Why the Tortoise Beats the Hare

There may have been a time when the long view predominated among investors, but if it did it’s more likely to be a fable than an historical fact. We live in an age when far too many investors are necessarily familiar with the Vix index (an index of equity market volatility), and this makes the decidedly unsexy world of low volatility investments especially appealing. People want to beat the averages, and they often try and do so in a hurry. In fact, one of the most reliable ways to win at investing is to be content at winning slowly.

We’ve run low volatility strategies for many years. We used to call them “Low Beta” to indicate their connection with the Capital Asset Pricing Model (CAPM) and a flaw we seek to exploit, but few people outside of Finance care about Beta and so this month we renamed them to be more plainly descriptive. The amount of return you expect depends on the amount of risk you’re willing to take; low volatility stocks suggest low returns, and yet investors who follow such a strategy wind up turning some of the worst instincts of other investors to their advantage. The renamed strategies are listed below. Nothing else has changed other than their names. Strategy descriptions are available on our website, or you can ask for more information.

New Name Old Name
Low Vol Long Only High Dividend Low Beta
Low Vol Hedged Hedged Dividend Capture
Low Vol Best Ideas Low Beta Long-Short

 

In our opinion, the persistent relative outperformance of low volatility stocks relies on an interesting behavioral finance quirk. A substantial portion of actively managed equity portfolios are benchmarked against an equity index, ranging from large separately managed institutional accounts to retail-focused mutual funds. Because the investors are human, they tend to focus most closely on the relative performance of their chosen manager when returns are positive; when returns are negative they’re more concerned with the magnitude of the losses rather than whether they look good compared with a benchmark. Just think back to your own experience of evaluating positive and negative investment results to see if this reflects your own biases. We ought to value beating the benchmark by 2% in any year, but it turns out to be more valuable when returns are positive.

Active managers on average respond to this by structuring portfolios that are more likely to outperform a rising market. This is most easily done by investing in stocks that have higher beta (or volatility) than the market because they will probably go up faster. Their proclivity to fall faster hurts the manager less, since assets are best raised in a rising market. Therefore, equity managers who are not personally invested alongside their clients have an incentive to run portfolios that are more risky than the market. An alternative interpretation is that investors inadvertently favor such managers, but in any event it’s why low volatility stocks outperform. Although low volatility stocks are widely owned, they’re not widely owned by active managers because they don’t rise enough in a bull market.

This is a form of principal-agent risk, and the most effective alignment of interests is to ensure that your chosen active manager is substantially invested alongside the client. This is what we practice at SL Advisors, and in 2015 low volatility exposure provided a welcome distraction from the turmoil of MLPs.

Some pundits regularly lament the increasingly short-term nature of today’s investors. John Kay’s recent book Other People’s Money; The Real Business of Finance is a fascinating read for those who fret that today’s capital markets are overly dedicated to trading rather than their more appropriate purpose of efficiently channeling savings to those businesses that can deploy capital in attractive ways. I am increasingly in that camp. The media, and most especially broadcast media, meets a very real need of their viewers to figure out where the market’s going today. It should be a misplaced need if you’re investing for the long run but today’s extraordinarily cheap access to public equity markets is wonderful if not wholly beneficial. The narrow difference between a day trader in stocks and one who spends his days betting on sports renders both little more than punters managing their shrinking capital.

The case that the short term outlook rules isn’t limited to perusing the media. Some of today’s investment products provide additional evidence. Leveraged ETFs, the subject of a blog in June 2014 (see Are Leveraged ETFs a Legitimate Investment?) are not intended to be used as part of any long term investment strategy and their prospectus plainly says so. Their successful existence illustrates the demand for cheap ways to bet on the market’s direction. Consenting adults are generally free to engage in any behavior they wish as long as it doesn’t hurt anybody else. Since such investments eventually have to go to zero (see “Compounding” below), the facilitation of self-harm to the buyers of one’s products surely puts the seller in the company of casino owners if not worse.

Tortoise v Hare Blog Jan 31 2016

Compounding returns has long been a reliable way to build wealth, but it’s important to make it work for you. Most readers will be aware that a 10% drop in a security requires an 11% jump to get back to even. Lose half your value and prices then need to double. This means that a security that is up 2.00% on half of trading days and -1.96% on the other half will remain stubbornly at your purchase price in spite of the up days being bigger than the down days. However, obtaining such exposure through a 2X Leveraged ETF, which has to rebalance its leverage every day, would have you lose 10% in the course of a year. Maintaining constant leverage causes you to buy more of the asset after it’s risen, and sell more after it’s fallen, a self-destructive course of action. In the stylized chart of two growing companies, Hare and Tortoise (Source: SL Advisors), Hare grows earnings at 10% annually with one stumble when they drop 20%. Tortoise grows at 6.55% every year, thereby equaling Hare’s 10 year compound growth rate. They reach the same place, but you’d rather own Tortoise for the less stressful ride even though their visible growth rate is only two thirds of Hare. The power of compounding works best with low volatility.

