Kevin McCarthy: Closed-End MLPs Offer Simplified Tax Filing

Kevin McCarthy: Closed-End MLPs Offer Simplified Tax Filing

Source: JT Long of The Energy Report (5/24/11)

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.

Companies Mentioned : Alerian MLP IndexJames River Coal Co.Kayne Anderson Energy Development Co.Kayne Anderson Energy Total Return FundKayne Anderson Midstream EnergyKayne Anderson MLP Investment CompanyMassey 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 MLPs?

Kevin McCarthy: 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

Total return. 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.

Yield. 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.

Tax advantages. 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 investments. 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) companies.

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 consistently.

  • Reasons for investor interest in Kayne Anderson's closed-end funds

Our closed-end funds simplify the tax aspects of owning MLPs. Investors receive a Form 1099-DIV instead of a Schedule K-1 . 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 states.

Our closed-end funds are suitable for IRAs and other tax-exempt accounts. MLPs generate 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 accounts.

Diversification. 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.

Professional management. 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 MLPs.

TER: 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?

KM: 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 independent.

TER: You reported in the Q111 earnings call that overall MLP return for the quarter was 8.5% and the Kayne Anderson Energy Development Co. ( KED ) fund total return for that quarter was 13.8%. Is that a sustainable level of return?

KM: 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 long-term basis.

TER: What role do energy prices play in MLP success?

KM: 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 plays.

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 demand.

TER: 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. ( JRCC ) for $475 million. How did that come about?

KM: 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.

TER: Are some funds doing better than others?

KM: 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 program).

At Kayne Anderson MLP Investment Company ( KYN ) , 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.

At Kayne Anderson Energy Total Return Fund ( KYE ) , 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, closed-end funds.

At Kayne Anderson Energy Development, our NAV return was 34.3% for fiscal 2010. Our newest fund, Kayne Anderson Midstream Energy ( KMF ) , 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.

TER: 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 other investments?

KM: 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 companies.

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.

Kevin McCarthy 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: None.

2) The following companies mentioned in the interview are sponsors of The Energy Report: None.

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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