For some reason, I get a lot of unsolicited mail. Maybe because it’s because I’m a registered investment adviser. But I am registered because I manage a hedge fund and am required to register by law, not because I advise individual clients. Nonetheless, firms that cater to individual investors like to send me their solicitations. But I really wish they would leave me alone.
Most of their mail enrages me because it is designed to lead investors to slaughter.
I recently told an investment relations person from the business development company Prospect Capital Corp. (PSEC) that I would report him to the SEC if he kept soliciting me to buy his company’s stock. PSEC is a troubled BDC that pays egregious and unjustified fees to its management and should be avoided by investors at all costs. After some back-and-forth, the guy finally got the message. I believe, by the way, that PSEC is under investigation by regulators, and its stock is down sharply over the last year.
Then I received a “White Paper” from a firm called Miller Howard Investments entitled “Are MLPs and Midstream Companies Still Like ‘Utilities Without Walls’?” and it really made me angry. The firm, Miller Howard, obviously led a lot of its clients to invest in MLPs and is now trying to justify what was catastrophically bad advice.
I responded to this unsolicited email by telling the sender that comparing MLPS to utilities was highly misleading and the only thing that was white about his paper was that it resembled toilet paper!
And I’m still furious.
Here’s why MLPs are a huge, hidden trap for investors.
There’s No Such Thing As A Free Lunch
MLPs were one of the ways that investors were supposed to generate income in a world where central banks drove interest rates to zero and destroyed bonds as an asset class. And for a while, they accomplished that goal. But like many investment products that promise high returns with low risk, they turned out to offer a free lunch in a world where free lunches don’t exist. Now investors feel like they’ve been hit over the head by a 2-by-4 as they’ve watched years of income go up in smoke while the principal value of their MLPs have dropped by 50% or more. The Alerian MLP ETF has dropped from $17.19 to $9.89 year over year.
MLPs were part of the great reach for risk (and yield) that former Federal Reserve Chairman Ben Bernanke thought would stimulate economic growth and help the U.S. economy recover from the financial crisis and the Great Recession of 2008-2009. Unfortunately, Mr. Bernanke’s solution didn’t work as planned; in fact, it worked in precisely the opposite way.
Rather than promote economic growth, zero interest rates created the biggest debt bubble in history. And much of this debt was incurred in the energy industry, which is home to the MLPs that attracted investors and ended up blowing up in their faces.
Now the investment advisers who convinced their clients to invest in these products are scrambling to justify what proved to be very bad advice. (Hence that atrocious “White Paper.”)
Don’t Be Fooled – High Income Always Means High Risk
The “White Paper” I received makes a series of intellectually false comparisons between MLPs and utilities in a devious effort to convince investors that MLPs will rebound in value. It focuses on midstream MLPs, which are companies like Kinder Morgan (which is not an MLP) that engage in the transportation, processing and storage of oil and gas rather than the exploration and production of energy. Midstream companies were supposed to be insulated from the collapse in oil prices, yet their stock prices were decimated along with the rest of the industry.
The “White Paper” makes all of the familiar arguments about the supposed strengths of midstream businesses: they provide essential services to the oil and gas industry and they have durable revenues. But it tries to make the case that midstream MLPs are in the same category of safe investments as utilities. It points out that like midstream MLPs, utilities have seen sharp sell-offs in the past and have recovered.
But the comparison is completely bogus because the problem with MLPs is not just their substance but their form.
In terms of their substance, MLPs were designed to pay out high income streams in a tax advantaged manner. The tax advantages come from the fact that they are structured as partnerships, which allows them to pass through both income and deductions that shelter that income from their partners. But there is no such thing as a free lunch in economics or investments. High income means high risk.
Because they pay out all of their income, MLPs need to look elsewhere for capital to expand and maintain their businesses. So naturally they end up borrowing a lot of money or selling additional partnership units that dilute existing holders. Since no business can expand indefinitely, when energy prices collapsed, energy MLPs collapsed with them, including those involved in the business of transporting oil and gas.
In terms of their form, the MLP structure has hidden traps for investors that they are now just learning about.
One hidden trap is the potential for investors to get hit with taxable income at the same time they are getting smashed with losses. As a partnership, a financially stressed MLP that restructures its debt in a transaction that reduces the face amount of the debt will produce “debt forgiveness” income for the partners without producing any income to pay for it. This means that in addition to the loss in value of their investment, MLP holders will get a bill from the IRS for their share of the debt that was written off. Talk about adding insult to injury – that isn’t something that happens when you invest in a utility!
|When Kinder Morgan announced in 2015 that it was cutting its dividend by 70%, it was a knockout punch to the midstream and MLP industries that were already badly battered. Kinder Morgan is considered the 900-pound gorilla of the midstream energy companies. Despite the fact that it had built up $40 billion of debt while its stock price was plunging by 70% between April 2015 and January 2016, the company swore it would never cut its dividend.But eventually reality trumped corporate doublespeak and the company had no choice if it wanted to survive. The dividend reduction shattered the myth that midstream companies could ignore the fact that their customers were facing existential threats to their businesses.Kinder Morgan has also built up an enormous amount of debt, which forced it to cut its distributions to unit holders in order to insure it could continue to make its interest payments and meet its other obligations. If Kinder Morgan had to cut its dividend, the outlook for other midstream MLPs was dire.
Don’t listen to shady investment firms that are trying to justify their bad decisions by sucking you into MLPs. They are not utilities. They’re not even useful.
Thanks. I just had to get that off my chest.