The Dark Side Of MLP Investments (2024)

Co-produced with Samuel Smith for High Yield Landlord

In a recent article entitled “REITs Vs. MLPs: Which Is The Better Investment?” I go on to explain that both MLPs and REITs present a lucrative opportunity for high-yielding investments right now. This is because both of these business models require companies to distribute a high percentage of cash flows to investors in exchange for being classified as a corporate income tax-exempt pass-through entity. REITs offer a totally passive means of gaining access to the time-tested wealth-building method of investing in a diversified portfolio of real estate, while MLPs offer a higher yielding and more stable cash-flow means of gaining exposure to the energy boom taking place in the United States right now.

MLPs in particular are an opportunistic investment right now for the following reasons:

• (1) MLPs enjoy an immense growth runway thanks to projected strong growth in global demand for oil and natural gas. The International Energy Agency's World Energy Outlook 2018 posits that energy demand growth will be driven by developing economies based on announced energy policy plans and targets. Global energy demand is expected to grow by at least 25% through 2040, thanks in large part to the strong economic momentum in Asian economies like India and continued strong global population growth. While renewable energy and energy efficiency certainly pose a long-term threat, these estimates already have been accounted in the sector's impact quite conservatively, by cutting the projected demand in half.

• (2) The US and Canada are expected to play a major role in meeting that demand as growing players in the world market of energy production and exportation. In fact, in 2018, the US became the world's largest oil producer, adding to its decade-long reign as the world's largest natural gas producer. Additionally, for about a week last year - for the first time in over 70 years - the US became a net exporter of crude and refined products. This shows just how far the US energy production industry has come over the past couple of decades, given that at the turn of the millennium the country was “being bled dry” by its thirst for foreign oil. With its strong growth momentum and record-level of proven reserves, the US is expected to retain its leadership in global oil and natural gas production growth for the next several decades, with some forecasts projecting that the US will account for almost three quarters of the total increase in global oil output and 40% of the global increase in natural gas production over the next 5-6 years. As a result, demand for new and sustained energy infrastructure (i.e., pipelines, storage, export terminals, and processing capacity) will be strong. Connecting supply with demand is going to require significant additional investments in energy infrastructure and this is where MLPs come in the picture.

• (3) MLP balance sheets and cash flow statements have shown significant improvements over the past several years. Not only have these businesses been steadily growing their EBITDA over the past few years, but it's now just beginning to translate into strong distribution growth. Over the past two years, MLPs have used these growing earnings to fix their balance sheets and reduce dependence on unforgiving equity markets to fund growth projects. Last year, the MLP sector grew EBITDA by a mid-teens rate. Meanwhile, infrastructure MLPs grew their distributions by double digits.

• (4) The very nature of midstream businesses is very attractive for an aging economic expansion. Most midstream MLPs own a significant number of regulated, demand-pull assets with long-term contracts. Additionally, commodity risk is minimized by the fixed fee volume-dependent nature of these contracts. Most of the counterparties involved in these contracts are creditworthy and the contracts also often contain inflation escalators, making them a good hedge against inflation.

• (5) Most importantly, MLPs offer very high yields and dirt cheap valuations relative to both the broader stock market as well as their own history.

With that said, it's important to recognize that, similar to REITs:

“Not all MLPs are created equal.”

Many times do-it-yourself investors get seduced by a juicy yield when picking MLPs and believe management’s rosy projections of how future growth prospects will come to fruition without any hiccups and will therefore support their enormous distributions and shower investors with riches. What these investors fail to realize is that management teams are often self interested, make poor capital allocation decisions, and excessive risk taking is common. Needless to say, this is a sector where you need to be very selective to maximize returns and avoid landmines.

As an example, at High Yield Landlord, for every investment that we make, we reject about 10 other alternatives:

MLPs and REITs can provide ample rewards to those willing to put in the work, but they also can be remarkably unforgiving to those who ignore the problems.

Below we discuss the "dark side" of MLPs and explain how we seek to avoid landmines.

#1 Self-Interested Management and Conflicts of Interest

The MLP industry has greatly improved for the better in recent years. Several years ago, it was not uncommon for parent companies/general partners to take advantage of their MLP entities by charging excessive IDRs and management fees while also issuing significant amounts of equity and debt in order to grow as much and as quickly as possible in order to line their own pocket books through fees. Meanwhile, unitholders in the MLPs would suffer significant dilution as well as overleveraging that contributed to the massive sell-offs in unit prices and distribution cuts that rocked the sector and scared many investors away for good. In recent years, as already discussed, MLPs have become much friendlier to unitholders, and today, many MLPs have bought out their IDRs and/or already merged with their parents/general partners to form full alignment of interest. Furthermore, most MLPs have become/are aggressively pursuing self-funding status and deleveraging so they do not have to issue excessive amounts of equity at unfriendly market prices while also de-risking their business models and laying the groundwork for sustainable distribution growth.

