10MLPsarepubliclytradedasseparateentities.Theseentitieshaveextraordinarygrowthcharacteris-ticsduetothearithmeticofa2-percentaverageinterestinprofitgrowingbya50-percentincrementalinterestinprofitgrowthintheunderlyingMLP.Bymy

“ Thestabil i tyof cashf lowsandthelow

sustaining-capital requirementsof thepipe-

l ineandstoragebusinessesmaketheman

ideal f i t with theMLPasset class.”

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estimate,general-partnerinterestsaregrowingper-shareflowsatabout2.4timesthegrowthrateoftheirrespectiveMLPunits.

Tax Efficiency

Partnershipsdonotpaytax,sodoubletaxationofprofitspaidoutindividendsisavoided.Butjustasimportant,MLPquarterlypaymentsaretreatedasdistri-butionsofcashoutofthepartnership.Thesecashdistributionsarenottaxableperse.Instead,theylowerthetaxcostbasisofaninvestor’sunits.Forexample,imagineaninvestorpays$40foranMLPwitha65-centquarterlydistribu-tion($2.60peryear).Mostofthisdivi-dendwillbedeemedreturnofcapital.If$2.00ofthe$2.60isreturnofcapital,thecostbasiswillgofrom$40to$38inthefirstyear,to$36inthesecondyear,andsoon.Theinvestorwillowetaxonthedifferencebetweenthislowerbasisandhiscost(calledrecapturetax),butthattaxisdueonlywhensharesaresold.Forlong-terminvestors,thepres-entvalueofthattaxliabilityissmall.

Performance, Volatility, and Covariance

Aspreviouslymentioned,returnsforMLPshavebeenveryattractiveonaverage.Assumingnomajorchangeinyield,MLPshaveexpectedfuturetotalreturnsapproximatingyieldplusgrowthinquarterlycashdistributions.Thisannualgrowthhasaveragedabout7percenthistorically,drivenbyvolumegains,returnsoninvestmentfromnewprojects,andaccretiveacquisitions.Recentgrowthhasbeenashighas13percentannually,butItendtothinkthat6-percentto7-percentannualgrowthismoresustainable.

AnnualizedmonthlyvolatilityofmidstreamMLPs(asmeasuredbytheWachoviaMidstreamMLPIndex)overthepast10yearshasbeen14.1percent.Overthisperiod,theS&P500monthlyvolatilitywas14.7percent,thePhiladel-phiaUtilityIndexwas17.1percent,andtheAMEXOilIndexwas20.1percent.

TheMidstreamMLPIndexhas31membersnow,but10yearsagotherewerefewerthanninenames,whichwouldhaveincreasedthevolatility.

Table1illustratesthecovarianceofenergy-relatedMLPswithotherassetclassesfrom1990to2003(recessiontorecession).

ThenearlynonexistentrelationshipbetweenMLPsandinterestrates(asmeasuredbythe10-yearbenchmark)issurprisingtomanywhoassumethat,asabondsubstitute,MLPswouldmovewithinterestrates.Buttwofactorsdrivethisnoncorrelationandareinstruc-tiveinunderstandingcovariancewithallotherassetclasses.First,interestratesoftencanmoveoppositeofcreditspreadsandtheresultinginvestorap-petiteforstocksversusTreasuries.Indeed,thishasbeenthecaseoverthepastsixmonthsandwasthecasefrommid-2003tomid-2007,wheninter-estratesrosefromunder3.5percenttoabout5percentyetcreditspreadsnarrowedasinvestorsmovedmoneyfromsafehavensintoriskierassetssuchasequities.Second,thecorrela-tionsaboverepresentthecovarianceoftotalreturns.BecausethebulkoftotalreturnsfrombondsandabouthalfthetotalreturnsfromMLPsaremadeupofsteadycashpayments,whichhaveacorrelationtoanythingofalmostzero,theresultingcovarianceofactualtotalreturnsislow.SomeMLPfundmanag-ers,however,hedgeexposuretointerestratesbyshorting10-yearbondsorbondfutures,despitecostandlackofbenefit.

A Final Thought

Survivorshipbiasisacommonprobleminanalyzinghistoricaldata.Butwhosurvivesandthrivesandwhodoesn’t

isanessentiallesson.Naturalselec-tioncreatesagroupofcompaniesthatbenefitedfrommistakesofthepast.ThisselectionprocesshascreatedanddemonstratedthesuccessofMLPsthatarenoncyclicalinfrastructurebusiness-eswithlowsustaining-capitalrequire-mentsandacorporatestructurethatpaysoutmostoralloffreecashfloweveryquarter.

Yetinthepasttwoyears,24newMLPshavegonepublic,14inoilandgasproduction,refining,oilservice,orshipping—allcyclicalbusinesses.Butcyclicalityisn’ttheonlyconcern;soissustainingcapital,andsustainingcapitalisabignumberforoilandgasproducers.Oilandgasproductionisthebusinessofdrainingnaturalreservoirs.It’sdifficulttomatchupalong-termdividendobligationwithadecliningas-setembeddedinacompanythatwilldonoexplorationdrilling.

ThesenewMLPs,ofcourse,havenonegativeimpactonthelegacyMLPs,theyjustincreasetherisktoan“index”buyer.Anindexbuyerwillmistakeas-cribingsuccesstotheentireassetclassratherthanthebusinessmodel.JustbecauseanenergycompanyisanMLPdoesnotmakeitagoodcompany.Onlygoodmanagementcanmakeagoodcompany.Agoodinvestmentisagoodcompanyintherightassetclass.

James J. Murchie is founder and chief executive off icer of Energy Income Partners , LLC, which manages funds that invest in energy master limited partnerships , income trusts , and other energy-related securities . He earned a B . A. f rom Rice University and an M. A. from Harvard University. Con-tact him at jmurchie@energymlp.com.

TABLE 1: COVARIANCE Of ENERGy-RELATED MLPs wITh OThER ASSET CLASSES, 1990–2003

Asset Class Beta R-squared

10-year u.S. Treasury 11% 4%

S&P 500 22% 3%

S&P Oil and Gas Producers 38% 9%

© 2008 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.

© 2008 Investment Management Consultants Association. Reprinted with permission. All rights reserved.IMCA® and INVESTMENT MANAGEMENT CONSULTANTS ASSOCIATION® are registered trademarks of Investment Management Consultants Association Inc. CIMA®, CERTIFIED INVESTMENT MANAGEMENT ANALYST®, CIMC®, CPWA®, and CERTIFIED PRIVATE WEALTH ADVISOR® are registered certification marks of Investment Management Consultants Association Inc. Investment Management Consultants Association Inc. does not discriminate in educational opportunities or practices on the basis of race, color, religion, gender, national origin, age, disability, or any other characteristic protected by law.

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