Kevin McCarthy: Closed-End MLPs Offer Simplified Tax
Source: JT Long of
In the past several years, MLP returns have exceeded S&P
500 performance. Kevin McCarthy, chairman and CEO of Kayne
Anderson's four closed-end funds, says MLPs are attractive to
investors who seek income and total returns. Although 2011
performance has lagged due, in part, to concerns about possible
MLP-taxation changes, Kevin explains why a widespread change in
the taxability of pass-through entities is highly unlikely in
this exclusive interview with
The Energy Report.
Alerian MLP Index
James River Coal Co.
Kayne Anderson Energy Development Co.
Kayne Anderson Energy Total Return Fund
Kayne Anderson Midstream Energy
Kayne Anderson MLP Investment Company
Massey Energy Company
The Energy Report:
Master limited partnerships (MLPs) have been around for decades.
Your first fund, the Kayne Anderson MLP Investment Company,
commenced operations in 2004. Why has there been so much more
interest in the last five years, particularly in energy-related
I'd like to address this question in two parts: First, why there
has been so much interest in MLPs in general and second, why
there has been so much interest in our closed-end funds.
- Reasons for investor interest in MLPs
MLPs are attractive to investors who seek income and total
returns (price appreciation plus distributions). In the past
several calendar years, the total return of the
Alerian MLP Index (NYSE:AMZ)
has exceeded the total return from the Standard and Poor's 500
Index (S&P 500), as shown in the following table. The
outperformance is especially striking for the years since the
2008 financial crisis.
Many retirees invest in MLPs because their yields are
significantly higher than those of other income-producing
investments, such as Treasuries, municipal bonds, CDs, utilities,
real estate investment trusts (REITs) and other fixed-income
securities. The current yield for the Alerian MLP index is
approximately 6.5%. However, because of the high returns that
MLPs have historically generated, MLPs are of interest to all
types of investors.
Distributions from MLPs are generally tax-advantaged. Generally,
between 80% and 90% of an MLP's cash distributions are treated as
"return of capital," for tax purposes, thus reducing an
investor's cost basis in the investment and, in very simplistic
terms, the taxes on return of capital are generally deferred
until the investor sells the investment. We encourage investors
to consult their tax advisors before making an investment in the
MLP asset class.
Lower commodity price sensitivity compared to other energy
The energy industry is often thought to consist of three general
functions: 1) Upstream; 2) Midstream; and 3) Downstream. In very
general terms, "upstream" refers to the exploration and
production (e.g., drilling) for oil and natural gas; "midstream"
refers to infrastructure, such as pipelines, processing plants
and storage facilities; and "downstream" refers to the refining
and distribution of energy commodities to industrial, commercial
or residential customers. Most MLPs are found in the midstream.
While there are differences from MLP to MLP, it would be fair to
say that midstream MLPs are substantially less sensitive to
commodity prices than exploring and producing (E&P)
Attractive characteristics of midstream energy assets.
Midstream assets are strategically important because they provide
the backbone of our nation's energy infrastructure. Typically,
they have high barriers to entry-permitting costs and
environmental review make certain assets irreplaceable. Many MLPs
have substantial fee-based revenues that have limited exposure to
changes in commodity prices. This enables them to generate
significant free cash flow in a variety of market conditions and
allows them to pay out cash distributions to their investors
- Reasons for investor interest in Kayne Anderson's
Our closed-end funds simplify the tax aspects of owning
Investors receive a
instead of a
. This allows our investors to avoid the headache of possibly
having to file state income tax returns in each state wherein an
MLP operates. For the larger MLPs, this could be dozens of
Our closed-end funds are suitable for IRAs and other
Unrelated Business Taxable Income (UBTI)
. If UBTI rises beyond a certain threshold in an IRA, the IRA
becomes liable for income taxes. Our closed-end funds do not
generate UBTI, so they are suitable for IRAs and other tax-exempt
By purchasing one share of one of our closed-end funds, an
investor gets exposure to a diversified portfolio of MLPs and
other energy investments.
