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Finding Yield through MLPs
Master Limited Partnerships are an active field as investors are looking for yield and income. Find out what is happening in the MLP space amid global pressures from our experts:
Steven C. Carhart, CFA - President, Chief Investment Officer and Portfolio Manager, Trust & Fiduciary
Tyler Rosenlicht - Research Analyst of Global Infrastructure and MLP Strategies, Cohen & Steers
Vinit Srivastava - Global Head of Strategy, S&P Dow Jones Indices
Kevin McCarthy - Chairman, President and CEO, Kayne Anderson Fund Advisors
Duration:
00:52:02
Transcript:
Evan Cooper: Hello everyone. In today’s Masterclass we’ll be discussing Master Limited Partnerships. Investors are looking for yield and for income and they’re turning to Master Limited Partnerships. Let’s find out exactly what’s going on. Steve, give us a view, what’s happening right now?
Steven Carhart: Well, I think that right now the Master Limited Partnerships are under some pressure in light of the situation we’re dealing with, with the slowdown in the world markets and declining energy prices. We’re really reassessing where that is going to be. I think there’s a chance that we are on the cusp of a reassessment of the US energy renaissance which I certainly think is of generational importance. But in previous years we’ve seen situations where important infrastructure build outs like the Internet in 2001 actually got ahead of themselves. And while it certainly remained important for the, you know, after a correction, the build out was corrected in the 2000/2001 market correction, had a similar over build in infrastructure with railroads in the 1890s, and the railroads collapsed because they were built ahead of where the actual demand was. There of course the centerpiece of the transportation system for the next half century, but there was a big correction for the over build.
Evan: We’ll go back to some of those issues later. Let’s hear from Tyler. What do you think is going on now?
Tyler Rosenlicht: I’d definitely echo that there’s some concern about MLPs and their exposure to commodity prices, crude oil and natural gas. And I think what a lot of investors are really focused on right now is what is that commodity exposure, and are we truly a derivative where we’re more fee based and less directly exposed and will the potential increase in demand for crude oil, natural gas and NGLs, actually outweigh potential declines in supply and so forth? So a little bit of concern about again what energy is really going to mean for midstream energy. But we feel really good about where we sit in the energy renaissance and where MLPs are going to really perform going forward.
Evan: And, Vinit, what do you see?
Vinit Srivastava: Pretty similar things, I mean I think there is still a lot of demand, especially like from our vantage point, from institutional clients interested in infrastructure assets, and MLPs, especially midstream MLPs have increased in demand.
Evan: Great. And Kevin, what do you see?
Kevin McCarthy: We think the MLP market continues to be very attractive, that the macro for this space is very, very strong, production in the US is growing from both natural gas and crude oil. And that growing production needs infrastructure. And the MLPs are the primary suppliers of the infrastructure for the new production.
Evan: The world of MLPs is complex and each of you looks at it through a slightly different lens. Can you tell us how you look at MLPs?
Vinit: As an index provider, we look at trying to provide the most representative index that captures the space. The flagship indices that we’ve reviewed are pretty much devoted to energy and focus primarily on the midstream sort of assets, covering about 90 companies or so. And so from our point of view it’s providing a sort of representative investable sort of universe to clients, and as someone who is not advocating the investment, we just say, “Okay, this is the market. This is what we give you.” And you make the assessment whether this is right for you, and whether it’s right for your portfolio.
Evan: And of course, your index is on the basis of ETFs.
Vinit: Yes, they’re the basis of ETFs and people use that to express a point of view, whether ETFs or institutional products or SMAs or index-linked funds or the like.
Evan: And Tyler, what about Cohen & Steers?
Tyler: Cohen & Steers is an active manager of MLP and midstream energy portfolios. And we think it’s really important to actively manage a lot of the securities because you can really add alpha as MLPs remain a fairly inefficient market. So we think it’s important to really understand the underlying business picks and so forth. You know, when we look at MLPs in midstream energy, we really focus on infrastructure companies. And we have a long history of investing in global infrastructure. We think it’s important to deconstruct the underlying MLPs that you own and understand the risk profile of the underlying investments because it used to be that MLP meant pipeline and then stability and then good cash flow. But now you have MLPs in the upstream marketplace, and you have MLPs that operate refineries, fracs and so forth. So again we think it’s important to focus on which part of the value chain you really want to look at. And that can mean more than actual MLPs — such as general partners and Canadian energy infrastructure companies — so again active managers really focus on midstream infrastructure because that’s what we know and that’s what we’re really focused on.
Evan: And Steve, tell us about your firm, what you look at?
Steve: Yes, we take a holistic view of the pass-through universe, by which we mean all exchange-traded securities that are exempt from federal income tax on the condition that they distribute substantially all of their profits to shareholders. So our portfolios — in addition to MLPs — include REITs, royalty trusts, business development companies and closed-end funds, which we mix and match according to where we are in different parts of the business cycle
Evan: And Kevin, tell us a little bit about Kayne Anderson.
