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Master limited partnership (MLP) basics

2013.01.21 - MLPs by Industry TypeEnlarge GraphThis article is designed to provide a basic overview of master limited partnerships (MLPs). More detailed explanations will follow in further articles.

A master limited partnership or “MLP” is a company that is specially structured so that it does not pay corporate taxes, and is fundamentally a publicly traded limited partnership. MLPs can only engage in certain types of businesses, and must generate at least 90% of income from qualifying sources as designated by the Internal Revenue Service. Some examples of qualifying income sources include natural resource activities, interest, dividends, capital gains, rental income and capital gains from real estate, and income from commodity investments. Most, but not all MLPs are engaged in energy infrastructure such as natural gas processing, pipelines, and other energy transportation. There are examples of MLPs which are involved in upstream energy (exploration and production of oil and gas), refinery services, and shipping amongst other industries. Please see the graph below to view the different types of industries in which MLPs are engaged.

MLPs are required to pay out a certain amount of the excess cash they generate to unitholders (the same as stockholders of a regular corporation). This means that MLPs cannot hold vast reserves of cash on their balance sheets, like some companies such as Apple. Another difference between MLPs and regular corporations is that unitholders of MLPs are “limited partners” and have no role in the organizations’ operations or management. The management is coordinated by the general partner (GP) which often has a 2% economic stake in the enterprise (the LP unitholders have the other 98%). Sometimes the GP has a special right to incremental distributions, dubbed incentive distribution rights (IDRs). In certain cases, both the LP and GP portions are public traded, such as in with Crosstex where the LP portion called Crosstex Energy LP (and traded under the ticker XTEX) and the GP portion called Crosstex Energy Inc. (and traded under the ticker XTXI). In this example, XTXI also owns a portion of XTEX, so an owner of a share of XTXI owns both GP and LP shares.

The following table summarizes the main differences between MLPs and corporations.

MLPs vs. Corporations

MLP Corporation

Taxable at the entity level

No

Yes

Required distributions

Yes

No

Restrictions on business lines

90% of income must be “qualifying income”

No

General Partner

Yes

No

IDRs

Sometimes

No

Investor voting rights

No

Yes

Because MLPs are exempt from entity level taxes, all else equal, they have a lower cost of capital and trade at higher valuations. Additionally, because MLPs pay a certain amount of cash out every quarter they tend to trade on a yield basis, yield being (cash generated per unit / cost of the unit). For example, XTEX’s last distribution was $0.33 per unit. To get the annualized yield, take $0.33 * 4 (as distributions are paid quarterly) and divide by the unit price of $15.64. The yield is ~8.4%. All else equal, as distributions grow, one could expect the value of the underlying unit to increase. Investors generally require a higher yield from riskier and smaller businesses. If it appears as if a company may cut or discontinue distributions because it does not have enough cash to meet this obligation (usually because of some downturn in the business), unit prices would be likely to fall.

An individual can invest in MLPs through buying units of individual companies such as Crosstex (XTEX), Kinder Morgan Energy (KMP), MarkWest Energy (MWE), and Enterprise Products Partners (EPD). Additionally, there are mutual funds available that invest in MLPs. Lastly, there are ETFs such as the Alerian MLP ETF (AMLP) which tracks an index that represents a capitalization-weighted composite of 50 energy MLPs.