Institutional Investors Take a Close Look at MLPs 2.0
In recent years master limited partnerships (MLPs) have been transitioning to what’s become known as the “MLP 2.0 model,” broadly defined by self-funding, capital discipline, and balance sheet strength. It is a long-overdue improvement for the asset class that has led institutional investors to take a new look at these vehicles.
(Estimated reading time: 3 min 35 sec)
Like stocks, MLPs are traded on public securities exchanges. But their limited partnership structure has different tax implications. MLPs are focused on yield and growth, and are frequently bucketed with real return strategies. Most MLPs concentrate on businesses engaged in natural resources and commodity investments, and some real estate enterprises, due to the tax laws that govern the partnerships as pass-through entities.
(For more detail on the asset class, please see our white paper “Inside Master Limited Partnerships: A Primer.”)
The MLP 2.0 shift gained traction starting in late 2014 after the price of oil collapsed, severely limiting the ability of these partnerships to borrow money and to raise equity in the capital markets for ongoing operations. MLPs pay their unitholders (akin to shareholders) distributions (akin to dividends), and in 2015 more MLPs cut distributions than in any other year in history in order to survive.
As the commodity collapse extended into 2016, fundamentals in the space continued to deteriorate and MLPs’ growth prospects and their ability to meet their distribution requirements were called into question. This caused share prices to decline—the Alerian MLP Index was down over 50% from 2014’s peak to 2016’s trough—but a large part of this plunge was also due to the asset class’ focus on growing and maximizing distributions instead of concentrating on total return and capital discipline.
Because of the tax treatment of MLPs, their distributions are typically high and make MLPs appear attractive for income-oriented investors. But the focus on distribution growth caused valuation metrics used by analysts in the space to be distribution-oriented, not based on other fundamentals. For the MLPs to meet the demand for these ever-growing distributions, new projects had to be funded to provide larger income streams to then distribute. Prior to the commodity collapse, these new projects were typically financed through equity issuance in the capital markets, but following the commodity collapse this source of fundraising was turned off. This forced MLPs to shift toward self-funding their distributions with retained cash flows, requiring far greater capital discipline than MLPs had ever exhibited, and was the first step toward the improvements of the MLP 2.0 model.
Unfortunately, shifting to the MLP 2.0 model cannot be done overnight. According to CBRE Clarion, fewer than 40% of MLPs have achieved MLP 2.0 status as of the end of 2018, but this is a large improvement over just 15% of MLPs being there in 2015. One issue is the distribution growth focus of the past that was reinforced by incentive distribution rights (IDRs) that some MLPs still have in place. As distributions grow, IDRs make general partners (GPs) eligible to receive a higher percentage of these distributions, which historically led managements to pursue growth at the expense of the balance sheet.
While Goldman Sachs reports that the percentage of MLPs with IDRs has fallen from 69% to 17% from 2013 to 2019, eliminating or reducing IDRs is another key aspect of MLP 2.0 that is necessary to reduce the cost of capital. As another step in reducing the cost of capital, many MLPs have smartly offloaded low-quality or non-core projects from their balance sheets in recent years. Similarly, many MLPs have been strengthening their balance sheets by paying down debt to improve leverage ratios.
Taken together, the shift from simply focusing on distributions to emphasizing self-funding, capital discipline, and balance sheet strength is the core element of the MLP 2.0 model. Importantly for investors, Wells Fargo highlights that MLP 2.0 companies (which it calls “midstream reformers”) have outperformed the broader MLP sector by nearly 30% from January 2017 to March 2019. But investors need to be diligent; achieving self-funding and executing the MLP 2.0 model is a way of running a business that many MLPs are still learning. Still, this movement has significantly increased institutional investor interest in this asset class in recent years, and it is a prime example of an investment trying to adapt to changing markets in order to survive.