Important Information about Master Limited Partnerships (MLPs)

Transcription

1 Rbert W. Baird & C. Incrprated Imprtant Infrmatin abut Master Limited Partnerships (MLPs) Baird has prepared this dcument t help yu understand the characteristics and risks assciated with an investment in securities f a master limited partnership ( MLP ), s that yu can make an infrmed decisin when buying r selling these securities. MLPs are incme-generating investments that may ffer attractive yields and distributin grwth rates, but they are cmplex investments that have unique tax characteristics and significant risks. As a result, MLPs may nt be suitable fr all clients. Yur Baird Financial Advisr can further explain the features, characteristics and risks f any particular security under cnsideratin fr yur accunt. Yu shuld cnsult with a tax advisr befre investing in MLPs. Characteristics f MLPs An MLP is a frm f publicly traded partnership and taxed as a partnership. An MLP is generally structured as a limited partnership r limited liability cmpany and managed and perated by a general partner r manager. Sharehlders f an MLP are called limited partners r unit hlders. Unit hlders wn interests r units in the MLP ( units ) that are traded n a stck exchange. MLPs make distributins t unit hlders f their available cash flws. The general partner generally hlds a minrity stake in the MLP (ften 2%), makes management decisins and receives incentive distributin rights based n the MLP s payuts (entitling the general partner t a higher prprtin f distributins as certain target distributin levels are reached). The general partner r its affiliates may als wn units as well as subrdinated units in the MLP. Smetimes, the general partner s wn securities are exchange-traded as well. Unit hlders ften d nt have vting rights and are nt entitled t elect a bard f directrs. MLPs typically establish a minimum quarterly distributin amunt that they seek t pay, with the gal f increasing the distributins ver time because f the general partner s incentive distributin rights. As a partnership, an MLP des nt pay entity-level incme tax, therefre enabling it t distribute mre cash flw t the unit hlders. Hwever, in rder t avid entity-level incme tax, an MLP must earn at least 90% f its incme frm certain qualifying surces, which includes incme and gains frm certain activities invlving natural resurces such as il, natural gas, natural gas liquids, refined petrleum prducts, cal, carbn dixide and bifuels. Such activities include explratin, develpment and prductin; mining, gathering, pipelines and prcessing; refining; cmpressin; transprtatin; and strage, marketing and distributin (but nt retail sales). Qualifying surces may als include interest, dividends, real estate rents, incme frm the sale f real prperty, gain n the sale f assets, and incme and gains frm cmmdities r cmmdity futures. Mst MLPs are invlved in the energy markets, which 2015 Rbert W. Baird & C. Incrprated. Member FINRA & SIPC. Rbert W. Baird & C. 777 East Wiscnsin Avenue, Milwaukee, Wiscnsin RW-BAIRD. Page 1 f 8

2 Imprtant Infrmatin abut Master Limited Partnership (MLPs), cntinued. is the fcus f this dcument, althugh there are sme MLPs with peratins in the real estate and investment/financial sectrs. MLPs typically distribute all f their available cash flws, althugh the general partner has cnsiderable flexibility in determining an MLP s available cash flws, which may vary based n the amunts retained fr maintenance, perating and grwth expenditures. An MLP s incme, gains and lsses pass thrugh t the unit hlders, wh receive a Schedule K-1 each year. MLPs can pass thrugh their deductible depreciatin r depletin expenses, allwing them t distribute a tax-advantaged return f capital t investrs that defers taxatin until the units are sld. Distributins d nt crrespnd t the amunt f an MLP s net incme. At times, distributins t investrs may be less than the amunt f an MLP s net incme, althugh generally they significantly exceed the amunt f the MLP s net incme, which results in a prtin f such distributins being regarded as a return f capital rather than as a taxable dividend. Thus, a high percentage f an MLP s distributins may be regarded