Kevin: Well, at Kayne Anderson we follow the entire MLP space and across the MLP space we tend to focus on midstream MLPs. We are overweight, the gathering and processing MLPs because we think they are best situated to take advantage and benefit from the growing production in the various shale space.
Evan: Could you define midstream for us?
Kevin Midstream MLPs are companies that are involved in the transportation, processing and storage of energy products, oil, natural gas, natural gas liquids, effectively bridging the gap between the producer and the end user, whether the end user is a retail consumer or a refiner.
Evan: And why do you prefer midstream to the other areas?
Kevin: Midstream tends to be a fee-based business, much less sensitive to commodity prices. We like to call midstream energy companies the toll roads of the energy space. They collect a fee based on the volumes transported and therefore aren’t as sensitive as the producers or the refiners to the absolute commodity prices.
Evan: As you said before, investors are looking for yield and it’s easy to see why investors are turning to MLPs. Kevin, give us some more insights on that.
Kevin: We think investors are buying MLPs for three reasons. First, an attractive yield in a low rate environment, MLPs are averaging 5.7% yield currently. Secondly is the growth rate in the distributions, MLPs have grown their distributions by 8% over the last 15 years and we expect them to grow their distribution by 7% or more over the next several years. And finally, MLPs offered tax deferral of their cash distributions. So the combination of an attractive yield, growing distribution and tax advantages makes it very appealing for retail investors.
Evan: Steve, tell us why investors are so interested in MLPs at this time?
Steve: Well, we think it’s primarily because there is a tremendous need for income. The baby boom generation is retiring, bond rates are near zero. And we have a situation where the monetary and fiscal authorities around the world are attempting to reflate world economies. So that probably means that we are moving towards … gradually towards a world of higher interest rates. And obviously that’s a problem if your income is fixed. But if you have the ability to grow your income along with growth in the economy or growth in some form of energy prices that’s a very positive thing to be part of. That’s not unique to MLPs. We also find that with REITs and business development companies, certain types of closed-end funds, we’re focusing on a broadly based reflationary income theme.
Evan: And Tyler, what do you see? Is this a search for income?
Tyler: You know, I think it’s a great question because MLPs have historically been great income vehicles and a lot of people still invest in MLPs because when you look at the income opportunity, it’s really superior, on average, to most REITs, utilities and fixed income. And when you couple that with future growth prospects, we think MLPs are going to grow their underlying distributions, seven to eleven percent per year for the next few years. That’s actually better than REITs, utilities or fixed income, which don’t grow. So relative to other income-oriented asset classes, the relative value of midstream MLPs is still really good. What’s important to note, though, is that not all MLPs are just income vehicles anymore. And there are actually really good securities out there that are more focused on growth, so dropdown stories for instance, or high-growth MLPs that might have a little bit lower yield.
Evan: What’s a dropdown?
Tyler: A dropdown would be a sponsored MLP, for instance. For example, you have a large refinery like Phillips 66, which has lots of captive midstream energy assets on their balance sheet that they don’t get credit for. So what they have done is spun out some of their midstream business into an MLP. And that MLP has a very low cost of capital because of the ability for them to grow distributions over time. And so what Phillips will do is drop down certain assets every year, which will provide underlying distribution growth at the LP. It really provides a very symbiotic relationship for the refinery, which is more volatile, and the midstream business, which are the more stable pipelines. And so there’s been a split in the market: There are high-yield, low-growth MLPs, some of which we think are attractive, and there are high-growth, low-yield MLPs, some of which we think are very attractive as well. So it’s important to look at MLPs for income but also for growth and really seek to maximize total return, in our view.
Evan: And, Vinit, how does the search for yield affect index construction?
Vinit: It doesn’t really. We have a pure MLP index, which covers the old space of MLPs and includes midstream, upstream, as well as refining companies. And we also have global infrastructure indices that have about 25% allocation to MLPs as well. And in both cases, as we’ve seen across all our asset classes, there’s a search for yield — whether it’s REIT products, BDCs, infrastructure, you name it, the across-the-board search for yield continues. We saw 2013 was when we saw our dividend indices for the equity-income indices almost double in terms of the assets that they were tracking. This year, we don’t see that slowing down. But to Tyler’s point, I think some of the quality story within income —whether it’s MLPs or other equities — is getting more complex. So when people are looking at an asset that’s generating income, they’re not only looking at the headline yield, they’re looking at what’s behind it. Is there distribution growth as in the case of MLPs? Or is it income growth with respect to other equity assets?
Evan: So with the increase in the interest, then, in MLPs — either for yield or for growth — I guess one question could be, are MLPs becoming overpriced? Kevin, what’s your take on that?
