April 2014
Private
Wealth
Advisory
MLP 101: What Investors
Need to Know About Master
Limited Partnerships
Master limited partnerships (MLPs) can be an attractive
source of income and diversification for investors. MLPs also
generate a lot of questions from investors given the asset
class’s unique ownership structure and tax consequences.
This paper is designed to help investors understand the
fundamentals of how MLP investing works, as well as
the return opportunities and risks associated with this
alternative asset class.
What Is a Master Limited Partnership?
A master limited partnership is an entity that is structured as a pass-through
partnership whose investment units are publicly traded on U.S. securities
exchanges, like common stock of a public company. Unlike a C-corporation, which
is taxed at the corporate level and separate from its owners, any profits earned by
the MLP are taxed at the level of the unitholders at their individual tax rates. As a
result, an MLP combines the benefits of a limited partnership structure with the
liquidity of a common stock.
To qualify as an MLP, per the Tax Reform Act of 1986, an entity must earn at least
90% of its income through qualified sources and/or activities relating to:
•N
atural resources (exploration, mining, production, processing, refining,
transportation, storage, and marketing of natural resources)
• I nterest
•D
ividends
•R
eal property rents
•G
ain from sale or other disposition of real estate
The disclosures of an MLP are regulated by the Securities and Exchange
Commission, and an MLP must file 10-Ks, 10-Qs, and notices of material changes
similar to any publicly traded corporation. An MLP must also comply with
the record keeping and disclosure requirements of the Sarbanes-Oxley Act.
It is important to note that a limited liability corporation (LLC) is similar to an
MLP and maintains the same tax advantages, including no taxes at the corporate
level and tax deferral for limited partners. LLCs and MLPs, however, differ in
terms of operational control. Specifically, an LLC generally does not have a
general partner managing the operations of the business and therefore does not
issue incentive distribution rights (discussed adjacent). Instead, stakeholders
of an LLC typically possess some form of control through voting rights, which
limited partnership unitholders of an MLP do not have.
Private Wealth Advisory −MLP 101
April 2014 | 1
Background: How the MLP Market
Became Dominated by Energy Companies
Investment Structure
The first MLP, Apache Oil Company, was launched in
1981. Other oil and gas MLPs as well as real estate MLPs
soon followed. The original intent was to raise capital
from individual investors by offering them a partnership
investment in more affordable and liquid securities.
During the 1980s, the number of MLPs grew rapidly,
and MLPs were created for a variety of businesses purposes,
including hotels, restaurants, and even sports franchises,
such as the NBA’s Boston Celtics, presumably to avoid
double taxation. Conscious of this trend, Congress stepped
forward with the Tax Reform Act of 1986 and passed
legislation that continues to serve as the framework for
publicly traded partnerships today.
MLP
C-Corp
LLC
Entity level Taxation
No
Yes
No
GP/LP Structure
Yes
No
No
Incentive Distribution Rights
Yes
No
No
Tax Reporting
K-1
1099
K-1
Tax Deferral on Distributions
Yes
No
Yes
Voting Rights
No
Yes
Yes
and distribution) to MLPs so the company could focus on
its core business. These energy spinoffs became
the core of the modern MLP universe.
During the late 1980s and throughout the 1990s,
the highly cyclical nature of many of these types of
businesses proved ill-suited for an entity that is
required to distribute large amounts of its cash flows.
Consequently, many of the original oil and gas exploration
MLPs left the space, as they were unable to maintain
distributions when oil and gas prices plummeted. In
addition, most of the original real estate MLPs converted
to real estate investment trusts (REITs). Integrated energy
companies sold or spun off midstream assets (the parts
of the business involved in gathering, processing, pipelines,
Today there are more than 130 MLPs, about 110 of
which are energy-related, meaning they are engaged
in the transportation, storage, processing, refining,
marketing, exploration, production, and mining of
minerals and natural resources. More than half of
today’s 110 energy MLPs are involved in midstream
assets (split almost equally between natural gas and oil
infrastructure), with an additional 17 in upstream
assets (exploration and production) and nine in
Size of the MLP Market
After the Tax Reform Act of 1986 redefined what types of businesses could qualify as an MLP, the MLP market
has become dominated by energy-related businesses. Today, 110 of the 134 total MLPs are businesses that provide
a service to the energy industry.
