The Sky High Expenses of MLP Funds

If the arcane tax accounting of the mutual funds and ETFs that invest in Master Limited Partnerships (MLPs) is of no interest to you, let me save you some time and advise you to skip reading.

As the rest of you who have proceeded past the warning probably know, the attractive tax-deferred yields offered by MLPs require the investor to receive K-1s rather than 1099s at tax time. Many investors want to invest in MLPs without K-1s, and consequently funds were launched that provided a solution, of sorts. ’40 Act funds can hold MLPs on behalf of their investors and provide 1099s, but they may have to pay corporate tax on the returns. If the fund is RIC-compliant, in that it owns less than 25% publicly traded partnerships (i.e. MLPs), investors get pass-through tax status. However, if the fund is not RIC-compliant it is structured as a C-corp and subject to corporate taxes. So the result is that the investors in non-RIC compliant funds only receive 65% of the return (i.e. 1 minus the 35% corporate tax rate). The Mainstay Cushing Fund (CSHAX) is an example, but there are others. Unfortunately, $52BN of the $64BN invested in MLP investments via ’40 Act funds are structured as C-corps (Source: Alerian). Ron Rowland wrote about this issue as long ago as 2010.

The tax drag shows up as part of the expense ratio, so CSHAX sports an eye-popping 9.42% expense for the year through 2/27/15, of which 7.49%-7.94% is taxes. Other funds are similar. Remarkably, few investors are aware of the tax drag in the MLP investment funds they own. Not surprisingly, it’s hard to get anywhere close to the benchmark Alerian Index under such circumstances, since such funds solve the K-1 problem by throwing substantial amounts of their investors’ money at it — or more accurately, to the U.S. Treasury.

There is an odd sort of silver lining to this tax drag though; it works in both directions. Just as the fund delivers 65% of the upside, it also delivers 65% of the downside. As MLP investors are painfully aware, prices have been in retreat since last August, and in recent weeks retreat has become rout. Since the tax bill comes from unrealized gains, a reduction in those gains through a drop in market prices reduces the future tax bite commensurately. It results in lower volatility, which is normally a desirable quality for investors although in this case of dubious value; volatility could be further reduced if the corporate tax rate was increased beyond 35%, which is clearly not the type of risk management investors want.

There is an interesting and so far unanswered dilemma that can face such a taxable MLP investment product during an extended market turndown (perhaps such as the one we’re enduring). Just as the Deferred Tax Liability for unrealized gains can fluctuate with market moves, it can in theory become a Deferred Tax Asset (DTA). This can come about when the non-RIC compliant investment fund holds investments that are at a mark-to-market loss, such that rather than creating a future tax burden they represent something similar to a tax-loss carryforward, or a net operating loss. CSHAX among others seems to contemplate holding a DTA where market moves create one, according to its prospectus. This has the effect of increasing the fund’s NAV above what it would be simply based on the securities it holds. However, the accounting can quickly get tricky if investors begin to exit the fund. This is because an exiting C-corp ’40 Act investor that receives an NAV on their shares subsidized by the DTA leaves behind a fund that is now slightly smaller but has the same DTA, meaning the DTA represents a larger share of the remaining investors’ NAV. Continuing redemptions could propel this process to where benefiting from the DTA was no longer plausible, at which point the DTA could be subject to a “valuation allowance” (the language in the CSHAX prospectus). At that point, the fund might be in the unenviable position of providing investors still only 65% of the market upside combined with 100% of the downside, a set of circumstances likely to induce further redemptions, exacerbating the situation. As the funds themselves point out, the appropriate tax treatment is not clear. It’s an untested area.

This is theoretical. We haven’t actually seen this play out yet, but it’s a useful scenario to consider for such investors.

What should you do? If you own an MLP mutual fund or ETF, look carefully at the expense ratio. Funds set up as C-corps (i.e. not RIC-compliant) are an expensive way to access the asset class, and are unlikely to offer satisfactory returns. The best course is to sell and consider replacing with a RIC-compliant fund. At least the harm of the original investment error has been mitigated by the recent sell-off, since the tax treatment has cushioned the losses you’ve incurred. And if the Deferred Tax Liability of your MLP investment fund is heading in the direction of becoming a Deferred Tax Asset, with its uncertain ultimate realization to the fund, consider a more speedy exit.