Closed end funds, perhaps most spectacularly including those focused on Master Limited Partnerships, employ leverage. As bad as the Alerian Index was in 2015 at -32.6%, it was possible to do far worse. A Kayne Anderson fund (KYN) lost 51% in part because it was forced to reduce leverage following market drops, as noted in last month’s newsletter. Two leveraged MLP-linked exchange traded notes (ETNs) issued by UBS did even worse, as briefly noted at the end of a recent blog (How Do You Break a Pipeline Contract?).

This letter began by expounding on the beauty of low volatility before moving on to the perils of leverage. If it’s not already clear, they are connected. Positive returns that don’t vary that much will often get you to a better place than those that fluctuate widely. Compounding works better with low volatility. It’s an area of investing where the low volatility, boring tortoise beats the volatile hare. If Aesop was a client of SL Advisors today, he would be in our Low Vol Strategy.

How Do You Break a Pipeline Contract?

Given the collapse in MLP prices over the last six months virtually any explanation is worth considering. Operating results continue to be unremarkable – Kinder Morgan (KMI) reported 4Q15 financials last week. Their full year 2015 results were 4% lower than their budget; two thirds of the miss was in their CO2 business which is sensitive to the price of crude oil. Overall they generated $7.6BN of EBITDA versus a budgeted figure of $7.9BN. Their Distributable Cash Flow of $4.7BN was 7% higher than in 2014. In April KMI was at $44, and closed the year at under $15.

But operating performance has never come close to justifying the performance of MLPs recently, hence we have cast around for other explanations. The rigidity of the investor base is, we think, an important cause (see The 2015 MLP Crash; Why and What’s Next). Another frequently raised concern is that the rates MLPs earn on their pipelines will be reduced, either because loss-making E&P companies will renegotiate terms or because they’ll fail and a bankruptcy court will impose a lower rate. Although there’s very little history of this, the views of the investor who chooses not to buy MLPs can be more useful than those of the MLP seller, and this issue is being raised more frequently.

It sounds plausible that if the company filling a pipeline with hydrocarbons at one end is losing money, the pipeline owner should care. A pipeline’s immobility requires reliable customers. An E&P company that is unwilling or unable to use previously contracted capacity can cause problems for the pipeline owner as well as for the customer at the other end awaiting receipt of the product.

The U.S. has 192,396 miles of liquids pipelines of which roughly a third each move crude oil, Natural Gas Liquids (NGLs) and refined products. There are over 302,000 miles of natural gas pipelines. There are over 240,000 miles of Gathering and Processing (G&P) lines – often single individual pipes to a single well. These are both narrow and numerous. There are nearly 2.2 million miles of natural gas distribution lines from utilities to residential and commercial customers. Historically, their utilization has been remarkably reliable. While Gazprom occasionally uses its power as a supplier to further Russia’s foreign policy objectives, it’s hard to think of an example where a domestic commercial dispute has impeded the flow of product. Once pipelines are built, they are used with a high degree of predictability. The Federal Energy Regulatory Commission (FERC) governs all natural gas pipelines (other than G&P) and all other pipelines that cross state lines. Interestingly, the thrust of regulation has largely been to limit the power of the pipeline operator, since a customer on the receiving end of a pipeline has few plausible choices if he’s suddenly faced with a price hike. Although a single pipe is immobile and obviously creates a symbiotic relationship with its customer, it’s part of a network which makes the product mobile, affording its owner substantially more flexibility on where to send product than the customer has on where to obtain it. Part of FERC’s role is to control the ability of MLPs to exploit this. Security of supply requires predictability of income. Pipeline projects are cancelled before breaking ground if insufficient commitments are in hand to assure its financial viability. In 2013 Kinder Morgan cancelled the $2BN “Freedom” pipeline that was intended to transport crude oil from West Texas to California for just this reason. The Field of Dreams approach is not widely used.

There isn’t a long history of broken pipeline contracts from which to draw examples. Disputes are hard to find, probably because there’s so little legal ambiguity.  Last year an Indian steel company, Essar Steel Limited, lost a case in Minnesota federal court when their acquisition of a local steel company led them to break an agreement with Great Lakes Gas Transmission Limited Partnership to take their supply of natural gas (used in steel production). Essar’s contention that the global economic crisis invalidated the contract was rejected by the court, which awarded $32.9 million to the plaintiff.

FERC has authority over many potential disputes. In 2015 Buckeye Partners reached agreement following a long-running dispute with several airlines over the rates they were charging to deliver jet fuel from New Jersey to three New York area airports. FERC oversaw the agreement and approved its resolution.

It can be useful to think of pipelines as networks of tributaries from individual plays feeding into processing centers and then into large-capacity trunklines on their way to population centers, power stations, refineries, export facilities and other users. Recently, “farther from the wellhead” has guided the investment recommendations of some, and it makes sense that a G&P network supporting a new, high cost crude oil baisin involves a totally different risk than a natural gas pipeline running into New York City to supply a power station’s electricity production.