Kevin: Well, the demand for MLPs has been very strong, but the supply of MLPs has also been growing. When KYN started 10 years ago there were 33 MLPs with a market cap of 43 billion today. There’s over 125 MLPs with a market cap of over 600 billion. The capital required to build the infrastructure to support the growth is very, very large. So there’s been a lot of new issuance come into the market. So we’ve had a relatively balanced increase in both supply and demand for MLPs. That being said, the MLP space is much more complex than it was before and you have to be very careful. Tabletop investing doesn’t work anymore, as it did in 2009/2010, where some MLPs that are fully valued now and still some where there’s substantial returns available. Back in 2010 you really could pick a basket of virtually every MLP, they were all undervalued and they all performed very, very well. Today the projected returns based on our research, there is substantial variation on projected returns.
Evan: And, Tyler, what do you think, are MLPs becoming overpriced?
Tyler: I think that on a micro level, if you compare MLPs against other MLPs, there’s definitely been a dispersion in terms of valuation. And in our view there are some MLPs that are a little bit overheated and some that really have attractive value. Broadly speaking, if you look at MLPs in the aggregate again, as I talked about before, the relative value to other income-focused asset classes, it’s still pretty good; better yield and better growth. So when you actually take a step back and compare MLPs to REITs and fixed income, we think there’s still a lot of value there. But definitely you’ve seen a lot of dispersion of return in the last four or five years. And you’ve seen winners that we think will continue to win, offer really attractive value. And you’ve seen some MLPs in our view that don’t have the underlying balance sheet strength, management expertise, growth profile or capital backlog to really justify some of the valuations we’re seeing. The MLP space is now over 100 companies, up from about 40 eight years ago. And so there are definitely more winners and more losers and more relatively attractive and relatively unattractive companies.
Evan: What do you think of the current situation, Steve?
Steve: Well, I think that the most attractive yield opportunities right now are in business development companies and publicly traded partnerships with asset managers. But within the MLP space, we very much like the downstream area. We think that in a low oil price world, upstream assets are suspect; they may well be hedged. We think that in the current slump in demand the volume-sensitive midstream pipelines may suffer some reduction in volume growth. But we think the downstream MLPs are very much underappreciated. Now, I’m talking about refineries, about fertilizer manufacturers, about shippers — all of which have oil or gas as an input and sell to final consumers. We think that part of the MLP space is very much underappreciated. And that’s where we think the most interesting opportunities are.
Evan: And do you think if oil prices or energy prices come down, those areas will benefit?
Steve: Yes. For instance the refineries — their profitability is a function of what’s called the crack spread, which is of course the difference between the cost of the crude oil that they purchase and the price that they get for the refined products such as gasoline, heating oil and jet fuel. And usually what happens when crude oil prices come down, those prices fall faster than the product prices. And those margins increase, so in fact the profit margin of a refinery can increase in a falling oil price environment.
Evan: And, Tyler, what do you think will happen if oil prices go down?
Tyler: I think that’s a great point. And downstream, we agree, would benefit. For us, though, we really focus on midstream. And we think downstream has unique risk characteristics that some MLP investors may not be appreciating when they think they’re buying pipelines. But from the pipeline perspective, you know, as oil prices decline, there’s definitely some concern about, well, what crude oil production is going to be because there are parts of shell basins that are less economic at $80 and $70 crude oil prices. I think the balancing factor, and what we’re really focused on now, is what the demand-pull is going to look like. So as we have lower crude oil prices, there’s going to be more demand for crude oil, there’s going to be more demand for NGLs and other petrochemical commodities and so forth, so you’re going to get a balance. So even though you might get less supply at a lower oil price, you’re potentially going to get more demand. And we think that that speaks well for certain pipeline volumes in the right basins and moving the right types of products and so forth. So as oil prices are high and steady I think no one’s concerned, but as prices decline, it really depends where are your underlying assets are, how much commodity exposure and how much volumetric exposure you have and how viable your assets are long term.
Evan: And also I think a number of European chemical companies are coming to the United States to build plants that would use the oil and natural gas because of the strong dollar and because it will be so much cheaper here for energy.
Tyler: Yes, I think that’s a really important point of the demand-pull that we talk about with investors all the time. And when you think about it, the U.S. is cost advantaged in just about every energy commodity now. But it’s not a quick overnight construction cycle to build the actual demand that you need. So demand can be liquefaction for NLG, those are five-, six-year type construction projects before you actually see the demand materialize. Petrochemical crackers are the same way. These are multibillion-dollar investments that are now in the construction phase, but aren’t even going to really start taking product until 2017, 2018, even 2020. So it’s going to take a while, and you could have some air pockets in terms of demand. But the good thing is that the investments are being green lined, and capital’s being spent and the facilities are being built. And the large European and other foreign buyers are really seeing the US as a long-term supply source for a lot of these energy commodities. That makes us feel good about the medium and long-term picture for MLPs.
