The Partnerships
Editor’s Note: The Energy Strategist is published twice per month, 24 times annually. As a result, twice a year we take a production break for one week, so your next issue will be released on Oct. 24.
Of course, I frequently supplement regular issues with special flash alerts. Be assured that I’ll be monitoring the markets carefully and issue a flash alert if I see any points that need to be addressed.
The third quarter brought plenty of volatility for the US and most global stock markets. In particular, a general credit scare gripped the market in late July. The epicenter of that scare was mortgage-related debt focused on subprime borrowers; however, the general panic spread, making it difficult for even higher-quality corporate borrowers in totally unrelated industry groups to garner access to capital.
Nevertheless, global markets finished the quarter to the upside, thanks to a solid rally that kicked off in mid-August. The S&P 500 managed to eke out a total gain of just more than 2 percent in the third quarter, bringing the year-to-date return to about 9.3 percent.
Energy stocks once again led the market’s advance. The S&P 500 Energy Index rallied 9.8 percent for the quarter and is up 28.71 percent year-to-date and 43.09 percent on a trailing 12-month basis. The Philadelphia Oil Services Index is up 12.1 percent for the third quarter, 48.1 percent year-to-date and 59.3 percent over the trailing one-year.
The Energy Strategist Portfolios beat the broader market averages but lagged the key energy benchmarks in the third quarter. Over the year-to-date and trailing 12-month periods, however, the TES Portfolios continue to handily beat both the broader market averages and the key energy-related indexes I follow. Check out the chart below for a closer look.
That significantly bests the S&P 500’s returns of 9.3 percent year-to-date and 16.6 percent over the trailing 12 months. And the Proven Reserves Portfolio has shown less volatility over the long term than the S&P 500.
The primary reason for the portfolio’s underperformance in the quarter was a poor showing from my recommended master limited partnerships (MLPs). I discuss this sector at length in today’s issue. But, to make a long story short, I see this underperformance as temporary and believe that income-oriented investors should use temporary weakness to accumulate larger positions in the MLPs. This is a buying opportunity.
The growth-oriented Wildcatters was the best-performing Portfolio for the quarter, up 5.83 percent; that brings the year-to-date and trailing 12-month returns to 34.1 percent and 56.7 percent, respectively. I typically benchmark this Portfolio against the S&P 500 Energy Index; it’s beating that index handily on both a year-to-date and trailing one-year basis.
Helping this Portfolio in the third quarter was a strong showing from our energy services and equipment recommendations. The energy MLPs in the portfolio were the weakest components.
Finally, my aggressive-growth Gushers Portfolio was up just less than 3 percent for the quarter. I typically benchmark this Portfolio against the more volatile Philadelphia Oil Services Index (OSX).
Although the Gushers Portfolio lagged in the third quarter, its year-to-date gain of 43 percent is roughly in line with the OSX and the trailing 12-month return of 95.3 percent bests the OSX’s 59.3 percent gain by nearly 40 percentage points.
That said, the end of the quarter is an opportune time to evaluate and review our main holdings and recommended investing themes. It’s also a good time to make any adjustments necessary to recommended holdings.
PTPs have been a major focus of this newsletter since it first began. However, there has been some weakness in the sector of late that I felt needs to be addressed. The newsletter sections below outline five primary issues plaguing the sector. See The PTP Rundown.
The August credit crunch was highly publicized in the financial media, so it should come as no surprise that PTPs fell victim to it as well. Most MLPs issue bonds or establish lines of credit with banks to fund their operations, creating higher-than-average debt burdens. However, this isn’t unusual activity for MLPs, and I expect confidence in the group’s access to capital to return as many PTPs work to make deals appropriate for the current credit market. See Access to Credit.
New bipartisan legislation has been proposed that would tax as corporations all PTPs that derive income from investment advisory or management services. There is also legislation regarding the concept of carried interest. Although these items don’t immediately affect the PTPs I cover in TES, there are possibilities for future regulation. See Politics and Taxes.
The number of new PTPs in the process of listing has tripled since last year. Such a large increase could affect the amount of money invested in each individual PTP as investors rush to buy the new hot thing or are limited in the amount they can invest because they’re spread too thin. See New Issues Rush.
I’ve received several customer inquiries regarding PTPs and commodity prices. However, I simply just don’t see much of a connection between the performance among the two sectors. See Commodity Prices.
Closed-end funds have been hit harder than average PTPs because some use debt capital to help leverage their portfolio and increase returns. However, investors won’t ignore the sector’s high, fast-growing yields forever. See PTP Closed-End Funds.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
I’ve written extensively about PTPs and MLPs in TES. The PTPs trade on the major exchanges just like ordinary stocks. However, unlike ordinary companies, PTPs pay no tax at the corporate level.
Instead, PTPs pass through their cash flows to shareholders (known as unitholders) as dividend distributions. These distributions aren’t taxed like normal dividends; in fact, MLP distributions offer huge tax advantages for investors. PTPs also tend to offer strong distribution growth and high current yields.
Rather than review all the tax advantages of PTPs and my rationale for recommending the group here, I recommend all subscribers unfamiliar with the group check out the Nov. 22, 2006, issue of TES, Leading Income. This lengthy, detailed issue covers just about every relevant aspect of PTP investing. If you read that issue, you’ll find that my comments on the group below make far more sense.
The table below lists all the PTPs I cover in TES, as well as the third quarter and year-to-date returns for each recommendation. I’ve also added a column listing each PTP’s current dividend yield and the projected growth in dividends for 2008 compared to 2007.
Source: The Energy Strategist
As you can see in the table, the average TES-recommended PTP fell more than 11 percent in the third quarter. That said, despite that nasty tumble in the past quarter, the list remains up around 7.1 percent so far year-to-date. And although I didn’t list the returns in the table, the MLPs are also performing far better than the S&P 500 on a trailing one-year basis.
But despite solid, long-term outperformance, a one-quarter loss of that magnitude is certainly notable for the PTPs. Typically, this group is far less volatile than the S&P 500.
The first point to consider is that the selling is absolutely nothing company-specific to the partnerships recommended in TES; rather, broader indexes of the group performed poorly last quarter. Check out the chart of the Alerian MLP Index below for a closer look.
Source: Bloomberg
Note, in particular, that the Alerian MLP Index saw one of its largest one-day drops in history in early August. This is despite the fact that the MLPs recommended and covered in TES reported solid second quarter numbers in July and August and continue to consistently boost their distributions for unitholders.
I see five primary issues that have been impacting the PTPs during the past few months. Below, I explain each in order of importance and offer my assessment:
Back to In This Issue
They tend to carry relatively high debt burdens when compared with, for example, your average S&P 500 firm. MLPs also tend to use debt capital to finance expansion projects and acquisitions of new income-generating assets.
Broadly speaking, I don’t see those higher-than-average debt burdens as a problem at all. The reason is that MLPs are typically involved in stable, high-cash-flow businesses such as operating natural gas pipelines.
In most cases, these operations aren’t significantly impacted by economic growth or commodity prices. Therefore, the group has the stable cash flows to handle a higher debt burden than most corporations without running into financial problems. All the partnerships I recommend have cash flows that are more than sufficient to cover their debt service obligations many times over.
Moreover, this is absolutely nothing new. The group has always carried a relatively high debt burden without negative consequences.
In fact, for much of the past three years, it would have been completely idiotic and irresponsible for PTPs not to use debt to finance expansion at least to some extent. The reasons are that access to debt capital has been easy and interest rates are near historic lows; this is a cheap way to finance growth. In addition, unlike issuing new units, taking on more debt isn’t dilutive to existing unitholders.
But here’s the problem: The credit markets all but locked down completely during the summer. As I noted earlier, the root cause of this credit crunch emanated from the mortgage bond market, but it spread quickly to other sectors of the economy.
The result was that it quickly became more expensive and far harder for even companies with stellar credit to issue bonds or take on new credit lines. For a few weeks, the market did quite literally shut down.
There are myriad ways to measure stress in the credit markets. One is to simply look at the performance of the Philadelphia Banking Index as compared to the S&P 500 more broadly; when banks are underperforming the averages, it’s a sign investors are worried about instability in the financial markets. Check out the chart below.