Kayne Anderson is the largest institutional investor in the MLP
space, with a track record going back to 1989. Many of our
investment professionals have spent their entire careers in
Are the benefits of the pass-through tax structure and liquidity
enough to compete with other investment options if returns are
lower than the S&P 500?
As noted earlier, MLPs outperformed the S&P 500 consistently
on a total-return basis between 2005 and 2010. In 2011 year to
date, MLPs have underperformed the S&P 500 due, in part, to
concerns about possible changes in MLP taxation. There has been
recent discussion on Capitol Hill regarding a proposal to
re-examine the taxability of pass-through entities across all
sectors, including private businesses, law firms and publicly
traded partnerships like MLPs. We have been advised by experts in
Washington that a widespread change in the taxability of
pass-through entities is highly unlikely.
We also believe Congress recognizes that MLPs have been very
successful in building new infrastructure to transport, process
and store energy commodities. This infrastructure represents a
highly reliable system of delivering energy to consumers, and it
has created a substantial number of jobs. Any changes to MLPs'
tax status could negatively impact MLPs' ability to continue the
infrastructure buildout needed to support the unconventional
resources that are making our country more energy
You reported in the Q111 earnings call that overall MLP return
for the quarter was 8.5% and the
Kayne Anderson Energy Development Co. (
fund total return for that quarter was 13.8%. Is that a
sustainable level of return?
We were pleased that some of the public MLPs in KED's portfolio
performed very well, but I think it's safe to say that no one can
guarantee returns that outperform the market by 60% on a
What role do energy prices play in MLP success?
Energy prices can play a role in the performance of MLPs. One
sector of the MLP space that performed especially well in 2010
was the gathering and processing MLPs, which have the highest
commodity-price sensitivity among MLPs. Natural gas gatherers and
processors performed well for two reasons: 1) They benefited from
high oil prices, which lead to high natural gas liquids (NGL)
prices and from low natural gas prices (natural gas is an expense
item for a processing company); and 2) Gathering and processing
companies benefited disproportionately from the infrastructure
buildout that was occurring in the emerging unconventional
Fundamentals for gathering and processing MLPs remained strong
in 2011 as NGL supplies have not kept pace with NGL demand
-especially ethane-from petrochemical companies. Based on the
significant cost advantage of NGL compared to other crude-based
feedstocks, there have been multiple announcements of new
petrochemical facilities that will serve to further increase NGL
Has distribution growth benefited from some of the merger and
acquisition (M&A) activity that has been occurring in the
sector? Your own IRP was sold to
James River Coal Co. (
for $475 million. How did that come about?
Yes, MLP distribution growth has benefited from M&A activity.
We believe distribution growth will be driven by two things: 1)
organic growth projects; and 2) acquisitions. The development of
our nation's unconventional reserves will provide substantial
growth opportunities for MLPs. MLPs' capital spending for
acquisitions and expansions in 2010 was over $40 billion-the
highest total we've seen since 2007 and more than double the
level in 2009-and we expect that trend to continue in the near
term. We believe acquisition prospects for MLPs remain good, but
we are carefully watching the prices being paid by MLPs (and the
resulting acquisition multiples). While recent transactions have
been accretive, the acquisition multiples have increased
substantially over the last 12-18 months.
We were very happy about the sale of IRP, a privately held
coal MLP in KED's portfolio. The coal market performed very well
last year. Strong demand in China, Japan and India, as well as
higher utilization rates at domestic steel plants, caused prices
for metallurgical coal (also known as "met coal") to surge during
the year. The widely followed international benchmark price
increased from $129 per metric ton in 2009 to $209 per metric ton
for the fourth quarter of 2010. The spot market for met coal has
been even more volatile over the last 12 months. Spot prices were
more than $250/metric ton after the tragic explosion at
Massey Energy Company's (NYSE:MEE)
Upper Big Branch mine in April 2010 and recently spiked above
$300/metric ton in response to the devastating flooding in the
major producing region of Queensland, Australia.