Evan: And, Kevin, what’s your reaction to lower prices or your view of what would happen if prices continue to decline?
Kevin: Well, if you think about the basics of the shale revolution, substantial increases in production, both natural gas and crude oil has had a negative impact on pricing. We’ve seen it first in the natural gas space and now in the crude space and NGL space. But if you think about it for midstream companies, their job is to transport that volume. And the reason prices have been going down is because of higher volumes. So the shale revolution has been very, very good for the midstream companies, it’s really been more selective on its impact on upstream companies. If you’re in a very good area with very good assets it’s been beneficial. But for a conventional producer it’s been difficult because of the impact on gas prices and now crude prices.
Evan: Vinit, what about you, what do you think?
Vinit: I won’t make any sort of comments on those points, but what I would like to highlight is the differences within MLPs in terms of the three sort of broad categories — upstream, midstream and downstream — that was reflected in early October. We saw some of the upstream companies get punished when the price started to sort of plummet. They’re pretty much in our index right now, about five percent are upstream companies, but they contributed a fair amount of downside to the overall total return so far in the year. So I think investors need to understand the different MLPs that are there and the different risk return characteristics of each. The midstream is very different — infrastructure-like, very stable, low return. You’re looking at very different IRRs if you’re investing directly versus upstream and downstream.
Evan: Let me ask a question related to the decline on energy prices. What if the economy slows? What if we enter a period of kind of modest growth, or if we get into a recession? How does that affect MLPs? Steve?
Steve: Well, I’ll take my chances downstream depending on how far down it goes, because I think the general consumer prices are stickier on the downside than upstream. I think that you’re going to start to see the more dramatic issues being around slowdowns in various projects. We’re already hearing anecdotally that various new drilling projects have been slowed down. We’re also seeing cancellation of some pipeline projects — the Bluegrass project in Kentucky was cancelled this year, the Dakota Express in the Bakken was cancelled this year, last year the Freedom Pipeline in California with the Kinder Morgan project was cancelled. So I think we’re likely to see a consolidation of infrastructure in that context. I think Richard Kinder’s move to consolidate the Kinder Morgan empire is not unlike what the great barons or the railroad barons did when they consolidated the railroad over-building in the 1890s.
Evan: And, Tyler, what do you think if the economy slows?
Tyler: When the economy slows, obviously you don’t get the benefit of the demand, or even though you have the supply decline in the lower energy price environment. So in that instance I think it’s going to be much more dramatic in terms of the potential winners and potential losers because if you’re a good pipeline operator with a solid balance sheet and a well-capitalized organic growth platform you can probably weather the storm pretty well. But if you’ve potentially overreached on acquisitions or you’ve started to build pipeline projects without guaranteed minimum volumes at guaranteed returns, I think that’s where you could really see some issues. So in the context of a weakening economy you don’t get the benefit of the demand-pull and that can really wear on some pipeline bonds. I would say that’s not our base case. We really feel like we are in a below-trend economic recovery and feel good that there’s going to continue to be good demand for the energy commodities and that North America’s now oversupplied.
Evan: And, Kevin, what’s your take on the potential for a slower economy and its impact on MLPs?
Kevin: Certainly the economy has an impact on demand for energy prices. We saw that during 2008/2009, especially in refined products; people are driving less now than they were then. But certainly we’ve seen substitution. We’ve seen more natural gas use for generating electricity, less coal. That’s very good for the midstream companies that transport, gather and process natural gas.
Evan: Okay. Let’s say the economy continues on its way, and the MLPs continue their payouts. Any concerns about that? Do you think they’ll continue with this rate?
Steven: I think that comes down to an individual issue. There’s no substitute for individual securities research, which we believe in. So it’s very hard to generalize. I think if I did have to generalize, I would continue to bet downstream rather than midstream or upstream, if you want to make a generalization.
Evan: And Tyler?
Tyler: From the midstream perspective, we actually think distribution growth has the potential to accelerate in the near medium term. The cost of capital is lower than really it’s ever been. And the organic growth platform and backlog for a lot of these companies is great. And a lot of them are underpinned by good, long-term take-or-pay type contracts. So we think distribution growth should continue to increase at a steady clip every year. Another big factor that you’re going to see, which was spoken of before, is consolidation. You’ve really already seen some consolidation occur in the industry beginning this summer and accelerating into the fall. And we think that that can be another good driver of growth. But when you look at underlying MLP distributed cash flow, a lot of companies have inflation protection, the contracts. A lot of them have volumetric increases either embedded in their pipelines or in the contracts for their pipelines. So organic growth could be another leg of growth. So we feel good about MLPs being able to sustain what’s been a pretty attractive distribution growth trajectory over the last few years.
Evan: And Kevin, your view on distributions?
