A One-Stop Fund for MLPs
09/07/2011 12:30 pm EST
Gaining access to all corners of the investment universe has never been easier, and closed-end funds offer an abundance of investment strategies to fit almost any investment need…in this case, dividend-rich Master Limited Partnerships, writes Cara Esser of Morningstar.com.
MLPs are unique investment vehicles that typically operate in energy and energy-related sectors, and can be publicly traded or privately held (closed-end funds, or CEFs, can invest in private MLPs, but individuals typically cannot).
Owning individual MLPs can be cumbersome, mostly because of their unique tax characteristics. But gaining access to MLPs via CEFs can reduce accounting headaches, diversify risks, and provide access to the private MLP market.
Kayne Anderson Energy Development (KED) began as a business development company, but it converted to a CEF in the summer of 2010. The conversion was attributed to three factors:
- a desire to have more flexibility in its investment strategy (including increased investments in public MLPs)
- better pricing for leverage
- and the ability to hold cash or cash equivalents, should the fund be forced to repay a portion of its leverage in the event of a market downturn
Aside from a slight increase in public MLP holdings, the overall strategy did not materially change.
KED invests in both the equity and fixed income of energy-related MLPs and other energy companies. Current holdings are invested in private MLPs (52%), public MLPs and MLP affiliates (30%), and the debt of energy companies (18%).
Following the fund’s conversion to a CEF from a business development company, it increased its holdings of public MLPs from the 20% held at the end of 2009.
Holdings are highly concentrated, as would be expected from its relatively small investable universe—close to 70% of assets are in the Top Ten holdings. The largest holding, International Resources Partners LP, is a whopping 31% of assets, up from just more than 17% at the end of 2009, because of strong performance.
The fund employs leverage through floating-rate debt, and its current leverage ratio (total assets/net assets) is about average at 1.27. The fund can borrow up to $70 million, but is currently borrowing $56 million at a rate of LIBOR plus 200 basis points. The debt matures on March 30, 2013.
Since the fund’s inception in September 2006, it has returned 3.5% on an annualized basis. Long-term performance comparisons are difficult because of the fund’s recent conversion to a CEF.
Over the past year, the fund is slightly outperforming its Morningstar US MLP peer group (15% versus 14%), and matched peer performance in calendar 2010.
Over the past year, it’s underperforming its Morningstar-assigned benchmark, the Dow Jones US Energy Index, by close to 15 percentage points. Its fixed-income holdings have added some stability to performance, as the fund lost "only" 31% in 2008 while the average MLP CEF lost more than half its value. The debt also generates income for distributions.
Before delving into the fund’s distribution rate and its history, we must address the prevalent use of return of capital in MLP CEFs. Under accounting rules, an MLP’s pipelines (most MLPs own and operate energy pipelines) are depreciated as an expense. This can lead to taxable income that is less than actual cash flow generation for MLPs.
In other words, cash available for distribution is usually far greater than the amount that is recorded as taxable income, giving rise to return of capital. Because of this, the usual constructive versus destructive return of capital calculation does not apply. We consider MLP return of capital to be pass-through (or "accounting") return of capital.
Investors who persistently avoid all return of capital should know that there is a tax benefit: Since return of capital distributions are not taxed (instead, the cost of the investment is lowered), long-term capital gains can be deferred until units are sold.
The fund’s current 7.6% distribution rate (at net asset value) has included return of capital in each of the past four calendar years. During 2010, the fund paid a relatively small portion of its distribution (about 16%) from return of capital and the remainder from income (53%) and long- and short-term capital gains (31%). In previous years, distributions have been mostly, or even fully, from return of capital.
The fund’s parent company, Kayne Anderson Capital Advisors, runs numerous portfolios within the energy and MLP investment universes. In addition to this fund, the company runs three MLP-focused CEFs, each emphasizing a different area of the MLP universe (including the largest MLP CEF by net assets, Kayne Anderson MLP (KYN)).
The CEF team includes more than 30 members, and is led by Kevin McCarthy and J.C. Frey. McCarthy is chairman, president, and CEO of each of the four Kayne Anderson CEFs. He has been in the energy investment business since 1995, and joined the fund’s team in 2004.
Frey joined Kayne Anderson in 1997, and was involved in the creation and launch of this fund. In sum, Frey manages $3 billion in assets, which includes CEFs and traditional mutual funds. The remainder of the team includes analysts responsible for covering certain industries within the fund’s investable universe.
Many investors may be turned off by the fund’s high fees: Its fiscal 2010 expense ratio was 3.24% and was among the highest in the peer group. This includes an outsized 1.75% asset-management fee for Kayne Anderson Fund Advisors.
But, for investors looking to gain access to energy MLPs, this could be a less risky and less expensive means than buying individual MLPs—not to mention much less cumbersome paperwork and filing come tax time.
Of course, there are a number of ETFs and ETNs with significantly lower fees investing in MLPs, including JPMorgan Alerian MLP Index ETN (AMJ) and ALPS Alerian MLP ETF (AMLP). These funds have a much shorter track record (AMJ’s inception was in April 2009 and AMLP’s in late August 2010).
AMJ’s 5% yield is smaller than KED’s distribution rate, and AMLP does not pay a distribution. Total share price returns have trailed KED this year as well: AMJ’s share price has fallen 1.5% and AMLP’s share price is down 0.32%, while KED’s share price is up and total return is 15%.
NAV performance has been similar for all three funds, highlighting the ability of CEF investors to cash in on discount/premium anomalies.