Some MLP Investors Get Taxed Twice

There is around $53BN invested in MLPs via ’40 Act funds – the term used to describe the three major types of funds issued under the 1940 Investment Company Act (mutual, exchange traded and closed end funds). It’s safe to say that an important motivating factor driving these selections is investors’ desire to hold Master Limited Partnerships (MLPs) without receiving K-1s. ’40 Act funds issue 1099s, which makes tax reporting simpler. We have warned before about these frogs masquerading as princes (see Are You in the Wrong MLP Fund?)

Providing investors MLP exposure while avoiding the K-1s was once an objective of industry pioneers who identified a new source of capital from retail investors, if only this problem could be solved. Although much energy and expensive tax advice were deployed, an elegant solution remained elusive at that time. All that remained was a decidedly inelegant one – offer retail investors shares in a C-corp, which would hold MLPs and issue its investors a 1099. The significant problem with this solution was that the C-corp’s returns would be subject to Federal Corporate Tax, as with any corporation. The investors in this C-corp would only receive 65% of the result, since 35% would go to the IRS.

Some dismissed this “solution” as impractical. After all, who would knowingly make an investment that could only earn around two thirds of what the assets themselves generate? But the absence of a better (i.e. more tax-efficient) solution frustrated a few, and they redirected their attention away from solving the problem to instead convincing investors that a deeply flawed structure was what they really wanted.

The result is that 83% of the $53BN mentioned above is invested in vehicles that have no hope of ever coming close to earning the return of the MLP sector. A careful reading of prospectuses issued by the offending vehicles reveals wording that is technically accurate while still misleading.

Quite a few claim an objective of results corresponding to their chosen index before fees and expenses. Since ’40 Act funds (outside of MLP funds) are very largely RIC-compliant (which means they don’t pay corporate tax), few MLP fund investors consider that by far the biggest line item in the inferior funds’ list of fees and expenses is taxes.

The Alerian MLP ETF (AMLP), the largest repository of mis-directed capital by poorly informed investors, goes further and says it, “…delivers exposure to the Alerian MLP Infrastructure Index”. Exposure to an asset class is not the same as providing good results from investing in it. The carefully worded prospectuses of AMLP and its tax-hindered cousins are technically correct. But I can personally attest that few holders of such securities are aware that they’ve essentially tied their running shoes together at the start of the race. What’s worse is that the tax expense isn’t deducted from the yield, but comes out of the NAV. So the 7.5% yield on AMLP is before the corporate tax expense is paid. Imagine if a corporation paid all its pre-tax cashflow out in distributions and then wrote another, separate check to the U.S. Treasury, thereby reducing its book value. That’s what taxable C-corp MLP funds are doing.

Pointing out to such an investor the mistake they’ve made is not especially fun, and I’ve had to do it numerous times. It’s somewhat akin to noting the toxic dump near an unwitting home buyer’s recent purchase. The reaction to missing such an obvious value destroyer is usually a combination of embarrassment (at their own evidently shallow research) and anger at being guided towards a fundamentally flawed investment.

Picking a tax-paying MLP fund is an especially tragic choice when returns have been good, and in some cases very good indeed. Moreover, based on recent fund flows some new investors are making the same mistake. Holders of such funds are accepting the downside risk of the sector while only being able to earn 65% of any upside. This is careless to say the least. By choosing to invest in a fund that splits its profits two thirds/one third with Uncle Sam, these investors are supporting the tax base twice – once, before they get their returns, and again after they pay their own tax obligation on what’s left.

The list of such offending funds is too numerous to include here, reflecting the unfortunate tendency towards highly superficial investment research by too many investors. However, if you look at Morningstar’s list of MLP funds and sort by the 1 Year Return column, the structurally impaired can helpfully be found in an undignified heap languishing towards the bottom. At the top you’ll find the funds who thought enough of their investors to at least provide the non-taxable, pass-through structure they assumed they were buying.

If you’re invested in one of the lousy funds, correct that mistake sooner rather than later. And if your financial advisor has put you in one, you may wish to reassess the depth of research carried out on your behalf.

 

Wall Street Needs More Clients Like Tetra

Once again a corporate executive team has demonstrated childlike innocence when dealing with the hard-nosed providers of equity capital. Tetra Technologies (TTI) is the latest firm to combine a good business with a clueless approach to funding it. TTI supports the oil and gas industry, providing a wide array of products and services including fluids, compression equipment, well-testing and decommissioning. They are as much part of the Shale Revolution as the E&P companies that drill for oil and natural gas.