as a return f capital, with the balance representing taxable incme. The amunt f a distributin characterized as a return f capital lwers an investr s cst basis in the units, which will lead t a larger gain r lwer lss upn sale. Sme f the tax upn an investr s sale f units may be taxed at a capital gains rate. The amunt f the dwnward adjustment t an investr s cst basis resulting frm the investr s allcatin f depreciatin and depletin expenses is recaptured and taxed as rdinary incme. An investment in an MLP may nt be advisable in an IRA r ther tax-exempt r tax-deferred accunt because the tax benefits are better utilized in a taxable accunt and the IRA r ther tax-exempt r tax-deferred accunt may be subject t unrelated business incme tax n its prprtinate share f the MLP s incme. Alternatives t MLPs, such as clsed-end r exchange-traded funds, may be a better slutin fr such accunts. An MLP can be frmed in several ways. An existing nn-traded partnership may decide t g public, r several nn-traded partnerships may rll-up int a single MLP. A crpratin may spin ff a grup f its assets r part f its business t an MLP in which the crpratin retains an wnership interest. The term MLP als is cmmnly used when describing crpratins, clsed-end, exchange-traded and pen-end funds that invest in MLPs, exchange-traded ntes that track varius MLP-related indices and ther MLP lk-alike structures that perate in the energy and natural resurces sectr. Ryalty trusts are als a cmmn structure fr upstream energy cmpanies. See Alternatives t MLPs belw. Baird s Equity Research department maintains research cverage n numerus MLPs. Please cnsult with yur Baird Financial Advisr n whether Baird prvides research reprts n the MLPs in which yu prpse t invest and btain cpies f such reprts. Baird s Investment Banking department may als serve as underwriter n public fferings f MLP securities. Yur Baird Financial Advisr will receive a 2015 Rbert W. Baird & C. Incrprated. Member FINRA & SIPC. Rbert W. Baird & C. 777 East Wiscnsin Avenue, Milwaukee, Wiscnsin RW-BAIRD. Page 2 f 8

3 Imprtant Infrmatin abut Master Limited Partnership (MLPs), cntinued. selling cncessin n the sale t yu f MLP securities that Baird underwrites and thus have an incentive t ffer them t yu. Types f Energy MLPs Energy MLPs are cmmnly divided int three types: upstream, midstream and dwnstream. These types fllw the flw r cmmercial mvement f il, natural gas, natural gas liquids, refined petrleum, cal and ther energyrelated natural resurces frm prducing wells (upstream) thrugh strage and transprtatin (midstream) t endusers (dwnstream). Upstream cmpanies perate at r near the il and gas wellheads and fcus n explratin, drilling and prductin activities. Midstream cmpanies engage in gathering, prcessing, cmpressin, transprtatin and strage activities, mving the prduct frm upstream lcatins. Dwnstream cmpanies are invlved in refining, marketing and distributin activities. Sme energy MLPs prvide energy-shipping and marine transprt services r ffshre drilling services, as well as cmpanies engaged in energy-related activities invlving ther natural resurces r materials such as cal, prpane, liquefied natural gas, high purity sand used in the fractinatin prcess, and ther minerals. There are varius sub-sectrs in the upstream, midstream and dwnstream sectrs in which MLPs perate. The perfrmance, results and risks f MLPs within each sectr and sub-sectr can vary dramatically, and will differ by the cmmdity r natural resurce type, cash flw stability and ther factrs. Alternatives t MLPs Persns seeking expsure t MLPs may instead buy shares in funds that in turn invest in MLPs. These typically include clsed-end funds, but can als include pen-end funds (i.e., mutual funds) and exchange-traded funds ( MLP funds ). Clsed-end and exchange-traded funds ffer shares that are traded n an exchange. Their shares may trade at a discunt r premium frm their net asset value. Mutual funds d nt trade n an exchange but their shares are redeemable n a daily basis at net asset value. Funds that are regarded as regulated investment cmpanies (such as mutual funds) fr tax purpses may nly invest up t 25% f their assets in MLPs, thus nt maximizing the tax