Source: StockCharts.com
This chart compares the price of the Banking Index to that of the S&P 500; when the line is rising, banks are outperforming and vice versa. As you can see, the banks dramatically underperformed the rest of the market in August, one of the most dramatic periods of underperformance in the past decade. The main concern was that weakness in all sorts of credit, as well as bonds backed up by mortgages and other types of loans, would sink earnings.
Some of this fear was justified. Citigroup, Bear Stearns and UBS, among other financials, have reported weak earnings results or issued warnings based on the credit turmoil.
Citigroup, for example, reported on Oct. 1 a 60 percent decline in earnings for the third quarter as it experienced rising losses in consumer credit and was forced to write down the value of its leveraged loan commitments. (These are basically loans that Citigroup had already agreed to fund but had been unable to sell to other institutions for the same valuations it had expected.)
At any rate, the credit crunch was very real this summer, and it had an effect on the cost of capital for the MLPs as well as most other industry groups. Simply put, because the MLPs must pay more for their capital, their returns from projects are lower. Theoretically, some expansion projects or acquisitions that would have been economic based on the easy credit terms available in June weren’t feasible in August.
But although I recognize that a rising cost of capital is a negative, this concern was and continues to be drastically overexaggerated. First, many of the larger cap MLPs I follow already have a good deal of existing funding and credit lines in place. Most have access to plenty of capital at pre-negotiated attractive terms and don’t need to go cap-in-hand to Wall Street looking for cash through at least the next few quarters.
Although that’s broad generalization, consider the case of Enterprise Products Partners, the largest MLP I recommend. Enterprise relies mainly on organic expansion projects to fuel growth in its cash flows and distributions; in other words, the partnership actually builds new pipelines and processing facilities. It’s less reliant on acquisitions than many smaller MLPs.
Enterprise has large capital spending plans. Roughly $1.2 billion in spending will be necessary for 2008 to fund its planned organic growth projects, and an additional $500 million or so will be necessary to fund expansion projects for the remainder of 2007. Therefore, if credit were unavailable to Enterprise, it could shut down its organic expansion projects and severely impact growth potential.
But Enterprise already has plenty of funding in place. The PTP has more than $63 million in cash on its books and about $750 million in available funding from an existing line of credit facility. That facility doesn’t expire until 2011; Enterprise won’t need to look to roll over it for another four years.
Let’s take a quick look at Enterprise’s existing debts; check out the chart below.
Source: Bloomberg
This chart shows that Enterprise has $11.13 billion in bonds outstanding, coupled with loan commitments from banks. This year only $500 million worth of bonds will mature, and next year a $1.8 billion credit facility expires. But, for the most part, Enterprise’s debt won’t need to be renegotiated until after 2010.
And this chart is only up-to-date through the end of June. The company actually sold $800 million of new 10-year bonds in late August, priced at a yield of 6.3 percent, an attractive interest rate. It’s using $500 million of that to repay its remaining $500 million worth of borrowings due this year. The company has about $150 million due in January of next year; the remainder of its $1.8 billion in borrowings maturing in 2008 is due in late August or later.
Bottom line: Enterprise doesn’t really need to worry about accessing the credit markets until sometime in the second half of 2008. That’s plenty of breathing room.
A good gauge of the cost of capital for Enterprise is to look at a chart of one of the company’s bonds. Check out the chart below.
Source: Bloomberg
This chart shows the price of Enterprise Product Partners 8 3/8 Percent Bonds of August 2066–an issue I wrote about in the Nov. 22, 2006, issue of TES. These bonds were issued a little more than a year ago; about this time last year, the bonds were trading at $102 to $103.
The bonds subsequently rallied to the $111-to-$112 range last spring. Recall that a rising bond price means that yields are falling. Although falling yields have no effect on the coupons that Enterprise has to pay to finance this debt, they do indicate that Enterprise might be able to issue other bonds at a lower rate. They suggest that Enterprise’s cost of capital for new debt is dropping.
You can clearly see the August credit crunch on this chart. The bond fell quickly from late May into early August and hit a low of about $100.
But note what’s happened since then. The bond has rallied again, back to that $103-to-$104 region. This is almost exactly where it was trading one year ago.
Bottom line: Although Enterprise’s cost of capital may not be quite as low as it once was, this chart hardly represents the profile of a firm with deteriorating credit quality or access to the bond market. Enterprise has had and should continue to have new funding. And credit costs really aren’t appreciably different than a year ago.
Of course, debt is only part of the story. Lately, most PTPs have been using a combination of debt and so-called private placements to fund their expansion.
Private placements involve selling additional units (shares) to an institutional buyer for a preset, usually discounted, price. Such deals offer the MLPs a ready, guaranteed buyer at a predetermined price.
This is preferable to trying to issue a huge secondary tranche of shares on the secondary market. Typically, private placements have had less of a negative effect on PTP stock prices than traditional secondary offerings to investors.
Institutional buyers, including hedge funds, have been eager buyers of these private placement deals this year. In total, publicly traded energy partnerships in the US raised more than $10 billion via private placements in 2007 alone.
The credit crunch also impacts this source of funding. Specifically, if institutional players are hurting because of market turmoil or are looking to cut back on risk, they’ll likely be less willing to take on private placements. Because private placements have been the most important source of funding for MLPs recently, this could be an even bigger problem than lack of access to debt markets.
But this concern is also overblown. Although the debt and private placement markets shut down in early August, that’s no longer the case.
Rather, on the debt front, capital isn’t quite as cheap as it was earlier this year for the PTPs. Banks are charging higher interest rates on loans. But capital is available, deals are being done, and the PTPs are still making plenty of cash despite the higher cost of debt.
On the private placement front, what appears to be happening is that institutions are demanding a bigger price discount on shares they purchase. Again, that raises the cost of this form of financing slightly.
However, some very large private placements deals have been closed since August. There’s still plenty of demand for these deals, albeit at slightly less beneficial terms.
And although private placement financing is more expensive, it’s still cheap by any historical measure. The cost of this capital just hasn’t risen enough to make the MLPs’ projects economically unattractive.
Here’s a brief rundown of just a few of the financing deals that have been completed in the past few weeks:
As more deals are funded and completed, I expect confidence in the group’s access to capital to return. Meanwhile, this lingering negativity is keeping prices down.
Consider, for example, the case of Linn Energy. The firm already has all its necessary financing commitments in place. And management is confident enough in its access to capital to suggest that it’s looking to make another $1 billion or more in acquisitions in the first half of next year.
Based on the growth from its current properties alone, Linn could exit 2008 paying an annualized distribution of close to $3 per unit; there’s upside to that if the company closes another big acquisition or if natural gas prices rise sharply.
At current prices and with a $3 distribution, Linn Energy would be yielding more than 10 percent. When you consider the tax deferral advantages of PTPs, that yield is easily as attractive as a yield in the low teens for a normal corporation.
Although investors may ignore the recent signs of a recovery in cost of capital for PTPs in the next month or two, they’re unlikely to ignore steadily rising distributions from Linn over time. Linn Energy remains an attractive buy.
Back to In This Issue
Two factors have heightened these concerns. One is the media’s misleading, confusing reporting on this issue. The second is the raw nerves and frustration left over from the Canadian government’s decision last year to change the taxation of income trusts; investors fear a big tax surprise from the Democrats now in charge of Congress.
The fact is that there have been two proposed tax changes floating around Congress this summer. The first was legislation proposed by Sen. Max Baucus and Sen. Chuck Grassley–a Democrat and Republican, respectively.
This legislation would tax as corporations all PTPs that derive income from investment advisory or management services. That means that the tax rate on such PTPs would rise to the full US corporate income tax rate. This would effectively eliminate the attraction of such firms organizing as PTPs.
Note the rather specific nature of this legislation: The bill would address only PTPs engaged in investment management or advisory services. This bill is aimed squarely at private-equity firms and hedge fund that have recently listed as PTPs. Namely, this law would affect The Blackstone Group and Fortress Investment Group, two recently listed PTPs that are involved in the investment business.