TTI decided they needed some additional equity capital as they were in danger of violating one of their debt covenants. On December 8th they issued a press release noting that the company was “…considering capital raise alternatives  to strengthen its balance sheet.” They blamed potential weakness in 2017 Gulf of Mexico activity along with the delay of certain projects from 4Q16 into early next year.

The phrase “capital raise alternatives” clearly includes more than one type of capital, and strongly suggests that the simplest form, a public equity offering, was not the most likely outcome. A reasonable guess would have been a private placement of some type of preferred security convertible into common. TTI stock duly fell as investors digested both the slowdown in revenues from certain projects and the likelihood of some additional equity dilution.

On December 9th, TTI then surprised the market by announcing a generously priced secondary offering of common equity. The 19.4 million shares (expected to be upsized to 21 million) along with 10.5 million warrants represented a substantial 33% increase of the share count, a hefty dilution for existing shareholders.

TTI’s poor handling of the offering weakened their stock price, requiring the issuance of more shares than was otherwise necessary in order to raise the desired amount of capital. To see how this is so, consider the two announcements they made twenty four hours apart.

Their first press release, on December 8th, was pointless unless they had secured capital in some form. Companies don’t have to disclose that they might raise capital. A company is always interested in raising capital if the terms are attractive. Most likely TTI believed they were sufficiently close on agreeing terms that the desired “capital raise alternatives” were pretty much done. Their stock price fell on the news.

Consequently, the announcement of a public offering the following day communicated that the presumed private capital raise implied in the prior release had fallen through. In fact, it’s highly likely that the potential investors watched TTI stock plummet after the first anouncement, and concluded that they needed more generous terms. The price of TTI now had to reflect that private equity investors had considered an investment and passed.

There was no point in the first press release. All it did was to weaken their negotiating position and eventually force them into a dilutive public offering. CEO Stuart Brightman was paid $2MM last year but only has around $3MM in TTI stock, so the market’s response to his poor handling of the capital raise didn’t cost him very much personally.

Wall Street underwriters (in this case JPMorgan and Wells Fargo) are blessed to have such incompetent clients. It makes their jobs much easier.

 

 

Give Your Loved One an MLP This Holiday Season

This is the time of year when thoughts turn to family and the holidays, but as you plan your celebrations keep in mind that MLPs care about the seasons too. In fact, MLP returns exhibit a marked pattern driven by the calendar and the idiosyncrasies of their investor base.

The chart below shows the average return for each month of the calendar year, and to illustrate how the 2014-15 bear market altered these, we’ve included what those averages were without the last two years. The most striking feature is that investing for just four months of the year gets you almost all the annual return. January, April, July and October are “distribution months”, the time when MLPs declare their quarterly distributions to holders of record (the actual payments typically go out a month later). Only those four months historically provide returns above the monthly average of 1.1%; so much above that the other eight months of the year in aggregate have provided less than a tenth of investors’ returns.

In theory an investor should be indifferent to whether a stock is about to declare a dividend or has just gone ex-dividend, but MLP investors love their distributions – irrationally so. The result is that there tend to be fewer sellers in those months as some holders opt to wait a little longer and receive that chunky payment.

The other clear pattern revolves around year-end. The power of distribution months wanes during the year, and is strongest earlier in the year when it combines with the turning of the calendar. K-1s are probably a factor here – clearly some investors contemplating a purchase of MLPs in November opt for delay so as to avoid the additional tax work of a K-1 for the last few weeks of the year. Similarly, selling before year-end rather than just after avoids an additional K-1 for a few weeks of exposure. Both factors tend to create more motivated sellers late in the year and more motivated buyers early in the new year. And many investors intersperse family time over the holidays with some personal portfolio analysis, at least some of which results in the decision to buy more MLPs in January.

Of course, seasonal patterns don’t always work, and in any one year the power of the prevailing trend can overwhelm these factors. Last year was an example, and January 2016’s -11% result was the worst of any January for the 21 years of the Alerian Index’s history. This one month was sufficient to turn April into the seasonally strongest period of returns, pushing January to #2. Nonetheless, January has been profitable 76% of the time since the inception of the Alerian Index in 1996.

But as long as the seasonal patterns are caused by something, they are likely to prevail more often than not. K-1s, investors’ attraction to MLP distributions and year-end planning all remain part of the financial landscape. Therefore, it’s worth paying attention to these because if you’re contemplating the timing of a buy or sell, understanding these forces could help you achieve a better result. As with many investment decisions, it’s worth bucking the trend. So November isn’t the best time to sell. For that, wait until the end of January or after the first month of the quarter.

