A Master limited partnership (MLP) is a publicly traded entity that combines the tax benefits of a limited partnership with the liquidity of a publicly traded company. MLPs are listed on the major U.S. stock exchanges, but because they are partnerships, MLPs do not have to pay corporate taxes at the state or federal level. To qualify for MLP status, a partnership must derive 90% of its cash flows from activities related to real estate, natural resources and commodities. Master Limited Partnerships are major owners of America’s energy infrastructure, controlling substantial assets in pipelines and storage terminals that U.S. energy firms have spun-off over the years. Some of the largest individual MLPs are Kinder Morgan Energy Partners LP (NYSE:KMP), Plains All American Pipeline, L.P. (NYSE:PAA), Magellan Midstream Partners, L.P. (NYSE:MMP) and Enterprise Products Partners L.P. (NYSE:EPD).
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There are two classes of MLP owners: the limited partner provides the capital and receives periodic income from quarterly cash flow distributions. The general partner is responsible for managing the day-today operation of the partnership and receives compensation based on the performance of the venture. General partners typically hold a 2% ownership, and enjoy all the voting rights in the partnership. Limited-partner units are publicly traded on a securities exchange, while general-partner units are not. Investors can buy “units” of the partnership using a brokerage account, or they can opt for exchange-traded notes or closed-end funds. Some of the benefits of investing in MLPs include:
- High yield: MLPs typically offer very attractive yields. The Alerian MLP index, a market cap-weighted, float-adjusted index of the 50 most prominent energy MLPs, has an average yield of 6.02%.
- Consistent cash distribution: Master Limited Partnerships tend to operate in very stable, slow-growing industries that produce consistent cash flows over time, making the cash distributions very predictable.
- Capital gains: Investors in Master Limited Partnerships avoid the double taxation generally applied to shareholders of corporations. While shareholders in a corporation pay taxes first at the corporate level, and then at an individual level when those earnings are received as dividends, owners of a MLP are taxed only when they receive the distributions.
- Lower cost of capital: Because Master Limited Partnerships do not have to pay corporate income taxes, they have a lower cost of capital compared to corporations, and are able to pursue projects that might not have been feasible had the company incorporated.
- General partner’s compensation depends on limited-partners’ distribution: General partners may be paid a fee of up to 50% for increasing the cash-flow distribution to the limited partners. Since their compensation is largely based on how well the limited partners do, it is in the best interests of the general partner to increase limited-partner distributions.
While there are risks to investing in Master Limited Partnerships, a reasonable allocation to the sector could boost portfolio returns. MLPs have historically shown low correlation with other areas of the market. As a result, an allocation to MLPs can help reduce portfolio volatility. The two biggest risks that could affect a MLP’s performance are rising interest rates and a change in their tax status. Master Limited Partnerships tend to typically underperform in rising interest rate environments. When interest rates are high, investors move out of riskier assets to seek income in U.S. Treasuries or other fixed income instruments. Master Limited Partnerships also face regulatory risks. Any adverse change in their tax status would hit the sector hard, and lead to substantial downside in their prices.
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