This proposed legislation clearly wouldn’t affect the energy and commodity-related PTPs that are recommended in TES. The specific nature of this legislation is obvious from a letter written by the two senators to Treasury Secretary Hank Paulson back in June. Here is an excerpt from that letter:
Dear Mr. Secretary:
We are writing to you regarding several recent initial public offerings (“IPOs”) of private equity and hedge funds. We believe that these IPOs raise serious tax questions that if left unaddressed have the potential to jeopardize the integrity of the tax code and the corporate tax base over the long term. We write to request your views on this matter, to ask what actions Treasury intends to take, and for your views on legislation we introduced to address this threat to the corporate tax base, if a change to statute proves necessary.
The basic structure of these IPOs is that they are classified as publicly traded partnerships (“PTP”) under section 7704(b) of the Internal Revenue Code (the “Code”). A PTP is taxed as a corporation unless it satisfies the qualifying income exception under section 7704(c), chiefly directed to passive-type income. Section 7704(c) requires that for any taxable year, 90 percent or more of the gross income must be “qualifying income.” Qualifying income is defined in section 7704(d) to include: interest; dividends; rents; gain from sale of a capital asset held for production of income; and gain from commodities contracts.
These funds clearly state that they are engaged in an active trade or business. For example, one fund states in its public filing that “[w]e believe that we are engaged primarily in the business of providing asset management and financial advisory services and not in the business of investing, reinvesting, or trading securities. We also believe that the primary source of income from each of our businesses is properly characterized as income earned in exchange for the provision of services.” In order to avoid failing the 90 percent qualified income test, these PTPs rely on the income from carried interests being treated as qualified income, and have created a subsidiary blocker corporation to absorb all nonqualified income. To the extent that any funds are then transferred from the subsidiary blocker corporation to the parent PTP, this blocker corporation will convert the nonqualified income into a payment of dividends (that is, qualifying income) to the PTP.
We believe that the PTP rules are being circumvented because the majority of the income is from the active provision of services to the underlying funds and limited partner investors in those funds…
–Excerpted from a letter to Secretary of the Treasury Hank Paulson, June 14, 2007, by Sen. Baucus and Sen. Grassley.
It’s obvious from this excerpt that this legislation would address only the private-equity firms and hedge funds seeking to list as PTPs. The Blackstone Group said in late August that the bill would roughly triple its tax liability. It makes no attempt to call into question or propose changes to qualified income exemptions; therefore, it would have absolutely no effect on the taxation of energy-related MLPs.
In politics, however, issues such as this are never simple or pure. Baucus and Grassley are from Iowa and Montana; although their proposed legislation targets private-equity firms and hedge funds, they’re actually proposing expanding the universe of PTPs to include those involved in the ethanol industry.
According to most analysts, existing PTP rules mean that companies deriving the majority of their revenues from blending, producing and transporting ethanol can’t really list as PTPs. Expanding the definition of PTPs to include ethanol would, therefore, be popular with elements of the electorate in Iowa and Montana.
Not surprising, this legislation isn’t popular on the East Coast, where most private-equity firms and hedge funds are based, or among senators from East Coast states–Republican or Democrat. Republicans are almost universally opposed to changing the rules on partnerships, so I’ll focus on Democrats here.
For example, Senator John Kerry requested a letter from The Blackstone Group. The letter was highly critical of the Baucus-Grassley legislation. And Kerry has been highly skeptical of the proposed bill.
Also, Senator Chuck Schumer has stated he doesn’t believe it’s fair to target private-equity firms and hedge funds and not apply legislation to the PTP industry more broadly. Bottom line: The Baucus-Grassley legislation wouldn’t impact our recommended PTPs, but it has strong opposition on both sides of the aisle.
This brings me to the second partnership tax issue that has cropped up this year–namely the issue of carried interest. This discussion, led by Senator Schumer, has gained more traction in recent hearings.
Carried interest is a fairly complex tax issue. The best way to illustrate is with a simple example.
Consider a traditional private-equity fund organized as a partnership. The limited partners in the fund invest cash that’s then used to buy a portfolio of private companies. The actual investments are handled by the general partner (GP), basically the management team, for the private-equity firm.
Typically, the GPs are compensated in two ways: via an annual management fee based on investors’ total capital and an interest in profits generated by the private-equity fund. Often that share of profits is around 20 percent–a so-called 2-and-20 compensation scheme.
The 20 percent profit share is known as “carried interest.” Typically, GPs are taxed on that carried interest at capital gains tax rates; in this case, that’s 15 percent. That’s less than half the 35 percent or so these managers would be forced to pay if “carried interest” were taxed at the full income tax rate.
Taxes on carried interest would be an issue for private-equity firms and other partnerships. It wouldn’t increase taxes for public limited partner (LP) unitholders (in MLPs) one whit, however. The MLPs I cover don’t generate carried interest for investors.
The income that MLPs pass through to unitholders is partially deferred; investors don’t owe tax on these distributions until such a time as the MLP is sold. However, when that deferred tax finally comes due, a good portion of it is taxed at normal income tax rates, not capital gains tax rates. Therefore, this legislation wouldn’t have an effect on LP unitholders.
Depending on exactly how the legislation is written, there might be an impact on GPs for MLPs. Recall two distinct parts really comprise MLPs: an LP and a GP. As an LP unitholder, you’re entitled to cash flows that arise from the operation of the MLP’s assets. For example, if the MLP owns a series of gas pipelines, LP untiholders are entitled to receive a good chunk of the cash that comes from operating those pipes.
But as an LP unitholder, you don’t actually manage the assets in the MLP; that’s the function of the GP. GPs typically own LP units as well in what are known as incentive distribution rights (IDRs). IDRs are a fee charged by the GP for managing the assets of the LP.
Typically, IDR payments are structured to encourage the GP to manage the partnership’s assets in a way that’s also beneficial to the LP unitholders. Most investors hold LP units because of the impressive quarterly distributions offered; investors want to see steady growth in distributions.
IDR payments are usually based on the quarterly distributions paid to LP unitholders; the higher the distributions, the more the GP gets paid. This way the GP and LP are both directly incentivized to increase distributions.
Therefore, the IDR payments are somewhat like the carried interest payments that GPs of private-equity and hedge funds receive. But even in such an event, I really don’t see that the new legislation would be a major problem.
That’s because, for the most part, the IDR income GPs receive is already taxed at the full income tax rate, not the special capital gains rate. It’s considered ordinary income arising from the operations of the PTP. And because many GPs are also corporations, they already pay corporate tax as well.
The only risk here is if new legislation were to contain language that specifically targeted IDRs in some way. Alternatively, there are a few PTPs out there that are managed by GPs majority-owned by private-equity firms; it’s possible legislation may be drafted to go after those GPs. But given the points I outlined above, I see that as unlikely.
In fact, in a recent hearing on the carried interest issue, energy PTPs were reportedly not discussed. And because the traditional PTPs have broad support on both sides of the aisle, its unlikely legislation would be drafted specifically targeting this group.
Bottom line: If anything, the PTPs may see their charter expanded to allow for investments in ethanol- and biodiesel-related fields, a positive for the group. Private-equity firms and hedge funds may also see some changes to carried interest taxation, but that likely won’t affect traditional PTPs.
My only GP recommendation is Hiland GP. This PTP saw the worst performance of any of my recommended PTPs in the third quarter as it tumbled more than 20 percent. I suspect that may be related to a greater perceived risk that GP stocks will be targeted by any legislation.
Again, I see this risk as relatively small. I continue to recommend Hiland GP as a buy. As of this issue, however, I’m shifting Hiland GP from the Proven Reserves Portfolio to the Wildcatters Portfolio to reflect the slightly higher risk profile.
Back to In This Issue
Quicksilver Resources, a stock I outlined in the Aug. 22 issue of TES, offers a perfect example of this. First, the company listed an MLP called Quicksilver Gas Services to house its midstream gas pipeline business. Basically, the company’s pipeline network throws off reliable cash flows, but Quicksilver is an exploration & production (E&P) firm, so Wall Street typically values the stock based on its ability to grow gas production.
But the solid, consistent cash flows generated by these pipelines are ideal for the MLP structure because they can be used to back up a generous distribution for unitholders. And the MLP structure also eliminates corporate taxation, lowers the cost of capital and makes it easier to fund pipeline expansions and other growth projects.