Most obviously, if you expect to pore over your investment portfolio during a quiet moment in late December, anticipating your MLP purchase decision and executing it a few weeks earlier could brighten up your returns. And if you do follow this advice and present your better half with a seasonally informed MLP gift, you might want to include some bling too, in case the romance of a well timed security purchase is lost on her.

The Flexibility of MLPs

A couple of weeks ago we came across a research note from Wells Fargo titled “Do MLPs Still Make Sense?” Their conclusion was a qualified “Yes”, although it’s not wise to be highly negative when you have a thriving business underwriting their equity offerings.

Last year’s collapse in the sector provoked the question. In our view, this wasn’t so much an issue of operating performance but one of financing growing capital expenditures. As we wrote in The 2015 MLP Crash; Why and What’s Next, the Shale Revolution has led to a substantial increase in the demand for new energy infrastructure, since the new reserves of hydrocarbons are not always well served by the traditional infrastructure configuration (i.e. North Dakota was only recently a significant region for crude oil production; similarly so for Pennsylvania and natural gas).

By 2014 the needed cash to finance this growth exceeded the cash generation capacity of the MLP sector. Since MLPs don’t retain earnings, they mostly tap the capital markets for such finance. The multi-year nature of many projects led to a “just-in-time” philosophy around financing in the same way manufacturing businesses maintain minimal supplies of inventory to limit their need for working capital. A temporary closure of the capital markets as the most recent MLP investors (mostly ETF and mutual fund buyers) fled late last year exposed this model. MLPs have taken many steps in response including greater distribution coverage, less leverage and higher return targets on new projects. They’ve adapted.

It really comes down to whether the Master Limited Partnership structure combined with the General Partner is the best way to finance the assets. Since MLPs are pass-through vehicles with no tax liability, it’s hard to improve on a tax-free structure as the holding vehicle. Any corporation holding eligible assets will be subject to Federal corporate income tax on the profits, which is why a common maneuver is to “drop down” those assets from a C-corp parent into an MLP. The C-corp often retains control through its GP interest in the MLP, and shares in the future economics without providing the capital. The retained connection can be value-enhancing for both entities. An Exploration and Production (E&P) company can finance its E&P assets as a C-corp where capital is cheapest, but still control the infrastructure critical to supplying its customers while using cheaper, MLP capital. Examples include Devon Energy (DVN) with Enlink Midstream Partners (ENLK) and Anadarko Petroleum (APC) with Western Gas Partners (WES). The MLP/GP structure often exists as a symbiotic relationship.

There are many analogous financing structures to be found. As regular readers know, we like the comparison with hedge funds and private equity, where the MLP is the fund and the GP is the hedge fund/private equity manager. The fees paid to the manager clearly take away from the returns earned by the investors – indeed, in the case of hedge funds, spectacularly so as I have often noted (see The Hedge Fund Mirage). However, the size and history of alternatives (hedge funds, private equity and real estate) confirm that a substantial pool of capital is available to finance assets that require active management with payments to the operators. MLP investors are in many ways better off than the investors in these private partnerships; they have the liquidity to sell whenever they want, their investments are subject to all the disclosures of publicly listed companies, and the ten year annual return of 9% is better than REITs, Utilities, the S&P500, Bonds and, most assuredly, hedge funds.

Another analogy is with companies that have two or more classes of equity outstanding. Alphabet (GOOG) and Facebook (FB) both sold shares to the public that allowed the founders to retain substantial control. You’re unlikely to see an activist acquiring a position in these two companies when their performance stumbles, because voting control doesn’t lie with the public shareholders. Clearly, to a substantial number of investors this passive ownership is no barrier. GOOG has returned 12.5% p.a. over the past decade, better even than MLPs.

From time to time investors ask us whether GPs are more volatile than MLPs, and therefore more risky. The history on this topic doesn’t go back that far, because only in recent years has a sufficient number of MLP GPs been publicly available to create a portfolio. Our own Separately Managed Account strategy (which focuses on GPs) has outperformed the Alerian Index by 4.0% p.a. since inception, albeit with modestly higher volatility (20.6% versus 19.8%). Last year certainly saw cases of GPs falling more than MLPs; perhaps most memorable was the 80% collapse in Energy Transfer Equity (ETE) from June 2015 to April 2016. This was mostly due to the ultimately failed effort to merge with Williams Companies (WMB), but nonetheless is now part of the historic performance of MLP GPs.