$700
105
$600
74
74
68
70
54
‘99
‘00
40
0
Aug ‘13
‘98
60
$302
‘12
‘97
80
20
‘10
$10
$90
$446
$490
$158
‘09
$11
$102
$145
‘08
$7
‘05
$5
‘04
$4
‘03
$2
$15
‘02
9
$242
‘07
34
$69
$45 $56
$26 $29
7
‘96
15
30
18
‘95
12
29
17
‘94
12
23
‘01
$200
41
‘06
$300
76
‘11
$400
$0
120
100
$500
$100
110
Source: HarvestFund Advisors
Private Wealth Advisory −MLP 101
April 2014 | 2
downstream assets (refining, marketing, and distribution).
The rest cover the spectrum of the energy value chain,
including propane, marine transportation, coal, and royalty
trusts.
The majority of MLPs receive a fee or toll for delivering
a customer’s product across their infrastructure systems,
resulting in relatively stable cash flows. The MLP, in
most cases, does not own the commodity, essentially
eliminating commodity price exposure and thereby
smoothing out its cash flows. Natural gas pipelines receive
stable income in the form of rental fees from pipeline
capacity reservations, independent of actual throughput
and largely through “take-or-pay” contracts. Other product
pipeline revenues typically depend on throughput, but
are protected by inflation escalators that act as a hedge.
Other midstream assets have similar fee-based contracts
that vary in risk depending on their position in the energy
value chain.
While it is not legally required to do so, an MLP typically
pays a substantial portion (70% to 100%) of its cash flow
from operations to unitholders in tax-deferred distribution,
which are not dividends. To accomplish this, the MLP
usually engages in businesses that provide robust, stable,
and predictable cash flows. Investors typically seek
partnerships that can grow distributions over time, and
an MLP accomplishes this partly by growing its asset base
through organic projects, asset purchases from its parent
known as “dropdowns,” or third-party acquisitions.
Ownership: General Partner and
Limited Partners
An MLP generally has two main classes of owners: the
general partner (GP) and limited partner (LP). The general
partner typically owns 1% to 2% of the partnership and is
responsible for managing the daily operations of the MLP.
In return, the GP receives its pro rata share of the MLP’s
available cash flows through distributions, which are
generally paid out on a quarterly basis, similar to dividends
on common stock. Distributable cash flow is calculated as
net income plus depreciation and other noncash items,
less maintenance capital expenditures. These distributions
from the MLP are at the discretion of the GP and in
accordance with the partnership’s documents.
Limited partners usually own the remaining interest in the
partnership in the form of publicly traded “common units.”
While LPs receive quarterly cash distributions in exchange
for contributing all of the capital to the partnership, they
have no role in daily operations nor do they have any voting
rights. Additionally, liability is limited to the amount of
capital invested.
Private Wealth Advisory −MLP 101
MLPs combine the pass-through
tax benefits of a limited partnership
structure with the liquidity of
common stock
Incentive Distribution Rights
In return for managing the business, the GP also
owns incentive distribution rights (IDRs), which specify
the GP’s share of the total cash distributions. The GP’s
share typically increases, as a percentage, as distributions
exceed certain thresholds. IDRs motivate the GP to operate
and grow the business in a manner that maximizes cash
distributions to the unitholders. They are generally agreed
to between the partnership and the GP at the creation of
the MLP and typically start with the GP receiving 2% of the
cash distributions. A GP’s IDRs can reach as high as 50%
and this is referred to as “high splits.”
High splits can stifle the growth of an MLP as projects and/
or acquisitions will require more cash flow generation to
compensate for the higher distribution flows to the GP.
Different IDR split structures have a material impact on
total distribution paid to LPs.
Percentage of Distributions
The general partner’s share of the total cash
distributions, known as the incentive distribution
rights (IDRs), typically increases above pretermined
thresholds. It is important for potential limited
partnership investors to understand how the IDR
schedule can influence the operations of the business.