In exchange for selling a stake in this MLP to the public, Quicksilver also benefited: The company received a large chunk of cash to fund its drilling program in the Barnett Shale play in Texas.
Quicksilver also sold off its slow-growing gas fields in Michigan to BreitBurn Energy LP–a PTP. These gas fields produce reliably and will continue to produce for at least another two decades at economic rates.
However, these fields aren’t showing much production growth. To optimize production, Quicksilver would need to spend more on the fields, but the company had better opportunities for growth in the Barnett Shale; the company allocated resources elsewhere.
By selling these mature fields to BreitBurn, Quicksilver was able to generate some cash. In addition, as part of BreitBurn, Quicksilver’s former assets will get more attention. The deal was a win-win situation.
The reason for recounting this little story is to point out that many companies are finding that the PTP structure is ideal for housing their slower-growing, highly cash generative assets. Therefore, many companies have announced plans to list new MLPs to do just that.
The end result is that there’s a heavy calendar of new PTP initial public offerings (IPOs) scheduled during the next three to six months. By most counts, there are around $3 billion to $3.5 billion worth of new PTP IPOs at some stage of the process to try to list their shares. That’s close to triple the number of PTP IPOs that were in the pipeline one year ago.
My concern is absorbing that supply. Investors might decide, for example, to sell down some of their existing PTP holdings to buy into the next hot IPO. Or investors may believe that, with all the new IPOs scheduled during the next six to 12 months, it will be more difficult for existing PTPs to raise cash through private placement and secondary offerings.
There’s some weight behind this concern. In the past, a heavy calendar of new PTP IPOs has negatively impacted the sector; a limited pool of funds chasing a larger supply of PTPs is an obvious negative.
And most of the private placements completed this year have been done through a handful of firms. No firm has unlimited capital to invest; a wider supply of MLPs needing capital could starve some MLPs of funding as institutions become more choosy about which private placements to invest in.
I do see offsetting factors. One is simply that the universe of PTP investors has been steadily increasing; a wider investor base is better able to absorb the new supply. And second, if investors do decide to sell existing PTP holdings to buy new issues, they’re likely to focus on weaker, slower-growing PTPs.
The marginal PTPs will be hit hardest. In TES, I focus on PTPs with either highly defensive asset bases or a clear, defined growth strategy. I see these picks as less vulnerable.
Finally, it’s by no means certain that all the proposed IPO deals will actually be completed. Quicksilver, for example, had planned an MLP IPO for its Michigan assets; the company eventually decided to sell those assets to an existing PTP instead.
The calendar of new IPOs is a factor to keep an eye on. However, I see any negative impact as only temporary; there’s enough capital out there to absorb the new supply eventually. And as long as distribution growth remains on track, investors will remain attracted to the PTP story.
Back to In This Issue
First, as I explained in the Nov. 22, 2006, issue, most PTPs aren’t particularly leveraged to commodity prices. Arguably, some, such as the PTPs focused on oil and gas production, do have exposure.
However, crude prices remain near all-time nominal highs, so that’s hardly a source of weakness. And natural gas price remain depressed but have recovered somewhat since midsummer; PTPs have been falling as natural gas prices have been rising. I’ll make this section short and sweet: I don’t see much link between commodity prices and the recent weakness in PTPs.
Back to In This Issue
However, closed-end funds have been hit harder than average PTPs. Tortoise is off nearly 18 percent for the third quarter. This underperformance relates to the fact that Tortoise uses debt capital to help leverage its portfolio and increase returns.
The problem isn’t the use of leverage. Tortoise is conservative in that regard and, using leverage, has produced stellar long-term returns for investors. Rather, the problem is with how the interest on those loans is priced.
The loans are floating-rate loans; the interest rate is charged based on the London Interbank Offered Rate (LIBOR). To offset this exposure to interest rates, Tortoise uses a derivative instrument known as swaps. Rising interest rates increase borrowing costs for Tortoise but cause its swap hedges to gain in value. Therefore, the swaps help offset the rising rates.
Here’s the problem: The normal relationship between the swaps and LIBOR broke down recently. The reason has to do with unusual trading patterns during the August credit crunch.
The result was that the hedges didn’t offset the increases in the company’s borrowing costs. This caused a short-term hit for the Tortoise funds in the form of higher interest expenses.
I do see this problem as temporary. Eventually, the traditional relationship between Tortoise’s swaps and LIBOR is likely to reassert itself. When that happens, the higher cost headwinds will disappear; in fact, that’s already happening.
However, Tortoise did post a note on its Web site (http://www.tortoiseadvisors.com/) about this issue for a time in September, and it did have a negative effect on the fund’s trading.
When stocks are soaring, investors often complain that they don’t want to chase valuations and risk buying in at the top. These investors often look to buy a “pullback” in price. Ironically, however, when the pullback actually comes, many just don’t have the courage to pull the trigger and buy into the stock.
That’s what’s happening here. The short-term concerns I outlined in this issue have hit the PTPs, and this volatility may continue for a few more weeks.
That said, in the end, I firmly believe the value will win out. The PTPs in my coverage universe continue to announce hikes to their distributions and not one has given any indication of needing to cut their payouts. The reason is simply that underlying business conditions remain solid.
As I noted above with respect to Linn Energy, the recent pullback in the PTPs has thrown up some mouth-watering yield opportunities. Some PTPs that were yielding 5 to 6 percent earlier this year are now set to end 2007 yielding 7 or 8 percent. And given distribution hikes slated for 2008, these same PTPs would be yielding 8 to 10 percent toward the end of 2008 if pricing doesn’t improve.
Investors won’t ignore the sector’s high, fast-growing yields forever. We have seen the dip. Now is a good time to take advantage of that opportunity.
Back to In This Issue
Of course, I frequently supplement regular issues with special flash alerts. Be assured that I’ll be monitoring the markets carefully and issue a flash alert if I see any points that need to be addressed.
The third quarter brought plenty of volatility for the US and most global stock markets. In particular, a general credit scare gripped the market in late July. The epicenter of that scare was mortgage-related debt focused on subprime borrowers; however, the general panic spread, making it difficult for even higher-quality corporate borrowers in totally unrelated industry groups to garner access to capital.
Nevertheless, global markets finished the quarter to the upside, thanks to a solid rally that kicked off in mid-August. The S&P 500 managed to eke out a total gain of just more than 2 percent in the third quarter, bringing the year-to-date return to about 9.3 percent.
Energy stocks once again led the market’s advance. The S&P 500 Energy Index rallied 9.8 percent for the quarter and is up 28.71 percent year-to-date and 43.09 percent on a trailing 12-month basis. The Philadelphia Oil Services Index is up 12.1 percent for the third quarter, 48.1 percent year-to-date and 59.3 percent over the trailing one-year.
The Energy Strategist Portfolios beat the broader market averages but lagged the key energy benchmarks in the third quarter. Over the year-to-date and trailing 12-month periods, however, the TES Portfolios continue to handily beat both the broader market averages and the key energy-related indexes I follow. Check out the chart below for a closer look.
Source: The Energy Strategist
The only Portfolio to show a negative return in the third quarter was the conservative, income-oriented Proven Reserves Portfolio. This Portfolio fell 4.2 percent in the quarter but remains up 13.2 percent this year and 27.91 percent on a trailing one-year basis.That significantly bests the S&P 500’s returns of 9.3 percent year-to-date and 16.6 percent over the trailing 12 months. And the Proven Reserves Portfolio has shown less volatility over the long term than the S&P 500.
The primary reason for the portfolio’s underperformance in the quarter was a poor showing from my recommended master limited partnerships (MLPs). I discuss this sector at length in today’s issue. But, to make a long story short, I see this underperformance as temporary and believe that income-oriented investors should use temporary weakness to accumulate larger positions in the MLPs. This is a buying opportunity.
The growth-oriented Wildcatters was the best-performing Portfolio for the quarter, up 5.83 percent; that brings the year-to-date and trailing 12-month returns to 34.1 percent and 56.7 percent, respectively. I typically benchmark this Portfolio against the S&P 500 Energy Index; it’s beating that index handily on both a year-to-date and trailing one-year basis.
Helping this Portfolio in the third quarter was a strong showing from our energy services and equipment recommendations. The energy MLPs in the portfolio were the weakest components.
