Master Limited Partnerships: High Returns Come with Higher Risks
On the surface, many Master Limited Partnerships (MLPs) might look like healthy investments. If managed wisely, MLPs can offer diversification as well as tax benefits. MLPs combine the tax benefits of publicly traded partnerships with the liquidity of traditional stocks.
To count as an MLP, a partnership must make 90% of its revenue from commodities, natural resources (like oil and gas), or real estate. MLPs that invest in a variety of sectors offer lower risk. Successful MLPs offer enviable yields, often as high as 7% to 9%. They also come with regular distributions, often in the form of monthly or quarterly payouts.
Unfortunately for some investors, many MLPs concentrate their money-making efforts in the volatile energy market. The advantages of an MLP can distract from the fact that their underlying investments might be high risk. In spite of their potential for good yields and hefty dividend payouts, experts caution that investors should still consider them as risky as regular stocks.
What is the Difference Between an MLP and a Corporation?
Technically, an MLP has no employees. Unlike a corporation, MLPs are partnerships. General partners manage the MLPs, and investors are “limited partners.” Instead of selling shares, MLPs sell units. For this reason, MLPs refer to their investors as “unitholders.” Investors can buy and sell MLP units on a public exchange, just as they would shares of a public company.
Tax Advantages of MLPs
The hybrid nature of MLPs offers some tax advantages that can make them attractive investments. Unitholders do not have to pay corporate taxes — instead, MLPs must distribute their cash flow to unitholders, who are responsible for paying taxes.
The IRS counts MLP distributions as a return of capital instead of income. Therefore, unitholders do not have to pay income tax on their distributions. Instead, they only pay a capital gains tax once they sell their units. (Capital gains tax offers a lower tax rate than a regular income tax.) Like a corporation, unitholders can take deductions for depreciation.
What Makes MLPs Risky Investments?
1. Energy Market Volatility
The majority of MLPs focus on oil and gas investments. Pipeline construction, for instance, generates income for many MLPs.
As oil prices fluctuate, so too do MLPs’ popularity. Crude oil prices fell from 2014 to 2016, and MLP distributions took a massive hit. Brian Sterz, a portfolio manager, told The Wall Street Journal, “Investors developed a false sense of security in these securities while oil prices were stable, but quickly found after 2014 that the elevated income yields came with elevated price risk.”
From then, oil prices began to creep back up, leading to a 2018 burst in MLP popularity. 2020 once again saw a major hit to the energy market following the pandemic. This cycle underlines the fact that investors should only consider energy sector MLPs if they can tolerate a substantial amount of risk.
2. Unexpected Tax Consequences
Following the oil bust of 2014, a major MLP offered investors a deal: They could swap their rapidly declining units for traditional shares of the MLP’s parent company. This was part of a “roll-up,” a strategy that dismantles an MLP and folds its assets into the parent company. When MLPs are forced to restructure or enter into debt forgiveness agreements, the tax consequences get passed along to investors.
As many investors discovered, the IRS counts this type of swap as a sale, which meant that investors had to pay taxes on any money they earned from the swap. When corporations offer these types of swaps, they continue to enjoy tax advantages, while ordinary investors end up shouldering more of a tax burden than they bargained for.
Why Did MLPs Lose So Much Money in 2020?
In 2020, during pandemic lockdowns, the demand for oil and gas plummeted. The Wall Street Journal reported that shares of popular MLPs like Goldman Sachs MLP and Energy Renaissance Fund fell by 73%. This constituted “unprecedented declines” in the value of energy MLPs’ underlying value. The two funds mentioned in the Journal article have cut back from monthly distributions to quarterly distributions.
MLPs often use leverage — or borrowing — to invest in long-term securities. This strategy can pay off when the underlying assets are performing well. But there are limits to how much money MLPs can borrow, and when the price of oil plummets, the use of leverage can backfire. MLPs might be forced to reduce their leverage by selling off assets, which exacerbates the fund’s losses. As Rebecca Babin, a senior energy trader told The Wall Street Journal, “Leverage is lovely when things are going up, and really awful when things are going down.”
What Should Investors Look For in an MLP?
Investor complaints from MLP unitholders allege that their financial advisors did not properly describe the fund’s risks. Be wary of MLPs that produce excellent returns in a bull market — chances are, those returns won’t last. MLPs that invest in a variety of sectors pose less risk, but also come with some risk, and should not be considered a replacement for traditionally low-risk investments.