How ironic that investors seeking to avoid the tax complexity of K-1s are nonetheless facing tax complexity of a different sort.

We also run a RIC-compliant mutual fund, and you can learn more about it here.

Nothing in this blog should be construed as offering tax advice.  Investors should seek their own tax adviser or tax attorney.  This document is not an offer to purchase or sell, nor a solicitation of an offer to purchase or sell an interest in a Fund.

 

 

 

A New Approach to Bonds

Countless investors and financial advisors wrestle today with the conundrum of how to approach bonds. We are reminded constantly of the likelihood of rising interest rates; most recently Fed chair Janet Yellen reiterated the case for a hike in short term rates later this year. She argued that uncertainty over Greece was likely to be merely a near term concern, and equity market turmoil in China did not deserve even a mention. It has been well forecast, if not overly forecast, for some years now. The Fed has consistently been too early in their expectations of timing, but it’s looking increasingly as if 2015 really is it.

As if walking a tightrope, today’s investors are forced to balance the impact of changed Fed monetary policy on bonds with their faith that holding an allocation to bonds must remain part of their portfolio construction. It’s a radical thought to reject bonds entirely — and yet that’s what we’ve done at SL Advisors since its formation in 2009. Reasoning that the government really doesn’t want you to own bonds (else why set rates at such unattractive levels) I wrote in Bonds Are Not Forever that  when public policy is to transfer real wealth from savers to borrowers, thoughtful investors take their money elsewhere. Not only are bond investors routinely subjected to insults to their intelligence by bond yields that fail to cover inflation plus taxes, but rowdy borrowers are increasingly announcing that they can’t repay what was owed, as I noted in our recent newsletter. Greece is seeking debt forgiveness (since winning independence from Turkey in 1822 the country has been in default 50% of the time); Puerto Rico’s governor announced they cannot repay their debt. Reaching for yield can mean sharing in the problems of the profligate. Consequently, we haven’t invested our clients’ capital in bonds for many years, and don’t see that changing until yields are more attractive (perhaps double current levels on ten year treasuries).

In this weekend’s Barron’s the cover story makes the case for abandoning bonds altogether.The article makes the case (as we have for years) against low fixed interest rates. It will probably attract the attention of many individual investors although I believe a serious omission has been to overlook Master Limited Partnerships, one of the most attractive income generating investments around with a current yield of around 6.45% on the Alerian Index and a long history of steady distribution growth.

A few years ago we sought to articulate the case for stocks over bonds by illustrating the relatively small amount of capital one needed to allocate to stocks in order to achieve the same cash return as with bonds. The crucial point is that coupon payments from bonds are fixStocks vs Bonds July 11 2015 (Stocks)ed while stock dividends grow. The S&P500 currently yields around 2%. Historically, dividends have grown at around 5% annually. So if you invested $100 in stocks today you’d receive a $2 dividend after the first year but if past dividend growth of 5% annually continued, in ten years your $2 dividend would have grown to $3.26. Put another way, if dividend yields are still 2% in ten years time, your $100 will have grown to $162.89 (that’s the price at which a $3.26 dividend yields 2%).  Since returns on stocks come from dividends plus their growth, a 2% dividend plus 5% growth equals a 7% return. Naturally, the two imponderables are (1) will dividends grow at 5%, and (2) will stocks yield 2% in 10 years (or put another way, where will stocks be?). These are the not unreasonable questions of the bond investor as he contemplates a larger holding of risky stocks in place of bonds with their confiscatory interest rates.

