With a veritable upsurge in issuance of master limited partnerships (MLPs) at the end of the third quarter, 2012 is forecast to be yet another record year for initial public offerings (IPOs) and secondary issues by MLPs. Moreover, it will mark the third year in a row that MLPs will have accounted for a major part of all issuances in the equity market, reflecting investors' ongoing search for yield in the current low interest rate environment.

With September registering two IPOs, nine secondary offerings and one private placement, equity issuance by MLPs reached $3 billion in the last month of the quarter, compared with $1.60 billion the prior month and $640 million in the same a month a year ago, according to data in Wells Fargo's MLP Monthly: October 2012 report. The bumper September crop brought MLP equity issuances through the first three quarters of the year to $14.3 billion.

For the full year 2012, "we estimate that there could be $21.7 billion of equity issuances," writes 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," exceeding the prior record level of $18.4 billion raised last year by almost 18%. Previous strong showings were the $14.7 billion in total MLP equity raised in 2007 and $14.5 billion in 2010.

In terms of IPOs, 2012 could represent a record year, too, given the number of MLPs expected to go public in what Wells Fargo calls its identified and shadow backlog. "If all identified and shadow MLP IPOs are completed, we calculate 24 MLP IPOs could be launched in 2012. As a point of reference, 13 MLPs went public in 2011. The most IPOs ever completed in one year for the sector was 18, in 2006," according to the report.

Not surprisingly, Wells Fargo identifies a "clear dichotomy" in year-to-date performance between the stronger performing oil-focused MLPs, up 19.9% through September, and gas-focused MLPs, up just 0.2%, barely above break-even (before distributions). MLPs as a whole, as measured by the Wells Fargo Securities MLP Index, have registered a year-to-date gain of 2.7% and a total return, including distributions, of 9.6%.

Take a breather

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 because of mean reversion after two years of beating the Standard & Poor's 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.

In terms of valuation, MLPs currently trade at levels that are largely in line with or modestly above historical metrics, Wells Fargo figures show. Looking at price to distributable cash flow, the median multiple is 11.8 times, based on 2013 estimates, versus five-year and 10-year median multiples of 11.6 times and 11.4 times, respectively. On enterprise value to adjusted EBITDA, the median multiple is 11.2 times versus 10.7 times for both the five-year and 10-year median multiple.

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 continues. "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, it notes.

2013 uncertainty

So is it all plain sailing for MLPs, without a single dark cloud on the horizon? 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 for MLPs. 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 from February to March by the House Committee on Ways and Means, chaired by U.S. Rep. Dave Camp (R-Mich.), ahead of marking up a bill, Mary Lyman, executive director of the National Association of Publicly Traded Partnerships (NAPTP), tells Midstream Business. Legislation introduced by Camp and passed by the House requires a bill be introduced 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 OK, both because we do have some very good arguments for retaining our current structure, and because tax reform is very hard to do," says 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."

What does she expect 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. More than 70% of MLP market capital was in the midstream sector, it said.

RBC Capital Markets Managing Director Joe Cunningham, expressed confidence in MLPs' continuing attraction as yield vehicles in a Midstream Business interview—but clearly has devoted time to think ahead to the implications of possible tax reform. At the end of the day, argues Cunningham, if MLPs were to lose their flow-through status, and instead of issuing K-1s to partnership investors became "1099-payers," the net effect may be that some MLPs end up having similar or sometimes higher market capitalizations—provided they continued to pursue a high-payout business model. He cites Pembina Pipeline as an example in Canada, where an end to the flow-through status of royalty trusts was implemented in 2006.

MLPs and tax reform

What are the odds of tax reform in the U.S. impacting MLPs? In Cunningham's view, 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 says that the feedback from MLP managers 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 in 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 income. Our view is, yes, in most cases, it would more than offset the decline," says Cunningham. In one example, he cites an MLP, which 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 its cash tax leakage and thus hold its current market value.

So 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," says Cunningham, citing a laundry list of items subject to possible change. "There's just huge uncertainty."

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