Tier
Annual Distribution
per LP Unit
LP
Interest
GP
Interest
1
Up to $1.16
98%
2%
2
Above $1.16 up to $1.31
85%
15%
3
Above $1.31 up to $1.58
75%
25%
4
Above $1.58
50%
50%
Tax Environment and Implications
for Investors
Classified as a partnership rather than a corporation,
an MLP is not subject to corporate-level federal income
taxes, eliminating double taxation at the unitholder level.
April 2014 | 3
This effectively provides an MLP with a cost advantage
over its incorporated peers when pursuing growth or
expansion projects. The tax liability of the entity is passed
on to its unitholders, and the GP and LPs are required to
pay taxes on their allocable share of the partnership’s
net income at the investor’s individual ordinary income
tax rate.
The Schedule K-1 (Form 1065)
The K-1 is the tax statement that an MLP investor receives
each year from the partnership which outlines the
investor’s share of the partnership’s income, gains, losses,
credits, and deductions, including accelerated depreciation
and amortization deductions. It is typically distributed in
February of each year and is similar to a Form 1099 that
an investor receives from a corporation. If the partnership
reports a net loss after deductions, it is considered a passive
loss under the tax code. While passive losses may not be
used to offset income from active sources, they may be
carried forward and used to offset future income from the
same MLP or other passive sources. The amount of taxes
an LP pays is determined by several factors, including
the unitholder’s ownership percentage, the timing of the
investment, and the cost basis.
Typically, the K-1 allocates partnership income and loss
items to each state in which the partnership conducts
business or owns property. Thus, a potential complication
with direct investing in an MLP is that an LP may be
required to file state and local income tax returns in some or
all of the various jurisdictions, regardless of the investor’s
residence. As a result, many investors are often discouraged
from allocating capital to this asset class due to the onerous
tax filings.
Tax Deferral
MLPs can generate two distinct sources of income each
year for investors:
1. A
n allocable share of an MLP’s net income
for tax purposes
2. Quarterly cash distributions
This distinction is important because the two income
sources are taxed differently. While the investor’s allocable
share of net income is taxable on an annual basis, the
amount tends to be very small relative to the annual cash
distribution. This is because an MLP typically generates
significant noncash deductions, such as depreciation
expenses, that substantially offset the allocated income
and greatly reduce the amount of taxable income. These
Private Wealth Advisory −MLP 101
noncash deductions do not affect the quarterly cash
distributions. Indeed, the allocable share of net income
typically accounts for only 10% to 20% of an LP’s total
income received in a given year. In other words, an investor
receives a tax shield equivalent to 80% to 90% of its cash
distributions in a given year until the investor sells the LP
units. At the time of the sale , however, there is depreciation
recapture and the net income that was shielded by the
deductions becomes deferred taxable income and is taxed
as ordinary income.
Unlike stock dividends, the quarterly cash distributions
are not taxed in the year received and are 100% taxdeferred. These distributions are treated as reductions
in the investment’s cost basis, or a return of capital, and
create a deferred tax liability. There are two primary events
that can trigger the end of the tax-deferred status of the
distributions:
1. Monetization: Once the investor sells his or her units,
the deferred portion of the distributions becomes taxed
at the investor’s personal income rate (capital gains
above the purchase price are taxed at the capital gains
tax rate).
2. Basis reaches zero: Each year, the portion of the
distributions that the net income allocation does not
offset goes toward decreasing the original cost basis of
the investment. If the sum of these offsets increases
beyond the original purchase price of the units, then
the future distributions lose their tax-deferred status.
MLPs are a unique estate planning tool for tax-efficient
wealth transfer. When an heir receives the units, the cost
basis is reset at the new price. Therefore, there are no taxes
on the prior deferred distributions. An investor’s basis is
calculated by taking the initial basis plus allocated income
less depreciation and less the cash distribution.
In general, tax-exempt vehicles such as pension accounts,
401(k)s, IRAs, and endowment funds are encouraged not to
directly invest in MLPs because the partnerships generate
unrelated business taxable income (UBTI). If a tax-exempt
entity receives UBTI in excess of $1,000 per year, the
investor would be required to file IRS form 990-T and
may be liable for tax on the UBTI.
