What Are Master Limited Partnerships, and When Are They Helpful?
After their initial launch in 1981, Master Limited Partnerships ("MLPs") have experienced significant growth as a tax-efficient legal entity structure for natural-resource and related extractive industries. Despite falling out of favor as an investment vehicle in the late 1980s because of more restrictive federal legislation, MLPs have found increased popularity in recent years, due in part to current low interest rates relative to historical levels. During recent months, greater stability in crude oil prices has increased expectations for strong performance from this asset class during 2017.
Ownership in MLPs offers individual investors an attractive yield relative to investment-grade debt, along with the potential for capital gains. What does that mean for the market? As of June 2016, there were 127 non-financial MLPs traded on U.S. exchanges, representing total market capitalization of approximately $450 billion. In conjunction with this resurgence of interest in recent years, unique valuation concerns have arisen for stakeholders to consider.
What are MLPs?
Simply defined, an MLP is a partnership that's publicly traded and listed on a national securities exchange. This structure often includes energy and similar natural-resource operations. Ownership is typically split between the founder (also called the "sponsor" - the individual or organization responsible for forming and operating the MLP) and the public. Generally, the sponsor forms an MLP to take advantage of favorable federal tax treatment for qualifying assets. Owners are typically referred to as unitholders.
Typically, the sponsor will retain 100 percent of the general partner ("GP") interest, often equal to 2 percent of the MLP, and the limited-partner ("LP") interest that's not sold to the public. The LP percentage that the sponsor keeps often depends on the size of the offering sold to the public and the MLP's optimal capital structure.
An MLP setup offers unique tax benefits. A business operating under this type of structure eliminates federal taxation at the legal-entity level, thus avoiding the double taxation resident within a "C" corporation ownership structure. As a result of not paying US federal income taxes, an MLP is generally able to distribute significantly more cash to investors than an identical entity operating as a “C” corporation. Only unitholders are subject to income taxes for their corresponding percentage of ownership in income and expenses. All income and deductible expenses pass through the MLP to the unitholders via a K-1, a federal income tax form used to report partnership income and expenses. Given their differing tax characteristics, individual - rather than institutional - investors typically invest in MLP interests.
As an investment vehicle, MLPs offer a combination of current income and an opportunity for growth. From their inception, they typically establish a minimum quarterly distribution amount they seek to pay, with GPs incentivized to increase distributions payable to unitholders over time. These quarterly minimum distributions commonly target 100 percent of the MLP's cash flow. Given the stability of certain MLP operations, forecasting future cash flows can represent a fairly straightforward exercise. As a result, yields on these investments routinely exceed investment-grade debt or similar income-generating investments in today's interest-rate environment.
From the '80s to today: what's changed?
Shortly after Congress made it legal to form these master limited partnerships, the tax code made no restrictions about which businesses MLPs could operate and manage. Accordingly, between the first MLP initial public offerings (IPOs) in 1981 and 1987, more than 100 MLPs issued IPOs in industries such as motels, restaurants, real estate, cable television and amusement parks.
Fearing the loss of income from corporate taxation, Congress enacted section 7704 of the Internal Revenue Code in 1987, requiring that at least 90 percent of an MLP's gross income during each taxable year represent qualifying income. Under this code, qualifying income includes income and gains from exploration, development, and production; mining; gathering and processing; refining; compression; transportation; or marketing of any mineral or natural resource, as well as certain passive income from these activities (e.g., interest, dividends and real property rents). Should they fail to satisfy the qualifying income test in any taxable year, MLPs will qualify as corporations for federal income tax purposes. As a result of this legislation, and its negative impact on the tax advantages of some MLPs, MLPs fell out of favor as an ownership structure for a number of years.
Restrictions aside, the MLP structure can be used for a variety of businesses. Concerning minerals or natural resources, qualifying industries can include fertilizer, geothermal energy, timber, oil, gas, oil-and-gas related products, coal, lignite, potash, salt, aggregates, limestone, sand and many other hard rock minerals. In 1988, Congress excluded certain industries, such as soil, sod, turf, water, mosses, minerals from seawater, air and other similar, inexhaustible sources.
Recent legislation has sought to add more qualifying industries. Congress expanded the definition of qualifying income for MLPs in 2008 to include assets related to the storage and transportation of biofuels, biodiesel, ethanol, methanol, liquefied petroleum gas and industrial-sourced carbon dioxide. Legislation proposed in April 2013, known as the Master Limited Partnership Parity Act, seeks to expand the industries eligible for MLP formation to include various clean-energy technologies, such as renewable energy and electricity storage. However, this proposed legislation remains in committee, and at this point is unlikely to pass committee and come up for vote.
When is MLP valuation important?
Valuation issues are relevant at various points in MLP management. In particular, valuation issues arise during initial asset contribution and subsequent drop downs (the sale/transfer of assets from a sponsor to an MLP). Fairness opinions or the determination of the fair market value of assets contributed by the sponsor are often required/desired. A drop down is an asset sale or transfer from a sponsor to an MLP. The additional cash flow generating capacity resulting from a drop down enables the MLP to expand distributable cash flow during subsequent periods.
Given its nature as a related party transaction between the sponsor and the MLP, the sponsor's board of directors and/or lender may require a fairness opinion regarding the transaction. Most commonly rendered by a financial advisor, which often includes an independent valuation firm, a fairness opinion offers assurance about whether the terms of a proposed transaction are financially fair. Fairness opinions serve to justify the decision-making process of directors and encourage unitholders to approve the terms of a transaction without resorting to litigation.
The fair market value of tangible or intangible assets included within a sponsor drop down into an MLP ultimately serves as a tax shield to the unitholders when these assets are depreciated or amortized for income tax purposes. An independent valuation firm develops an opinion of the fair market value of both the tangible and intangible assets of the dropped-down operations. As MLP assets operate within the context of a business enterprise, the earnings capacity must be evaluated to ensure the assets within the business earn an adequate rate of return.
Within the context of the Internal Revenue Code, fair market value is defined within Treasury Regulation §1.170A-1(c)(2) as: "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts."
MLPs offer a tax-efficient ownership structure to select entities generating income from natural resource or mining activities, avoiding the burden of double taxation and often providing a vehicle for attractive yields relative to alternative investment opportunities.
Gordon Brothers offers unparalleled experience and insight into the issues associated with MLP formation and valuation of the underlying assets of MLPs and MLP units themselves. Gordon Brothers can work with sponsors, LPs and their advisors to ensure a smooth drop down of assets into an MLP ownership structure. Gordon Brothers can provide fairness opinions and formal appraisals to support MLP transactions. Call us when you want guidance specific to your needs.