Finally, my aggressive-growth Gushers Portfolio was up just less than 3 percent for the quarter. I typically benchmark this Portfolio against the more volatile Philadelphia Oil Services Index (OSX).
Although the Gushers Portfolio lagged in the third quarter, its year-to-date gain of 43 percent is roughly in line with the OSX and the trailing 12-month return of 95.3 percent bests the OSX’s 59.3 percent gain by nearly 40 percentage points.
In This Issue
I’m never pleased to see the TES Portfolios lag the energy benchmarks on a quarterly basis, but I’m far more interested in longer-term outperformance. On that basis, the Portfolios continue to run far ahead of the energy-related indexes, and I’m confident that will continue to be the case.That said, the end of the quarter is an opportune time to evaluate and review our main holdings and recommended investing themes. It’s also a good time to make any adjustments necessary to recommended holdings.
PTPs have been a major focus of this newsletter since it first began. However, there has been some weakness in the sector of late that I felt needs to be addressed. The newsletter sections below outline five primary issues plaguing the sector. See The PTP Rundown.
The August credit crunch was highly publicized in the financial media, so it should come as no surprise that PTPs fell victim to it as well. Most MLPs issue bonds or establish lines of credit with banks to fund their operations, creating higher-than-average debt burdens. However, this isn’t unusual activity for MLPs, and I expect confidence in the group’s access to capital to return as many PTPs work to make deals appropriate for the current credit market. See Access to Credit.
New bipartisan legislation has been proposed that would tax as corporations all PTPs that derive income from investment advisory or management services. There is also legislation regarding the concept of carried interest. Although these items don’t immediately affect the PTPs I cover in TES, there are possibilities for future regulation. See Politics and Taxes.
The number of new PTPs in the process of listing has tripled since last year. Such a large increase could affect the amount of money invested in each individual PTP as investors rush to buy the new hot thing or are limited in the amount they can invest because they’re spread too thin. See New Issues Rush.
I’ve received several customer inquiries regarding PTPs and commodity prices. However, I simply just don’t see much of a connection between the performance among the two sectors. See Commodity Prices.
Closed-end funds have been hit harder than average PTPs because some use debt capital to help leverage their portfolio and increase returns. However, investors won’t ignore the sector’s high, fast-growing yields forever. See PTP Closed-End Funds.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
- Duncan Energy Partners (NYSE: DEP)
- Eagle Rock Energy Partners (NSDQ: EROC)
- Enterprise Products Partners (NYSE: EPD)
- Hiland Holdings GP (NSDQ: HPGP)
- Linn Energy (NSDQ: LINE)
- Natural Resource Partners (NYSE: NRP)
- NuStar Energy (NYSE: NS)
- Penn Virginia Resources (NYSE: PVR)
- Sunoco Logistics (NYSE: SXL)
- Teekay LNG Partners (NYSE: TGP)
- Tortoise Energy Infrastructure (NYSE: TYG)
- Williams Partners (NYSE: WPZ)
The PTP Rundown
As noted above, I recommend a total of 12 publicly traded partnerships (PTPs) in the TES Portfolios; eight are in the income-oriented Proven Reserves Portfolio, and the remaining four are held in the Wildcatters Portfolio. Most of these PTPs are organized as MLPs.I’ve written extensively about PTPs and MLPs in TES. The PTPs trade on the major exchanges just like ordinary stocks. However, unlike ordinary companies, PTPs pay no tax at the corporate level.
Instead, PTPs pass through their cash flows to shareholders (known as unitholders) as dividend distributions. These distributions aren’t taxed like normal dividends; in fact, MLP distributions offer huge tax advantages for investors. PTPs also tend to offer strong distribution growth and high current yields.
Rather than review all the tax advantages of PTPs and my rationale for recommending the group here, I recommend all subscribers unfamiliar with the group check out the Nov. 22, 2006, issue of TES, Leading Income. This lengthy, detailed issue covers just about every relevant aspect of PTP investing. If you read that issue, you’ll find that my comments on the group below make far more sense.
The table below lists all the PTPs I cover in TES, as well as the third quarter and year-to-date returns for each recommendation. I’ve also added a column listing each PTP’s current dividend yield and the projected growth in dividends for 2008 compared to 2007.
|
MLPs in The Energy Strategist
|
||||
|
Company Name (Exchange: Symbol)
|
Third Quarter Return (%)
|
Year-to-Date Return (%)
|
Dividend Yield (%)
|
Proj. 2008 Dividend
Growth (%) |
| Duncan Energy Partners (NYSE: DEP) | -11.9 | 11.1 | 7.1 | 9.5 |
| Eagle Rock Energy Partners (NSDQ: EROC) | -13.0 | 5.0 | 7.3 | 14.3 |
| Enterprise Products Partners (NYSE: EPD) | -3.7 | 9.0 | 6.3 | 6.3 |
| Hiland Holdings GP (NSDQ: HPGP) | -21.7 | -1.5 | 3.2 | 47.0 |
| Linn Energy (NSDQ: LINE) | -1.2 | 4.7 | 7.4 | 13.9 |
| Natural Resource Partners (NYSE: NRP) | -18.0 | 10.7 | 6.1 | 10.5 |
| NuStar Energy (NYSE: NS) | -11.5 | 11.8 | 6.4 | 7.9 |
| Penn Virginia Resources (NYSE: PVR) | -10.3 | 10.5 | 6.1 | 9.8 |
| Sunoco Logistics (NYSE: SXL) | -12.4 | 7.2 | 6.6 | 4.5 |
| Teekay LNG Partners (NYSE: TGP) | -4.8 | 5.5 | 6.2 | 8.7 |
| Tortoise Energy Infrastructure (NYSE: TYG) | -17.9 | 1.6 | 6.5 | 7.0 |
| Williams Partners (NYSE: WPZ) | -13.8 | 9.8 | 5.1 | 21.7 |
Source: The Energy Strategist
As you can see in the table, the average TES-recommended PTP fell more than 11 percent in the third quarter. That said, despite that nasty tumble in the past quarter, the list remains up around 7.1 percent so far year-to-date. And although I didn’t list the returns in the table, the MLPs are also performing far better than the S&P 500 on a trailing one-year basis.
But despite solid, long-term outperformance, a one-quarter loss of that magnitude is certainly notable for the PTPs. Typically, this group is far less volatile than the S&P 500.
The first point to consider is that the selling is absolutely nothing company-specific to the partnerships recommended in TES; rather, broader indexes of the group performed poorly last quarter. Check out the chart of the Alerian MLP Index below for a closer look.
Source: Bloomberg
Note, in particular, that the Alerian MLP Index saw one of its largest one-day drops in history in early August. This is despite the fact that the MLPs recommended and covered in TES reported solid second quarter numbers in July and August and continue to consistently boost their distributions for unitholders.
I see five primary issues that have been impacting the PTPs during the past few months. Below, I explain each in order of importance and offer my assessment:
Back to In This Issue
Access to Credit
The main cause of that early August selloff was the ongoing, well-publicized turmoil in the credit markets. Specifically, most MLPs issue bonds or establish lines of credit with banks to fund their operations.They tend to carry relatively high debt burdens when compared with, for example, your average S&P 500 firm. MLPs also tend to use debt capital to finance expansion projects and acquisitions of new income-generating assets.
Broadly speaking, I don’t see those higher-than-average debt burdens as a problem at all. The reason is that MLPs are typically involved in stable, high-cash-flow businesses such as operating natural gas pipelines.
In most cases, these operations aren’t significantly impacted by economic growth or commodity prices. Therefore, the group has the stable cash flows to handle a higher debt burden than most corporations without running into financial problems. All the partnerships I recommend have cash flows that are more than sufficient to cover their debt service obligations many times over.
Moreover, this is absolutely nothing new. The group has always carried a relatively high debt burden without negative consequences.
In fact, for much of the past three years, it would have been completely idiotic and irresponsible for PTPs not to use debt to finance expansion at least to some extent. The reasons are that access to debt capital has been easy and interest rates are near historic lows; this is a cheap way to finance growth. In addition, unlike issuing new units, taking on more debt isn’t dilutive to existing unitholders.
