From the February 2014 issue of Research Magazine • Subscribe!

Midstream Energy Infrastructure: A Growth Opportunity in a Low-Yield, Low-Growth World

In the low yield, low growth environment we live in, we believe that owning growing, high quality midstream energy infrastructure investments will prove beneficial to investors' portfolios. We also believe that the best way to invest in midstream energy infrastructure is via master limited partnerships (MLPs) and the affiliated corporations that serve as the owners of MLPs.

What is an MLP? MLPs are publicly traded partnerships. They have the unique advantage of trading publicly like a large corporation while enjoying pass-through tax status similar to a private partnership.

They must generate the correct form of revenue in order to qualify as an MLP under the tax code. The types of entities that qualify are generally in the energy infrastructure and real estate businesses. Today our team tracks more then 100 MLPs with a market capitalization of $470 billion.

Many MLPs have parent companies that are also publicly traded. The parent companies typically own an economic interest in the affiliated MLP and may own additional energy infrastructure assets. These parent entities are often corporations as opposed to publicly traded partnerships.

A large majority of MLPs own midstream energy infrastructure assets such as pipelines, natural gas processing plants, and storage facilities that have attractive investment characteristics. They are critical to the functioning of the economy, often monopolistic in nature, and generate a strong level of cash flow. Investors in midstream energy infrastructure can expect the following:

Current Yield: MLPs generate a high level of cash flow that is often passed through to investors in the form of a distribution. Current yields average 6.5%, which is a significant premium to commonly held income securities such as corporate bonds and real estate investment trusts.

Growth Potential: MLPs are benefiting from the current boom in U.S. energy production. The associated build out in energy infrastructure provides growth opportunities for MLPs and can fuel growth in future distributions. We expect MLPs to grow their distributions by approximately 7% in 2014 and by 5% per annum over the next 10 years.

Portfolio Diversification: MLPs have a relatively low correlation to the growth in the broader domestic economy. The build out in energy infrastructure will likely continue except in the most extreme of economic scenarios. Historically, MLP investors have benefited from low correlations to traditional asset classes such as equities, fixed income, and commodities.

Tax Advantages: MLPs traditionally have high levels of depreciation which serves to reduce taxable income. MLPs have the additional benefit of being pass-through vehicles from a tax perspective. Investors tend to face a lower overall current tax burden when investing in energy infrastructure compared to traditional asset classes.

MLPs have generated strong returns for investors for the 10-year period ended December 31, 2013. The annualized return for MLPs, including distributions, was 15.0% as measured by the Alerian MLP Index. This compares to 7.4 % for the S&P 500 Index and 4.6% for the Barclays Capital U.S. Aggregate Bond Index.

We believe that strong domestic energy infrastructure fundamentals position MLPs to deliver 6% to 10% total returns over the next 10 years. Importantly, much of this return will be in the form of quarterly distributions. We expect these distributions to grow steadily, enhancing the total return potential.

As in the past we expect these returns to be accompanied by occasional volatility. Historically, rising interest rates and equity market disturbances have hurt MLP performance over short periods of time. We expect that investors who hold MLPs through the next decade will be rewarded with a total return that compares favorably to many traditional asset classes.

U.S. Energy Production Growth

The shale revolution has positioned North America to reach energy independence by 2020, thereafter becoming a net energy exporter. This is an extraordinary turn of events for the United States, a country that suffered from steadily declining oil and gas production during the 1980s and 1990s.

A turning point occurred when the first hydraulically fractured, horizontal well was drilled in Texas’ Barnett Shale in 2002. The event marked the combination of two drilling techniques that led to a remarkable increase in domestic production. Recently updated projections by the U.S. Energy Information Administration estimate that the growth rate of U.S. oil and gas production will double from 1.1% to 2.2% per year from 2012 through 2025.

The Need for Midstream Energy Infrastructure

Rapidly growing U.S. oil and gas production has put a significant strain on the existing U.S. midstream infrastructure complex. There is a need for new infrastructure to get the hydrocarbon products processed and delivered to end users.

According to a mid-2011 report issued by the Interstate Natural Gas Association of America, the natural gas, natural gas liquid and oil midstream sectors will require total capital spending of $10 billion per year through 2035 to accommodate the increasing supply and demand.

Investing in MLPs & Energy Infrastructure

MLPs are an increasingly popular and visible investment class given their strong historical returns. An example of this popularity is the growth of exchange traded funds and notes offering MLP exposure. These index-based products raised nearly $5 billion in 2013, remarkable for a set of products that are less than five years old.