The thing is, while nobody knows the answer to these two questions, it doesn’t take much of your capital in stocks to replicate the cash return you might achieve with bonds in the scenario just outlined. The Treasury Bond Interest chart (Source: SL Advisors) shows the annual interest on a 2.3% yielding bond (the current level on ten year treasury notes)  if you invested $100 (assuming a 40% tax rate, approximately the top margin Federal income tax rate, so $2.30 annually falls to $1.38). The Stocks Total Return chart (Source: SL Advisors) shows the return from investing just $25 in stocks, so the $0.50 dividend (2% on $25) is, after 24% taStocks vs Bonds July 11 2015 (Bonds)xes, around $0.38. This assumes the Federal dividend tax rate and the ObamaCare surcharge but excludes state taxes.

The intent is to show visually what the Math does, which is that given the assumptions described you only need use 25% of your bond money invested in stocks to achieve the same cash return that you might expect from bonds. While switching out of bonds into stocks might sound imprudent to many, the real choice is between $100 in bonds or $25 in stocks with the other $75 in Cash. The 25/75 barbell portfolio of stocks and cash can quite plausibly replace the bond portfolio. If stocks fall 50%, your barbell would lose a quarter of that, or 12.5%. Whereas, a move in ten year yields from, 2.3% to 4% would cause the same loss of value. Consider for a moment which is more likely.

Of course, an investor may prefer the certainty of a loss of real value after inflation and taxes that bonds offer, compared with the uncertainty of stocks. In effect, that is what every bond investor is choosing by virtue of owning bonds. But in the 25/75 barbell portfolio we’ve assumed that there’s no return to the cash portion, and while that is more or less true today it will change over ten years; in fact, cash will probably begin earning a return (albeit still small) later this  year if Janet Yellen does as expected. The Math of stocks over bonds is compelling. It’s this analysis that has informed our rejection of bonds for years. This is the unspoken logic behind Barrons and their article, A New Approach to Bonds. It’s not quite as new as they think.

Energy Insights from Enterprise Products Partners

We noticed several interesting slides from an investor presentation by Enterprise Products Partners (EPD) recently. The first concerns future capital investment plans of Master Limited Partnerships (MLPs). As you can see on the first chart, lower oil prices have caused some moderation in forecast capitaEPD Shot of Organic Growth Capex May 2015l expenditures (“capex”) and a drop in 2016 versus 2015. However, the numbers remain substantially higher than the pre-2013 period, and support the forecast of $30-50BN in annual capex for energy infrastructure (since while MLPs are the main operators of such assets, integrated oil companies and utilities also fund energy sector projects).

Part of the MLP story in recent years has been the growth in infrastructure build-out to support the exploitation of shale assets. While the rate of growth is flattening out, projected asset growth at MLPs remains strong. Just as hedge fund managers benefit from asset growth in hedge funds, so should MLP General Partners expect to benefit from runningEPD Shot of New Projects Using Cheap Domestic Energy May 2015 bigger MLPs.

Another interesting slide concerned the growing interest in petrochemical facilities to take advantage of cheap natural gas in the U.S. As the table at right shows, the U.S. is fast developing a healthy trade surplus in petrochemicals exports.

Perhaps the most interesting insight was contained in the third chart, highlighting where oil production has been growing and where it hasn’t. As the chart title asks, “Why Couldn’t OPEC perform?” The rational response to the steady increase in oil prices over the past decade (albeit with a substantial fall and recovery in 2008-9) caused by growing demand from emerging economies should have been to match that increase with higher output, thus arresting the price increase and rendering other, unconventional sources of crude oil production uneconomic while still at a nascent stage. But OPEC, and most notably Saudi Arabia, failed to take this logical step. This created the opening for North American output to develop, meeting the increased demand while lowering its unit cost of production through economies of scale and ongoing technological improvements.

That OPEC didn’t do this suggests that they couldnEPD Shot of Oil Production May 2015‘t, and highlights the difference between very low production costs for proved, developed reserves in the Middle East versus relatively high costs to develop new resources beyond what is already in production. Clearly, from the perspective of a group of producers that still satisfies roughly one third of global oil demand, a modest increase in output to maintain market share and render new sources of supply uneconomic early on would have been a far less costly strategy than the current one of maintaining fairly constant output regardless of price. It suggests that even countries such as Saudi Arabia have a fairly limited capacity to increase output over the short term.