Pipelines that are “demand pull,” in that they’re paid for by the end-user (such as a refinery or power station) are less risky than “supply-push”. In addition, 75% of hydrocarbon production in the U.S. is done by investment grade companies, so performance risk ought to be limited. Take-or-pay contracts assure the pipeline operator of revenue regardless of whether the E&P company uses the capacity. Like virtually all U.S. commercial contracts, they are enforceable. None of these seem to represent significant risk of changing contract terms. The place to look for problems is close to the wellhead where a bankruptcy judge is overseeing a failed E&P company’s obligations. However, bankruptcy need not impede the flow of product, since the bondholders could continue operations with a reduced cost of capital having shed the equity holders. While it’s conceivable that a struggling E&P company could seek to renegotiate a contract with the threat of shutting in the well, the problem of weak prices is one of excess supply. Other producers would presumably be willing to use capacity albeit not necessarily in the same place.

2015 saw 41 energy companies file for bankruptcy representing $16BN in debt. So far there are few reports of any meaningful consequences for the MLPs that provide their infrastructure, although there are reported instances of contracts being renegotiated. Williams Companies (WMB) and Chesapeake (CHK) have agreed on lower rates for natural gas transportation in Ohio and Louisiana in exchange for higher future volumes, but this is not a typical case: CHK spun out their midstream assets into Access Midstream with unusually lucrative contracts probably because they were more highly valued by Access investors than their cost as reflected in CHK’s valuation. WMB subsequently acquired Access Midstream. In Pennsylvania, leasehold contracts have been challenged by the state on behalf of many landowners who have seen their royalty checks for drilling leases slashed. But it seems so far to be an isolated case. In another interesting case brought to my attention by Ethan Bellamy of RW Baird and also Dick Flex (see comment on right panel), Quicksilver Resources , which is in bankruptcy, continues to send natural gas through Crestwood Midstream’s (CEQP) G&P network, although Quicksilver is seeking to renegotiate their agreement and has used bankruptcy to reject contracts with other G&P firms. Bankruptcy doesn’t have to lead to a cut in production. Kinder Morgan’s recent results did include a $45 million credit charge in their Terminals business due to two failed coal companies. Of course this reflects the shift away from coal towards natural gas, a trend for which MLPs including KMI are well positioned.

Moreover, demand is not the problem. Last year in the U.S., natural gas production of around 80BCF (Billion Cubic Feet Per Day) was 4BCF higher than in 2014. Exports are expected to double this year. Auto sales were a record 17.5 million with gas-guzzling pick-ups and SUVs representing half of this. Cheap hydrocarbons are producing a demand response.

While MLPs have always paid attention to the credit profile of their customers, there is increased focus on this area from investors.  We’ll continue searching for examples of the likely impact on an MLP when its E&P customer fails.

A poorly designed MLP product Crashes

This could almost be the topic of a second blog post: last week UBS announced the mandatory redemption of two exchange-traded notes that were designed to provide MLP exposure leveraged 2:1. The results have been predictable, and the notes (ticker: MLPV and MLPL) duly performed as designed. MLPV fell from $22 last Summer to under $5 at which point the abovementioned mandatory redemption was triggered. The more seasoned MLPL reached $75 at the MLP peak in August 2014 and recently touched $10. Incidentally, the management of vehicles such as these requires selling MLPs when they fall and buying them when they rise to maintain constant leverage, the type of behavior that has exacerbated the sharp moves in the sector recently and causes a permanent loss of capital for the investor. The clients of UBS were poorly served indeed.

We are long BPL, CEQP, KMI and WMB

Funny Snow Cartoon Jan 2016

Pity the Equity Analyst

This week I felt a pang of pity for a sell-side research analyst. Not an obviously sympathetic constituency, you might well retort. There are many other categories of employment more deserving of such consideration – indeed, probably too numerous to list here. But I did, and here’s why.

This particular analyst (he’ll remain nameless because I don’t wish to embarrass him) has been a relentless cheerleader for Master Limited Partnerships and increasingly so as their prices have plummeted. That’s already sufficient reason for me to express my sympathy. You may have spotted that we have something in common.

Explaining why MLPs keep falling in willful defiance of what an evident minority asserts is compelling valuation can be tiring, and some become weary of it before others.

Plains All America (PAA) is the midstream infrastructure MLP most clearly linked with falling crude oil prices. Like most MLPs they rely on issuing equity to fund their growth plans, and PAA has been growing in recent years to accommodate increased domestic oil production. Acknowledging the unwillingness of investors to fund growth as well as the reality of falling domestic production, PAA recently cut their 2016 growth plans from $2.1BN to $1.5BN.

On Tuesday, January 12th PAA announced they had raised $1.5BN through a convertible preferred security yielding 8%, some 5% less than the yield on their equity. It was privately placed with several institutions, and as a result PAA has no need to issue equity through 2017. Moreover, it was pretty cheap capital since it is convertible to equity at the holder’s option in two years or at PAA’s option (under certain circumstances) in three. In any event, it is junior to all their other liabilities and is in reality equity (which is how PAA regards it). Private equity investors, not normally accused of superficial research, saw fit to invest $1.5BN in equity in an MLP.