benefits f MLP wnership. Clsed-end and exchange-traded funds can elected t be treated as a crpratin fr tax purpses r may create subsidiary crpratins t invest in MLPs in rder t avid such limitatins. As taxable crpratins, these funds will pay crprate level taxes n their net incme, which reduces the amunt f distributins they can pay t sharehlders, but the sharehlders will nly be subject t ptential incme tax liability t the extent the funds pay distributins. In cntrast, a regulated investment cmpany is nt subject t entity-level tax s lng as it pays ut nearly all f its net incme and capital gains each year and meets ther cnditins. As is the case with distributins made by an MLP, a high percentage f the distributins made by an MLP fund is tax deferred and recaptured when the investment is sld, but with an MLP fund the investrs will pay tax at the capital gain rate when they sell their investment rather than at rdinary incme rates paid t recapture depreciatin in a direct MLP investment. MLP funds avid the tax and administrative burdens f direct MLP wnership. Investrs in MLP funds will nt receive cmplicated Schedules K-1; instead, they receive a Frm In additin, IRAs and ther tax-exempt r tax-deferred accunts d nt recgnize unrelated business incme tax n their investments in MLP funds. MLP funds are managed by prfessinal investment advisers registered with the SEC Rbert W. Baird & C. Incrprated. Member FINRA & SIPC. Rbert W. Baird & C. 777 East Wiscnsin Avenue, Milwaukee, Wiscnsin RW-BAIRD. Page 3 f 8

4 Imprtant Infrmatin abut Master Limited Partnership (MLPs), cntinued. MLP funds impse annual management and perating fees and expenses that d nt apply with a direct MLP investment. An investment in a MLP fund may ffer greater diversificatin thrugh wnership f units f multiple MLPs than a direct MLP investment, althugh MLP funds may be regarded as nn-diversified under the Investment Cmpany Act and are cncentrated by sectr r industry. MLP funds may als engage in leverage, which wuld add t the leverage embedded in the MLPs themselves, as well as hedging techniques such as ptins, futures, swaps and ther derivatives transactins. Energy cmpanies may als be structured as crpratins and issue shares f cmmn stck that are publicly traded. A crpratin is subject t crprate-level tax, s a prtin f its ptential distributable cash flw is taxed befre distributins are made t sharehlders. In additin, distributins are subject t an additinal incme tax at the sharehlder level. A crpratin may als pay ut a smaller prtin f its cash flw t sharehlders than an MLP and instead reinvest it in the business r finance an expansin prject. Sharehlders f an energy cmpany taxed as a crpratin will receive a Frm 1099 each year shwing their incme frm distributins rather than a mre cmplicated Schedule K-1 which unit hlders receive fr an investment in an MLP. U.S. ryalty trusts are a type f structure in which a cash flw stream frm a designated set f assets (such as il and gas reserves) is paid t sharehlders in the frm f cash dividends. They can set up as partnerships r grantr trusts. Ryalty trusts are nt actively managed entities. Their assets are perated by a separate entity, which is ften the spnsr (r creatr) f the trust. They d nt make acquisitins r increase their asset base. Ryalty trusts typically have n debt. Ryalty trusts are nt MLPs. Unit hlders are typically taxed n their pr rata share f the ryalty trust s incme and gains attributable t the assets f the trust and will be entitled t their pr rata share f the deductins and expenses attributable t the assets f the trust (subject t certain limitatins). Hwever, term interests r prductin payments in a ryalty trust may be treated as debt fr tax purpses and nt entitled t depletin deductins. With a ryalty trust, a spnsr cntributes t the trust ne r mre types f interests in prved undevelped reserves (PUDs) and/r prved develped reserves (PDPs). The types f interests include prductin payments, pure r verriding ryalty interests and net prfits interests. A prductin payment is a termlimited right t a specific share f the prductin; pure ryalty interests are interests in a percentage f the grss revenues frm the prductin; and net prfits