North American shale production, with its ability to adjust output quite quickly in resopnse to price changes, is turning out to be the swing producer. If this analysis is correct, it should result in a more stable oil price than we’ve seen in the last year since a more flexible supply response to price movements now exists.

MLPs Report Encouraging Prospects

It’s earnings season, and last week Enterprise Products Partners (EPD) reported another solid quarter. An appealing feature of EPD is the absence of a General Partner (GP). So unlike many other MLPs, EPD LP unitholders do not suffer a haircut to Distributable Cash Flow (DCF) from GP Incentive Distribution Rights (IDRs) before the cash makes its way to the LPs for their distribution. This allows the growth of DCF from EPD’s portfolio of assets to flow right through to EPD unitholders, thereby giving it a lower cost of capital than would be the case if there was a GP. Insiders also own 35% of the units, a significant alignment of interests.

EPD’s full year results came in modestly better than expected and their distribution growth from 2013 was +5.8%. They also have unusually high DCF coverage of 1.4X which allows them to fund part of their planned growth through this excess of DCF over declared distributions. EPD is positioning itself to support the U.S. shift to role of refined products exporter, and its planned growth capex is on the same trajectory as it was last Summer when oil was above $100 bbl.

Kinder Morgan (KMI) held their Analyst Day on Wednesday and provided further detail on the business following their earnings release the prior week. As they pointed out numerous times during the day of presentations, 85% of their 2015 cashflows are fee-based and a further 9% are hedged, leaving only 6% subject to commodity price swings.

NuStar (NS) was also interesting, in that their reported earnings showed distribution coverage of 1.1, at last sufficient to cover payouts to unitholders. It’s not that long ago that  their distribution was at risk, but they have exited the asphalt business, greatly reduced their commodity sensitivity and focused on the storage business. Analysts on the earnings call were even asking about the timing of a distribution increase. NS has a publicly traded GP called NuStar GP Holdings (NSH). Its current distribution generates a yield of 5.8%, very high for a GP. NSH receives up to 23% of the DCF of NS and it is currently at that level. As the business returns to growth NSH’s IDRs, 13.1% LP interest and smaller outstanding number of unit compared with NS should translate into roughly twice the distribution growth rate as that experienced by the other LP unitholders in NS. It’s why we prefer the GPs.

We are invested in EPD, KMI and NSH.

Energy Transfer Shows the Power of the General Partner

This morning Energy Transfer Partners (ETP) agreed to merge with Regency Energy Partners (RGP). Terms included an equity swap whereby RGP holders will receive 0.4066 ETP units and $0.32 in cash for each RGP unit they hold. ETP is also assming RGP’s debt. Energy Transfer Equity (ETE), ETP’s General Partner,  already owns the GP and Incentive Distribution Rights (IDRs) for RGP. However, the IDR’s were only at the 25% split level with respect to RGP, meaning that ETE was receiving 25% of RGP’s Distributable Cash Flow (DCF), whereas ETE is at the 50% splits on its share of ETP’s DCF. Simply put, prior to the merger ETE was getting more of each dollar generated by ETP than it was from RGP. Following the merger, RGP’s DCF will in effect be subject to the same 50% split at ETP’s. ETE has agreed to forego $320 million of IDR distributions over the next five years as a sweetener. It is nonetheless a nice deal for ETE and the relative performance of the stock prices reflects this. ETE is currently up over 4% reflecting its improved cashflow outlook, while ETP is down more than 5%, perhaps in part because of the issuance of additional units. RGP is up because the terms of the transaction represented a premium to RGP’s Friday close. RGP’s projected 2015 distribution yield was 8.9% prior to the transaction compared with 6.6% for ETP, so even allowing for the modest premium the transaction is still accretive to ETP. Importantly though, ETE investors most notably including CEO Kelcy Warren did not have to provide any capital to make this transaction happen; it’s been funded by ETP, as directed by ETE, its GP. The subsequent entity will also have a stronger balance sheet with a lower cost of debt, making future acquisitons easier to execute.