So you have a piece of news that is unambiguously positive, in that PAA raised capital on surprisingly inexpensive terms from informed investors and is no longer a seller of its own equity. Now let’s return to our sell-side analyst.PAA Chart for Jan 17 2016

Research reports include a history of the Certifying Analyst’s prior recommendations on the stock. PAA had been a Buy (called an “Overweight”) since October 2011, at which time it was trading at $30 with a price target of $34.50. Through 19 subsequent revisions the Buy recommendation remained, with the price target regularly adjusted so as to be always 10-20% higher than the current price. In October 2014, with PAA at $58 the peak price target of $66 was recorded.

To quote a friend of mine, from that point down was a long way and on Monday, January 11th just prior to PAA’s announcement, its stock closed at $20.36, 70% below its target of fifteen months earlier. Now put the numbers aside, and consider what the past fifteen months have been like for the sell-side analyst. He has doggedly articulated the bullish case through the most relentless selling. He has noted the fee-based nature of PAA’s cashflows, the highly regarded management and their history of solid execution. His analysis is widely read and his day must have increasingly been one of verbal jousting with his firm’s salespeople as they relayed client dissatisfaction and most likely anger. When losing money on an investment it’s some small solace to blame one of the unapologetic cheerleaders.

Sell-side analysts can be highly paid (although one suspects that MLP analysts face a supply/demand imbalance similar to crude oil). But even highly paid people have a breaking point, and this week our analyst reached his. We know this because on Wednesday, January 13th following PAA’s $1.5BN capital raise the sequence of 20 consecutive Buy recommendations was finally broken with a switch to Neutral. The unspoken message was clear:

I am tired of this. Let me hide in the obscurity of the current market price. I no longer wish to explain what cannot be explained to my colleagues or my clients. I am out.

This is how it feels to sell after intending to never sell. If you’re planning to panic, it’s best done immediately.

How do I infer this from a research report that doesn’t make such a confession? Because of what it does say. Acknowledging that the capital raise was undoubtedly good, our analyst nonetheless downgrades the stock because of lack of visibility around crude oil. Of course the crude oil price remains both highly visible and unpleasant. Moreover, because all good research must include a Mathematical basis by which the current price target is derived, the discount rate on PAA’s future cashflows was arbitrarily jacked up to 11% and a zero growth rate was assumed on their terminal value beyond ten years. This last point will seem obscure but is important – PAA is highly unlikely to forego forever price increases on its assets in the future. Or put another way, how do you change the spreadsheet inputs so as to get the desired output, which is an innocuous price target close to the current market so I don’t have to talk about PAA anymore.

Also of note was that our analyst didn’t rely on any of the familiar criticisms of industry bears, such as that the MLP model is irretrievably broken, that contracts will suffer widespread renegotiation or abrogation in bankruptcy court, or that MLPs are a Ponzi scheme. This is because he for one can’t find much evidence of that or he would most assuredly have relied on such to justify his about-face following a 70% drop. He’s just had enough.

Meanwhile, on Wednesday PAA yielded 14% on an unchanged dividend newly declared. Its General Partner, Plains GP Holdings (PAGP) which we own yielded 11.5%. The analyst isn’t even forecasting a dividend cut.

The point of this story is not to argue that PAA or PAGP are cheap, but to show why MLPs remain so weak. The people involved are reaching the limits of their tolerance for remaining bullish when the P&L’s of countless MLP holders say very loudly that any MLP proponent must have an IQ lower than room temperature. The facts as reflected in market prices relentlessly say so. One guy’s had enough, and I feel his pain but shan’t follow his lead.

We’re All Crude Oil Traders Now

Pioneer Natural Resources (PXD) was dubbed “The MotherFracker” by David Einhorn last May at the Ira Sohn Value Investing Conference. Einhorn is bearish on PXD and other E&P companies that use hydraulic fracturing to release crude oil from shale formations because he calculates that after properly accounting for their capital investment they don’t grow their reserves or generate free cash flow. We have no position in PXD and no view on Einhorn’s bearish call. PXD has lost roughly half its value from its high is the Summer of 2014 and has also fallen sharply since Einhorn’s presentation last May. Like the Alerian Index, PXD has followed crude oil lower.

MotherFracker

The other day an investor presentation from PXD caught our attention, in part because PXD executed a $1.4BN secondary offering. We never like it when a company issues new equity following a substantial fall, and I doubt PXD investors were happy about it either. But it shows there is money available to domestic E&P companies in spite of plummeting crude oil.

Part of the reason probably relates to the continued operating efficiencies being squeezed out by companies such as PXD. As the charts from their December presentation show, costs have been falling 18-25% over the past couple of years; time to drill a well has fallen 40%. As a result, they increased production by 12% last year.

