This note was originally published at 8am on May 14, 2014 for Hedgeye subscribers.
“Today, I want to tell you about an investment opportunity with potential high cash flow, a superior structure, a unique sharing agreement, and low risk.” – 1983 Prudential-Bache Energy Income Fund marketing video
Between 1983 and 1991 Prudential-Bache Securities raised $1.4 billion from the sale of 35 “energy income fund” limited partnerships to more than 130,000 individual investors. The yield chase was on as interest rates fell in the wake of the early ‘80s inflation scare, and Wall Street was eager to fill the demand with new products that commanded high fees and commissions. Prudential-Bache brokers touted the limited partnerships to their retail clients as high-yielding, tax-advantaged, low-risk investments…
Of course, what seems too good to be true proved to be just that. By the late ‘80s distributions began to trail false promises as hefty fees ate into the income and asset values fell. Some of the partnerships borrowed money to maintain the payouts, but it wasn’t a sustainable solution. Eventually, most of the partnerships slashed distributions and collapsed.
In the class action lawsuits that followed, the plaintiffs alleged that Prudential-Bache “misrepresented and omitted material facts concerning cash distributions to investors by creating the appearance that the partnerships were distributing monies derived from operating income when in reality the distributions were returns of capital…”
I traveled to Omaha, Nebraska two weeks ago to pitch the bear case on Master Limited Partnerships to a group of value investors. Buffett couldn’t fit me into his schedule, but I was lucky enough to meet with seasoned money managers cut from the same cloth.
These guys understood the MLP basics – tax-exempt energy companies with high current yields, etc. – but not much more. So I walked through a few of the more surreptitious aspects of the story: the enormous “incentive” fees that many MLPs pay to their General Partners; the conflicts of interest and limited fiduciary duties; the gimmicky accounting; the serial capital raising; and the valuations.
I was showing the group how, since its inception, retail-favorite LINN Energy (LINE) has lost more than $1.4 billion while paying out $3.1 billion in distributions, when a salty Australian in the back blurted out, “The whole thing seems like a big Ponzi scheme to me.” I shrugged, “My compliance officer doesn’t let me use that word.”
MLPs are essential to the build-out of energy infrastructure that’s needed to support the recent US hydrocarbon production boom – the story is real – but that doesn’t mean all will profit. The building of the American railroads in the late 19th century was ripe with self-dealing and stock schemes. James Surowiecki of “The New Yorker” called it, “one of the biggest cons the country has ever seen, with huge losses for investors and huge fortunes for the moguls. Still, we ended up with a national transportation system.”
It’s been said that there are no new eras, only new errors – most things in finance are cyclical. We look at the fees that some of the largest MLPs are paying to their GPs today and wonder if this time will be different. How long can a business that pays two-thirds of its income to its manager survive?
It’s a unique instance of information asymmetry. MLPs are mostly owned by retail investors – not surprising given the exorbitant fees that they hand over to the wealthy individuals and institutions that own their GPs. A well-informed investor is unlikely to give his money to a hedge fund manager who defines his own performance, collects a 50% performance fee, and owes limited fiduciary duties to his investors. Would you invest in that fund? I hope not. Giving your money to that hedge fund is a liability, but with the Alerian MLP Infrastructure Index currently trading at 2x the earnings multiple of the S&P 500 (see the Chart of the Day below) despite lower returns on equity (~8%) and higher leverage (~42% debt/capital), that’s still way out-of-consensus.
But we’re OK with that. It’s a lonely view but we’re not contrarian merely for the sake of it – there’s ample justification for being negative on certain MLPs, and perhaps the timing is right as we enter the later innings of the US infrastructure growth boom, and the Federal Reserve weans markets off of the morphine drip.
Over the past year, we’ve expressed this view with reasonable success with negative calls on the E&P MLPs (most notably, LINN Energy), Kinder Morgan Energy Partners (KMP), and Boardwalk Pipeline Partners (BWP), while the MLP indices marched to new all-time highs. Our most recent work delves into the numerous issues of Atlas Energy LP (ATLS) and its limited partnerships (ping firstname.lastname@example.org to see that research). In the first conference call after we published our note, one Atlas executive declared that because his stock has not fallen, “Truth and good have prevailed!”
Of course, I’m the bad guy. Well, for now at least…
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.56-2.65%