Are some funds doing better than others?
One of the measures we employ to evaluate our performance is net
asset value (NAV) return, which is equal to the change in NAV per
share, plus the cash distributions paid during the period
(assuming reinvestment through our dividend reinvestment
Kayne Anderson MLP Investment Company (
, our NAV return was 43.2% for fiscal year 2010, which ended on
November 30, 2010. This put us at the "top of the class" compared
to other MLP closed-end funds. During the same period, the
Alerian MLP Index had a total return of 42.4%. Given our
structure as a taxable entity, we are very pleased to have
exceeded the performance of the Alerian MLP Index, which is an
index that does not factor in expenses or corporate taxes.
Kayne Anderson Energy Total Return Fund (
, our NAV return was 43.6% for fiscal 2010. As with KYN, this put
KYE at the top of the class compared to other MLP-focused,
At Kayne Anderson Energy Development, our NAV return was 34.3%
for fiscal 2010. Our newest fund,
Kayne Anderson Midstream Energy (
, was not in operation for the full fiscal year, but we're very
proud of the fact that we recovered the IPO discount within two
months of launching the fund.
You have four funds-the MLP Investment Company, Energy Total
Return Fund, Midstream Energy Fund and Energy Development
Company. What is the emphasis in each portfolio between upstream,
midstream, shipping, energy debt, private, coal, propane and
The investment objectives for the funds are described in their
prospectuses, and each one is designed to pursue a different
strategy for investing in MLPs and other energy investments.
Our largest fund, KYN, with $3.7B in total assets, focuses on
publicly traded MLPs. Roughly 70% of our portfolio is allocated
to midstream MLPs and the remainder is allocated to MLP
affiliates, general partners, gathering and processing MLPs,
shipping MLPs, propane MLPs, coal MLPs and upstream MLPs.
Our second-largest fund, KYE, with $1.5B in total assets, is
more diversified and focuses on six income-producing sectors: 1)
Publicly traded MLPs; 2) Debt securities issued by energy
companies; 3) U.S. and Canadian income trusts; 4) Marine
transportation companies; 5) Coal companies and 6) Midstream
Our newest fund, KMF, with $800M in total assets, focuses on
midstream companies (including C-corporations and MLPs) and debt
securities issued by energy companies.
Our fourth fund, KED, with $300M in assets, focuses on
privately held MLPs but it also invests in publicly traded MLPs
and debt securities issued by energy companies.
is chairman, president and CEO of Kayne Anderson's four
closed-end funds (KYN, KYE, KMF and KED). Prior to joining
Kayne Anderson in 2004, Mr. McCarthy was most recently global
head of energy at UBS Securities LLC. In this role, he had
senior responsibility for all of UBS' energy investment banking
activities, including direct responsibilities for securities
underwriting and mergers and acquisitions in the MLP industry.
From 1995 to 2000, Mr. McCarthy led the energy investment
banking activities of Dean Witter Reynolds and then PaineWebber
Inc. He began his investment banking career in 1984. In
addition to his directorships at KYN, KYE, KMF and KED, he is
also on the board of directors of Range Resources Corporation,
ProPetro Services, Inc., Direct Fuel Partners, L.P. and K-Sea
Transportation Partners LP. Mr. McCarthy earned a BA in
economics and geology from Amherst College in 1981 and an MBA
in finance from the Wharton School at the University of
Pennsylvania in 1984.
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1) JT Long of
The Energy Report
conducted this interview. She personally and/or her family owns
shares of the following companies mentioned in this interview:
2) The following companies mentioned in the interview are
The Energy Report:
3) Kevin McCarthy: I personally and/or my family own shares of
the following companies mentioned in this interview: KYN, KED and
KMF. I personally and/or my family am paid by the following
companies mentioned in this interview: KYN, KED and KMF.
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