While we understand the appeal and convenience of MLP-dedicated funds, we recommend that investors carefully examine all of the MLP-related investment opportunities to determine the best fit with their needs.

For investors seeking dedicated exposure to MLPs, we believe that actively managed separate accounts are the preferred investment approach. We believe that for taxable investors separate accounts are also optimal for managing tax. A long-only, low turnover separately managed account strategy should allow for optimizing the long-term, after-tax return.

Annual tax-related reporting should also be a significant consideration for MLP investors. Owners of MLPs will receive a K-1 each year for every holding. A K-1 is a tax document used to report a partner's income, losses and dividends.

If avoiding K-1s and other tax complexities is a priority, then consider a fund approach that offers convenient 1099-based tax reporting. An MLP- dedicated closed-end fund can have attractive characteristics for smaller or tax-exempt investors seeking an MLP-dedicated approach.

Our team's view is that fund investors may be well served by considering an opportunistic investment approach that focuses on owning the best energy infrastructure. We suggest a portfolio that includes the securities of MLPs and the affiliated corporations that serve as the owners of MLPs.

We anticipate that this opportunistic approach will generate total returns over the next 10 years that are similar to the returns of an MLP-dedicated approach but with the benefit of significantly lower volatility along the way. This approach can be implemented via a separately managed account or an open-end mutual fund.

Active management is also increasingly important as today there are over 100 MLPs with varying levels of risk and expected return. This represents a three-fold increase over the past decade. A long-term differentiator for our approach and a great active management opportunity is investing in smaller MLPs that we believe offer strong investment merits and are underrepresented in the large cap dominated MLP indices.

Focus on Quality

MLPs are not all created equal. There is a perception that all MLPs are midstream companies engaged in the transportation of energy products for a fixed fee. It is expected that these midstream MLPs will pass through steadily growing quarterly distributions to investors.

In reality, there are a wide range of MLPs that cover the risk spectrum. An example of a higher risk MLP may be one that owns a single refinery. An example of a lower risk MLP may be one that owns a broad suite of fee-based midstream assets located across the country.

2013 will be recorded as the year when a core historical principle of MLPs was set aside. Since the late 1980s, MLPs were brought to market with the stated intent of providing steady, and typically growing, distributions to investors. This market standard was disregarded beginning in 2011 with the advent of the variable rate MLP.

Variable rate MLPs promise that their distributions to investors will vary up and down with their cash flow. Many of these variable rate MLPs are in businesses, such as refining, that have historically been very volatile. We expect that many investors, long accustomed to the steadily growing nature of MLP distributions, will be caught off guard when the distributions of variable rate MLPs are eventually cut.

Our team has a rigorous and time tested approach to assessing quality. It is a true differentiator and a driver of our investment returns. We assess the quality of nearly 100 MLPs based on their assets, management teams, financial strength, diversification and parent affiliations.

The results of this work are compelling historically. The lowest quality MLPs (below the 20th percentile) generated returns of 7.5% over the three-year period ended December 31, 2013. This compares to 15.0% for the Alerian MLP Index over the same period. Quality matters, and an active process to avoid higher risk MLPs is key to performance.

Concerns

Many investors are concerned about the possibility of rising interest rates in the U.S. In this environment, it would be expected that securities with characteristics similar to bonds would be exposed to lower prices.

We believe that growth will be a key factor to strong investment performance in a rising interest rate environment and that securities without growth, such as many fixed income securities, will be challenged to provide reasonable returns to investors. The strong growth story behind energy infrastructure, should serve to support MLP prices in a rising interest rate environment in comparison to prices of lower growth securities.

There is also investor concern around the tax treatment and regulatory environment for energy infrastructure assets. MLPs, in particular, benefit from favorable tax treatment. We believe that the MLP tax advantage is supported politically by the strong case MLPs can make in regards to their importance to the United States’ economic well-being and geopolitical strength.

Recent legislation actually contemplates expanding the MLP advantage to renewable sources of energy, which would make the MLP structure a market-based energy policy for the U.S. The regulatory environment, particularly as it relates to fracking, will continue to be a challenge for both regulators and producers over the coming years. We expect a pragmatic policy to develop that allows the U.S. to take advantage of its resources while assuring the citizens that appropriate care is being exercised.

A last concern we hear frequently is about valuation. MLP performance for the last decade has been strong. While we do not expect similar returns in the future, we do believe that MLPs are attractively valued in comparison to other higher yielding securities. We expect a total return of 6% to 10% per annum in the future, driven by a high, sustainable current yield and growing distributions.

In our view, investors in MLPs over the next decade will be rewarded with yield and growth in a world starved for both.

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