But here’s the problem: The credit markets all but locked down completely during the summer. As I noted earlier, the root cause of this credit crunch emanated from the mortgage bond market, but it spread quickly to other sectors of the economy.
The result was that it quickly became more expensive and far harder for even companies with stellar credit to issue bonds or take on new credit lines. For a few weeks, the market did quite literally shut down.
There are myriad ways to measure stress in the credit markets. One is to simply look at the performance of the Philadelphia Banking Index as compared to the S&P 500 more broadly; when banks are underperforming the averages, it’s a sign investors are worried about instability in the financial markets. Check out the chart below.
Source: StockCharts.com
This chart compares the price of the Banking Index to that of the S&P 500; when the line is rising, banks are outperforming and vice versa. As you can see, the banks dramatically underperformed the rest of the market in August, one of the most dramatic periods of underperformance in the past decade. The main concern was that weakness in all sorts of credit, as well as bonds backed up by mortgages and other types of loans, would sink earnings.
Some of this fear was justified. Citigroup, Bear Stearns and UBS, among other financials, have reported weak earnings results or issued warnings based on the credit turmoil.
Citigroup, for example, reported on Oct. 1 a 60 percent decline in earnings for the third quarter as it experienced rising losses in consumer credit and was forced to write down the value of its leveraged loan commitments. (These are basically loans that Citigroup had already agreed to fund but had been unable to sell to other institutions for the same valuations it had expected.)
At any rate, the credit crunch was very real this summer, and it had an effect on the cost of capital for the MLPs as well as most other industry groups. Simply put, because the MLPs must pay more for their capital, their returns from projects are lower. Theoretically, some expansion projects or acquisitions that would have been economic based on the easy credit terms available in June weren’t feasible in August.
But although I recognize that a rising cost of capital is a negative, this concern was and continues to be drastically overexaggerated. First, many of the larger cap MLPs I follow already have a good deal of existing funding and credit lines in place. Most have access to plenty of capital at pre-negotiated attractive terms and don’t need to go cap-in-hand to Wall Street looking for cash through at least the next few quarters.
Although that’s broad generalization, consider the case of Enterprise Products Partners, the largest MLP I recommend. Enterprise relies mainly on organic expansion projects to fuel growth in its cash flows and distributions; in other words, the partnership actually builds new pipelines and processing facilities. It’s less reliant on acquisitions than many smaller MLPs.
Enterprise has large capital spending plans. Roughly $1.2 billion in spending will be necessary for 2008 to fund its planned organic growth projects, and an additional $500 million or so will be necessary to fund expansion projects for the remainder of 2007. Therefore, if credit were unavailable to Enterprise, it could shut down its organic expansion projects and severely impact growth potential.
But Enterprise already has plenty of funding in place. The PTP has more than $63 million in cash on its books and about $750 million in available funding from an existing line of credit facility. That facility doesn’t expire until 2011; Enterprise won’t need to look to roll over it for another four years.
Let’s take a quick look at Enterprise’s existing debts; check out the chart below.
Source: Bloomberg
This chart shows that Enterprise has $11.13 billion in bonds outstanding, coupled with loan commitments from banks. This year only $500 million worth of bonds will mature, and next year a $1.8 billion credit facility expires. But, for the most part, Enterprise’s debt won’t need to be renegotiated until after 2010.
And this chart is only up-to-date through the end of June. The company actually sold $800 million of new 10-year bonds in late August, priced at a yield of 6.3 percent, an attractive interest rate. It’s using $500 million of that to repay its remaining $500 million worth of borrowings due this year. The company has about $150 million due in January of next year; the remainder of its $1.8 billion in borrowings maturing in 2008 is due in late August or later.
Bottom line: Enterprise doesn’t really need to worry about accessing the credit markets until sometime in the second half of 2008. That’s plenty of breathing room.
A good gauge of the cost of capital for Enterprise is to look at a chart of one of the company’s bonds. Check out the chart below.
Source: Bloomberg
This chart shows the price of Enterprise Product Partners 8 3/8 Percent Bonds of August 2066–an issue I wrote about in the Nov. 22, 2006, issue of TES. These bonds were issued a little more than a year ago; about this time last year, the bonds were trading at $102 to $103.
The bonds subsequently rallied to the $111-to-$112 range last spring. Recall that a rising bond price means that yields are falling. Although falling yields have no effect on the coupons that Enterprise has to pay to finance this debt, they do indicate that Enterprise might be able to issue other bonds at a lower rate. They suggest that Enterprise’s cost of capital for new debt is dropping.
You can clearly see the August credit crunch on this chart. The bond fell quickly from late May into early August and hit a low of about $100.
But note what’s happened since then. The bond has rallied again, back to that $103-to-$104 region. This is almost exactly where it was trading one year ago.
Bottom line: Although Enterprise’s cost of capital may not be quite as low as it once was, this chart hardly represents the profile of a firm with deteriorating credit quality or access to the bond market. Enterprise has had and should continue to have new funding. And credit costs really aren’t appreciably different than a year ago.
Of course, debt is only part of the story. Lately, most PTPs have been using a combination of debt and so-called private placements to fund their expansion.
Private placements involve selling additional units (shares) to an institutional buyer for a preset, usually discounted, price. Such deals offer the MLPs a ready, guaranteed buyer at a predetermined price.
This is preferable to trying to issue a huge secondary tranche of shares on the secondary market. Typically, private placements have had less of a negative effect on PTP stock prices than traditional secondary offerings to investors.
Institutional buyers, including hedge funds, have been eager buyers of these private placement deals this year. In total, publicly traded energy partnerships in the US raised more than $10 billion via private placements in 2007 alone.
The credit crunch also impacts this source of funding. Specifically, if institutional players are hurting because of market turmoil or are looking to cut back on risk, they’ll likely be less willing to take on private placements. Because private placements have been the most important source of funding for MLPs recently, this could be an even bigger problem than lack of access to debt markets.
But this concern is also overblown. Although the debt and private placement markets shut down in early August, that’s no longer the case.
Rather, on the debt front, capital isn’t quite as cheap as it was earlier this year for the PTPs. Banks are charging higher interest rates on loans. But capital is available, deals are being done, and the PTPs are still making plenty of cash despite the higher cost of debt.
On the private placement front, what appears to be happening is that institutions are demanding a bigger price discount on shares they purchase. Again, that raises the cost of this form of financing slightly.
However, some very large private placements deals have been closed since August. There’s still plenty of demand for these deals, albeit at slightly less beneficial terms.
And although private placement financing is more expensive, it’s still cheap by any historical measure. The cost of this capital just hasn’t risen enough to make the MLPs’ projects economically unattractive.
Here’s a brief rundown of just a few of the financing deals that have been completed in the past few weeks:
- 08/08/07–Sunoco Logistics entered into a new $400 million credit facility, replacing a $300 million facility set to expire in 2010. Therefore, Sunoco accessed bank lending right in the heart of the August credit mess.
- 08/31/07–Linn Energy announced the completion of its huge $2.1 billion acquisition of oil and gas properties from Dominion Resources. The company financed this deal via two transactions, a $1.5 billion private placement of units and a new $1.8 billion credit facility that expires in August 2010.
Apparently, despite the credit market woes, Linn wasn’t overly affected: The company is going ahead with its announced bump in distributions for the fourth quarter to an annual rate of $2.58 per unit up from the current $2.28 per unit. - 09/12/07–BreitBurn Energy Partners announced a deal to acquire Quicksilver Resource’s Michigan assets. (See the Aug. 22 issue of TES, Drilling Down, for an explanation of Quicksilver’s business.)
As part of the funding for this transaction, BreitBurn used a $450 million private placement at about a 16 percent discount to the price of the stock at the time. This discount is wider than what other deals went for in the spring, but the fact that BreitBurn set up such a big placement so quickly is encouraging.
As more deals are funded and completed, I expect confidence in the group’s access to capital to return. Meanwhile, this lingering negativity is keeping prices down.
Consider, for example, the case of Linn Energy. The firm already has all its necessary financing commitments in place. And management is confident enough in its access to capital to suggest that it’s looking to make another $1 billion or more in acquisitions in the first half of next year.