MLP Investors
Historically, MLPs have been mostly owned by individual
investors rather than institutions. In 2000, individual
ownership approximated 90% of total MLP units, with
limited institutional participation.
April 2014 | 4
Before 2004, institutional investors such as mutual funds
and other registered investment companies were restricted
from investing in MLPs because distributions and allocated
income from publicly traded partnerships were considered
nonqualifying income. To retain their special tax status
as regulated investment companies (RICs), mutual funds
and other registered investment companies were required
to receive at least 90% of their income from qualifying
sources. Since the passage of the American Jobs Creation
Act in October 2004, however, it is now incrementally
easier for RICs to own MLPs. Still, the current parameters
specify that no more than 25% of a fund’s asset value may
be invested in MLPs and a fund may not own more than
10% of any single MLP. So any fund with an MLP focus
would easily exceed these thresholds and would no longer
be eligible to file as a RIC. As a result, the fund would likely
file as a C-corporation, which is subject to income taxes
at the corporate level, negating the taxation benefits of the
MLP structure.
subject to double taxation but it must also reduce its net
asset value (NAV) to reflect withholding for the future tax
liability on deferred income and distributions. For these
reasons, many critics question whether mutual funds can
adequately track the performance of MLP indices. At the
time of this writing, there were 12 open-ended funds.
Investment Vehicles
MLP Investment Options
As previously mentioned, the most tax-efficient means
to invest in MLPs is through direct ownership of the
securities by either buying them in a brokerage account or
in a separately-managed account. However, direct owners
receive K-1s which can require tax filings in multiple
states. Various investment vehicles have been created to
consolidate tax reporting, and each have their own pros and
cons.
Closed-End Funds (CEFs)
For MLP-dedicated funds, the closed-end structure
has been preferred over the open-ended one, and today
there are 23 distinct options. However, many closed-end
funds are structured as C-corporations because of the
aforementioned RIC limitations on owning MLPs.
Therefore CEFs are subject to corporate level taxes. While
CEFs offer intraday liquidity, they may trade at a price that
differs from NAV, creating a price discount or premium.
Pros
Separate
Account
• K-1 for each
MLP
• Tax deferral
• High minimum
investment
• Professional
management
• Consolidated
K-1
Limited Partnerships
Accredited investors and qualified purchasers can obtain
MLP exposure through limited partnerships that pool
investor capital. While these vehicles provide a single
consolidated K-1, they tend to have high minimums
and liquidity constraints. Unlike other vehicles, limited
partnerships may not protect against the generation of
UBTI, which can make them restrictive for tax-exempt
accounts.
• Professional
management
• Wealth transfer
benefits
Limited
Partnership
Open-end
Mutual Fund
• Professional
management
• Consolidated
1099
Closed-end
Mutual Fund
Cons
• Professional
management
• Consolidated
1099
• Lock ups
• High minimum
investment
• Corporate tax
if fund does not
qualify as a RIC
• Corporate tax
if fund does not
qualify as a RIC
• Leverage
• Tracking error
Open-End Mutual Funds
Mutual funds replace the burden of multiple K-1s for
investors with a single 1099 and provide professional
management. However, the MLP investment parameters
of the American Jobs Creation Act restrict a RIC’s
investments in LP structures to 25%. While mutual funds
will include the GP portion of MLPs, or invest in other
creative structures to increase exposure to the LPs, they
are not considered pure plays on the MLP space. If an
open-ended mutual fund elects to concentrate in MLPs and
file as a C-corporation instead of a RIC, the fund is not only
Private Wealth Advisory −MLP 101
ETF
• Consolidated
1099
• No professional
management
• Corporate tax
if fund does not
qualify as a RIC
ETN
• Consolidated
1099
• No professional
management
• No tax deferral
• Credit risk
April 2014 | 5
Exchange-Traded Funds (ETFs)
An MLP ETF holds units in a diversified basket of MLPs,
with the benefits of providing a single 1099 and intra-day
liquidity. While ETFs are generally less expensive than
funds, they are structured as C-corporations, making all
income and capital appreciation subject to the corporate
tax rate of 35%. Therefore, ETFs must adjust their NAV
for any deferred tax liability, which may lead to substantial
tracking error. Distributions from the ETF, however, do
retain the characteristics of the underlying MLPs. As such,
most of the distributions from MLP ETFs to date have been
treated as a return of capital, though this could change as
the ETFs turn over their underlying positions. The first
of now six MLP ETFs, the Alerian MLP ETF (AMLP), was
launched in August 2010.
