Will MLP Funds Sell MLPs?
Although an MLP fund selling most of its MLPs might seem implausible, it represents a growing risk for their holders.
MLP-dedicated funds are structured as corporations, which means they pay corporate taxes. They’re unique in this regard; few ETF or mutual fund investors stop to check on this. In MLP Funds Made for Uncle Sam we showed how much it hurts returns.
But now such investors need to consider another problem. MLPs are losing favor as big energy infrastructure companies convert to corporations, where they can access a far broader set of equity investors. They’ve found that MLP buyers are mostly older, wealthy Americans who want stable, growing income. MLPs used to provide this by paying out most of their Distributable Cash Flow (DCF). However, the Shale Revolution created many new opportunities to add infrastructure, which ultimately led to some DCF being redirected to pay for projects. MLP investors balked, yields rose and companies concluded that they needed new investors (see The Changing MLP Investor).
Regulatory unpredictability (see FERC Pushes Pipelines Out of MLPs) provided an additional incentive to become a corporation. This led Alerian, provider of eponymous MLP indices and a reliable cheerleader for the structure, to publish a list of 16 MLPs that will no longer be MLPs. They called it the MLP Graveyard. Although the MLP continues to be tax efficient, its income-seeking investor base is poorly matched with companies that increasingly want to grow their asset base (see Are MLPs Going Away?). Consequently, many big companies are becoming corporations.
This shrinking pool is a developing problem for MLP-dedicated funds who invest 100% of their money in MLPs. If they do nothing, they’ll have fewer names to choose from, and those remaining will be smaller than in the past. The list of large energy infrastructure corporations that such funds don’t hold includes Enbridge (ENB), Kinder Morgan (KMI), Oneok (OKE), Targa Resources (TRGP) and TransCanada (TRP). Williams Companies (WMB) will soon join this list, leaving only a handful of large MLPs remaining.
Their promoters argue that MLP funds can invest in corporations like these, which is true. But none of them have, because the optics of a tax-paying fund owning a tax-paying corporation to deliver taxable returns to investors would just look too ridiculous.
They might decide to convert to a normal, non-tax-paying fund. But RIC-compliance is a binary issue, like pregnancy. As long as such funds hold more than 25% of their investments in MLPs, the whole fund faces a corporate tax bill. A gradual shift from MLPs to corporations wouldn’t help until completed.
It’s a move they’d probably all like to pull off, if it could be done without disruption. The Cushing MLP Total Return Fund (SRV) is an MLP-dedicated Closed End Fund (CEF) that has announced plans to become RIC-compliant by selling MLPs. SRV’s destruction of investor capital is legendary (see An Apocalyptic Fund Story), which has brought its market capital down to $80MM and a share price 90% below its 2007 IPO level. SRV is small enough that its MLP sales don’t matter, but its conversion to a RIC-compliant structure reveals a preference to become a normal fund where possible.
There are many MLP funds that are too big to pull this off. This includes the Alerian MLP ETF (AMLP), and various mutual funds from Oppenheimer SteelPath, Cushing and others. Their supporters argue that there’s no problem with their structure. In aggregate, we estimate that such poorly conceived, tax-burdened funds hold $40BN in MLPs. If they all became RIC-compliant, $30BN in MLPs would be for sale. AMLP alone owns 8% of the float-adjusted market cap of its benchmark. Selling this much would require substantially lower prices.
But what if one of these funds decides to jump, to follow the example of SRV whose small size aided by long-term value destruction afforded them the flexibility to change. The PGIM Jennison MLP Fund (PRPZX) has $560MM in AUM. If they moved first, perhaps they could sell their MLPs without much disruption, becoming RIC-compliant with improved investment flexibility. Bigger funds don’t really have this option, because upon announcing their intention the MLPs they own would quickly fall.
The dilemma for all these funds is correctly assessing what their peers will do. Don’t expect to see any new MLP-only funds launched. The structure is clearly an anachronism. The MLP funds that exist are stuck with their out-dated, corporate structure and its tax burden. They have too much in MLPs to easily exit and become RIC-compliant. They must hope their peers agree.
Investors in AMLP and Steelpath MLP funds might consider that Alerian, their benchmark provider, has an MLP Graveyard list. Moving first might work, but you sure don’t want to be last.
We are invested in ENB, KMI, OKE, TRGP, TRP and WMB.
We are short AMLP.