Many asset owners take considerable time and effort in building lists of stocks which they wish to have excluded from their portfolios. Investment managers (like Realindex) implement their investment strategy using these lists as universe exclusions, position restrictions or exposure restrictions. Examples might include:
maximum exposure to scope 1 and 2 carbon emissions,
no buy restrictions for substantial or strategic holdings, and
Investment managers may also potentially have self-imposed lists of exclusions or restrictions. For example, Realindex excludes all tobacco and cluster munitions stocks (as defined by the GICS “tobacco” sector 302030 and by the UN Convention on Cluster Munitions).
One common asset owner exclusion list is that of Master Limited Partnerships (MLPs). These stocks have a certain corporate and investment structure that can make them undesirable in client portfolios. This note aims to:
define what MLPs are,
outline the size and shape of the MLP universe, and
discuss what might make them undesirable.
Realindex is currently evaluating whether to exclude MLPs from our investment universe, extending our exclusion of private partnerships. The rationale for exclusion (or inclusion) are discussed below but in summary:
MLPs have been structured historically as an advantageous tax structure for US tax payers. The tax benefits for non US-tax payers are non-existent.
Governance is such that MLPs do not give shareholders the same rights as normal corporations.
Index providers (like MSCI) explicitly exclude MLPs from their universes as they are not sufficiently “equity like”1.
As noted, some clients have explicit exclusions of MLPs, and as Realindex is formalising its approach to exclusion as well we thought a brief discussion of them would be useful.
Structure of Master Limited Partnerships (MLPs)
Master Limited Partnerships (MLPs)2 are not well known corporate entities in Australia, but are fairly common structures in the US3. There are also a few examples in other equity markets which have similar structures and so potentially fall under the same definition. In the US, MLPs can also be known as Publicly Traded Partnerships (PTPs), although the term “PTPs” can also include a slightly broader category of firms which choose to be taxed like an MLP.4 Third party data providers (like FactSet) provide a data feed which classifies MLPs.
The MLP legal structure is an aggregate of partners rather than a separate corporation. Units rather than shares are issued, and are publicly traded. An MLP structure is fairly simple:
A Sponsor forms the MLP and contributes the initial assets. In return they receive incentive distribution rights (IDRS), which yield a proportion of the MLP’s distributions. This proportion increases as revenue increases.
The Sponsor appoints a General Partner (GP) to run the MLP.
Limited Partners (LPs) (unitholders) are invited to contribute capital (that is, to own units).
The MLP owns the assets through operating subsidiaries.
The diagram below outlines this structure 5:
This means that two types of partners exist - general partners and limited partners. The general partners make the day to day investment decisions for the business, and are compensated on this basis. Limited partners contribute capital and benefit from the investment outcomes (like shareholders in a corporation) in terms of any capital gains, distributions and tax benefits. In this way, limited partners can be thought of as “silent” partners. General partners can own units in the MLP, but are more heavily incentivised based on the business outcomes.
History, classification, current size and number
The first MLP arose when Apache Corporation formed Apache Petroleum Company (APC) in 1981. This listed vehicle was constructed as an aggregation of existing drilling partnerships into a single entity, to give investors in the vehicle the benefits of the liquidity of a traded security, while at the same time offering the tax benefits that arise from a partnership.
Prior to that time, the world had been experiencing high oil prices following the crises of 1973 and 1979. During the period from 1979 to 1981, US Presidents Jimmy Carter and Ronald Reagan enacted legislation to remove price controls on oil products, which opened up oil production markets in an attempt to lower prices. OPEC decreased production from 1981 to 1986, in an attempt to keep prices high.