Kevin: MLPs have a tremendous track record of growing their distributions. Over the last 15 years, MLPs have averaged eight percent growth in their distributions. We expect MLPs to continue to grow their distributions. We’re forecasting growth rates of seven percent or more for the next several years. What’s really emerged over the past several years is some of the super growth MLPs. There is a large number of MLPs now that expect to grow distributions by 10% or more over the next several years. And that’s really driving the performance of certain MLPs.
Evan: Okay. All of you in our Masterclass today represent different forms of ownership of MLPs or different ways of looking at them. Some overlap. Let’s get a view of that and how you actually look at MLPs and how you own them. Steve, tell us a little bit about that.
Steve: We look at MLPs as one option for pass-through yields. So in our work, the MLP is not sacred by virtue of its own legal structure; it’s of interest because of its yield, its potential to grow yield, its tax sheltered advantages and always compared relative to alternatives and closed-end funds, business development companies and asset managers, royalty trusts and REITs. So we’re trying to look consistently across the different sectors. So we are looking in that context, we’ll be looking at the individual security in terms of cash flows, potential to increase cash flow, valuation, its management and its business plan, of course. And relative to where we think the different sectors are, relative to one another. There are times when we actually are quite negative on MLPs. One example might be in late 2011 when we felt that most of the MLP sector was quite overpriced. We found real relative value in commercial mortgages and real estate investment trusts and rotated the portfolio in that direction during 2012, which was a very difficult year for MLPs.
Evan: And tell us, how do you hold them, what form is it in?
Steve: We have publicly-listed exchange traded units, normal custody, normal trading.
Evan: And Tyler, how does Cohen & Steers handle that?
Tyler: At Cohen & Steers, in terms of MLP and midstream energy-direct products, we have a closed-end fund and an open-end vehicle as well. And one thing that’s unique about our vehicle is that we’ve actually elected to structure our fund as a regulated investment company. So when you think about investing in MLPs in fund products, you really have two options. You can invest in 100% MLPs, but if you elect to go that route you have to structure your fund as a C Corp, and there are some tax disadvantages in our view around that structure because it’s now at double taxation — the fund pays taxes and the end investor pays taxes. So we actually have structured, as I said, our fund so that it has a full tax pass through. Now, to do that you can only own 25% MLPs directly. You’re capped at what you can own and it actually qualifies as a publicly traded partnership. But in our view there are lots of great investment opportunities within midstream energy but outside the MLP tax structure. Some examples would be general partner C corps or Canadian energy infrastructure companies, offshore-contracted LNG shipping and large diversified midstream utility companies. So we think that the RIC structure is really the best tax and actively managed structure to operate and invest in, in a midstream energy total-return-focused strategy. And so that’s how we’ve elected to structure and invest our fund.
Steve: Let me just add, our funds we have the same structure. We will have the MLPs be within the same 25% limitation. The other 75% will be things like REITs, royalty trusts, business development companies, closed-end funds, things like that. So that’s how we handled that.
Evan: And, Vinit, your indexes are the basis of ETFs. Tell us how that works and why it works.
Vinit: Sure. So this is where two structures are very common. One is ETNs and the other is ETFs, which are getting a little more popular. As Tyler mentioned, ETFs — if their MLP holdings exceed 25% of the total fund — have to restructure as a C corp and you carry the full tax assets and liabilities. So you essentially will be underperforming the benchmark in bull markets and slightly outperforming of bear markets. So there are issues with the ETF structure when you look at MLPs. Most of the trackers tend to be ETNs, which give you a total return. And they’re extremely popular, with close to $17 billion in assets now. They’re pretty big products and the attractiveness of ETNs is that you don’t have to worry about any of the paperwork or any of the other issues. It’s basically a note that a bank issues giving you the total return of the index. So not only are ETNs popular with retail investors here in the US, but we see a lot of investors from outside the US, primarily because they want to play the US growth story in energy, both the production as well as the midstream build out. I think a significant part of the investments that you see in ETNs actually come from investors that are not US based because of the attractiveness of the ETN structure.
Evan: And just explain exchange-traded notes a bit, because they’re different from ETFs.
Vinit: It’s a bank issuing you a note that gives you the total return of a particular index or whatever the investment it’s tracking. It’s as simple as that; it’s like a swap if you will. ETFs, you know, are replicated physically. The issuer is actually holding the securities and there’s a process of creation or redemption associated with it. The banks, which issue the ETNs typically, have other ways to replicate. But at the end, the investor is getting the total return of the index.
Evan: And which banks typically issue ETNs?
Vinit: The bigger ones are J.P. Morgan, UBS and Barclays and there are others obviously as well.
