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Commentary &
Additional Information:
EGA MLP Commentary Q2 2018
What are Master Limited Partnerships?
An MLP is a business that is organized as a limited partnership and trades proportionate shares of the partnership (units) on a public exchange.

What sort of businesses choose to be Master Limited Partnerships?
The typical business that chooses to be an MLP produces stable cash flow in a resource related industry. Examples include hydrocarbon pipelines, coal royalty owners, and certain real estate companies. There are also MLPs involved in non-resource related businesses such as theme parks and investment management. MLP units represent a share of real businesses that have real assets and produce real cash flow.

Where are Master Limited Partnerships listed and traded?
The vast majority of MLP units are listed on the NYSE. The NYSE has more restrictive listing requirements in terms of assets and earnings, than other U.S. exchanges.

How can MLPs offer high returns?

1. Lower cost of capital for stable cash flow assets
MLPs generally acquire high cash flow, high depreciation assets (pipelines, terminals, platforms) which produce relatively low accounting earnings. As a consequence of the low GAAP earnings produced by the assets, traditional public companies do not find the assets attractive. By collecting the high cash flow assets together, the MLP is able to unlock the value in the assets. The MLP investor focuses on the cash flow of the assets not on the accounting earnings. Frequently a sale of a productive asset from an affiliated c-corporation to a MLP is both accretive to the earnings of the seller, and accretive to the cash flow of the acquirer.

2. Taxation
The partnership structure avoids double taxation. In a traditional c-corporation, income is taxed first at the corporate level, and any distributions to shareholders are taxed again at the personal level. In a limited partnership, the income is not taxed at the partnership level, but rather all profits and losses are proportionally passed to the limited partners, and taxed at the personal level.

In summary, MLPs have a lower cost of capital for stable, high cash flow assets because their investors are focused on cash flow, while traditional equity investors are more focused on assets which grow accounting earnings. The limited partnership structure also reduces the total taxes paid.

Why have MLPs frequently outperformed other asset classes?

1. Lack of institutional sponsorship
There is almost no institutional investment in MLP units. The asset class is too small for many pension funds, and as a consequence there are no specialty investment managers involved. Mutual funds have historically avoided due to the complexity of tax reporting. The potential for unrelated business income from the underlying partnership makes MLP units potentially complicated for IRAs, since sufficient unrelated business income could necessitate a tax filing for the IRA. Smaller foundations and endowments have generally not invested in MLP units due to the potential tax consequences. The main investor segment that holds MLP units is high net worth individuals.

2. Complexity
MLP units are slightly more complex to understand, and this likely presents a barrier to investment for some high net worth individuals. Many investors are reluctant to purchase a security that receives virtually no coverage in the financial press, and does not fit neatly into the asset allocation mixes promoted by Wall Street and the media – namely stocks, bonds, and cash. Additionally, limited partners do not have the same rights as those that stockholders typically exercise through their proxy vote (e.g. election of directors, approval of auditors, etc.). Limited partnerships usually do not have annual shareholder meetings.

3. Taxation
MLP unit holders receive a K-1 from the partnership each year, and may also need to file tax returns in each state where the LP has generated income. This increased level of tax filing is sufficient to send many potential investors running. Although the LP’s generally provide the tax benefit of a high level of depreciation to allow most income to be deferred until sale, the increase in filing is a further barrier to investment for the incremental high net worth investor.

In summary, we believe that MLPs must offer higher expected returns for the level of risk in order to attract a limited pool of potential investors away from traditional asset classes.
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