|Course 503: Unconventional Equities|
|Benefits of MLPs|
In recent years, many U.S. energy firms have reorganized their slow-growing, yet stable businesses, such as pipelines and storage terminals, into master limited partnerships, or MLPs. There are some important differences between buying shares of a corporation and buying a stake in an MLP. With MLPs, investors buy units of the partnership, rather than shares of stock, and are referred to as "unitholders."
There are two classes of MLP owner: general partners and limited partners. General partners manage the day-to-day operations of the partnership. An MLP technically has no employees, so all services, from management to bookkeeping, are provided by the general partner. All other investors are limited partners and have no involvement in the partnership's operations. Limited-partner units are publicly traded, while general-partner units usually are not. The general partner stake is often 2% of the partnership, though the general partner can also own limited-partner units to increase its percentage of ownership.
Companies that use the MLP format tend to operate in very stable, slow-growing industries, such as pipelines. These types of firms usually offer dim prospects for unit price appreciation, but the stability of the industries that use the MLP format means below-average risk for investors. Cash distributions usually stay relatively steady over time (growing at little more than overall inflation), causing MLP units to trade somewhat like bonds, rising when interest rates fall and vice versa.
Some benefits of MLPs include:
High Yield. Most MLPs offer very attractive yields, generally falling in the 6%-7% range.
Consistent Distributions Over Time. The businesses operated as MLPs tend to be very stable and produce consistent cash flows year after year, making the cash distributions on MLP units very predictable.
Capital Gains. Firms primarily switch to the MLP structure to avoid taxes. While shareholders in a corporation face double taxation--paying taxes first at the corporate level, and then at the personal level when those earnings are received as dividends--owners of a partnership are taxed only once: when they receive distributions. There is no partnership equivalent of corporate income tax. Cash distributions to owners often exceed partnership income, and when they do, the difference is counted as a return of capital to the limited partner and taxed at the capital gains rate when the unitholder sells. Not only are capital gains deferred until an owner decides to sell, but capital gains tax rates are lower than income tax rates. In fact, we're particularly fond of pipeline MLPs, which have ample growth opportunities thanks to shifting sources of supplies of crude oil and natural gas. However, unlike other energy companies, MLPs tend not to take on commodity exposures, reducing risk and cash flow volatility. With distributions typically yielding 6-8% (and growing by 5-10% annually) and offering the opportunity for capital gains, MLPs could provide a compelling total return to investors.
Lower Cost of Capital. The absence of taxes at the company level gives MLPs a lower cost of capital than is typically available to corporations, allowing the MLPs to pursue projects that might not be feasible for a taxable entity.
General Partner Compensation Aligned with Limited Partners' Interest. Most general partners are paid on a sliding scale, receiving a greater share of each dollar of cash flow as the limited partners' cash distributions rise, giving the general partner an incentive to increase limited-partner distributions.
Next: Drawbacks of MLPs >>
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