Tyler: And just to highlight that, look at the performance characteristics of the ETF. I haven’t seen the most recent numbers, but I think that the expense ratio of the MLP ETF is almost a 1,000 basis points per year. And it’s actually underperformed its benchmark by 800 basis points per year since inception. It’s a passively managed ETF product, but it’s just the C corp structure tax drag associated with how you’ve got to structure your fund that way. And in our view, that’s a good way to maximize income because it pays a good yield. But the C Corp structure again has lots of tax drag, it makes it really difficult to actively manage your portfolio over time because you end up getting to the point where you never want to sell security because when you do and recognize that the taxable gain, you actually have to write a check to the government and you erode your asset base — which shows just some of the structure considerations that you really need to think about when you’re allocating and investing in MLP fund products.
Steve: Can I just mention that we are very agnostic between active and passive management. Our TFMS High Income Pass-Through Securities, or HIPS, index, is also RIC compliant and is approximately 25% in MLPs, the rest in other types of pass-through securities such as REITs, royalty trusts, business development companies and closed-end funds. So that’s another approach to looking at this diversified pass-through notion with MLPs being a very important component.
Evan: And, Kevin, give us your take on how Kayne Anderson handles this.
Kevin: The majority of our MLP holdings are held through four publicly traded closed-end funds. These closed-end funds have differences, our largest and oldest closed- end fund KYN is a pure MLP portfolio, 100% MLPs. We generally invest in publicly-traded securities, although we also purchase securities directly from the MLPs to help facilitate certain acquisitions. We call those transactions, pipe transactions where we’re buying unregistered securities that will become public securities over a period of time. There are certain advantages to our retail investors in owning MLPs through a closed-end fund vehicle like KYN. First of all is professional management, secondly we facilitate the ownership versus owning individual MLPs. With individual MLPs, investors receive K1s; we consolidate all those K1s and provide a 1099 to the retail investors. We shelter investors from UBTI, so therefore by owning KYN they can get MLP exposure in their tax-exempt accounts, their IRAs where they couldn’t through direct ownerships of MLPs.
Evan: Obviously the question that comes up in investing in MLPs is where they fit in someone’s portfolio. Are they equity? Are they fixed income? Are they something different? Kevin, give us your view of that.
Kevin: It really is a hybrid. You have a substantial fixed income return, so in that way it’s very attractive to investors looking for a consistent income. But it also has an equity component because these MLPs are growing their distributions over time.
Evan: Tyler, what’s your take, where do they fit?
Tyler: It’s a great question that we come across quite a bit, because they’re a bit of a hybrid. Cohen & Steers is really a liquid real assets firm. And we think MLPs fit squarely within liquid real assets. When we think about that we think they’re a good diversifier, a good high-income product. You get equity-like returns, but some diversification and it’s not fully correlated with the equity market. So it’s not fully an alternative, and not fully an equity either. We think it’s a good diversifier that kind of sits in that real asset allocation that we think is really important for all investors’ portfolios.
Evan: And, Vinit, where do you think it fits?
Vinit: Very similarly, actually. When you isolate sections of the MLP, we’re talking about midstream MLPs, which are infrastructure like. Infrastructure fits very well in the real assets side of the investor equation. And what we have seen lately is the real asset allocation for even retail investors has been increasing pretty significantly in the recent past. So when it used to be four to five percent, now it’s creeping up to like more than 10. And several firms hope that this goes up to 25% to 30% in the future, and primarily because of the level of sophistication aspect of that. So you get correlations around 80 to 85 depending on what you pick. But you do get a fairly good link to inflation, even if you’re doing it through equities. So obviously the best way to invest in these assets is directly and you get that direct link as to inflation. But sort of the concern of level of sophistication is pretty big among investors. And that’s driving higher allocations to this real assets market. And that’s where we see this fitting.
Evan: And Steve, what do you think?
Steve: Our view is that the relevant asset class is to take pass-throughs as a group and to look at them collectively as a third asset class, alternative to either stocks or bonds. The Economist had an excellent article on this subject early last year reporting that academic research indicates a two-thirds of all new corporate energies in the United States are one of these pass-through structures. And we think that these as an income-producing corporate structure really represent an in-between strategy, between bonds and stocks. And also this represents the exodus of the mature domestic industries from the US tax code, we see people doing inversions where you’re seeing increasingly more and more of US industry being moved into one or another of these pass-through structures. So we think that’s the most useful way to look at this universe.
Evan: MLPs are one of those products where few people buy the direct MLPs; they’re buying from a packager in some way, shape or form. So tell us what you bring to the equation. Why should they be concerned about the people like you — the middlemen in the MLP world — and what you bring to the party? What they should be looking for in terms of a provider like you? Steve, let’s start with you.
Steve: What we believe we provide is a combination of high yield and liquidity and active management in our active products and also an index for a passive approach. Our sense is that most of the people who are looking at MLPs or REITs or closed-end funds or any of these other securities like business development companies, are looking at it primarily for yield and looking at it primarily for a good fundamental story. But many, many people we talk to are confused or don’t know when to be in one sector or another. And so our mission is to offer an alternative. You can put assets with a firm such as ours and we will do the research day in and day out and look at the relative attractiveness between these different yield-oriented sectors.
