By Jon Sallah
In the current low-yield environment, investors and advisors have been seeking alternative investments that offer better returns than those that are currently available through banks or corporations. In recent years, investors and brokers began purchasing partnership units in Master Limited Partnerships (“MLPs”) because they offer higher than average yields in the form of distributions. MLPs appeared to be a high-yielding bond substitute with tax advantages, which seem to be perfect for retail investors seeking income. However, there are many risks associated with these investments.
MLPs were created in the 1980’s to incentivize investment in domestic energy infrastructure. For a business to qualify as a MLP, at least 90% of its revenue must come from the natural resources industry or real estate. MLPs combine the tax benefits of a limited partnership with the liquidity of a publicly traded security. Investors purchase partnership units of the MLP and receive distributions. These distributions are specified in the MLP’s partnership agreement and require the partnership to pay out most of their current income to investors. The distributions provide an incentive to investors because they are considered as a “return of capital” and the income is not taxed until the investor receives back their principal investment. A distinguishing characteristic of MLPs is that they carry on an active business so the prior quarter’s performance can have an effect on distributions.
In order for MLPs to prosper, two conditions must be met. First, capital markets must be accessible. Since MLPs pay out the majority of their cash flow to investors, they may be dependent on borrowing or selling additional units to grow. As a result, investors face the risk of dilution of their units and possibly subordinating their right to payment to secured creditors. This is an unforeseen risk as many investors would not anticipate their units being diluted as a result of limited access to the capital market.
Second, energy prices have to be stable. The performance of MLPs is almost entirely linked to the performance of energy prices and the risks associated with those sectors. For example, when the price of oil or gas falls (or production declines), MLPs are frequently sold off and their value may decrease significantly. Investors may still receive distributions, but the value of their units are likely to decrease. An investor who does not fully understand the sector they are investing in may face unwanted surprises.
The risks discussed above shed light on the unsuitability of MLPs for unsophisticated investors. However, the spotlight on MLPs in securities law did not arise until a few years ago. Advisors and brokers began purchasing units of MLPs to replace low-yield bonds and REITS with a high-yield alternative. Years of stable energy prices led many advisors and brokers to advise the purchase of additional MLP units, resulting in over-concentrated portfolios. When energy prices plummeted, these over-concentrated portfolios experienced significant losses, and actions were brought against many brokers/advisors.
In sum, investing in MLPs should be limited to sophisticated investors who have a high-risk tolerance. Investors who seek to generate income may be advised of the associated risks; but, knowledge of the energy sector, capital markets, and the various risks facing active businesses is crucial before purchasing such a high-risk investment.