What would you think about an asset class whose membership universe over the last decade has declined in terms of both security selection and diversification? Master Limited Partnerships (MLP), a legal structure built to fund certain kinds of operating businesses, were once seen fondly by investors as the source of ever-growing distributions and low risk returns. Those days appear to be over, which says more about their tax-driven structure than the future of the underlying businesses they support.
MLPs were created in 1981 for the purpose of raising capital from small investors in an affordable and liquid security that offered tax benefits for investors as well. Advantages included greater after-tax income, tax deferral, diversification from other asset classes and higher yields. Disadvantages included complicated tax calculations, little diversification within the asset class and a narrow margin of safety for the business due to high payout ratios. Demand was so great that by 1986 Congress, recognizing the loss of potential tax revenues, limited MLPs to industries that had traditionally operated through partnerships.
Over the next few decades, while MLP returns lived up to the promise, they also became more concentrated. In 1990, MLP assets were roughly split between Energy, Real Estate and Other. By 2017, Energy assets alone comprised 82% of all MLPs. Of the Energy MLPs, those having to do with transportation grew from 27% of the total to 50%. What began as a lightly diversified asset class at inception became even less diversified.
Over the last several years, crashing oil prices, distribution cuts, tax code/regulatory changes and unsustainable distribution growth targets soured investors on the MLP model. Managements responded by converting MLPs to a traditional corporate structure at a faster pace while fewer initial public offerings (IPO) were brought to market. In 2013, there were 23 MLP IPOs to raise new capital. In 2016 there was one, and in 2018, zero.
According to Alerian, a company that tracks MLPs, the number of energy MLPs peaked in 2014 at 124 and ended 2019 with 71. More and more, operators and investors simply do not see value in the MLP structure. It isn’t hard to see why. Quarterly distribution growth over the last three years was negative half the time. And year over year distributions have declined since 2015. This is worse than a bad look for an asset class built on the reputation of slow and steady distribution increases.
Alerian also offers an exchange traded fund (ETF), launched in 2006 and made up of publicly traded energy infrastructure MLPs. Today it is remarkably concentrated. As of June, 2020, it included 29 companies, the largest 10 of whom comprised 75% of the index market weight. Over the last decade it offered the worst kind of diversification, losing -1.4% per year while fixed income returned 3.8%. Even boring dividend-paying utilities returned 11.3%.
None of this is to suggest the businesses behind MLPs are going away. Energy-related transportation services will be needed for years to come. It has simply become clear that a business structure which once offered benefits to both companies and investors is not what it once was.