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April 21, 2006 4:27 pm

Seeing the wealth beneath your feet

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In 1996, Richard Kinder left Enron – long before its demise – and bought its pipeline division with William Morgan. Through a massive acquisition spree, the company, known as Kinder Morgan, today controls more than 40,000 miles of pipeline. And the beauty is that – rather unlike Enron – Kinder Morgan has produced cash by the bucketload and shared all of it with its partners. It is structured as a master limited partnership (MLP), and over the past 10 years it has increased its partnership distributions by 350 per cent.

Kinder Morgan not only makes cash but it has a great defence against new entrants on its turf. New pipelines are prohibitively expensive to build. That creates a barrier to entry. “New, competing pipelines are very rare,” says Doug Rachlin, who manages $300m in an MLP portfolio at Neuberger Berman.

MLPs, very quietly, have become one of the hottest assets for the wealthy. Ten years ago, Rachlin says, there were 15 oil and gas MLPs with a market value of $10bn. Today there are 50 worth more than $70bn. He predicts the market will exceed $100bn in the next one to two years.

Those wanting income, and despairing of getting it from the government bond market, have used them to buy into a range of other businesses – from race tracks to orchards, amusement parks and cemeteries – but primarily into pipelines.

Under the sweeping 1986 tax reforms, MLPs were limited to energy, natural resources and real estate. The idea was to encourage infrastructure investment but also to close a tax loophole that some companies had been exploiting. The Boston Celtics basketball team had been structured as an MLP until the loophole was closed under the legislation which, appropriately enough, had been sponsored by a former New York Knicks player, former Senator Bill Bradley.

While MLPs have none of the potential for golf course gloating possessed by hedge funds, nor any of the awe-inspiring complexity of derivatives, they do have the benefit of simplicity and transparency. And since the partnership must distribute about 90 per cent of its income, it is not taxed at the corporate level; that falls to the individual shareholders.

“It’s a vehicle that captures investor attention as a prospect for stable cash return,” says Jack Caffrey, equity strategist at JP Morgan Private Bank. Some private banks are recommending them for 5-10 per cent of a client’s portfolio

She remains fond of the energy sector. She likes exploration companies such as Apache, Burlington and Kerr and is particularly fond of dividend payers ExxonMobil and ChevronTexaco. “Both these companies have used the excess cash they generate to pay off debts and pre-paid pension obligations. Now, they will show people what they have got.”

The MLP structure works particularly well for investors in pipelines because they do not require much capital once they have been built and enjoy consistent revenue from the fees collected to move oil and natural gas through them.

Since they do not own the underlying commodity, their risk from price movements is relatively low: regardless of how much petrol costs, it still needs to be moved from point A to point B. “There is limited pricing risk,” says Rachlin. “Our way of life is to consume products.”

Between 1990 and 2004, this asset class returned 16 per cent on an annualised basis and is showing no signs of slowing down. “[MLPs] have outperformed the S&P, Reits, the 10-year bond,” says Joseph Grunfeld, private wealth advisor at Merrill Lynch. “Because they are oil- and gas-related, you would think because the prices of oil and gas have gone up that would have an impact. That is irrelevant. Oil and gas MLPs are toll roads.”

He sees substantial growth ahead. “Less than 25 per cent of companies capable of being an MLP are one. There’s a lot of room for growth.”

For MLPs that go into acquisition mode, the cost of capital is relatively low because of their tax structure. Yet John Tysseland, director of MLP research at Citigroup, says this is going to be a year when the market gets a bit trickier and picking pipeline operators is going to become important.

He notes that last year total returns ranged from negative 20 per cent to plus 40 per cent – averaging out at 6.3 per cent. Tysseland adds: “We believe picking individual MLPs is going to be very important for performance.”

His favourites are those that are growing internally and not through acquisition. His reasoning is that the acquisition multiples are too high now compared with five years ago, when energy companies were selling pipeline assets. “We see 12-20 per cent for organic growth returns against acquisition returns in the 8-10 per cent range,” he says, recommending companies such as Enterprise Products, Magellan Midstream, Plains All American, Boardwalk Partners and Energy Transfer.

Regardless of what type of MLP a person invests in, the entities offer tax benefits for individual investors: 80 per cent of the distributions are considered return of capital. For example, if an entity earned $2, an investor is taxed on 40 cents of it. And that 20 per cent is taxed as ordinary income, which can be deferred.

“If you are getting ready to retire or you foresee a time when you will move into a lower tax bracket, you can defer your taxes [from MLPs] until then,” says Tysseland. The assets most MLPs own – pipelines and terminals – are also subject to depreciation; excess depreciation can be a tax shield. MLPs are also a good vehicle for estate planning because the return of capital lowers the cost basis, meaning the inheriting generation gets a step up in cost basis.

But there is one large downside. If a pipeline runs through several states, an investor could be responsible for filing taxes in all them. “There’s one that has operations in 37 different states; ostensibly you would have to file a tax returns in 37 different states,” says JP Morgan Private Bank’s Caffrey. The fewest states an MLP pipeline runs through is five. “You have a business presence in those states.”

He says most states have a de minimis law whereby an investor does not have to file a tax return if the amount of income is not large. But the question remains how “large” is defined.

The lesser risk is that Treasury bond yields start going up, which would siphon off some investors. Citigroup predicts dividends from oil MLPs will grow by 8.8 per cent this year, so that trade-off is not a near-term concern.

“As a diversifier, they add significant benefit,” says Merrill Lynch’s Grunfeld “They have almost no correlation to equities, they have almost no correlation to bonds, virtually no correlation to Reits . . . They’re really in a league of their own. You’d think they’d have a correlation to energy stocks but they don’t.”

And that is the best part. Rachlin’s fund has returned 20 per cent since its inception in 1996, where the S&P 500 has returned 9 per cent and Lehman’s US government/credit index has returned 6 per cent. His best year was 2000 with a 37.68 per cent return; his worst was 2002 with a negative 3.76 return.

Most important, people will always need income. “We live in a low yield world and people have income needs,” says Caffrey. “Many people look at the 9-10 per cent and say I can’t make that income elsewhere. Then they figure oil pipelines are stable.”


Stonemor Partners describes itself as “one of the largest companies in the death care industry”. It owns 155 cemeteries and 14 funeral homes in 14 states Áwith revenues totalling $100m, and it became an MLP in September 2004. “One of the things being an MLP does is give us a new currency to acquire cemeteries. Our business model fits nicely into that,” says Tim Yost, director of investor relations. The company has made one acquisition as an MLP, of 22 cemeteries and six funeral homes. But Yost says the company wants to revive the acquisition spree of the 1990s, when SCI, the leading cemetery company, and the Loewen Group, then its arch-rival, battled it out until Loewen went bankrupt. “We are re-pioneering that acquisition mode,” says Yost. Demand for its services is, of course, the only thing as certain in life as taxes. However successful its acquisition campaign may prove to be, there should be a consistent flow of income. On the fringes, there are other MLPs that may appeal to people with a quirkier investment sense. Alliance Bernstein, the fund manager, and Cedar Fair, which operates a chain of amusement parks, were grandfathered in under the 1986 tax revisions. Macadamia Orchards offers exposure to nuts, while Equus Gaming owns horse tracks. But with only about a dozen non-pipeline MLPs, investors need to evaluate them as individual securities. They cannot be compared as an asset class with energy partnerships, so homework is more important.g

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