Based on the growth from its current properties alone, Linn could exit 2008 paying an annualized distribution of close to $3 per unit; there’s upside to that if the company closes another big acquisition or if natural gas prices rise sharply.
At current prices and with a $3 distribution, Linn Energy would be yielding more than 10 percent. When you consider the tax deferral advantages of PTPs, that yield is easily as attractive as a yield in the low teens for a normal corporation.
Although investors may ignore the recent signs of a recovery in cost of capital for PTPs in the next month or two, they’re unlikely to ignore steadily rising distributions from Linn over time. Linn Energy remains an attractive buy.
Back to In This Issue
Politics and Taxes
Another factor that’s been weighing on the PTPs during the past few months is the potential for a change in US tax laws that would make partnership taxation less attractive.Two factors have heightened these concerns. One is the media’s misleading, confusing reporting on this issue. The second is the raw nerves and frustration left over from the Canadian government’s decision last year to change the taxation of income trusts; investors fear a big tax surprise from the Democrats now in charge of Congress.
The fact is that there have been two proposed tax changes floating around Congress this summer. The first was legislation proposed by Sen. Max Baucus and Sen. Chuck Grassley–a Democrat and Republican, respectively.
This legislation would tax as corporations all PTPs that derive income from investment advisory or management services. That means that the tax rate on such PTPs would rise to the full US corporate income tax rate. This would effectively eliminate the attraction of such firms organizing as PTPs.
Note the rather specific nature of this legislation: The bill would address only PTPs engaged in investment management or advisory services. This bill is aimed squarely at private-equity firms and hedge fund that have recently listed as PTPs. Namely, this law would affect The Blackstone Group and Fortress Investment Group, two recently listed PTPs that are involved in the investment business.
This proposed legislation clearly wouldn’t affect the energy and commodity-related PTPs that are recommended in TES. The specific nature of this legislation is obvious from a letter written by the two senators to Treasury Secretary Hank Paulson back in June. Here is an excerpt from that letter:
Dear Mr. Secretary:
We are writing to you regarding several recent initial public offerings (“IPOs”) of private equity and hedge funds. We believe that these IPOs raise serious tax questions that if left unaddressed have the potential to jeopardize the integrity of the tax code and the corporate tax base over the long term. We write to request your views on this matter, to ask what actions Treasury intends to take, and for your views on legislation we introduced to address this threat to the corporate tax base, if a change to statute proves necessary.
The basic structure of these IPOs is that they are classified as publicly traded partnerships (“PTP”) under section 7704(b) of the Internal Revenue Code (the “Code”). A PTP is taxed as a corporation unless it satisfies the qualifying income exception under section 7704(c), chiefly directed to passive-type income. Section 7704(c) requires that for any taxable year, 90 percent or more of the gross income must be “qualifying income.” Qualifying income is defined in section 7704(d) to include: interest; dividends; rents; gain from sale of a capital asset held for production of income; and gain from commodities contracts.
These funds clearly state that they are engaged in an active trade or business. For example, one fund states in its public filing that “[w]e believe that we are engaged primarily in the business of providing asset management and financial advisory services and not in the business of investing, reinvesting, or trading securities. We also believe that the primary source of income from each of our businesses is properly characterized as income earned in exchange for the provision of services.” In order to avoid failing the 90 percent qualified income test, these PTPs rely on the income from carried interests being treated as qualified income, and have created a subsidiary blocker corporation to absorb all nonqualified income. To the extent that any funds are then transferred from the subsidiary blocker corporation to the parent PTP, this blocker corporation will convert the nonqualified income into a payment of dividends (that is, qualifying income) to the PTP.
We believe that the PTP rules are being circumvented because the majority of the income is from the active provision of services to the underlying funds and limited partner investors in those funds…
–Excerpted from a letter to Secretary of the Treasury Hank Paulson, June 14, 2007, by Sen. Baucus and Sen. Grassley.
It’s obvious from this excerpt that this legislation would address only the private-equity firms and hedge funds seeking to list as PTPs. The Blackstone Group said in late August that the bill would roughly triple its tax liability. It makes no attempt to call into question or propose changes to qualified income exemptions; therefore, it would have absolutely no effect on the taxation of energy-related MLPs.
In politics, however, issues such as this are never simple or pure. Baucus and Grassley are from Iowa and Montana; although their proposed legislation targets private-equity firms and hedge funds, they’re actually proposing expanding the universe of PTPs to include those involved in the ethanol industry.
According to most analysts, existing PTP rules mean that companies deriving the majority of their revenues from blending, producing and transporting ethanol can’t really list as PTPs. Expanding the definition of PTPs to include ethanol would, therefore, be popular with elements of the electorate in Iowa and Montana.
Not surprising, this legislation isn’t popular on the East Coast, where most private-equity firms and hedge funds are based, or among senators from East Coast states–Republican or Democrat. Republicans are almost universally opposed to changing the rules on partnerships, so I’ll focus on Democrats here.
For example, Senator John Kerry requested a letter from The Blackstone Group. The letter was highly critical of the Baucus-Grassley legislation. And Kerry has been highly skeptical of the proposed bill.
Also, Senator Chuck Schumer has stated he doesn’t believe it’s fair to target private-equity firms and hedge funds and not apply legislation to the PTP industry more broadly. Bottom line: The Baucus-Grassley legislation wouldn’t impact our recommended PTPs, but it has strong opposition on both sides of the aisle.
This brings me to the second partnership tax issue that has cropped up this year–namely the issue of carried interest. This discussion, led by Senator Schumer, has gained more traction in recent hearings.
Carried interest is a fairly complex tax issue. The best way to illustrate is with a simple example.
Consider a traditional private-equity fund organized as a partnership. The limited partners in the fund invest cash that’s then used to buy a portfolio of private companies. The actual investments are handled by the general partner (GP), basically the management team, for the private-equity firm.
Typically, the GPs are compensated in two ways: via an annual management fee based on investors’ total capital and an interest in profits generated by the private-equity fund. Often that share of profits is around 20 percent–a so-called 2-and-20 compensation scheme.
The 20 percent profit share is known as “carried interest.” Typically, GPs are taxed on that carried interest at capital gains tax rates; in this case, that’s 15 percent. That’s less than half the 35 percent or so these managers would be forced to pay if “carried interest” were taxed at the full income tax rate.
Taxes on carried interest would be an issue for private-equity firms and other partnerships. It wouldn’t increase taxes for public limited partner (LP) unitholders (in MLPs) one whit, however. The MLPs I cover don’t generate carried interest for investors.
The income that MLPs pass through to unitholders is partially deferred; investors don’t owe tax on these distributions until such a time as the MLP is sold. However, when that deferred tax finally comes due, a good portion of it is taxed at normal income tax rates, not capital gains tax rates. Therefore, this legislation wouldn’t have an effect on LP unitholders.
Depending on exactly how the legislation is written, there might be an impact on GPs for MLPs. Recall two distinct parts really comprise MLPs: an LP and a GP. As an LP unitholder, you’re entitled to cash flows that arise from the operation of the MLP’s assets. For example, if the MLP owns a series of gas pipelines, LP untiholders are entitled to receive a good chunk of the cash that comes from operating those pipes.
But as an LP unitholder, you don’t actually manage the assets in the MLP; that’s the function of the GP. GPs typically own LP units as well in what are known as incentive distribution rights (IDRs). IDRs are a fee charged by the GP for managing the assets of the LP.
Typically, IDR payments are structured to encourage the GP to manage the partnership’s assets in a way that’s also beneficial to the LP unitholders. Most investors hold LP units because of the impressive quarterly distributions offered; investors want to see steady growth in distributions.
IDR payments are usually based on the quarterly distributions paid to LP unitholders; the higher the distributions, the more the GP gets paid. This way the GP and LP are both directly incentivized to increase distributions.
Therefore, the IDR payments are somewhat like the carried interest payments that GPs of private-equity and hedge funds receive. But even in such an event, I really don’t see that the new legislation would be a major problem.
That’s because, for the most part, the IDR income GPs receive is already taxed at the full income tax rate, not the special capital gains rate. It’s considered ordinary income arising from the operations of the PTP. And because many GPs are also corporations, they already pay corporate tax as well.