interests are interests in a percentage f the net prfits f the prductin after deducting prductin csts. A ryalty trust may terminate n a specified date r cntinue until the trust assets are exhausted. A perpetual ryalty trust usually cntains a ryalty interest and/r a net prfits interest and nt a prductin payment. A term ryalty trust usually cntains a prductin payment. Cmmn ryalty trusts are drilling trusts (treated as partnerships) t which mst f the assets cntributed are interests in PUDs wning ryalty interests, and PDP trusts (treated as grantr trusts) wning net prfits interests. Understanding the risks The risks assciated with an investment in an MLP are imprtant cnsideratins in making a purchase decisin. The risks fr any particular MLP investment are generally cntained in the prspectus and/r in the MLP s infrmatin filings (such as annual reprts, quarterly reprts and current reprts that are filed with the Securities and 2015 Rbert W. Baird & C. Incrprated. Member FINRA & SIPC. Rbert W. Baird & C. 777 East Wiscnsin Avenue, Milwaukee, Wiscnsin RW-BAIRD. Page 4 f 8

5 Imprtant Infrmatin abut Master Limited Partnership (MLPs), cntinued. Exchange Cmmissin), which are publicly available at Please read the infrmatin carefully and cnsult with yur Baird Financial Advisr befre investing in MLPs. Cmmn risks assciated with an investment in an MLP include but are nt limited t the fllwing risks described belw: Market risk. An investment in an MLP is subject t risk that the price will fluctuate based n market, sectr, cmpany-specific and ther cnditins, events r develpments. At times, the market price f an MLP may be crrelated with the equities markets, but at ther times, it may nt be s crrelated. Cmmdity price risk. The value f an investment in an MLP and the amunt f distributins it makes may depend n the prices f the underlying cmmdity, such as il r natural gas. Many MLPs are sensitive t changes in the prevailing level f cmmdity prices. Macrecnmic risk. A general ecnmic dwnturn may negatively impact energy demand, trigger a reductin in explratin and prductin activity and adversely affect an MLP. Macrecnmic factrs may als cause a decline in the equities markets generally, including the prices f MLP units. Interest rate sensitivity risk. MLPs have shwn sensitivity t interest rate mvements. In an increasing interest rate envirnment, MLPs can experience upward pressure n their yields t stay cmpetitive with ther securities that are interest-rate sensitive. At times, the prices f MLPs have been crrelated with the bnd markets, as they can be viewed as yield-based investments. Liquidity risk. There can be n assurance that MLP units will have an established trading market, adequate trading vlumes r sufficient liquidity. Units in MLPs are particularly attractive fr retail investrs and have nt prven t attract significant institutinal interest. The lack f institutinal interest in MLPs may affect liquidity and price efficiency. MLP perating risk. The price f units in an MLP and the amunt f cash flws it generates and distributes t unit hlders are subject t varius risks assciated with the business and activities cnducted by the MLP, which vary based n the MLP s applicable sectr r sub-sectr, including the fllwing: Changes in applicable cmmdity prices A decline in the prductin r a decrease in the vlume f il, gas and ther cmmdities Reduced applicable il and gas drilling activity Natural decline in the prductin f wells and mines in the MLP s area f peratin Incrrect estimates f reserve quantities and anticipated revenues Disruptins in the supply f and demand fr il, gas and ther natural resurces, which can be affected by varius factrs such as seasnality, weather cnditins, catastrphes, envirnmental incidents and acts f terrrism 2015 Rbert W. Baird & C. Incrprated. Member FINRA & SIPC. Rbert W. Baird & C. 777 East Wiscnsin Avenue, Milwaukee, Wiscnsin RW-BAIRD. Page 5 f 8

