Master limited partnerships rely heavily on external financing to fund growth
Master limited partnerships or MLPs are specially structured entities that must pay out most of the cash they generate to unitholders. So MLPs rely especially on external funding sources (as opposed to internally generated cash) to execute growth projects and acquisitions, as they’re limited from keeping much cash on hand. Because of this reliance, the state of the capital markets (which generally refers to the equity and bond or loan markets) is an important factor in determining whether an MLP can find the money to participate in growth-oriented activities.
MLPs appreciated in June, decreasing yields and reducing the cost of equity capital
The cost of equity capital across most of the MLP spectrum decreased over June. This decrease is positive in the sense that it’s less expensive for MLPs to fund growth, and it makes more growth projects and acquisitions attractive. The downside is that cheaper equity capital inherently comes from lower MLP yields as a result of stock price appreciation. That means that while lower equity cost of capital is a positive for MLPs, investors looking to enter into MLPs now will receive lower yields (and a higher entry price) than they would have at the beginning of June. Using the Alerian MLP ETF (exchange-traded fund) as a proxy for the MLP universe, the current dividend yield (as of June 28) is 5.9%, compared to roughly 6.1% on May 31.
The dividend yield of Enterprise Products Partners (EPD, $58.8 billion market cap), one of the largest MLPs by market cap, was 4.51% on May 31, compared to 4.32% on June 28. Another large cap MLP, Kinder Morgan Energy Partners (KMP, $33.2 billion market cap), had a dividend yield of 6.24% on May 31, compared to 6.09% on June 28. The dividend yields on small and mid cap MLPs also generally increased. For example, Targa Resources Partners (NGLS, $5.4 billion market cap) had a dividend yield of 6.00% on May 31, compared to 5.53% on June 28. Genesis Energy (GEL, $4.4 billion market cap) had a dividend yield of 3.97% on May 31, compared to 3.84% on June 28.
MLP yields are also down significantly since the financial crisis
Though recently, MLP yields have increased somewhat, from a longer-term perspective, MLP yields have compressed dramatically since the financial crisis. So raising funds by issuing equity has become a more and more attractive option over the past few years, as the cost of equity continued to get cheaper. During the financial crisis of 2008, yields on the aforementioned MLP stocks spiked up to levels from ~10% (KMP) to over 30% (NGLS) compared to levels of ~4-7% now on the same names.
Cheaper equity capital means more growth projects may be attractive
Again, the long-term yield compression on MLP stocks has been a positive for growth because generally speaking, the lower the cost of funds, the more projects a company may find attractive. For example, if a company has identified a project that has returns of 15% and the company’s cost of funds is 10%, the company may pursue the project. If the cost of funds increases, for example to 20%, the same project may no longer be viable to the company. Usually, the more attractive projects a company’s able to pursue and fund, the likelier an increase in a company’s assets and cash flow.
Currently, equity capital is relatively cheap, and it became even cheaper in June. This helps fund MLPs’ growth, which is positive for the companies—though the stock price appreciation may make the MLP sector less attractive to investors. The equity financing environment is an important factor for the majority of MLP names such as KMP, EPD, NGLS, and GEL. For more on MLPs, please see Why debt is now a less attractive financing source for master limited partnerships.
© 2013 Market Realist, Inc.
But if I knew how to manage my portfolio safer and smarter than most hedge fund managers, I could realistically grow my wealth.