Whether or not this is good for the oil market, it can’t be bad for the energy infrastructure companies that gather, process and transport their output. It highlights the resilience of the domestic E&P industry to the collapse in crude.PXD Slide1 for Jan 10 2016 Blog

Not every E&P company looks like Pioneer though, and crude production is falling in North America as U.S. output expected to be lower this year versus 2015 with both the Bakken in North Dakota and Eagle Ford in south Texas contributing to the drop. Canadian producers in Alberta have long struggled with limited options to get their output to market. This is why the Keystone pipeline is such a big deal for them. The limited transport options mean Alberta crude trades at a substantial discount to the benchmarks, and it recently dropped below $20 a barrel which has caused some wells to be shut in rather than fail to cover even their operating costs. Reports indicate a reduction of more than 35,000 barrels a day of output from two producers.

PXD Slide 2 for Jan 10 2016 Blog

At this point I imagine the discussions over crude oil strategy within the Saudi government must be heated to say the least. The stubborn refusal of large swathes of non-OPEC production to collapse is opening an enormous hole in Saudi Arabia’s budget as well as many other countries. If the Saudis have a strategy, it requires substantial optimism to find examples of its eventual success. What they need is a face-saving way to shift gears; to declare victory and leave the battlefield. They produced 10 million barrels a day in November and around 25% of this is consumed domestically. Assuming they receive $30 a barrel (their grades of crude are typically subject to a few dollar discount) and it costs them $5 a barrel to produce, they clear $188 million a day on the 7.5 million barrels they export. If they claimed that their strategy had been a success and were therefore announcing a one third reduction in exports, the loss of 2.5 million barrels of supply would cause the global oil market quite a jolt. A $12.50 jump in crude would see Saudi oil revenues unchanged. It’s a thought experiment, but with crude this low some odd things become possible.

 

The 2015 MLP Crash; Why and What’s Next

The 32.6% collapse in MLPs was in many ways worse than the 2008 financial crisis. Although not as bad as 2008 when MLPs lost 36.9%, almost every asset class was down that year so there was little unique about MLP performance. In 2015 MLPs endured their own, private performance disaster. The Energy sector was in the background singing a similar tune, but midstream energy infrastructure with its reliably boring toll model behaved like a group of highly-leveraged, high-cost oil drilling businesses, sucking investor positions seemingly into a black hole. Like most MLP investors, we didn’t see it coming. A forest from the trees problem due to being too close. We’re going to offer our perspective on how we got here and what it means for future returns.

How We Got Here

First, a little bit of history. The Master Limited Partnership (MLP) legal structure was enshrined in the 1986 Tax Reform Act signed by President Reagan. Provisions to this law passed by Congress in 1987 limited the use of the MLP structure to natural resource activities. Through subsequent IRS rulings this has evolved to mean anything to do with oil, natural gas, natural gas liquids and coal all along the value chain from extraction to distribution.

The exemption from corporate income tax represents the main and significant advantage of the MLP for equity owners. The familiar “double taxation” of corporate profits via corporate income tax followed by dividends or capital gains tax to the equity holder is avoided with MLPs, since they are “pass-through” vehicles. Their profits are only taxed once, at the equity holder’s level. Because more of the profits from an asset go to the owner, MLPs are a good legal structure within which to hold eligible assets. However, because the MLP itself doesn’t pay tax, the tax code ensures that the owners of the MLP most assuredly do.

The structure is most suitable for U.S. High Net Worth (HNW) investors. MLP tax reporting, as with limited partnerships in general, uses a K-1 form rather than the simpler 1099. Few people who file their own tax returns without the help of an accountant will tolerate this. Many accountants guide their clients away from K-1s although in my experience it’s because they find them tiresome and disregard the economic benefits to their clients.

Most of the money invested in U.S. public equities that might consider MLP equity securities isn’t subject to U.S. taxes, either because it’s tax-exempt (such as pensions, endowments and foundations) or because it’s non-U.S. (sometimes subject to dividend taxes; specific tax treatment isn’t important for our purposes). U.S. tax-exempt investors who choose to hold MLPs can be liable for UBIT (Unincorporated Business Income Tax) which they usually reject because they don’t wish to file a tax return. Non-U.S. investors can be subject to Effectively Connected Income Tax (ECI), which can reach Draconian levels and effectively eliminates their MLP appetite. Taxable corporations (such as insurance companies) can hold MLPs so the investor base isn’t limited to U.S. HNW investors. However, expanding the universe of MLP investors beyond its traditional base is not easy, and this remains an important consideration as we learned in 2015.

My first involvement in MLPs was back in 2005, when at JPMorgan we seeded Alerian Capital Management’s offshore hedge fund. Gabriel “Gabe” Hammond, Alerian’s founder, launched the Alerian Index with his partner Kenny Feng (now Alerian’s CEO). Because the K-1 tax reporting was unpalatable to millions of smaller U.S. retail investors much effort was expended with tax accountants in search of the holy grail, which was a tax-efficient way to allow MLP investors to receive a 1099. Solving this problem would open up an entirely new investor class to MLPs. The payoff was potentially huge. Many different structures and solutions were considered. It just wasn’t possible.

