Regent Atlantic’s Kapyrin Answers 5 Questions on MLPs
We sat down to talk about MLPs with Andy Kapyrin, from Regent Atlantic, and discussed different structures for accessing MLPs, including Regulated Investment Company (RIC) ETFs, C-corp ETFs, and ETNs.
1. What is the appeal of using an ETF structured as a RIC (regulated investment company), rather than a C-corp, to access the MLP space?
The primary appeal of a RIC-structured ETF (“RIC ETF”) is its greater tax efficiency than a C-corp fund. The RIC structure is common among ETFs and mutual funds: the fund itself is exempt from taxes as it “passes-through” its income and earnings to investors. The C-corp structure, however, is a necessity for a fund that wants to invest more than 25% of its assets in MLPs, due to IRS tax rules. A C-corp structured fund is unusual in that it is taxed at the fund level. This means that a C-corp fund has to accrue a tax liability on its earnings, which can limit dampen gains in a bull market. Therefore, investors who are looking for more tax efficient access to MLPs or potentially more participation in an MLP bull market, could be drawn towards a RIC-structured ETF that limits MLP exposure to less than 25% of the fund and allocates the remaining 75% or so to securities with high correlations to MLPs.1
2. How do you view RIC-structured MLP ETFs versus MLP ETNs?
First, both of them avoid the tax drag issue associated with C-corp MLP funds discussed above, so both can be good options for total return focused investors. But there are distinct benefits and drawbacks to each structure.
An MLP exchange traded note (“ETN”) is a debt instrument issued by a bank, rather than a fund with physical ownership of MLP shares. MLP ETNs can track an index of 100% MLPs and make distributions based on this index. Therefore MLP ETNs may make higher distributions than a RIC ETF, which only has limited MLP exposure. The downside of ETNs is that because they are notes, investors in ETNs have exposure to the credit risk of the issuing bank. Investors using ETNs must commit to doing more up-front homework to assess their comfort level with the issuer before investing in an ETN. Many ETN issuers are institutions based in Europe, which has been in a rolling financial crisis for some time and may give investors pause.
RIC ETFs, with exposure to MLPs and pipelines, often have more tax efficient distributions than ETNs. ETN distributions are treated as ordinary income, while RIC ETF distributions can often have distributions treated as qualified dividends or return of capital. This characterization can make the distributions more attractive to tax-sensitive investors as qualified dividends are typically taxed at a lower rate than ordinary income and return of capital lowers the basis of the investment instead of incurring taxes in the current year. RIC-structured ETFs can also offer more diversification: rather than tracking indexes that only have MLPs, RIC ETFs will often invest in MLP affiliates, general partners, and other types of businesses in the energy pipeline space as well.
3. What is your outlook on the MLP space in general? Are you bullish on the total return opportunity?
We continue to be bullish on the total return opportunity in the MLP space. Dividend yields are still well above 2014 levels and we believe the underlying fundamentals are solid. As we expected, pipeline companies experienced only minor declines in earnings and distributions over the course of this low oil price environment, which has helped renew investor confidence and allowed shares to bounce back in 2016.
More importantly, regardless of energy prices, these pipeline firms are still in an enviable business position. They own critical infrastructure with well-defined contractual tolls they may charge to transport energy. Energy production in the U.S. has leveled off and declined slightly, but is unlikely to fall to pre-shale exploration levels. All this means that the long-term opportunity for pipeline companies remains strong.
4. What is your view on owning the general partners of MLPs versus the MLPs (limited partners) themselves? Is there more opportunity in the general partners, or is the exposure to general partners just result of preferring the RIC-structure?
The structure of many pipeline firms includes limited partners that have a passive investment in the profitability of a firm and often a separately traded general partner, which can benefit from running the business well and fostering its growth.
I think there’s room for exposure to both entities in a well-diversified pipeline investment strategy. General partners typically have lower dividend payments, but investors are compensated with something else for owning them: faster potential growth in distributions. When the general partners deliver on running the pipeline businesses well, the GPs can wind up with a bigger slice of the pie, and earning that bigger slice enables them to grow their dividends faster.
5. How much do you think oil and natural gas prices are influencing the MLP space right now?
Oil and gas prices are driving pipeline returns much more than I would like. If you study the correlation between MLP returns and oil prices, you’ll see a very small relationship except in periods of stress. One of those periods was in 2008 and 2009. The financial crisis took most assets down and we saw big spikes in correlations for most asset classes, MLPs being no exception.
More recently, we’re seeing the same spike in correlations starting in mid-2014. In recent months the relationship is not as strong, and it would help a lot if oil prices stay stable and out of the news for a while.