Evan: And, Kevin, what should investors know about Kayne Anderson?
Kevin: We think it’s very important to have experience across several energy cycles. Many new entrants in this space have never seen a substantial decline in commodity prices and don’t know how to react. I have been in the MLP space for 30 years, 20 years as a banker, 10 years as an investor. My partner, JC Fry has been managing portfolios for a dozen years. And it’s important to have context and to have seen how producers react, how midstream companies react in periods where we have falling oil prices. We’ve seen that before, we have a pretty good idea of how the producers will react.
Evan: Vinit, in your case, a lot of index providers, what should they know about S&P Dow Jones Indices?
Vinit: In representing the indexing community in general, what I would like to say that our role is to provide the purest access to that opportunity set. Market cap weighting the available opportunity is actually a very good way to access it, because when you look at what’s available — and there’s definitely room for active management in the space — the dispersion of returns is pretty high. You look at the worst performer this year, it’s down 50 odd percent. But one is up to 24%, and it’s a set of like 80 names. So there is opportunity to add value by doing fundamental research. But when you look at what’s available, you need to make sure that when you’re making those bets, the opportunity is what’s available. There’s only five percent available in upstream and five percent available in downstream, so you’re making bets there. There’s not much available when you want to double down. So we want to highlight the opportunity set and show what you would realistically get out of this asset class — and that’s a benchmark. It’s useful for a lot of investors who want to transparently see what’s going on here across this available set.
Evan: And Tyler, why Cohen & Steers?
Tyler: Well, one thing that I talk about with all MLP or most MLP fund products, which is a huge advantage that we all offer is, is a 1099 instead of a K1. So I think one of the big hurdles for a lot of individual investors when they look at MLPs is they don’t want to deal with the burden of a K1. And our fund, like most funds, actually cleanses that; investors get a 1099, which is a much better way to handle your taxes. In terms of Cohen & Steers, we have a longstanding track record in MLPs. We’ve been investing in this space since 2004. We’ve got our global infrastructure strategy and we’ve had dedicated MLP strategies for over four years. It’s really important to understand the underlying businesses that you’ve invested in. We’ve talked about that a lot today, there’s upstream MLPs, there’s downstream MLPs, there’s fracs MLPs, there’s pipelines that are well contracted, poorly contracted, good balance sheets, good management teams, bad balance sheets and bad management teams. So we think MLPs are still one of the places where active managers truly can add value and you can find good companies that are going to outperform, and beat their benchmark, which is the more passive product. Similarly, you can make sure that you steer clear of the companies that are going to cut their distribution or don’t have their pipelines to enter that space. And so we thin, MLPs really offer one of the great places to add value as a manager.
Evan: Okay. One question I have to ask because most of the investors, they’re probably aware that MLPs exist because of the tax law that encourages this kind of investment, that’s why they get the tax breaks. What are the chances of the tax benefits going away. Kevin, what’s your take on that?
Kevin: We think the threat of changes to tax laws are very … impacting MLPs are very minimal. They changed the tax law back in 1986 to promote the development of energy infrastructure. I think that’s been very, very successful, not only in having a very modern and safe energy infrastructure but in creating jobs. Job creation is very important and it’s been a successful use of tax policy. In fact what’s on the table right now in front of congress is an expansion of the tax benefits of MLPs to include renewable resources. And we’re very much in favor of that proposal. We think there is a possibility that there’ll be changes to export laws, whether it’s through crude oil or through condensate, we’re watching that very closely. Clearly the US has become a low-cost producer of energy products. And I think it makes sense to relook and reexamine the laws that were put in place in the early 70s as a result of the OPEC crisis.
Evan: Steve, what do you think?
Steve: I think the chances are quite small and that is because the tax law that MLPs live under has been in place for many years and is entirely separate from the US corporate income tax. I think that if the corporate income tax is revised it will be to make the corporate income tax more like the MLPs than to take it away. In addition, the Republicans generally are more favorably disposed to pass-through securities. That said, that does not mean that the market cannot discount the likelihood that this will be taken away. And in fact that happened most recently at the end of 2012 when there was a fear in the marketplace that the MLP tax treatment would be taken away as part of the fiscal cliff negotiations. So we do need to keep the possibility in mind, even if it’s a false warning like the old saw about the market forecasting nine of the last five recessions; there is a chance it can happen.
Tyler: I think that’s a great point and I don’t want to try to handicap what’s going to happen in Washington because I don’t think that you can really have confidence about what you’re going to say. But if you step back and you look at MLPs and you look at the tax advantage they get and the benefits that they provide in terms of infrastructure development, incentivizing upstream production, low prices for energy commodities, adding to job growth and really adding as a source of stimulus for the US economy, it seems the MLP structure added about $12 billion or $13 billion dollars to the economy over five years, according to some estimates. So you’d hope that Washington doesn’t get that equation wrong. You’ve actually also seen in DC, they’ve tried to increase adding renewables into the MLP tax structure for instance. So when you get a more accommodative DC that’s trying to increase what qualifies for income, that makes me sleep a little bit better at night that the MLP structure’s not going to go away. But it’s never something that you can’t discount because it’s always going to be a lingering issue in MLPs.