6 Imprtant Infrmatin abut Master Limited Partnership (MLPs), cntinued. Dependence f key suppliers, cntract peratrs, lessrs, lessees and custmers, and the lss r unprfitability f imprtant cntracts Gegraphic cncentratin and dependence n particular fields, mines and reserves Cmpetitin, including the availability f alternative energy surces and changing technlgy Increased perating csts Labr shrtages, equipment challenges and related difficulties Increased regulatin and heightened regulatry enfrcement, including ptential envirnmental liability and climate change laws Dependence n the general partner and key persnnel Upstream, midstream and dwnstream energy MLPs have ther risks that are particular t their sectrs and sub-sectrs. MLP funds have additinal risks assciated with their structures. Capital access risk. Because MLPs pay ut mst f their perating cash flws, they rely n capital markets fr access t equity and debt financing in rder t fund rganic grwth prjects and acquisitins and make targeted distributins. If market cnditins limit an MLP s access t capital markets, the MLP s distributin grwth prspects culd be at risk. MLPs may als face increased csts f capital, and at times may have significant interest csts and ther debt burdens. Cvenants and ther restrictins impsed by an MLP s lenders may limit its grwth. Grwth risk. Because MLPs distribute mst f their available cash flws and are under pressure t grw their distributins, they generally need t make acquisitins. Difficulties experienced by an MLP in btaining acquisitin financing may slw its grwth. Additinally, an MLP may face challenges in making acquisitins n acceptable terms due t cmpetitin. Acquisitins and grwth initiatives are als subject t cnstructin, integratin and implementatin risks. Distributin risk. Mst MLPs establish minimum quarterly distributin amunts they intend t pay based n certain assumptins, and seek t grw thse amunts. Hwever, thse assumptins may prve t be incrrect and are subject t significant risks and uncertainties. As a result, the actual amunt f distributins made t unit hlders may be less than the minimum quarterly distributin amunts. In additin, the amunt f distributins that an MLP makes is based n its distributable cash flws, which will be affected by changes in the MLP s revenues, expenses, capital expenditures and reserves and by determinatins made by the general partner. Thus, at times, distributins made by an MLP may be less than anticipated. An MLP may issue additinal units r incur indebtedness in rder raise capital t make distributins, which culd decrease the amunt f distributins it can make in the future. The general partner and/r its affiliates may wn subrdinated units, which receive distributins after the minimum distributin amunts plus arrearages are paid t the cmmn unit hlders. Hwever, thse subrdinated units are cnvertible int cmmn units upn achievement f certain dividend levels. The cnversin f the subrdinated units may adversely affect the amunt f future distributins that are paid per cmmn unit Rbert W. Baird & C. Incrprated. Member FINRA & SIPC. Rbert W. Baird & C. 777 East Wiscnsin Avenue, Milwaukee, Wiscnsin RW-BAIRD. Page 6 f 8

7 Imprtant Infrmatin abut Master Limited Partnership (MLPs), cntinued. Cnflicts f interest risk. MLPs are cntrlled by their general partners. MLPs are nt gverned by a bard f directrs. Unit hlders have limited vting rights and very little say in the management r peratin f the MLP. Unit hlders d nt elect the general partner r its bard f directrs. It is very difficult fr unit hlders t remve r replace the general partner. Althugh the general partner has a duty t act in the best interests f the MLP, the general partner als has duties t its wners. As a result f these relatinships, cnflicts f interest may arise between the MLP and its unit hlders n the ne hand and the general partner and its wners n the ther hand. The general partner may make decisins r take actins that may be detrimental t the MLP and its unit hlders. Fr example, the general partner is entitled t make decisins that will affect the amunt f distributins that the MLP makes t unit hlders (such as acquisitins and grwth initiatives r the issuance f additinal units), which will impact whether the general partner will receive incentive distributins and the amunt f thse distributins. The general partner may have the right t reset r mdify the minimum quarterly distributin amunts r cancel the MLP s distributin plicy. The general partner may be able t transfer