The Apache entity traded from 1981 to 1987. During that time, oil prices halved, and then collapsed following a breakdown of the concerted OPEC actions. Production soared and oil prices fell to a low of about $10.40 in March 1986, from a high of nearly $40 in July 1980. In 1987, following this collapse, Apache Corp offered to exchange the APC units for any of three listed corporations (include Apache Corp itself) and the structure ceased to exist.6
The growth of MLPs from this beginning was steady but not spectacular. One limiting issue concerns revenue sources. Following a period when many businesses chose this structure, US statutes were enacted which limited MLPs to businesses which earned more than 90% of their revenue each year from qualifying sources7. These sources are transport, processing, storage and production of natural resources and minerals.
|Other Natural Resources||1.0%|
|Real Estate Properties||3.0%|
|Midstream: Non Marine||72.0%|
Currently, the industry body (the Energy Infrastructure Council or EIC) lists 94 PTPs trading on US exchanges8. Of these, 80 are MLPs (as defined by US statute) and 14 are in Real Estate, Investment/Financial and Other Businesses. The largest MLP is Houston-based Enterprise Products Partners (EPD-US) at a market cap of USD 43.2bn (at 16 June 2020), providing pipeline, refining and storage for natural gas and petrochemicals.
The sub-sector Midstream: Non Marine is by far the largest. These are MLPs which own the land-based assets used for the transport of oil and gas from upstream (production) to downstream (consumption). Most of these are pipeline assets, but they can include rail or trucking. These MLPs act like a toll road - extracting a fee for the volume of flow between upstream and downstream. This means that their values are highly susceptible to changes in the supply and demand of oil and gas within the US.
The largest market capitalisation based index providers (MSCI, FTSE and S&P) do not include MLPs in their universes, unless these entities choose to be taxed as corporations. (S&P does offer specific MLP indices however; for example, the index SPMLP measures the aggregate performance of energy and gas MLPs which trade on the NYSE or NASDAQ.)9
Ownership of MLPs can be desirable for tax-effective income generation, although the tax benefits are largely applicable only to US domiciled entities or individuals. It seems that they are not widely held outside the US; one reason for this is that a withholding tax of the top marginal tax rate is applied10. Despite this, and although exact ownership data which shows the domestic/international split is difficult to find, there is some suggestion that up to third of owners are foreign11.
There is substantial discussion within the industry that the opportunity set for MLPs may be declining, and the structure has lost its appeal12. Further, recent significant reduction to US corporate tax rates have made investment in MLPs less attractive from a tax perspective13 and has led to many MLPs:
converting to normal corporations (examples include Antero Midstream (AM-US) and Enbridge (ENB-US)). A recent speech by the EPD CFO suggested that the MLP structure conversion to a normal corporation (called a C Corp in the US) may be inevitable, even for this, the largest MLP.14
changing their corporate structure so that they are taxed as corporations (TallGrass (TGE-US) merging with its general partner Tallgrass Energy).
being acquired by other corporations or private equity, or merged (Equitrans Midstream Corporation (ETRN-US) acquiring EQM Midstream (EQM-US)).
Despite this, we can still see that there is a very wide spread of institutional and insider ownership among the top 70 MLPs by market capitalisation:
ETFs and the Alerian Index15
Alerian is an MLP and energy midstream index provider. Its primary MLP index (AMZ and AMZX) comprises 32 liquid MLPs with an aggregate market cap of USD166bn (at 16 June 2020). Alerian has its own series of Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs) based on this index, the largest of which is AMLP with a market cap of approximately USD3.9bn16. The index and ETF values have had fairly poor capital gain, especially recently, although yields remain strong compared to returns on official cash rates. With the dramatic oil price selloff during the COVID-19 crisis and the OPEC-Russia oil dispute, MLPs (which are mostly midstream) have been very heavily sold down. The chart below 17 shows this recent move as well the price of AMLP over the last 5 years. Note that the recent improved performance has coincided with the oil price rebound.
The selloff from the start of 2020 became very sharp in early March, falling almost 30% on March 9 in step with falls in global oil prices.
Positives and negatives - Tax, Liquidity and Governance issues
While there may be benefits in terms of liquidity and tax effectiveness, one primary reason is complexity of tax compliance, especially for those who are not US-domiciled18. Probably more importantly for Australian super funds clients, there are questions around governance and transparency which can make these vehicles much less attractive.
