MLP Asset Class for Dividend Growth Portfolio

This article was originally published on The DIV-net on May 7, 2009

I continue to believe that every asset class has its significance and its own importance. Every asset class has a role to play in investment portfolios. However, individual investors need to understand these factors in the context of their own portfolios. Being a do-it-yourself investor, I like to ignore the market noise and understand how any asset class will affect my portfolio objectives. In earlier posts, I have discussed about my investing approach with respect to commodity asset class, international developed/emerging asset class, and the investment vehicles that I like to use.

Master Limited Partnership (MLP) is another asset class that provides relatively higher yields than compared to commonly known dividends. MLPs were established by congressional act in mid-to-late 1980s to increase investments in energy and natural resource projects. If not always, then in most of cases, there are the companies that are engages in exploration, production, mining, processing, refining, marketing or transportation of mineral and natural resources. These natural resources could be oil, coal, propane, natural gas, timber, etc. Among other, MLP asset class has three significant differences when compared to corporate equities. These differences are:

Cash Distribution (and not cash dividends): The cash paid by MLPs to it’s until holders is known as distributions (and not dividends) which come from “distributable cash flow”. The distributable cash flow consists of MLPs entire cash flow less expenses such as operations, maintenance, and debt servicing. After looking at about five to eight MLPs, it was difficult for me to understand how companies determine distributable cash flow. There was no consistency across multiple MLPs. This lack of consistency makes it difficult to understand its ability to continually pay and raise distribution. For example, the cash flow can be increased by selling partnerships units and/or taking debts. In addition, distribution is increased without any increase is operational cash flow (or operational income?). It is not clear to me how the distributions are continually increased.

Tax Structure: MLPs operate as partnerships (instead of corporations). Therefore, they pass on their income to their unit holders. In this way, collectively the partnership does not pay tax. This is called favorable taxation. There is another school of thought that says since MLPs do not pay tax, there is more cash available for distribution. However, the tax is supposed to be paid at individual partner or unit holder. For the first few years, individual units do not pay any tax because the distribution is termed as “return of capital”. Every year this “return of capital” reduces unit holder’s cost basis. At certain point in time in future, this cost basis will become zero, and then cash distribution becomes taxable as current income. In addition, any sale of units will be taxed as capital gain/loss tax structure.

Growth: MLPs are required to pay out a significant portion of their earnings to unit holders (or partners) so that they can qualify for their favorable tax treatment. They cannot retain large portion of their earnings. Therefore, the only way to grow is to either issue new additional equity or use debt funding. Increasing equity dilutes existing unit holdings (i.e. no growth) and debt funding has potential to reduce distribution (service costs).

The market performance of MLPs as an asset class can be measured by Alerian BearLinx MLP Select Index ETN (BSR). It tracks the Alerian MLP Index. I did not like the structure of this index fund, because the index is top heavy with top 10 MLPs occupying more than 50% of the its assets. In addition, there are many other closed-end funds that are based on MLPs.

MLPs that caught my attention were the ones that are known as mover and transporters of oil, natural gas, etc., These MLPs act as transporters and their earnings come from renting their infrastructure for movement. They are not exposed to volatility of commodity pricing. In addition, they are able to raise their pricing to track inflation, and hence provide long term inflation hedge. Pipeline MLPs bring in earnings (or cash flow) from their existing infrastructure. At the same time, they are expanding their infrastructure using new equity or new debt.

To summarize…
MLP industry sector is part of energy infrastructure, and hence I believe pipeline MLPs as a asset class may have longer term promise. I plan of taking a dip and make a small seed investments. This seed investment will allow me to continuously watch, read more, and follow happenings in MLP industry sector.

  • In short-to-intermediate term, I do not believe they are good high quality investments. Therefore, I will be making a very small allocation in my dividend growth portfolio. The distribution yield may be high, but I believe the high yield is an indicator of high risk of investments in MLP sector. One of the major drivers for high yield has been the high payout factor. MLPs do not retain major portion of the earnings. The growth and capital needs are funded by new equity or borrowed cash (i.e. more debt). In the recent past, the credit environment was able to support this business model. How long will this continue?
  • In is only in last 10 to 12 years that MLPs have become more prominent and investable for common individuals. The promised benefits of tax deference and other factors are perhaps, still not realized. In majority of the cased, they are most likely still paper benefits.

Dividend growth investing is a long term process. Borrowing from future (tax deferred, debt funding) and showing rosy present (high yield, no tax) is something that is never sustainable. I consider this present performance which is borrowed from future.

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