MLP Debate

There is no doubt that 2012 has been more than robust for equity issuances by master limited partnerships (MLPs). With September registering two IPOs, nine secondary offerings and one private placement, 2012 is poised to set a new record for MLP offerings. For full-year 2012, “we estimate that there could be $21.7 billion of equity issuances, “according to the Wells Fargo MLP research team, led by senior analyst Michael Blum. “This would represent the highest annual amount of equity issuances in a single year.”

Having come off a record year with strength across all business lines in investment banking, Joe Cunningham, managing director and cohead, U.S. energy group, RBC Capital Markets, has an upbeat outlook for 2013.

After chalking up total returns as strong as 37% in 2010 and 15% in 2011, the MLP group has “taken a breather” this year, the report says. Why the dip in performance? Partly mean reversion after two years of beating the S&P 500, coupled with caution on the part of some investors with regard to “relatively full” valuations heading into 2012.

In addition, the index has been held back by lagging performance by MLPs involved in the natural gas and propane sectors. Also, the heavy forward calendar of MLP equity issuances tends to weigh on performance at least temporarily.

For many investors, it is the search for yield that dominates, and here the median MLP sector yield has naturally trended lower in the current low-interest-rate environment. At 7%, the current median yield compares to five-year and 10-year median yields of 7.7% and 7.4%, respectively.

However, even facing an array of uncertainties—presidential elections, the “fiscal cliff” at year-end, and volatility in Europe—Wells Fargo says the recent Federal Reserve policy announcement “makes us incrementally more positive, as these actions should continue to sustain low interest rates and drive equity valuations.”

“MLPs’ robust yields should continue to attract investment in a low-interest-rate environment,” the Wells Fargo team notes. “Based on the outlook for the global economy and the Federal Reserve’s continued accommodative stance, we expect interest rates to remain low for the foreseeable future.”

And given investors’ income requirements, “MLPs continue to offer among the most attractive yields relative to alternatives, especially on a risk-adjusted basis, in our view.” Many infrastructure-related investments are, importantly, fee-based and backed by long-term contracts, the report notes.

So is it all plain sailing for MLPs? Perhaps for the last few weeks of 2012, but looking out into 2013—in the aftermath of the November elections and politicians’ campaign pledges of broad-based tax reform—uncertainty may be on the rise.

As tax reform is tackled in the new term, what may be at stake for MLPs is whether the “pass-through” status enjoyed by MLPs currently is at risk of being included in broader draft legislation focused on reducing specific tax “preferences,” in efforts to lower corporate tax rates closer to those of foreign competitors.

Early indications of what may be encompassed in tax reform proposals could come with hearings and committee discussions, expected to be held by February-March by the House Committee on Ways & Means, chaired by Dave Camp (R-MI), ahead of marking up a bill, according to Mary Lyman, executive director of the National Association of Publicly Traded Partnerships (NAPTP). Legislation introduced by Camp and passed by the House (HR 8) requires a bill to be passed by April 30. Much will depend , she says, on the composition of Congress following the elections.

In a sweep by one party, chances of consensus on tax issues would be more likely, and the opposite in the event of a split Congress subject to ongoing partisan politics.

“I think that there is a good chance that MLPs will come out O.K., both because we do have some very good arguments for retaining our current structure, and because tax reform is very hard to do,” states Lyman, who represents the MLP sector through the NAPTP lobby. Changes in tax legislation “inevitably create a lot of winners and losers. You are talking about taking away a lot of deductions that industries have built their planning around.”

Bottom line, if one assumes a sweep by one party helps expedite tax reform? “I wouldn’t say there is no danger, but I would say that we are cautiously optimistic.”

In a written statement submitted to a Senate finance committee hearing on tax reform last August, the NAPTP stated that with MLPs’ current pass-through status, “the single-taxed MLP structure lowers the cost of capital, allowing a more reasonable return on investment” in the midstream assets that are now in large part built by the MLP sector. Since 2007, it noted, the largest MLPs had made non-acquisition investments of approximately $66 billion, with a further $21.8 billion forecast for 2012, bringing total investments to $88 billion. Over 70% of MLP market capital was in the midstream sector, it said.

A bird’s-eye view of the Houston skyline and beyond from the JPMorgan Chase Tower in Houston’s central business district. At 75 stories, it is the tallest in Houston.

What are the odds of tax reform in the U.S. impacting MLPs? RBC Capital Markets’ managing director Joe Cunningham thinks a Republican sweep holds a greater likelihood that MLPs’ pass-through status may be amended, “because the Republicans are committed to lowering marginal tax rates, and they have a pretty serious attitude about doing away with tax preferences and broadening the base to accomplish that.” He said that the feedback from MLP managements that had held meetings with Republican politicians in Washington, D.C., was such that they received “a pretty chilly reception on this topic.”

Two factors support the argument that losing pass-through status would not impact MLPs as much as some think. One is that “cash tax leakage would be fairly minimal, because MLPs are capital intensive and use a lot of leverage on the balance sheet,” resulting in large depreciation and interest deductions, observes Cunningham.

“But the bigger offset is that you would open the doors to unfettered ownership of the MLP sector by non-taxable institutions and retirement accounts, both of which have problems investing in the sector because of UBTI (unrelated business taxable income),” with K-1 reporting.

In essence, the premise rests on the projection that if institutions could buy MLPs without restrictions, the added buying power would lift MLPs to the point of trading at lower yields. “The question is whether the yield would go down enough to offset the cash tax leakage on the distributable cash flow. Our view is, yes, in most cases it would more than offset the decline,” says Cunningham.

For example, he cites an MLP that calculated that, with a wider audience to buy MLPs, it would have to trade at only a 45-basis-point lower yield than previously to offset itse cash tax leakage and thus hold its current market value.

Will all this forward thinking come into play? Or is the political posturing in Washington such that, at day’s end, MLPs will be left unaffected in the important role they play in helping build out new energy infrastructure and enhance U.S. energy security?

“I have never seen anything in the course of my career that even approaches the level of uncertainty we have about the tax code at this point,” Cunningham says.