MLP Sources and Use for Jan 3 2016 Blog

However, the absence of a tax-efficient way to give MLP investors 1099s didn’t remain a hurdle for long. Within a few years mutual funds and exchange traded funds appeared which were structured as C-corp ’40 Act funds[1].  They invested in MLPs, delivered 1099s to their investors and paid 35% corporate income tax on the returns. There was no tax-efficient way to avoid the K-1, so it was done in a decidedly tax-inefficient way. To this day, most of the mutual funds and ETFs that focus on MLPs are taxed as corporations, although a few are highly tax efficient RIC-compliant structure such as ours that limit their MLP investments to 25% of the fund. Investors are amazingly oblivious to this, in part because it doesn’t reduce the stated yield but rather comes out of the fund’s Net Asset Value. Although the taxes show up in the form of eye-popping expense ratios of as much as 9%, few retail investors or their financial advisors are aware of this. Even worse, those that do have knowledge of this substantial burden operate under the belief that the tax component is somehow not real. Maybe an expense ratio this high looks like a mistake. Who could possibly design such a thing? These funds carefully avoid stating that achieving the return on the Alerian Index is their objective, because it is of course unattainable and their historic returns show this. The sequential thought process through 2013 was (1) MLPs have done well (2) I don’t want K-1s (3) Here’s a vehicle that gives me MLPs without K-1s. Fund inflows boomed.

Many things are clear in hindsight. One of them is that much of the new money entering the MLP sector via very tax-inefficient funds didn’t possess the same understanding of what they were buying as the HNW investor. They hadn’t examined underlying holdings or thought much about future prospects. Recent positive returns were their investment thesis. Consequently, just as rising prices drew them in, falling prices have seen them flee.

The HNW investor was attracted by stable distributions that were largely tax-deferred (another benefit of investing directly in MLPs) with modest growth. Such investors don’t trade their positions, because to do so would undo the tax deferral benefits. As a result, MLPs enjoy far more stable ownership than most public companies, just the sort of long term outlook many commentators despair is absent from today’s capital markets. Midstream businesses are steady, fee-generating sources of income and they attracted appropriate long-term investors not looking for excitement or high growth. As long as MLPs paid their distributions things were fine.

Dividends are an inefficient way for corporations to return money to shareholders because they create a quarterly tax liability, as well as being taxed twice (once via corporate tax and a second time to the investor). Stock buybacks return capital more efficiently because an investor can always manufacture a 3% dividend by selling 3% of her stock while retaining control of the timing. Nonetheless, reliable dividends are valued. MLP distributions are generally not taxable when they’re paid and so their high payout model doesn’t suffer the same tax inefficiency. The MLP model of distributing its free cashflow relies on external financing (i.e. issuing debt and equity) to fund growth. The average corporation pays out a third of its profits and generally uses internally generated cash to fund growth. The MLP model of higher payouts and greater reliance on external funding sources is not inherently bad. Some feel it imposes extra financial discipline on management through making an explicit connection between capital and its intended use. Indeed, the Miller-Modigliani theory holds that investors should be indifferent to how a company sources its capital (debt, equity or reinvested profits); they should only care about how it’s invested. However, count Miller-Modigliani adherents among those MLP investors who were run over in 2015. The HNW investors who are the predominant financiers of MLPs like the high payout MLP model, so it has prevailed.

For many years, MLPs generated $1 of DCF, paid $1 of distributions (what MLPs call dividends) and tapped capital markets for $0.25-$0.50 to finance their growth plans. The shale revolution has challenged this model.

The Shale Revolution

The development of horizontal drilling and hydraulic fracturing unlocked enormous supplies of crude oil, NGLs and natural gas in parts of the U.S. that weren’t established sources of hydrocarbons. Increased output from regions not previously supported with infrastructure added an important growth element to the MLP story. In 2014 the Interstate Natural Gas Association of America estimated that $640BN of new investment in energy infrastructure will be required over the next twenty years, as this table shows.

INGAA Infrastructure Estimates Blog Jan 3 2016

The high payout MLP model whereby most cashflow is returned to investors via distributions meant much of the new capital to fund this growth would need to be externally financed.

KMI Slide for Blog Jan 3 2016

Tapping pools of investor capital beyond the K-1 tolerant, taxable U.S. HNW faces formidable barriers as noted above. The most important new source was from smaller retail investors whose insistence on receiving the simpler 1099 tax reporting form was accommodated via the growing number of 40 Act funds that held MLPs. Falling crude oil challenged the growth element of the MLP story since reduced domestic production diminishes the need for new infrastructure.In spite of the collapse in crude oil, the fee-driven midstream MLP operating model turned out to be fairly robust to commodity prices – not immune, but with limited exposure. 2016 EBITDA forecasts for diversified midstream energy infrastructure names have been revised down by mid-single digit percentages; farther from the wellhead means less commodity sensitivity. Kinder Morgan’s 2015 operating results are coming in 5-6% below budget (and still up 5% on the year). Investors are clearly anticipating far worse.  As fund flows to the sector fell and finally turned negative, HNW investors were unwilling to provide additional capital even while MLP equity issuance fell. In 2015, MLP returns were dictated much more by capital flows than operating performance.