Financial performance of MLP GPs is highly correlated with the MLPs they control but not obviously more volatile. GPs can exercise substantial control over their cashflows by, for example, directing their MLP to raise capital or divest assets. Moreover, most MLPs today are investing in new infrastructure in support of the Shale Revolution. This increase in their assets will continue to benefit their GPs, similarly to how hedge fund asset growth directly profits the hedge fund manager. If you could buy a hedge fund manager knowing his assets would be growing, how much concern would you really feel over the volatility of his cashflows given that they’ll be increasing?

Finally, MLPs can get too big. Like hedge funds, beyond a certain size it can be hard to generate attractive returns while still growing. There is, in effect, a lifecycle to MLPs. Kinder Morgan (KMI) most obviously demonstrated this. Their solution, to collapse their structure back into a C-corp, was inevitable in hindsight if clumsily executed (see Rich Kinder’s Wild Ride). In 2014 when KMI acquired the assets of Kinder Morgan Partners and El Paso, its two MLPs, the stepped up cost basis created a substantial tax shield for KMI (see The Tax Story Behind Kinder Morgan’s Big Transaction). These two MLPs had depreciated their assets far below their economic value, to the profit up until then of their taxable investors who directly benefited from tax-deductible depreciation not matched by actual economic depreciation in those assets. KMI revalued them, thereby creating a much higher annual depreciation charge on these same assets.

The next logical step will be for KMI to drop down some of these assets into a newly created MLP where the cashflows will not be taxable and the investors in this new MLP can benefit from this higher depreciation. It’s probably too soon for KMI to contemplate such a move, but the tax code creates the possibility of a virtuous cycle whereby assets are first dropped into, and depreciated in, an MLP; subsequently acquired by the C-corp parent with a stepped-up cost basis that resets the depreciation based on current values; and then later dropped again into an MLP. As long as the assets involved have recurruing cashflows, minimal need for maintenance capex and appreciate over time, it’s a legitimate strategy.

The MLP/GP structure contains myriad possibilities. Note also that in November the U.S. was a net exporter of natural gas. Existing in support of an industry that is taking America towards Energy Independence, we think adverse changes to the tax code are highly unlikely and that MLPs have a rich future.

We are invested in ENLC (GP of ENLK), ETE, KMI, WGP (GP of WES), and WMB

The Hedge Fund Mirage Turns Five

Five years ago this month John Wiley published my first book.  The Hedge Fund Mirage; The Illusion of Big Money and Why It’s Too Good to Be True explained how hedge funds have in aggregate been a great business and a lousy investment. The opening sentence asserted that treasury bills would have been a better choice for the average hedge fund investor. This was a startling conclusion, since money had long been flowing to hedge funds in willful defiance of steadily worsening results. Surely, the flows were confirmation that the smart money was in hedge funds.

Hedge fund returns are conventionally presented from the perspective of a single investment at the beginning of the period. Such an approach is far from reflective of the experience of investors, since few were fortunate enough to invest in hedge funds in those early years. From 1998-2002 hedge fund investors enjoyed great returns; there just weren’t that many investors. A more meaningful analysis considers everyone’s returns. For this, you need to look at the asset weighted return, or IRR; the return on the average dollar invested rather than the first dollar. The difference is most stark when percentage returns (the left panel in the chart) are recalculated and shown as actual investment profits (the right panel). Viewed this way, hedge funds have delivered mediocre returns at great expense.  The high percentage returns of the early years didn’t generate much actual profit for investors, because the investors were few. They benefitted from exploiting many inefficiencies in financial markets without the burden of too much capital.

Substantial sums followed with the misplaced hope of achieving similar results. The book was aimed not at hedge fund managers but at the stewards of this misdirected capital; hedge fund managers are an intelligent bunch and scarcely needed any advice. The goal was to help the star-struck institutional investors challenge the guidance of their consultants, and avoid high fee strategies that too often enrich the managers but not the clients.

Five years is probably a fair period of time over which to assess the most important prediction made in the book, which was that hedge fund returns would be disappointing. This was a lonely view at the time – not as completely obvious as it should have been. The entire industry was being weighed down by the growing pool of assets it was managing. The availability of uncorrelated returns, which is what hedge funds try to provide, is finite; inevitably, dilution of returns followed.

