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

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.