MLP Exposure Minus the Tax Complexities
05/17/2012 7:30 am EST
Energy master limited partnerships have become popular for their high dividend yields. But, says fund manager Quinn Kiley, investing in them as standalone vehicles can create complicated tax situations. He explains how his fund delivers yield, but avoids some of the burdensome tax issues.
Quinn, as I understand it, your main focus is on pipelines and delivery, rather than exploration and production. So can you tell us a little bit about the fund's objective and your investing methodology?
Quinn Kiley: Sure. As you said, we're focused on energy infrastructure, primarily through what are called master limited partnerships, which is a niche of the energy world. They're publicly traded partnerships, and they're a great investment vehicle.
However, there are some tax complications associated with MLPs. This fund that we've launched a couple years ago is focused on more returns through the MLP asset class, but do it without the tax complications.
We're trying to get a relatively high-yield growth component in the returns, a low correlation to other asset classes—it’s a great diversifier—and trying to do it with lower volatility. All through a publicly traded fund that provides a 1099 and solves some of the tax complexities of owning MLPs directly.
Kate Stalter: As you mentioned, this is a fairly new fund, formed back in 2010. What was the reason to form a new fund in the energy space at that time?
Quinn Kiley: Like I said, there are some complications with owning MLPs directly.
And although we have a large business focused on that strategy, we've noticed that there's a whole series of new exchange traded products and new funds that have come out, trying to address the tax complexity of MLPs. Because there's great investor demand to own them, but there are some hurdles to owning them. And in our view, a lot of these funds were flawed in structure.
So we wanted to develop a product that gave people the investor experience of owning the characteristics and attributes of MLPs, would replicate MLP performance over a cycle, but do it in an efficient manner. And this fund does it in a tax-efficient manner, unlike the other open-ended funds that are 100% MLPs.
And we're also trying to broaden the opportunity set here. We're investing across MLPs, similar energy infrastructure companies, and we're doing that across their capital structure. So not just equity; we're also looking to buy some of the bonds, which provide some of that lower volatility that I mentioned earlier.
Kate Stalter: Before we began recording today, we were chatting briefly, and you had mentioned that this particular fund really is something that could be appropriate for a wide range of retail investors?
Quinn Kiley: It's generally available on many of the broker-dealer systems that many retail investors have their accounts on, so it's easily accessible. It's a very affordable share price. You can buy as little as one share and there are no tax complexities associated with it, like there would be if you owned MLPs directly.
And those complexities, I keep generalizing them, but they're getting a K-1 instead of a 1099, having the obligation of potentially filing your tax returns in multiple states. And those complexities don't come along with this fund.
Additionally, a lot of investors do a majority their investing through retirement accounts, with tax-exempt accounts. This fund is appropriate for those types of accounts as well.
Kate Stalter: I wanted to talk a little bit about some of the holdings in this fund. Maybe just name two or three, and tell us why you like these?
Quinn Kiley: Sure. One name that we found interesting that we've owned for the majority of the life of the fund is Williams Companies (WMB).
And when we bought it early on in the fund, the theme was several fold: One, they're exposed across the energy value chain to the growth that's going on domestically in energy, as we're developing these shale reserves for both oil and gas around the country.
And Williams had exposure on the oil and gas side, the producing side, as well as, and primarily, on the infrastructure side—the pipelines that carry these products around the country.
And our view was that they were going to realize great growth and great value through those business lines. But also, they were the general partner in an underlying master limited partnership. We thought that the value there was not properly recognized by the market, and that there was an opportunity for a separation or reorganization of this business through separating the E&P business, and also a realization of the value of the general partner.
That came to fruition last year when Williams spun off its E&P business to its shareholders. And since then, we've had just great performance and a realization of value there. So that's one example of a theme that we've been exposed to throughout.
Actually, I should say it's two examples of themes that we're exposed to. We really like the idea of the restructuring theme, where there's huge growth and a need for capital in the energy space. You need to realize that capital in the most efficient form, and that can lead to restructuring.
And then secondly, the growth story that underlies all this is the development of shale domestically in this country. It's really a game changer for the energy spectrum across the board, and specifically to oil and gas companies.
Kate Stalter: I'm looking at a chart of this as you're speaking, Quinn. In addition to the dividend yield, you've got some nice price appreciation on this one in the past several months. Are you looking for these total return plays?
Quinn Kiley: I think that's fair. There are really two components to it. We think that yield is a significant portion of the return expectation inside the portfolio. We think it's an important expectation of the investors in the fund, so we want our own securities that generate that yield.
In the energy infrastructure world, you tend to have very stable cash flows. And that's because these are essential assets that are required for energy to be delivered around the country, which I like to think about as job one in the economy. If MLPs and energy infrastructure companies don't do that job, nothing else works. And that means that they have stable, visible cash flows.
The stable, visible cash flows can then be paid out of the stable dividend, and because they're associated with growth, and the growth of energy domestically, there's going to be a growth component as well. So that combination is a good total return story, but it's really anchored by the yield and the income produced by the assets.
Kate Stalter: Do you have maybe another name, or even two, that you can mention to us today?
Quinn Kiley: Sure, there a large MLP that is widely held, Enterprise Products Partners (EPD). It's a decent position in the fund, and it is exposed to natural gas and natural gas liquids, as well as crude oil and refined products all across the country.
It's the largest MLP by market cap and the most liquid by market cap, ad by daily liquidity, as well. And it's a great way for people to have exposure to MLPs in a single holding.
Now again, the tax complexities aside, it's a great single name to own. And it gives you exposure to all the good things that are happening domestically in the US right now, with significantly less commodity price exposure than you would if you were to buy an Exxon Mobil (XOM) or something like that.
And also it is entirely focused domestically, which we think is great, because there's a lot of geopolitical uncertainty. There are some issues going around in Europe, or whether it be the Middle East, that might lead to uncertainty in operations, as well as prices of commodities. So if you can curtail that risk exposure to the US, I think it's a good place to be.
Another name that we really like is Energy Transfer Equity (ETE). That name has been in the news recently because of two large M&A deals that they've done in the past year.
One, they have announced and then closed, which was the acquisition of Southern Union Gas, which was an MLP buying a corporation. We hadn't really seen deals like that in the past. And then just recently, they announced that they were going to acquire Sunoco (SUN), the large refiner and oil and refined-product pipeline company.
So you're starting to see these MLPs, which historically were a small niche area of the energy world, step up and grow. And because of that growth and because of the quality of their long-term growth plan, they are able to access the capital needed to do larger acquisitions.
So Energy Transfer is a great example of a mid-cap growing to a large cap, and Enterprise Products Partners, a great example of a large-cap MLP that is executing across the country.
Kate Stalter: Last question for you today, based on something you just said: Do you anticipate that the MLP area will be ripe for further M&A activity in the next few years?
Quinn Kiley: I do. I wouldn't go so far as to call for MLPs to continue to acquire large energy companies. It might happen on a one-off basis.
What I think you're going to see is that MLPs are going to continue to build and buy energy infrastructure across the country, and that's going to be a significant growth platform.
Historically, it's always been focused on buying assets—less so than companies. Today, you're starting to see them step out and buy more companies, so I think the larger MLPs have access to capital that will allow them to do big acquisitions.
But all MLPs have access to enough capital to do smaller acquisitions, and this has been to build out on top of their geographic footprint, so that's really the growth. Whether it's new asset by acquisition or new asset by building, that's the growth story of the MLPs.