its incentive distributin rights, which may cause the general partner nt t be as highly mtivated t increase the amunt f distributins the MLP makes. It is als pssible that the general partner r its wners may engage in ther businesses r take actins that cmpete against the MLP. An MLP s partnership agreement may cntain prvisins that restrict r eliminate certain duties f the general partner and limit the general partner s liability t the MLP. The general partner may have a limited call right t require the unit hlders t sell their units at unattractive prices. Tax risk. MLPs are generally taxed as partnerships, meaning that their incme, gains, lsses and expenses are passed thrugh t their unit hlders wh receive a Schedule K-1 each year While this structure prvides ptential tax benefits, it can als create burdensme tax reprting bligatins t unit hlders. Unit hlders may be subject t state and lcal taxes (in additin t federal taxes) n the MLP s incme allcable t them. It is pssible that, at times, unit hlders may recgnize their share f the MLP s taxable incme withut receiving distributins equal t such share f incme r sufficient t cver the taxes wed n such incme. Many MLPs pay distributins in amunts that exceed their net incme, ften significantly s. As a result, a prtin f distributins made t unit hlders is classified as return f capital, nt as an incme distributin r return n capital. Such prtin reduces the unit hlder s tax basis in the units and results in a larger gain upn sale. A significant amunt f the distributins may be subject t recapture and taxed as rdinary incme upn sale f the MLP units. An investment in an MLP may nt be ideally suited fr an IRA r ther tax-exempt r tax-deferred accunt because sme f the incme generated by the MLP, as well as the prceeds received upn the sale f the MLP, may be subject t unrelated business incme tax (UBIT). This is a tax assessed n incme frm pass-thrugh entities, such as MLPs, held in retirement and ther taxpreferred accunts. The cst f filing the tax return fr these accunts is als an expense assessed against the accunt. Fr mre infrmatin n the taxatin f MLP s, please see this FAQ. Investments in MLP funds als can have varying tax cnsequences. Mrever, the tax treatment f MLPs culd be subject t ptential legislative, judicial r administrative changes r differing interpretatins. A change in an MLP s business r ther actins taken r nt taken by an MLP culd cause the MLP t lse its status as a partnership fr tax purpses, which may cause the MLP t pay federal incme tax n its incme at the crprate tax rate. If an MLP were classified as a crpratin fr tax purpses, the amunt f cash available 2015 Rbert W. Baird & C. Incrprated. Member FINRA & SIPC. Rbert W. Baird & C. 777 East Wiscnsin Avenue, Milwaukee, Wiscnsin RW-BAIRD. Page 7 f 8

8 Imprtant Infrmatin abut Master Limited Partnership (MLPs), cntinued. fr distributin wuld be reduced and part r all f the distributins might be taxed as dividend incme. Investrs shuld cnsult with their tax advisrs befre investing in MLPs r MLP funds. Regulatry risk. The prfitability f MLPs may be adversely affected by changes in the regulatry envirnment. The businesses, peratins and assets f mst MLPs are heavily regulated by federal and state gvernments. Increased regulatin can dramatically increase an MLP s perating csts. Applicable envirnmental laws prvide fr civil penalties and regulatry remediatin, thus adding t an MLP s ptential expsure. Befre investing in MLPs, it is imprtant t understand and discuss with yur Baird Financial Advisr the structure and terms f the security and the ptential risks. If buying such investments in an ffering, yu shuld btain and read the prspectus. If buying in the secndary market, yu shuld review the issuer s publicly available financial and ther infrmatin (such as recent annual, quarterly and current reprts). Yu can btain these materials frm yur Baird Financial Advisr r n the SEC s EDGAR database at Mre infrmatin abut MLPs can be btained frm the Natinal Assciatin f Publicly Traded Partnerships at its website, Rbert W. Baird & C. Incrprated. Member FINRA & SIPC. Rbert W. Baird & C. 777 East Wiscnsin Avenue, Milwaukee, Wiscnsin RW-BAIRD. Page 8 f 8