You can't have corporate fraud without a corporation

Every company you can invest in has to be a corporation by definition, right? The corner barbershop that operates as a sole proprietorship can’t trade publicly, nor can any partnership.

Not quite. One of the least publicized securities available to you, the private investor, is the master limited partnership. People buy these when they want income, rather than capital gains. And despite their obscurity, MLPs are easy to buy.

You already know what a partnership is – multiple people create a business; and for tax, credit and legal purposes, those people are the business. They have no protection against being sued for more than the business is worth, which is why most entrepreneurs will forgo a partnership to create a limited liability company or corporation. Long story short, the tax rate is more favorable. If you want the details, read Chapter X in “the best personal finance book ever written” (Len Penzo.)

The general form of a partnership is called, somewhat anticlimactically, a general partnership. In its variant, a limited partnership, some of the partners aren’t liable beyond what they’ve invested. For these limited partners, the partnership works like a corporation in this respect. The remaining partners, the general partners, are on the hook for everything. If you’re wondering what the advantage is to being a general partner, well, someone has to be. And the general partner(s) are the only ones who receive dividends. The limited partners enjoy a proportionate share of profits, or losses, but that’s it. As you can imagine, the general partners have enormous incentive for the company to do well. If it does, the general partners enjoy bigger dividends.

Master limited partnerships trade publicly. The limited partners again receive a share of the profits, while the general partner manages the MLP and gets paid contingent on how well it does. Managers form an MLP when they want to avoid the scourge of double taxation, which plagues standard corporations (a/k/a C corporations, as opposed to the S corporations that small businesses operate as.) Major corporations’ profits are taxed first when the corporations calculate their earnings. When the corporations pay dividends out to the shareholders, the shareholders also pay income tax on that.

There’s more to it, though. Not every limited partnership can qualify to be a master limited partnership. At least 90% of an MLP’s cash flow has to come from commodities, natural resources, or real estate. In practice, almost all MLPs are in the energy business.

MLPs offer “units” that pay out quarterly “distributions”, rather than “shares” that pay out quarterly “dividends”, a distinction largely without a difference as far as we’re concerned. Sell your units, regardless of how much the MLP appreciated while you owned it, and the IRS will charge you at standard income tax rates, rather than capital gains tax rates. Should the MLP depreciate while you own it, that’s what’s called a “passive loss”. If the MLP eventually appreciates, you can use the losses to offset the gains for tax purposes.

Enterprise Products Partners is the biggest MLP in existence. They transport natural gas and oil through 50,000 miles’ worth of pipelines. They also gather, process, ship and store it. The company is a giant, with $32 billion in revenue during its last fiscal year (comparable to Aetna) and shareholders’ (check that, unitholders’) equity totaling $11 billion, which is larger than that of M&T Bank. Enterprise Products Partners trades on the New York Stock Exchange, under the symbol EPD. Management owns 39% of the units, the remainder available to the public.

Let’s look at one of EPD’s biggest competitors, both to illustrate the similarities and to explain the subtle differences.  (And to show you how serious the general partners are about enriching themselves in concert with the company, rather than in spite of it.) Kinder Morgan Energy Partners (NYSE: KMP) also deals in stuff extracted from the earth, and clearly owes AC/DC a royalty whenever they produce something with the company logo on it:

To the casual observer, Kinder Morgan’s business is almost identical to Enterprise Products’. The former transports refined petroleum and natural gas, operates terminals, and also transports carbon dioxide. According to the company’s website, its namesake and CEO Richard Kinder draws a $1 salary and doesn’t receive stock options.

Ha! It seems they just wanted to see if we were paying attention. Of course he doesn’t receive stock options, there’s no stock. Only units. KMP also goes to the trouble of telling us that they don’t screw around with “unnecessary overhead…such as corporate aircraft, sponsorships, sports tickets…” And “we cap senior executives’ base salaries far below industry standards. (The executives’ bonuses) are tied directly to the performance of the company.”

Wow. Is it too late for Richard Kinder to run for president?

KMP’s equity stands at around $7 billion, its revenues $8 billion. And these two are just the tip of the industry. A disproportionate number of the players are situated in Texas, specifically Houston, for reasons that are hopefully obvious.

Like anything else that can be securitized, master limited partnerships can be packaged into mutual funds, too. One of the biggest is the ClearBridge Energy MLP Fund (NYSE: CEM). ClearBridge Advisors is a subsidiary of Legg Mason, one of the biggest mutual fund companies in existence. Another MLP Fund is SteelPath MLP Income Fund (NASDAQ: MLPDX), founded 2 years ago. CEM’s biggest component comprises less than 10% of the fund, MLPDX’s biggest barely 6%. MLP funds typically hold fewer components than do your standard mutual funds, largely because there are so few MLPs for the funds to be comprised of in the first place.

Master limited partnerships are attractive to many investors because the managers clearly have skin in the game. Managers are less inclined to jump ship, too: when you’re running a successful MLP, why would you want to leave? From our perspective, there’s plenty of reason to look at MLPs (and their funds) over more notorious securities. We don’t expect you to sit through consecutive posts about MLPs, so we’ll do something wildly different Friday and then hit this topic in detail a week from today. And, as always, look for value that most people can’t bother to find. ‘Til then, class dismissed.

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