Exchange-Traded Notes (ETNs)
An exchange-traded note operates as an index-linked bond
that provides access to an index, such as the Alerian MLP
Index (a market-cap weighted, float-adjusted index created
to provide a comprehensive benchmark for investors to
track the performance of the energy MLP sector.) The
unsecured note pays coupons linked to the distributions
of MLPs tracked in the underlying index less fees. Because
the payment is a coupon, income distributions are treated
as ordinary income and there is no deferral mechanism.
ETNs typically track the index better than ETFs because
they are not constrained by proportion of ownership of
the securities in the index. In this structure, the sponsor
essentially guarantees that funds will be available to
replicate the value of the index holdings at the date of
maturity. This makes credit risk a concern with ETNs, as a
decline in credit rating or bankruptcy of the note-issuing
bank can erode the value of the securities. Highlighting
this risk is that the first MLP ETN was started in 2007 by
Bear Stearns, which failed in 2008. Many institutions have
constraints that prohibit them from taking on significant
credit exposure from a single issuer, so investments in
ETNs may be limited. At the time of this writing, there were
six ETNs listed for trading.
Investment Risks
Investing in MLPs involves risks that differ from
investments in common stock. These risks include those
related to cash flow risk, interest rate risk, the ability to
access capital markets, taxation risk, regulatory risk, and
industry-specific risk.
Cash Flow Risk
Distribution yields and their growth serve as an essential
driver of MLP performance. MLPs typically pay out a large
proportion of their excess cash flows through quarterly
distributions to unitholders. The distribution yield is
typically inversely related to expected distribution growth
because investors are willing to forego current yield in
return for future distribution growth. Historically, those
MLPs with the fastest distribution growth tended to
outperform those with little or no distribution growth.
Thus, any reduction in an MLP’s distribution yield and/or
distribution growth will likely be met with falling prices.
Tax-efficient Investing in MLPs
While mutual funds, ETFs, and other investment vehicles can provide exposure to MLPs in retirement accounts
without generating “unrelated business taxable income,” the most tax-efficient way to invest in MLPs is through
direct ownership.
Investment Structures for MLPs
Double Taxation
Tax Deferral
Tax Reporting
Direct Investing
No
Yes
K-1
Seperately Managed Accounts
No
Yes
K-1
Open-End Mutual Fund - RIC
No
Yes
1099
Open-End Mutual Fund - Corporation
Yes
Yes/No*
1099
Closed-End Mutual Fund - Corporation
Yes
Yes/No*
1099
Exchange Traded Fund (ETF) - Corporation
Yes
Yes/No*
1099
Exchange Traded Note (ETN)
No
No
1099
* NAV will reflect 35% withholding for future tax liability
Private Wealth Advisory −MLP 101
April 2014 | 6
Interest Rate Risk
Investors are often attracted to MLPs because of the
relatively high current yield the securities offer. Interest
rates represent an important driver of MLP performance as
MLP yields are compared with government bond yields. As
government bond yields fall, MLP prices may rise, as they
become more desirable alternatives for income-producing
securities; but the reverse is also true: as government
bond yields rise, MLP prices may fall, as they become less
desirable alternatives. Rising interest rates could also raise
an MLP’s cost of capital, which may drive investors into
other investment opportunities.
Most MLPs have become public since 2000, a period in
which the United States was in a declining interest rate
environment. There have been intermittent periods of
rising rates within the broader declining rate environment
and, during these periods, MLPs lagged the S&P 500, but
tended to outperform utilities and REITs. According to a
Credit Suisse analysis, there were 11 instances when 10-year
Treasury rates increased from trough to peak. Out of those
instances, the Alerian MLP Index underperformed the
S&P 500 seven times but mostly outperformed utilities
and REIT indices. This data suggests that while rising
interest rates may force MLPs to lag the broader equity
markets, they may hold up better than other yield-oriented
securities.