The high payout MLP model has come in for criticism from some who argue that MLP distributions are partially funded by issuing equity. This is untrue, but what is clear is that the growing infrastructure need to support increasing domestic hydrocarbon production has severely strained the available sources of capital. We believe 2015 performance is about the inadequacy of the long-established investor base to meet this growing need and the inability of alternative sources of capital to fill the gap. Operating results at midstream infrastructure businesses remained resilient with only modest exposure to collapsing crude oil prices. The growing conflict between high payouts and increasing growth plans is exemplified by Kinder Morgan.

RRC Nat Gas Projections Blog Jan 3 2016

Kinder Morgan

A simplistic model of how MLPs fund themselves is to examine what portion of the distributions MLPs pay out is then tapped as new capital via IPOs and secondary offerings. New equity raised increased from $5BN in 2008 to around $30BN in 2013. Distributions received by MLP investors grew from $10BN to $25BN. Therefore, new capital went from taking half of MLP distributions to well over 100%. Kinder Morgan Partners (KMP) reflected this trend, as their need for new equity capital rose from 73% of distributions paid out in 2008 to 101% in 2013. KMP investors in aggregate were reinvesting all of their distributions back into the business.

For a while the industry’s need for additional capital came from the growing number of MLP-focused ETFs and mutual funds, whose inflows increased tenfold from 2011 to 2013. This helped bridge the gap between the limited desire of K-1 tolerant MLP investors to reinvest more of their distributions back into the sector and the need of MLPs to finance growth.

Nonetheless, the yield on KMP units remained stubbornly high, consuming much management attention as their ambitious growth plans pushed up against the limits of customary MLP investors to provide financing. In 2014 they embarked on a significant restructuring that eventually resulted in a catastrophic destruction of value and betrayal of their core investor base. Recognizing the limits to external financing as an MLP, they became a conventional corporation (a “C-corp”) instead. Although this now gave them access to virtually any public equity investor, they persisted with the 100% MLP payout model and its reliance on external financing for growth. This variance with the more typical corporate funding model of a one third payout ratio and mostly internal financing eventually drove their cost of equity to where it no longer made sense to raise external funds. KMI had many choices including cutting their growth plans, selling assets and seeking JV partners. However, the 2014 restructuring had been about financing their growth and in 2015 that remained their priority.

For a while the market supported the new structure. KMI shares maintained their uptrend into 2Q15, but as the inflows to ’40 Act funds petered out and switched to outflows in the Summer the increasing selling pressure on MLPs affected KMI too. It was in some ways similar to a bank run; as long as the market believed they could finance growth by issuing equity at a 5% yield, they could. As the market began to question that by pushing the yield higher, their growth prospects became less attractive in a negative spiral.

Original KMP investors suffered enormously; they endured a dividend cut in 2014 as they received lower-yielding shares in Kinder Morgan Inc. (KMI); their exchange of KMP units for KMI was a taxable event; their new KMI units eventually collapsed, and then they suffered a second dividend cut in late 2015. KMI management owns around 18% of the shares, so they have suffered with their investors. It nonetheless shows that alignment of interests doesn’t guarantee good judgment.

KMI’s situation was different because they are bigger, more leveraged and have more ambitious growth plans than other MLPs. But the industry is being forced to reconcile its desired growth with the limited interest of traditional MLP investors to finance it. The shallow commitment of many ’40 Act fund investors became apparent when MLP prices stopped rising. The biggest monthly inflow to such funds of just under $3BN occurred in September 2014, merely a month after the Alerian Index peaked. A group that looks past the 35% tax drag prevalent on most funds and expense ratios as high as 9.4% (see Mainstay Cushing MLP Premier Fund[2]) can’t be expected to have done much research on their holdings. Their proclivity to be momentum investors, providing growth capital on the way up, continued on the way down. The cycle will probably repeat.

Valuation

At the risk of stating the obvious after such a year, valuations are as compelling as they’ve ever been for MLPs. The Alerian Index ended the year yielding 8.5% based on most recent distributions. Our SMA portfolio of GPs yields 7.3% and grew at 13.4% in 2015 (including KMI’s dividend cut). We expect 10% distribution growth over the next two years, and distribution coverage is 1.08X (excluding KMI which now covers its reduced dividend 4.6X).

Operating performance for many midstream infrastructure businesses was barely different in 2015 than expected a year earlier. For example, we went back and found JPMorgan forecasts of 2015 Distributable Cash Flow (DCF) per unit/share as they were in August 2014, when the market was peaking. We compared these forecasts with where 2015 results are coming in for the names in our MLP Strategy that are covered (around two thirds). DCF figures are coming in 1-2% lower than expected in the Summer of 2014, while their equity prices have fallen 40-50%. MLPs fell a long way for good reasons, but 2015 operating results were clearly not the major cause and we find it implausible that investors are looking ahead to far worse results in 2016. This is what prompted us to examine more closely the investor base, and to consider capital flows and the apparent unavailability of crossover buyers to invest at depressed prices.