Among the positives, cash yields from ownership are very high. The Alerian MLP index currently shows a cash yield of nearly 11%, compared with US REITS (3.9%) and US Utilities (3.7%).19. (It should be noted that this reflects the recent selloff in these stocks.) Combined with tax benefits to this income (see below), this makes these vehicles very attractive for yield seeking institutions and individuals.
The significant tax benefit available to US-based investors in MLPs arises from the proportion of the distribution that is a “return of capital”20. This return of capital is not taxed immediately, so the after-tax distribution is much higher than it would be for an equivalent corporation. It is worth noting under various US retirement account laws (e.g., 401(k)), or for foreign domiciled investors, this benefit may not be available.
Lastly, on the positive side, the listing of MLPs on publicly traded venues like the NYSE make the benefits of the partnerships structure available in a liquid setting. This liquidity can be a significant benefit to investors.
The main negatives relate to transparency of operations and governance that arise from the lack of the usual corporate structure21. For example:
The General Partner controls the MLP and is wholly owned by the sponsor.
The board is appointed by the sponsor and does not need to be majority independent.
The Limited Partners do not elect board members and in fact have limited voting power on any issue.
Conflicts of interest can arise, including around allocation of business opportunities and expense allocation.
More conventional corporate structures allow individual unit holders significant rights regarding board membership and decision making. Many MLPs do not allow this and so may not meet minimum governance standards for universe inclusion on this basis alone.
Lastly, unlike in a corporation, there is no fiduciary duty owed by general partners to limited partners, which can act as a significant deterrent to investment. This has been mitigated somewhat in recent years by having new MLPs domiciled in the US state of Delaware. Under Delaware law, certain corporate fiduciary duties like duty of care can be applied to make the relationship more “fiduciary like”.22
It is clear that MLPs are considerably more complicated than this short note can hope to address. References given below can help this shortfall for those readers interested. We do not intend here to speak for or against investment in MLPs, we simply aim to provide some background and context on a long standing decision for many Australian super funds to exclude them from investment universes. Investment characteristics appear to be good from the point of view of liquidity, distributions and selective tax effectiveness; however, the significant drawbacks due to governance structure, structural complexity and lack of transparency may preclude them from universe inclusion.
Third party research notes:
This note is primarily for information. It discusses ideas drawn from a variety of market sources on topics that are of interest to both Realindex and our clients.↩
Modified version of a chart from https://eic.energy/uploads/VE-MLP-Primer-Brochure_AE18-042318.pdf↩
Section 7704 of the US Federal Tax Code↩
https://eic.energy/uploads/MLPsOnExchanges_01032020.pdf. Other sources suggest slightly more or less than 94.↩
https://research.ftserussell.com/products/downloads/FTSE_Global_Equity_Index_Series.pdf, https://www.msci.com/eqb/methodology/meth_docs/MSCI_GIMIMethodology_Oct2019.pdf, https://us.spindices.com/documents/methodologies/methodology-sp-us-indices.pdf, https://www.spglobal.com/spdji/en/indices/strategy/sp-mlp-index/#overview↩
Note that negative oil prices were truncated at zero.↩
This note is not intended as a full examination of the tax or operational treatment of MLPs. An excellent reference for further reading is https://eic.energy/uploads/VE-MLP-Primer-Brochure_AE18-042318.pdf↩
This is a little complex, but to help explain it note that depreciation and other non-cash charges in MLPs are large. This means that while cash generated is high, reported income is not. The result is that the cash generated within the partnership is fully paid as a distribution, but it has to be classified as income plus return of capital. The capital return component can be very large - perhaps 80% or more of the distribution. This has the effect of reducing an investor’s cost basis for tax purposes on the distribution. Tax on the return on capital is deferred - it is only paid on sale of the MLP units.↩