In addition, rising interest rates may increase an MLP’s
debt costs, which would further reduce the available capital
for the general and limited partners.
M
LPs involve a distinct set of risks
for investors relative to the risks of
investing in common stock.
Access to Capital Markets
The success of MLP partnerships depends on their ability to
effectively manage projects as well as to execute profitable
acquisitions. Because MLPs pay out the majority of their
cash flow as distributions, MLPs rely heavily on access to
capital markets to issue debt and equity to finance growth
projects and acquisitions. Limited access to financing
would negatively affect MLPs that require significant
capital resources to continue producing strong returns.
The financing mix for these projects averages around 50%
equity and 50% debt. Following the credit crisis in 2008,
the capital markets have continued to improve and remain
accessible today. In 2013, MLPs completed about 70 deals
including IPOs and secondary offerings to raise a total of
more than $20 billion, according to RBC Capital Markets.
Legislative Risk
MLPs do not pay U.S. federal income tax at the partnership
level. Rather, each partner is allocated a share of the
partnership’s income, gains, losses, deductions, and
expenses. A change in current tax law by Congress, or a
Annual Equity Issuance - IPOs and Follow-ons
Access to capital markets is vital to the growth and success of MLPs. Since the credit crisis, capital markets have been
relatively open to MLPs.
77
Deals
ANNUAL MLP EQUITY ISSURANCE
(IPO & FO) $BN
IPOs
Follow-ons
68
Deals
40
Deals
36
Deals
$3.6
$1.5
2005
34
Deals
$3.1
$5.0
$8.3
$4.0
2006
2007
21
Deals
$3.4
$0.9
2008
49
Deals
$12.9
$6.4
2009
$1.8
2010
67
Deals
66
Deals
$18.2
$16.3
$2.7
$3.6
$3.9
2011
2012
2013
$13.9
Source: RBC Capital Markets
Private Wealth Advisory −MLP 101
April 2014 | 7
change in the underlying business mix of a given MLP, could
result in an MLP being treated as a corporation for U.S.
federal income tax purposes. Further, the classification of an
MLP as a corporation for U.S. federal income tax purposes
would have the effect of reducing the amount of cash
available for distribution by the MLP.
Regulatory Risk
The IRS has called an internal working committee to
evaluate REIT qualification principles in response to a
growing list of companies with nontraditional real estate
assets seeking conversion. Primarily, the committee is
looking at the definition of real property, the framework
for determining rents versus service revenues, and tax-free
spin-offs of REITs from a C-corporation. While the IRS
has yet to establish an internal working group to evaluate
current principles used to determine qualification for MLP
status, a modification of the tax code could be a negative
event.
Industry-Specific Risk
Energy infrastructure companies also are subject to risks
specific to the industry they serve, including:
• Reduced volumes of natural gas or other energy
commodities available for transporting, processing,
storing, or distributing
• Sustained reduction in demand for crude oil, natural
gas, and refined petroleum products resulting from a
recession, an increase in market price, or higher taxes
• Depletion of the natural gas reserves or other
commodities if not replaced
• New construction risks and acquisition risk that can
limit growth potential
• Changes in the regulatory environment, and
• Extreme weather, such as warm winters or
natural disasters
This information has been prepared solely for informational purposes and is not intended to provide or
should not be relied upon for legal, tax, accounting, or investment advice. We recommend that you consult your
attorney, tax advisor, investment or other professional advisor about your particular situation. This material is provided
for information purposes only and is not intended as investment advice nor is it a recommendation to buy or sell any
particular security. Any discussion of particular topics is not meant to be comprehensive and may be subject to change.
Data shown does not represent the performance or characteristics of any William Blair & Company, L.L.C. product
or strategy. Any investment or strategy mentioned herein may not be suitable for every investor. Factual information
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Private Wealth Advisory −MLP 101
April 2014 | 8
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