Evan: Let me just touch on risk. Where do you see risks, what gets you worried? Kevin, what do you see is a risk in the MLP space?
Kevin: I think in the short term risks are rising interest rates, they are fixed-income investments. And what we have seen in the past is that over a very short period of time rising rates can have a negative impact on MLPs. What we’ve always said is that in a rising rate environment, MLPs are the one fixed-income security that you want to own because they’re able to grow their distributions to offset the rise in rates. I would say that we’ve been worrying about rising rates for the past three years and we really haven’t seen that. But we know that eventually rates will rise and that you want to own the MLPs that will continue to grow their distributions to offset those rising rates.
Evan: Vinit, what do you see is a risk?
Vinit: I think it’s complexity. As an index provider, when you look at names and when you look at the corporate structures of some of these firms, it’s very to navigate the structures of who’s paying who and where the assets lie. How do you navigate this and figure out where something could go wrong? So I think overall complexity is a little concerning.
Evan: Tyler, what worries you?
Tyler: I think a big risk that doesn’t worry me too much today but is always kind of risk Number One or Number Two in MLPs is access to capital. When you think about the MLP structure, you’re paying out all your distributable cash flow to your investors. But you need to build to grow your distributable cash flow, you need to acquire to grow. And that means you’re really just like REITs, relying on external financing in the form of both debt and equity. So it’s really important to have healthy capital markets where you can, as a company, go to equity investors and go to debt investors and say, “Hey, I have a great project, will you give me the billion dollars that I need to go and build it?” Because unlike most corporations that can retain earnings, MLPs don’t have that luxury. I think it’s a benefit because only good MLP management teams that have a demonstrated track record of success are going to be able to access capital at a cheap rate over the long term. But that’s really important, if you get into a strained scenario where MLPs can’t finance their growth or can’t finance guarantees that they’ve made, that’s where you could have some serious issues.
Evan: And, Steve, what worries you?
Steve: I think the biggest risk is that the midstream infrastructure is overbuilt relative to the demand and to the future of the industry. If we get into a period of slower growth, lower energy prices, I think we may well need to have a significant consolidation, not unlike what we went through with the Internet and the railroads in the 19th century. That doesn’t mean it’s not going to be central to our economic future, but it just means that the investable securities and the valuation’s got way ahead of the aggregative fundamentals.
Evan: Okay. As I said, we’re reaching the top of the hour. So let’s get some takeaways. Kevin, let’s hear from you.
Kevin: We think it’s very important to have a detailed understanding of the various MLPs and what drives their performance. Investors will often ask me, “What happens to MLPs in falling gas prices? And I explain to them, “Well, it depends on the MLP.” There are certain MLPs where falling gas prices hurts the results. There are other MLPs, gas processing MLPs for example, where natural gas an input not an output of their business. So lower gas prices actually benefits their cash flow. So having a detailed understanding of all the various MLPs and all the various subsectors, we think is very important to be a successful investor in the MLP space.
Evan: Vinit, what’s your takeaway?
Vinit: MLPs are still a very attractive asset class, especially for investors interested in playing the US story in the energy markets. And we do feel that the way to look at it for an average investor is through a diversified index approach in this space.
Evan: Tyler.
Tyler: I think, more than ever, dispersion of returns are going to increase and there’s increasingly going to be winners and losers. I think a lot of management teams have talked about consolidation and think that there’s going to be great opportunities since there are management teams that might have overstretched on acquisitions or on expenditures and so forth. So it’s important to really understand the underlying business model of the MLP you’re investing in. How is it financed? How is it going to grow? How stable is its distribution? What’s its commodity exposure? This space has just grown so dramatically in the last few years that dispersion is going to increase and relative winners and losers are going to increase.
Evan: And, Steve, what’s your takeaway?
Steve: I think the important thing is that we’re in a period over the next several years where there’ll be very low growth in the world. The best growth is in the United States, highest interest rates in the United States, strongest currency in the United States. There will be an enormous flow of money from around the world into income-bearing dollar-based securities. And then once the hedge fund or the carry trade people around the world get their fill of bonds, they’re going to be looking for the next tier up, which would be income-offering pass-through securities that are dollar based. MLPs will get their share, and we think REITs, business development companies, closed-end funds, other similar vehicles will do well also.
Evan: Terrific, thank you gentlemen, for ending it on an optimistic note, and thank you all for your insights on MLPs. Thank you, too, you for joining us.
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MASTERCLASS: Master Limited Partnerships - November 2014
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