EC MLP Funds Made For Uncle Sam

Promoters will explain that all MLP funds are taxable, which is true. When investing in energy infrastructure meant MLPs, that was perhaps a defensible argument. But many of today’s biggest energy infrastructure businesses have abandoned the MLP structure. They’ve found the investor base to be fickle, limited to older wealthy Americans who prefer income and are unwilling to finance the growth opportunities opened up by the Shale Revolution. These long-time buyers have been badly abused, with multiple distribution cuts and adverse tax outcomes when their MLP simplifies by combining with its corporate parent. It should be no surprise that MLP yield spreads versus ten year treasuries remain historically wide.

In May, Williams Companies (WMB) rolled up their MLP into their corporate parent (see Transco Dumps Its MLP). Enbridge (ENB) also simplified their structure on the same day. Both cited regulatory uncertainty caused by the FERC ruling (see FERC Ruling Pushes Pipelines Out of MLPs). But the difficulty of raising equity capital for an MLP is an issue for many.

As a result, tax-burdened MLP-dedicated funds are now confronting a shrinking set of opportunities. They are becoming an anachronism, as the energy infrastructure industry steadily leaves the MLP buyer behind in favor of a far bigger set of investors.

Moreover, the shrinking MLP universe is going to create further challenges for such funds (see The Alerian Problem). At the annual MLP conference in Orlando, many participants commented that an MLP-only index was now inadequate, no longer reflective of the energy infrastructure sector (see The Uncertain Future of MLP-Dedicated Funds). MLPs are less than half of North American midstream energy infrastructure, a point recently tweeted by Hinds Howard of CBRE Clarion Securities (@MLPGuy).

Managers of MLP-dedicated funds are telling their clients not to worry — as they would given their MLP-centric business model. But a shrinking index is rare in Finance, and offers the fund manager few good options: (1) Do nothing, and hope your clients tolerate a more concentrated portfolio with smaller names; (2) Start holding corporations as well as MLPs. This would require an ingenious explanation, because you’d now have taxable corporations sitting in a tax-paying fund delivering taxable returns to investors, a solution with poor optics; (3) Switch to a broader index and become RIC-compliant. This is the nuclear option, since it requires an MLP-dedicated fund to shed 75% of its holdings in order to come under the 25% MLP limit necessary to be RIC-compliant. If the $10BN Alerian MLP ETF (AMLP) sold $7.5 billion of MLPs, they’d find that by the time they were done with that, for MLP prices, down is a long way. It’s unlikely they could seriously contemplate such a choice — their investors should hope they never do.

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Disclosure: 

We are long ENB and WMB. We are short AMLP.

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Michael Molman 8 months ago Contributor's comment

Very interesting, I believe there are enormous opportunities in midstream energy and have been looking for ways to invest in it. MLP's seemed like a good option but I did realize the specific intricacies.