Small hedge funds outperform big ones. Any big hedge fund did better when it was small (which is how it became big). These first two insights are generally accepted, and yet very few investors take the third logical step in this sequence of thoughts – a small hedge fund industry generated higher returns than a big one. Hedge funds were, and remain, over-capitalized.

Today, it’s not hard to find critics of the industry including some of its most successful practitioners. Assets are too plentiful and fees too high. This now passes for conventional wisdom although in 2011 that was certainly not the case.

A disappointing consequence of America’s increasing political polarization is the tendency of each side to assume the other is intellectually challenged. I try hard to guard against this tendency myself, but have to concede that on the subject of hedge funds I have failed. Which is to say, the hedge fund professionals who praised The Hedge Fund Mirage when it came out, merely confirmed the superior investing intellect that their businesses had already demonstrated. The critics (who generally aspired to invest money rather than actually doing so) similarly confirmed their place at the other end of this intellectual spectrum.

Hedge fund managers are by no means the villains in this story. Some of the smartest people around run hedge funds because that’s where the financial rewards are greatest. If every hedge fund manager sincerely believes their fund is the best, this is no different than individual business owners in any industry. Many managers have long recognized the challenges of asset size even while maintaining they could rise above the weight of mediocrity.

The fault lies with those who aggregate all those optimistic individual views into a positive one of the industry without considering the obvious negative consequences of too much money. Not every institutional investor has the ability to run a hedge fund. Some of the least sophisticated investors I’ve ever met are the trustees of public pension plans. They understandably rely heavily on consultants to guide them, not just for their expertise but also because as fiduciaries their decisions are subject to scrutiny under ERISA (the Employee Retirement Income Security Act).

Although critics of The Hedge Fund Mirage  were few in number, a couple are worth noting. The London-based Alternative Investment Management Association (AIMA), led at the time by Andrew Baker, abandoned any pretense of objectivity in their eagerness to defend the indefensible. They do represent hedge funds if not actually running one. An initial attempt at making the case for hedge funds was followed by a more lengthy but no more persuasive effort. One journalist famously noted that, “…the AIMA paper has convinced me of the deep truth of Lack’s book in a way that the book itself never could.”

Thomas Schneeweis, an academic and hedge fund consultant, descended from his ivory tower to criticize what he called “baby hedge fund analysis 101.” For the sake of investors everywhere, one must hope that his investment acumen surpasses his business building ability, ensuring few victims of any Schneeweis insight.

In short, the critics were dead wrong.

Although on average hedge fund investors have done poorly, there are great hedge funds and happy clients. There probably always will be. It’s not all bad. While it’s extremely hard to pick hedge funds, some investors are good at it. Some hedge fund investors focus on smaller managers where research has shown returns are higher. As hedge funds have become more generic their returns have become more prosaic. Success relies on leaving the well-traveled path and considering more obscure strategies.

Perhaps the strongest criticism of The Hedge Fund Mirage is that inflows to hedge funds have continued when they shouldn’t have. The reason this has happened in spite of overwhelming evidence that disappointment will follow lies in some quirky accounting. Public pension funds (such as the $300BN California Public Employee Retirement System, or CalPERS) don’t use GAAP (Generally Accepted Accounting Principles) accounting like public companies. Under GASB (Governmental Accounting Standards Board), investing in riskier assets has the odd result of lowering the present value of your pension obligations. There’s no economic connection between the two, and the flawed underlying logic is slowly creating a massive problem. It’s why public pension funds are today’s biggest hedge fund investors, a folly that will ultimately saddle taxpayers with the bill for unfunded pensions to retired teachers, firefighters and policemen in many U.S. states. Returns will continue to come up short.

The hedge fund consultants sit between the expensive, poorly performing hedge fund industry and the unsophisticated trustees of many public pension funds. The consultants are smart enough to understand the consequences of GASB, and commercial enough to know how to exploit this knowledge by guiding their naïve clients towards complex investments whose sourcing generates further consulting fees. There is a special place in Investment Purgatory for those who ply such a trade. The poor bargain this represents is gradually being acknowledged, often by early adopters including CalPERS who concluded hedge funds were going to create more problems than they’d solve.

That attractive hedge fund returns are a mirage is slowly dawning on the not-so-sophisticated institutions whose portfolios include them. The industry remains over-capitalized. Few of today’s investors even think to consider what level of total hedge fund assets is consistent with their aspirational returns. Until they do, continued disappointment awaits.

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