If you want to sell an income-driven deal to retail investors, make sure to pay what looks like a big income yield. Chances are, it won’t matter too much if the investment isn’t very good and turns out to lose money, so long as purveyors can quote a big income yield, (i.e. 7% or more) as the public will likely rush to buy it no matter what it is. There are many types of income paying assets investors can buy, some of them better than others, but among the most dangerous and junky of all high yielding income investments are Master Limited Partnerships or MLPs.
Exactly what is an MLP? Most owners of MLPs could not properly explain them to you, but are often quick to boast about the big income yield they are getting and how their income is “tax free”.
An MLP is a publicly traded interest in a partnership consisting of a General Partner, (usually the issuer, a corporate entity looking to sell depleting assets at a high price) and “Limited Partners”, the shareholders, who are usually retail investors. MLPs are considered “pass through” entities for tax purposes, so their payouts are not taxed in the same way as dividend or interest income. Instead, income payments are applied to lower the cost basis of each unit. In this way MLPs are not “tax free”, but are taxed more like capital gains. But since most MLPs lose money for shareholders, capital gains taxes are usually not an issue.
Under prevailing IRS code, in order to qualify as a “pass-through” for tax purposes, MLPs must derive at least 90% of their income from “qualifying sources” generated by depleatable natural resources, such as petroleum or natural gas. That key word “depleatable” is one that investors too often overlook.
MLPs usually have two classes of ownership, one for the General Partner and one for the shareholders. The General Partner class has all the voting power and makes all decisions, and has no fiduciary duty to shareholders. Investors hold a subordinated, temporary and diminishing interest in some sort of mineral or gaseous resource, or a pipeline interest, or maybe something else, receiving an income stream derived from normal commercial operations. In addition to a preferred interest in the depleting asset pool, the General Partner also receives a generous management fee from limited partners, which can sometimes be quite high. In addition, MLPs generate pesky K-1 tax forms instead of standard 1099 income reporting. These K-1s are often complicated, late in arriving, incorrect and routinely make your tax preparer very upset.
If that were not enough, the net investment results of MLPs can even be more negative. Take a look at the long term price charts of any number of MLPs and you notice an interesting similarity. Their long term price trajectory is usually downward. Which brings us back to the word “depleatable”. If you read the prospectus and other offering materials for MLPs, (almost no one does) they state that Limited Partner interest in the MLP underlying asset diminishes over time and then at some point expires. This means as time passes, shareholders own less and less of whatever it is the MLP is supposed to represent until in some cases, they own nothing at all. Therefore, it is natural for the share values to decline over time, but that is not the only reason MLPs usually lose value.
MLPs lose value because investors who hold them often panic when MLP share prices are under pressure, causing a steep and less than orderly decline that can reduce MLP values by 50% or more. This actually happened in the first quarter of 2016, when crude oil prices tumbled by more than 65% from their highs. MLP investors lost their shirts as share prices collapsed with petroleum quotes. As crude oil partially recovered in the months that followed, MLPs regained only a portion of their 2015 values, stranding investors with big losses. This was not an isolated one-time event. Truth is that MLPs have been making investor money disappear ever since their introduction back in 1981.
Since MLPs pay good income yields and offer what appear to be certain tax preferences, investors and their brokers routinely look past all the hazards of MLPs and grasp on to their big yields, as the income return is all they want to see.
There are other much better places in financial markets to derive income and total returns, but if you insist on whistling past the MLP graveyard, good luck, you’ll need it.