It highlights the advantages of investing in the General Partners of MLPs. They have all the control, and can execute M&A transactions that improve their economics with little or no obligation to provide additional capital. We are invested in ETE, as is Kelcy Warren who owns almost 80 million units of ETE worth around $4.5 billion. He figured this out long ago.

Kinder Morgan Finds Value in a New Pipeline Network

Master Limited Partnerships (MLPs) have been falling along with the rest of the Energy sector since oil began its plunge last Summer. Following its peak in August, the Alerian MLP Index is down 15.1%. So far it’s down 1.6% in January, typically a strong month as retail investors implement asset reallocations settled on over the Christmas holidays. However, there are some signs of stabilization as the Index was -8.9% for the month by January 13th so has rebounded since then.

We’re in earnings season, a time during which those firms with solid fundamentals and limited direct commodity price exposure can differentiate themselves by reporting their results and providing guidance. Kinder Morgan (KMI), although no longer technically an MLP since their reorganization last year, still derives over half their cashflows from natural gas pipelines and is solidly in the midstream sector. During the conference call following their earnings they went through the coverage of their $2 distribution and although there are many moving parts the distribution coverage looks comfortable even with crude oil substantially lower (into the $20s per bbl) and natural gas down to $1 per MCF. Their direct exposure to crude oil and natural gas prices is limited. They reaffirmed 10% distribution growth through 2020. The stock yields 4.7% on its 2015 dividend.

KMI also made their first investment in the Bakken Shale in North Dakota by acquiring Hiland Partners LP, a privately owned MLP with pipeline assets in a still under-served area, from Continental CEO Harold Hamm. The $3 billion price tag will help fund Hamm’s expensive divorce.

KMI expects to invest an additional $800M in these new assets, expanding their capacity to transport crude oil from North Dakota. At a time when many are worrying about production cutbacks by U.S. shale producers this decision to make a new capital commitment highlights an interesting advantage pipelines retain over other form of crude oil transportation such as rail or truck. Only around half the 1.2 million bpd of output from North Dakota moves by pipeline, so increasing the Double H Pipeline (for example) from 80,000 bpd to 108,000 by next year will help. Pipelines operate at as little as 25% of the cost of rail and truck. While the latter two can offer greater flexibility, once a pipeline is in place its substantial cost advantage makes it a formidable competitor, and the long term commitments required of shippers provide far greater certainty about future cashflows. Some have suggested that E&P firms will press their MLP partners for price cuts on transportation, but they’re more likely to start by cutting use of more expensive rail and trucking assets. Pipelines are also far safer, with proportionately fewer injuries or spills.

The impact of production cutbacks is more likely to be felt by the higher cost transportation networks such as rail and truck. The area of the Bakken served by Hiland’s network has, according to the North Dakota Department of Mineral Resources, an IRR of 10% even with oil as low as $38 bbl. It’s one of the more profitable areas, and likely to keep producing output at current price levels. The Hiland acquisition is expected to be accretive to KMI by 2017. The company isn’t immune to reassessing its backlog of projects though, and although the figure only fell slightly (from $17.9BN to $17.6BN), $785MM of planned capex was shelved, mostly in its CO2 division where they have more direct exposure to the price of oil. So there clearly are some reductions in planned investment because of the drop in oil. These figures offer a measure of their likely magnitude, at least for a bellwether midstream operator.

In other news, Markwest Energy (MWE) increased its dividend by 4.7% YOY. It currently yields 6.2% based on its expected 2015 distribution. MWE owns its General Partner too, so unlike many MLPs there is no drag on distributions to investors from Incentive Distribution Rights. Consequently, all the growth directly benefits MWE investors.

We own both KMI and MWE in our portfolios.

Health Care Versus Energy Within the S&P500

The chart below shows the performance of different sectors of the equity market so far this year. Of course, there are always sectors that are outperforming, so nothing much new there. However, if in general as an investor you don’t commit much to health care and you are overweight energy, recent months have likely given you reason to examine comparative performance rather more closely, as we have. If in addition you’ve had a couple of small positions in smaller energy names, you’ve also experienced first hand the relative underperformance of small cap stocks versus the market. Suffice it to say that the results of owning a handful of large health care stocks and being short a smattering of small energy stocks would have been about as perfect a position to hold over the last three months.

