Sunday’s announcement that Kinder Morgan Energy (KMI) will be buying the Kinder spin-offs Kinder Morgan Energy Partners (KMP) and Kinder Morgan Management (KMR), plus El Paso Pipeline Partners (EPB) could be the beginning of the end for MLP-focused indexes. The consolidated Kinder company will be a C-corporation, abandoning the master limited partnership structure that Richard Kinder helped pioneer.
MLP indexes hold MLPs, not C-corps. The biggest indexer in the MLP space, Alerian, requires all its constituents to be publically traded partnerships or limited liability corporations, as do Solactive, S&P and Miller/Howard. Not so Cushing, which allows “common units of a limited liability company or C-corporation.” The Credit Suisse Cushing 30 MLP ETN (MLPN) won’t need to do a thing with the 10 percent of its constituents in the Kindersphere.
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The rest of the indexes, and the funds that track them, are most likely in for some reshuffling. This can bring tax consequences, and change the makeup of MLP indexes.
Kinder Morgan and the three target funds are in nearly every MLP index, sometimes comprising north of 13 percent of the fund. If MLP indexers like Alerian don’t change their rules, they’ll be either reweighting their remaining constituents, or admitting new ones as they adapt to the loss of the Kinder suite.
Alerian MLP (AMLP), the $8.86 billion MLP ETF, with 12.3 percent in the Kinder and EL Paso MLPs, stands to see more than $1 billion in portfolio turnover upon shareholder approval of the merger. In any rebalancing, turnover can produce capital gains, but MLPs will be hit especially hard, because of their tax structure.
The majority of MLP distributions are not taxed as ordinary income or even qualified dividends. They’re considered return of capital. Shareholders owe zero taxes on these. But here’s the catch:Returns of capital lower the security’s cost basis.
If AMLP must liquidate its positions in KMP and EPB, shareholders could face substantial capital gains taxes. The situation could be even worse in the actively managed First Trust North American Energy Infrastructure (EMLP), which currently has 13.15 percent of its portfolio in the Kinder quartet, and Global X MLP & Energy Infrastructure (MLPX), with 13.21 percent in the four securities as of Friday, Aug. 8.
For an in-depth explanation of MLP ETF and ETN taxation and distributions treatment, please see ETF.com’s Definitive Guide to MLP ETFs and ETNs.
MLP ETNs like the JPMorgan Alerian MLP ETN (AMJ) should dodge this bullet, because ETNs are debentures (bonds, effectively), not funds. ETNs hold no securities, and therefore “sell” nothing when indexes reconstitute.
After the tax hit, MLP investors will be left wondering, What’s next? MLP pioneer Richard Kinder renounced the MLP structure in favor of one positioned for “accretive investments in new energy infrastructure,” (Kinder Morgan press release Aug. 10, 2014). Kinder Morgan has announced a shopping spree in the MLP space.
MLPs saw immediate price boosts, as investors assess each MLP’s takeover prospects. MLP-tracking indexes will follow suit, short term. Longer term, MLP investors could see a bifurcation of the space, with growth-oriented firms bought out of the MLP structure, leaving Steady Eddie income generators to keep passing their profits to investors.
Take the what-ifs one step further, and imagine a world where yields matter less, or where MLPs lose their tax treatments. In this world, if firms follow Kinder Morgan’s new model and ditch the MLP structure, effectively trading tax-sheltered yields for growth, MLP ETFs and ETNs could be left hunting for constituents.
Even in a less drastic situation, MLPs could lose their luster if bond yields rise, and bonds once again compete for income-oriented investor dollars. As of Aug. 8, 2014, ETF.com counts 23 MLP-oriented ETFs and ETNs in the U.S. market, with more $20.5 billion in assets. Only one, AMJ, is more than five years old. Five have launched in the past year alone.
One has to wonder if today’s announcement will mark the beginning of the end for MLP ETFs and ETNs.
At the time this article was written, the author held no positions in the securities mentioned. Contact Elisabeth Kashner at firstname.lastname@example.org.