That said, there still exists a number of MLP managers that keep acting in their self interest at the expense of unit holders. Management teams and parent companies are more worried about their own pay and fees than the performance of the MLP units. The good thing here is that these MLPs are fairly easy to identify as they often possess one of the following traits:

1. They will often have an external management/IDR agreement.
2. The managers will have little skin in the game other than their salary.
3. The MLP will not hesitate to issue units at a higher cash flow yield than their “growth” projects produce.
4. The fees will be directly tied to the assets under management (AUM).

This leads to what we like to call “empire building.” In other words, they will seek “growth at all cost” and dilute the current shareholders just to grow an ever larger pie to justify higher fees.

While this practice is increasingly rare in the highly scrutinized world of large caps, investors must still pay very careful attention when investing in MLPs. Even if an MLP is cheap - it does not make it an investment candidate if we cannot rely on management’s competence or integrity. This has allowed us to avoid numerous serial underperformers such as Buckeye Partners (BPL) even when its yield made it appear very cheap. Once their price more accurately reflected their fundamentals plus a large margin of safety, we eventually invested and turned it into a major profitable investment for us.

#2 High Volatility and Disparities in Performance

It's not a secret to anyone following the sector in recent years that MLP unit prices can be very volatile. While this often leads to opportunities, investors should know that it can be a bumpy ride – and the actions of the management team have significant influence on the volatility.

Management actions that lead to greater volatility in the MLP space:

• Issuing unit at discount to returns on equity.
• Overleveraging the balance sheet.

Actions that lead to lower volatility in the MLP space:

• Appropriately timed buybacks.
• Reasonable capital structure.
• Pursuing the self-funding model.

Anything that leads to shakier fundamentals will lead to wider price fluctuations, and when dealing with leveraged MLPs, every management action has an amplified effect on the price.

MLP investors can tend to be very impatient and will trade in and out of their positions based on the next quarter’s outlook – causing massive disparities in performance. To maximize your chances of being on the right side of the trade, it pays to keep a close eye on the actions of management.

#3 Lack of Dedicated Investment Research

Today, many (especially smaller cap) MLPs and MLP-focused CEFs lack adequate coverage from investment research institutions. The consequence for investors, especially individuals, is that it becomes very difficult and expensive to access quality research on these opportunities. Analyzing MLPs is no walk in the park and it requires specialist skills that are not widely available.

My point here is that you must know your limits. For us, we feel that we are able to adequately sift the wheat from the chaff in this challenging sector in both individual picks as well as actively managed MLP funds given that we are multiple analysts spending thousands of hours performing due diligence on real asset investment opportunities (disclosure: the objective of High Yield Landlord is to streamline this research process to the public and allow interested members to emulate our strategy). However, if you lack an edge, you are better off pursuing well-diversified index funds or ETFs to avoid stepping on the landmines while still collecting attractive and growing distributions along with expected long-term capital appreciation as sector sentiment improves.

MLP Landmines - An Example

To put theory into practice, we will elaborate on one MLP that recently raised some of these red flags and ended up burning investors. American Midstream Partners (AMID) cut its distribution last summer, sparking a massive sell-off in the shares.

However, a prudent investor would have seen numerous red flags signaling the impending cut as it suffered from excessive leverage, dilutive equity issuances, poor management execution, and mistreatment from its general partner (ArcLight Capital, whose energy division has unsurprisingly recently taken AMID private at a very cheap valuation).

The excessive leverage led to credit rating downgrades and forced the company to issue debt as well as preferred and common equity at very expensive levels to simply fund its capital expenditure requirements while also maintaining its distribution. Management also routinely failed to meet guidance as well as consensus expectations. The biggest red flag of all, perhaps, was that management made some disastrous acquisitions and the general partner dropped down several underperforming assets that ended up being very overpriced. As a result, units turned out to not be so cheap after all, and the MLP ended up getting bought out at less than 50% of its pre-distribution cut valuation, crushing investors in the process. Such steep losses could have been avoided had investors simply maintained disciplined in their insistence on quality management, a supportive rather than exploitive general partner (or better yet, none at all), a reasonable amount of leverage, and a capital allocation strategy that did not routinely dilute investors.

Closing Notes: MLPs Are Wonderful (if you pick the right ones…)

Priced at a huge discount to other real asset classes and the broader market as a whole, there's no doubt that there exist some lucrative opportunities in the MLP space today.

You must however exercise very prudent attention to your selection of individual investments as return disparities can be massive.

To illustrate this point, consider the following: The average returns of most asset classes over the past decades have vastly outperformed the results of the average individual investor over the same time frame:

Clearly, the average investor does NOT know what they are doing. They are consistently making the wrong decisions, trading too much, and stepping on landmines.