"EnergyThe chart tells the story, but to put numbers on it, while the S&P500 is +14% this year, Healthcare (defined as XLV, the sector ETF) has returned almost double at +27% while Energy is -19%. A good portion of the Health Care/Energy relative performance has occurred just in the past three months (28%). Interestingly, the daily returns of MLPs have been most highly correlated with Energy (64%), even though MLPs have outperformed Energy by a whopping 19.5%. In fact, at +11% for the year the performance of MLPs is not far short of the S&P500.  What’s happened is that bigger than typical daily falls in Energy spill over to MLPs even though midstream energy infrastructure (what most MLPs are engaged in) has a very different risk profile from Exploration and Production. So on days when XLE fell 1%, the correlation with MLPs was higher than normal, at 76%. MLPs react to sudden moves, but on the days when Energy is not down 1% or more (84% of the time this year) they react to their own economics.

So what does one conclude? The surprise of the past 2-3 years has been that ACA (The Affordable Care Act, or “Obamacare”) has been very good for the health care sector. I doubt many architects of that legislation expected to create such wealth for health care providers. However, the major news story of 2014 is clearly Oil. Small energy sector servicers have been extremely weak, while the economics for many energy infrastructure businesses have remained sound notwithstanding big drops in some of their customers’ stock prices. Friday was such a day. with the Energy sector -6.3% and MLPs -5.3%. There are substantial crosscurrents beneath the simply headline result of the S&P500.

 

Another Activist Exposes a Weak Board with a Lousy CEO

It’s an odd phenomenon that, although capitalism as a philosophy is built around the meritocracy of free markets, in the area of corporate governance the power of profit maximization has often failed to dump ineffective boards of directors and/or management in favor of more competent people.

Boards are usually made up of invited friends, and sometimes their supervision of senior management resembles that of golf partners where it’s good manners to ignore others’ poor shots while offering congratulations on the good ones. The pressure to avoid rocking the boat is felt by everyone.

Hence the Economist this weekend noted an innovative solution to the issue of weak, sometimes unqualified board members. Why not outsource the function to companies whose business it is to provide such services? This currently happens with audit and legal work. Board members are hardly engaged full-time by any one corporation. Why not develop specialists who are truly independent and full-time?

It struck me as quite a clever suggestion. It ought not to be necessary, but the many failings we see week after week highlight that capitalism is often coming up woefully short in this important area of corporate governance, or how the very stewards of capital are managed and evaluated. Even Warren Buffett punted when a few months ago he was asked about the egregious compensation plan recommended by Coke’s (KO) management.

Although Berkshire (BRK) is KO’s biggest shareholder and Buffett about as vocal on investor rights as anybody, the great man meekly abstained rather than vote against a plan he freely admitted was needlessly generous.  “If you keep belching at the dinner table, you’ll be eating in the kitchen,” was his typically folksy and non-combative explanation. He understands as well as anybody the duty of board members to be only occasionally critical and then in the nicest possible way.

Other examples include ADT, which as I’ve written before is busy demonstrating the ham sandwich test (invest in a company that could be run by a ham sandwich, because one day it will), as shown by their buyback of Corvex’s position in ADT stock last year at $44 just before disappointing earnings took its price eventually below $30. Activists are often a force for good as they seek to expose management failings, but Keith Meister’s Corvex is a negative since he’ll readily throw other investors under the bus for a quick profit. We own ADT in spite of its leadership since we think anybody could run it as badly as current management and many could do better. It’s an option on executive suite change.

Currently the role of using capital to improve management is taken by activists such as Carl Icahn. He just provided a stark reminder of how shareholders often need activists to correct some of their self-seeking behavior. Family Dollar (FDO) just the other day agreed to sell itself to Dollar Tree (DLTR), an unlikely partnership since they operate different business models and would continue to do so afterwards.

