MLP Overview
What is an MLP?
In business, the acronym MLP is short for the term “Master Limited Partnership”. A master limited partnership is simply a legally recognized way of structuring a business (just like a corporation). More specifically, an MLP is a special type of limited partnership that can be publicly traded on exchanges such as the NYSE or NASDAQ. That is, investors can buy or sell shares (called units) of an MLP like shares of stock.
In an MLP, the business consists of a general partner (GP) and one or more limited partners (LPs). The GP is the managing partner and is responsible for daily operations and management, while the LPs are passive investors who provide capital to the business. The partnership is “limited” in that LPs are only liable up to the amount they have invested in the business (i.e., in the event the firm goes bankrupt). Typically, units of the LP are sold to investors, but in some cases units of the GP are also offered as well.
MLP - Basic Structure
How Do Investors Benefit?
MLPs are designed so that the majority of cash generated from the business is paid out quarterly to investors. This payout, known as the “distribution” is similar to a dividend paid to stock investors. However, the distribution yield paid by MLPs is typically higher than stock dividend yields. For example, at the time of this article the S&P 500 dividend yield is around 1.9% compared to the 6.1% yield for the Alerian MLP Index (AMZX). Even if we compare AMZX to the top 50 yielding stocks from the S&P 500, the S&P still falls short with a yield of 4.9%.
AMZX Yield vs. S&P 500
Data Source: Alerian Capital Management, The Wall Street Journal
Income & Price Appreciation
Like a dividend stock, a unitholder’s return has a yield component and a price appreciation component (i.e., the appreciation in price of the unit over time). This helps to boost total returns, especially given the compelling history of cash distribution growth to investors. Over time, the AMZX has outperformed the S&P 500 over 1, 3, 5, and 10 year intervals from a total return perspective.
Total Returns - AMZX vs. S&P 500
Data Source: Alerian Capital Management, Standard & Poor’s
Tax Benefits
In addition to attractive yields and solid returns, the MLP structure also has enticing tax benefits as well. Unlike public corporations, MLPs are not taxed at the entity level (i.e., there is no corporate income tax). Taxes only have to be paid on distributions at the unitholder level. Therefore, investors avoid the “double-taxation” of stock dividends. Further, the majority of the taxes that unitholders must pay are deferred. That is, around 80-90% of cash distributions are not taxable until the unit is actually sold.
Risks
As with any investment, there are also inherent risks which potential investors must consider. While MLPs must file with the Securities & Exchange Commission (SEC), the regulatory environment in which MLPs operate tends to vary. This contributes to business risk, especially in portions of the industry where regulation is relatively loose (e.g., natural gas gathering, etc.).
In addition, while MLPs have tax advantages, investors must pay careful attention to filing requirements. For example, investors in pipeline MLPs that operate in several states must file in each state the MLP does business. This can be a cumbersome and laborious process.
Finally, while MLPs are liquid in the sense that they can be traded on major exchanges, they are illiquid from an institutional perspective. That is, large institutions such as mutual funds avoid them for fear they won’t be able to find buyers when ready to sell their units. This is one of the key factors contributing to the small number of institutions investing in MLPs.
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