The only risk here is if new legislation were to contain language that specifically targeted IDRs in some way. Alternatively, there are a few PTPs out there that are managed by GPs majority-owned by private-equity firms; it’s possible legislation may be drafted to go after those GPs. But given the points I outlined above, I see that as unlikely.
In fact, in a recent hearing on the carried interest issue, energy PTPs were reportedly not discussed. And because the traditional PTPs have broad support on both sides of the aisle, its unlikely legislation would be drafted specifically targeting this group.
Bottom line: If anything, the PTPs may see their charter expanded to allow for investments in ethanol- and biodiesel-related fields, a positive for the group. Private-equity firms and hedge funds may also see some changes to carried interest taxation, but that likely won’t affect traditional PTPs.
My only GP recommendation is Hiland GP. This PTP saw the worst performance of any of my recommended PTPs in the third quarter as it tumbled more than 20 percent. I suspect that may be related to a greater perceived risk that GP stocks will be targeted by any legislation.
Again, I see this risk as relatively small. I continue to recommend Hiland GP as a buy. As of this issue, however, I’m shifting Hiland GP from the Proven Reserves Portfolio to the Wildcatters Portfolio to reflect the slightly higher risk profile.
Back to In This Issue
New Issues Rush
PTPs have become a more popular vehicle in recent years, and the number of PTPs has gradually expanded since the mid-1990s. Lately, much of this has been driven by corporations looking for a way to improve the valuations for their slow-growing, cash generative assets.Quicksilver Resources, a stock I outlined in the Aug. 22 issue of TES, offers a perfect example of this. First, the company listed an MLP called Quicksilver Gas Services to house its midstream gas pipeline business. Basically, the company’s pipeline network throws off reliable cash flows, but Quicksilver is an exploration & production (E&P) firm, so Wall Street typically values the stock based on its ability to grow gas production.
But the solid, consistent cash flows generated by these pipelines are ideal for the MLP structure because they can be used to back up a generous distribution for unitholders. And the MLP structure also eliminates corporate taxation, lowers the cost of capital and makes it easier to fund pipeline expansions and other growth projects.
In exchange for selling a stake in this MLP to the public, Quicksilver also benefited: The company received a large chunk of cash to fund its drilling program in the Barnett Shale play in Texas.
Quicksilver also sold off its slow-growing gas fields in Michigan to BreitBurn Energy LP–a PTP. These gas fields produce reliably and will continue to produce for at least another two decades at economic rates.
However, these fields aren’t showing much production growth. To optimize production, Quicksilver would need to spend more on the fields, but the company had better opportunities for growth in the Barnett Shale; the company allocated resources elsewhere.
By selling these mature fields to BreitBurn, Quicksilver was able to generate some cash. In addition, as part of BreitBurn, Quicksilver’s former assets will get more attention. The deal was a win-win situation.
The reason for recounting this little story is to point out that many companies are finding that the PTP structure is ideal for housing their slower-growing, highly cash generative assets. Therefore, many companies have announced plans to list new MLPs to do just that.
The end result is that there’s a heavy calendar of new PTP initial public offerings (IPOs) scheduled during the next three to six months. By most counts, there are around $3 billion to $3.5 billion worth of new PTP IPOs at some stage of the process to try to list their shares. That’s close to triple the number of PTP IPOs that were in the pipeline one year ago.
My concern is absorbing that supply. Investors might decide, for example, to sell down some of their existing PTP holdings to buy into the next hot IPO. Or investors may believe that, with all the new IPOs scheduled during the next six to 12 months, it will be more difficult for existing PTPs to raise cash through private placement and secondary offerings.
There’s some weight behind this concern. In the past, a heavy calendar of new PTP IPOs has negatively impacted the sector; a limited pool of funds chasing a larger supply of PTPs is an obvious negative.
And most of the private placements completed this year have been done through a handful of firms. No firm has unlimited capital to invest; a wider supply of MLPs needing capital could starve some MLPs of funding as institutions become more choosy about which private placements to invest in.
I do see offsetting factors. One is simply that the universe of PTP investors has been steadily increasing; a wider investor base is better able to absorb the new supply. And second, if investors do decide to sell existing PTP holdings to buy new issues, they’re likely to focus on weaker, slower-growing PTPs.
The marginal PTPs will be hit hardest. In TES, I focus on PTPs with either highly defensive asset bases or a clear, defined growth strategy. I see these picks as less vulnerable.
Finally, it’s by no means certain that all the proposed IPO deals will actually be completed. Quicksilver, for example, had planned an MLP IPO for its Michigan assets; the company eventually decided to sell those assets to an existing PTP instead.
The calendar of new IPOs is a factor to keep an eye on. However, I see any negative impact as only temporary; there’s enough capital out there to absorb the new supply eventually. And as long as distribution growth remains on track, investors will remain attracted to the PTP story.
Back to In This Issue
Commodity Prices
Some subscribers have asked if I think the weakness in PTPs is because of commodity prices. I don’t believe that’s a valid explanation.First, as I explained in the Nov. 22, 2006, issue, most PTPs aren’t particularly leveraged to commodity prices. Arguably, some, such as the PTPs focused on oil and gas production, do have exposure.
However, crude prices remain near all-time nominal highs, so that’s hardly a source of weakness. And natural gas price remain depressed but have recovered somewhat since midsummer; PTPs have been falling as natural gas prices have been rising. I’ll make this section short and sweet: I don’t see much link between commodity prices and the recent weakness in PTPs.
Back to In This Issue
PTP Closed-End Funds
Finally, I wanted to address the closed-end MLPs funds separately. The only one I recommend in TES is the Tortoise Energy Infrastructure Fund. These funds buy portfolios of MLPs and PTPs, offering diversified exposure to the group. In addition, the distributions paid by Tortoise are taxed like normal qualified dividend income; some investors may find this simpler to deal with at tax time.However, closed-end funds have been hit harder than average PTPs. Tortoise is off nearly 18 percent for the third quarter. This underperformance relates to the fact that Tortoise uses debt capital to help leverage its portfolio and increase returns.
The problem isn’t the use of leverage. Tortoise is conservative in that regard and, using leverage, has produced stellar long-term returns for investors. Rather, the problem is with how the interest on those loans is priced.
The loans are floating-rate loans; the interest rate is charged based on the London Interbank Offered Rate (LIBOR). To offset this exposure to interest rates, Tortoise uses a derivative instrument known as swaps. Rising interest rates increase borrowing costs for Tortoise but cause its swap hedges to gain in value. Therefore, the swaps help offset the rising rates.
Here’s the problem: The normal relationship between the swaps and LIBOR broke down recently. The reason has to do with unusual trading patterns during the August credit crunch.
The result was that the hedges didn’t offset the increases in the company’s borrowing costs. This caused a short-term hit for the Tortoise funds in the form of higher interest expenses.
I do see this problem as temporary. Eventually, the traditional relationship between Tortoise’s swaps and LIBOR is likely to reassert itself. When that happens, the higher cost headwinds will disappear; in fact, that’s already happening.
However, Tortoise did post a note on its Web site (http://www.tortoiseadvisors.com/) about this issue for a time in September, and it did have a negative effect on the fund’s trading.
When stocks are soaring, investors often complain that they don’t want to chase valuations and risk buying in at the top. These investors often look to buy a “pullback” in price. Ironically, however, when the pullback actually comes, many just don’t have the courage to pull the trigger and buy into the stock.
That’s what’s happening here. The short-term concerns I outlined in this issue have hit the PTPs, and this volatility may continue for a few more weeks.
That said, in the end, I firmly believe the value will win out. The PTPs in my coverage universe continue to announce hikes to their distributions and not one has given any indication of needing to cut their payouts. The reason is simply that underlying business conditions remain solid.
As I noted above with respect to Linn Energy, the recent pullback in the PTPs has thrown up some mouth-watering yield opportunities. Some PTPs that were yielding 5 to 6 percent earlier this year are now set to end 2007 yielding 7 or 8 percent. And given distribution hikes slated for 2008, these same PTPs would be yielding 8 to 10 percent toward the end of 2008 if pricing doesn’t improve.
Investors won’t ignore the sector’s high, fast-growing yields forever. We have seen the dip. Now is a good time to take advantage of that opportunity.
Back to In This Issue