FDO CEO Howard Levine noted that no discussions had taken place with the more obvious and bigger merger partner Dollar General (DG), to whose steadily improving operating metrics FDO eternally aspired but never reached. DG’s CEO Rick Dreiling flatly contradicted this by noting that DG had expressed interest in a combination multiple times in recent years. Carl Icahn backed this up, recounting a dinner with Levine at which the subject of a combination with DG was discussed. With DG, Howard Levine will lose his job to the superior operator, whereas with DLTR he’d keep it. As Icahn memorably noted, Levine thinks that because his father founded the company the son owns it. But he doesn’t. FDO’s stock has consistently underperformed DG’s in recent years as has its business. As close competitors it’s been helpful for investors as well as the companies themselves to compare their relative operating performance which has invariably favored the larger, better run DG (we are currently invested in DG, and were until very recently invested in FDO).

DLTR was a better merger partner for a CEO putting his own job ahead of his fiduciary obligation to his shareholders, and the FDO board passively acquiesced. Levine even agreed to a $300 million break-up fee in the DLTR transaction, a final slap in the face to those stockholders who thought he had their interests at heart.

Investors though should be far more assertive. If well-run boards with good corporate governance were more highly valued, they’d arrive more quickly. The more a poorly run company’s stock is shunned the quicker activists or competitors can buy a stake and fix it. The best solution to poor corporate governance is to invest with competent management and avoid the poorly run, at least until they’re cheap enough to draw in an activist. FDO had at least met this test in the last couple of years. Even institutional investors don’t have to own every publicly listed large cap company. Until investors become even more discriminating in their allocation of capital, activists will continue to correct perhaps the biggest weakness in contemporary capitalism – the management of the executive suite.

The Trading Risk Confronting Some MLPs

Barron’s has one of their by now regular articles on MLPs this weekend as they interview their “MLP Roundtable”. These write-ups are invariably constructive, and the most recent one is no exception. As well as noting the many opportunities offered to build out infrastructure in support of America’s shale boom, General Partners (GPs) received a mention. Roundtable member Douglas Rachlin of Neuberger Berman pointed out that, “GPs are not required to contribute capital to the organic-growth projects or acquisitions their MLPs make; yet they benefit in a disproportionate manner through their ownership of distribution rights.”

Becca Followill of U.S. Capital Advisors added, “Some MLPs don’t have a general partner, which makes them easier to take out and can make a deal more accretive more quickly.”

These are both features of MLPs that we’ve long identified and reflected in our own MLP strategy.

Quite a few names reported quarterly earnings last week. The numbers were generally good and MLPs are overwhelmingly reporting increases in future capital investment which for GPs at a minimum assures continued growth in distributed cashflow received and therefore in dividends paid. But not everything was good. Buckeye Partners (BPL) issued a surprisingly disappointing report which included losses in their Merchant Services division. We’re investors in BPL and have been for years.

The most attractive businesses for MLPs are fee-based whereby they earn recurring income from storage and pipeline assets. BPL largely does this, but like a handful of other MLPs they also have a marketing division which incurs basis risk on its underlying products on behalf of customers, often in exchange for quite narrow margins.

These activities can be quite tricky to manage. MLPs face a principal-agent problem here, in that their desire is to generate a return through using their inside knowledge and control of product to charge more than the cost of the basis risk incurred. However, there is inevitably judgment involved, and while the MLP wants to exploit an additional element of its franchise, if not properly managed the traders involved will seek to make money from the risk taking side of this. In fact, risk-averse basis trading maximizes the firm’s franchise value and minimizes the value added of the trader. The trader’s incentive can therefore be to minimize the apparent value of the franchise so as to maximize the apparent value of his skill-based activities. It can lead to excessive risk-taking, since profits from properly exploiting the MLP’s position in the middle of all kinds of information about supply and demand can appear to value the trader less than trading profits generated through his own skill/judgment.

It’s not only banks that can get themselves into trouble with risk. And in BPL’s case, it appears that a poorly constructed hedging strategy went wrong during the 2Q, causing the Merchant Services unit to swing to an operating loss.

Positions were liquidated, people fired and a more modest business model adopted. But it shows that unwelcome surprises can come from units that appear to offer steady if unspectacular returns, if the principal-agent conflict described isn’t carefully managed.