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Understanding Master Limited Partnerships

BY DAVID SKIPPER CEO, ASSURANCE CAPITAL MANAGEMENT LLC

Understanding Master Limited Partnerships

If you are affluent and purchase investments through a full service broker, then you have most likely been solicited to purchase the debt and equity securities of Master Limited Partnerships. Master Limited Partnership or MLP’s are very popular investments today. MLP’s are popular because they can offer significant yields and tax deferral opportunities to investors. However, MLP’s are not very well understood by individual investors and can carry additional risks.

MLP’s are in the business of exploring for, developing, mining, producing, processing, refining, and transporting minerals and natural resources. Therefore, an investment in a MLP is most likely an investment in the energy industry. Today there are over 100 publicly traded MLP’s. The largest share of MLP’s are in the midstream business of the energy industry. The midstream business is where pipeline companies ship oil and gas from the field where it is produced to the residential or industrial consumer. The midstream business is favorable to MLP’s due to the fact that it generally produces a steady stream of income that the partnership can distribute to its unit holders. Other MLP categories include Exploration & Production, Refining, Marine Transportation, and Coal. A key distinction in terminology between corporations and partnerships is that corporations pay dividends and partnerships pay distributions. Another key distinction in terminology is that investors own shares in a corporation and units in a partnership.

Additionally, MLP’s are publicly traded limited partnerships. Limited partnership are structured so that limited partners, usually outside investors, put in the majority of the capital while the general partner manages the operations and investments of the partnership The general partner usually contributes a limited amount of the capital to the partnership and receives compensation for managing the partnership. Usually the general partner maintains managerial control of the partnership and the limited partners have very little input into the dayto- day operations of the partnership. A similar structure would be a doctor starting and managing a new practice by purchasing equipment and supplies with money from investors while he or she maintains control of the practice. The doctor would be compensated out of the income of the practice and control the practice; however, the investors would own a portion of the practice and therefore be entitled to a portion of the practice’s profits.

In general Master Limited Partnerships fund themselves differently than regular corporations. For the most part, corporations in the United States are able to fund their expansion out of internally generated cash flow. In other words, the amount of cash that the business generates is reinvested into new equipment and facilities to expand the company. However, MLP’s operate differently. Because distributions are valued so highly by MLP investors, MLP’s distribute as much cash as they can to their owners. Therefore, most of the cash that is generated by the partnership is distributed to the unit holders. Any funds needed for additional expansion are borrowed or the partnership sells additional units to the public. Borrowing is usually the first option. This means that MLP’s usually have more debt and are less financially secure than comparable corporations. The manner in which MLP’s fund themselves is usually safe during a rising market; however, during a bear market their funding can be problematic. Their high debt loads can make solvency a concern and they often need to reduce their distributions to unit holders during a recession.

Due to their funding mechanisms MLP’s can carry additional risks; therefore, it is important to assess these risks before purchasing their equity or debt. Master Limited Partnerships are most appropriate for sophisticated investors who are willing to spend the time and effort to understand their investment or are willing to pay adviser to manage their investments for them.