What Next?

The absence of readily available capital to replace the exiting ’40 Act funds has highlighted the limited investor base. Although some commentators claim to see increasing institutional investment in MLPs, it’s more limited than they suggest. Google “Pension plans and MLPs”, examine SEC filings or look up who are the largest owners of MLPs, and you’ll find little evidence of pension funds, endowments or foundations. Such institutional investors that do exist are managing money on behalf of retail and HNW investors who have chosen the sector. There simply aren’t large pools of professionally managed institutional capital able to opportunistically and quickly increase their exposure to MLPs. The tax barriers substantially reduce the portion of the return they can keep, which drives up their required return (although current valuations may well be sufficient to draw in such capital in the months ahead). The fact that most MLP ’40 Act funds are highly tax-inefficient demonstrates that better alternatives generally don’t exist, unless you focus on MLP C-corps as we do. MLP closed-end funds (CEFs), which at least have permanent capital, nonetheless behaved like open-ended funds because forced deleveraging turned them into sellers too as prices fell. For example, Kayne Anderson (KYN), a large CEF, was down 51%.  Even other, generalist mutual funds which can theoretically hold up to 25% of their assets in publicly traded partnerships (which includes MLPs) are unlikely to shift much of their assets without doing careful research on a new sector, making them relatively slow-moving. As ’40 Act investors have been redeeming, their sales require a K-1 tolerant HNW investor to take the other side, often increasing his MLP exposure in a falling market. Anecdotal reports of macro hedge funds shorting the sector added further pressure.

As a result, the supply of MLP funding has turned out to be quite inelastic. Since crossover investors from other sectors are constrained by taxes, finding a balance between demand for capital and its supply relies mainly on traditional MLP investors shifting more of their portfolios to MLPs, something that has required an unexpectedly substantial drop in valuation.  The transfer from one type of investor to another has been highly disruptive.

Financing growth is the challenge facing the energy infrastructure industry. They have an advantageous tax structure but the investor base isn’t growing as fast as their need for new capital. How MLPs perform in 2016 and beyond will depend on how management teams resolve the conflict between their key investor base’s finite desire to reinvest more of their distributions and the industry’s growth plans. Clearly, new money from HNW investors required substantially higher yields, probably reflecting the fear that other managements will abuse them like Kinder Morgan and reinvest their capital for them by slashing payouts. The good news is that IPOs and secondary offerings fell sharply in 2015, reducing the portion of MLP distributions reinvested to below a third, lower than in 2008. This represents new buying capacity for the sector.

Kinder Morgan spectacularly demonstrated that converting to a corporation is not a solution. Smart management will slow existing growth plans so as to limit their need to access very expensive equity while maintaining payouts and will shift towards more internal financing, JV partners and asset sales. Buckeye Partners (BPL) and Magellan Midstream (MMP) both fund all their growth internally and have ample distribution coverage. All the General Partners we own have have coverage >1X.  Moreover, new projects should have higher required returns since MLPs’ cost of capital has risen. Less reliance on new equity should lead to faster per unit distribution growth in the future.

The MLP General Partner, as we have often written, still looks very much like a hedge fund manager and internally financed asset growth at the MLP can be just as profitable as using external capital. The pursuit of growth as a priority is not a value creating strategy, as Kinder Morgan showed. The shockingly high volatility of MLP prices in 2015 will lead to heightened perception of risk among investors for some time. The price collapse was not anticipated and initially we, like many others, struggled to reconcile it with steady operating results. In recent months our thinking has evolved to examining the investor base more carefully. We’ve concluded that capital flows were a far more important driver of MLP returns than operating results in 2015.

More modest growth plans can, by preserving payouts, attract more capital from long-established investors which will stabilize the sector and restore the trust between the industry and its providers of capital. Too much pursuit of growth will result in significant investor turnover and value destruction. Those MLP managements whose growth plans exceed investor appetite will abandon the MLP structure in favor of a C-corp, foregoing the tax advantages of the MLP structure in search of a bigger pool of clients and turning over their existing investor base in the process. More thoughtful management will tailor their growth to the MLP capital available. New equity issuance dropped sharply in 2015 coincident with fund outflows, and as a result the portion of distributions reinvested fell, potentially freeing up new capital to be invested. Current valuations are such that a demonstrated commitment to maintain payouts is all that’s needed to provide stability and thereafter positive returns. Our investment approach is guided by these views.

We are invested in BPL, KMI, and MMP

[1] Non ‘40 Act Exchange Traded Notes (ETNs) also provided MLP access to non-K-1 tolerant investors

[2] This was the expense ratio for the year ended 2/27/2015 as of 12/19/2015

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