What Are Master Limited Partnerships?

Master limited partnerships (MLPs) offer attractive returns for investors in the energy sector. MLPs focus on natural resources like oil, gas, timber and solar energy. They offer a favorable tax structure of a limited partnership along with the liquidity of a corporation or publicly traded stock. Should you add master limited partnerships to your investment portfolio? Read on to understand the governance structure, pros and cons of this investment opportunity. 

How Do Master Limited Partnerships Work?

Master limited partnerships (MLPs) are a unique type of business structure that combines the tax advantages of partnerships with the liquidity of publicly traded stocks. In other words, MLPs are limited partnerships that trade on a national securities exchange. This feature combines the legal protection of a limited partnership with the partners with additional liquidity.   

An MLP must generate 90% of its revenue from natural resources. For this reason, most MLPs focus on natural resource-related activities like oil, gas, coal, timber, pipelines, natural resource storage facilities, renewable energy projects and certain ways of transporting commodities.  

Structure and Governance of MLPs

A master limited partnership is a hybrid of a partnership and a corporation. An MLP is considered the aggregate of its partners, like a partnership, but it issues units comparable to shares in a corporation. Those who hold units in MLPs are called unitholders. In this way, it offers some of the benefits of both legal structures, along with some of the risks. 

The typical structure of an MLP is similar to that of a general partnership. There is a general partner (GP) and a limited partner (LP) or multiple limited partners called limited partner units. 

The role of the general partner involves managing and operating the MLP. The general partner functions as the owner and is responsible for management and operations. The general partner is personally liable for the business’s debts. If, for example, the business becomes over-leveraged and can’t meet its debt obligations, then the general partner might need to cover the debt with personal savings or assets. 

Limited partners, on the other hand, are not actively involved in the day-to-day decision-making for the MLP.  The limited partners provide capital and receive distributions but are not personally liable for the business’s debts or other liabilities, nor are they open to litigation related to the business. They only risk losing their investment in the partnership.  

Of course, there are always potential conflicts of interest between general partners and limited partners as general partners manage the overall day-to-day operations and limited partners are interested in maximizing returns. That is one of the major risks of investing in an MLP, along with a lack of diversification or concentrated market exposure of most MLPs.  

How to Evaluate MLP Investments

MLP investments come with significant volatility risks because of concentrated market exposure. Key factors to consider when evaluating MLPs include: 

• Growth prospects: What new investments or sectors is the company investing in? How are they working to expand operations?
• Distribution coverage ratio: The ratio of net investment income, as adjusted, for that period to distributions, which offers insight into a company's profitability and stable cash flow. 
• Debt levels: Companies that are over-leveraged carry greater risk.  

It's essential to analyze and understand the MLP's assets, contracts and partnerships within the energy sector to verify risk exposure. As an MLP's performance is tightly tied to management, consider the track record and reputation of the management team in driving long-term shareholder value. You can also check recent press releases and financial reports for an in-depth understanding. 

Advantages of Investing in MLPs

The advantages of MLPs that drive investors to consider this option include liquidity and potential tax benefits. Key reasons to consider MLPs include:

• Tax benefits: Pass-through taxation where MLPs do not pay tax at the corporate level, resulting in potentially higher distributions to investors.
• High yield potential: MLPs are known for providing attractive dividends or distributions to their limited partners. However, researching and understanding individual offerings remains essential. 
• Liquidity advantage: MLP units are listed and traded on major stock exchanges, allowing investors to easily buy and sell their positions. As compared to other non-liquid investments in limited partnerships, MLPs can offer greater flexibility and liquidity. 

Risks and Challenges of Investing in MLPs

Master limited partnerships, as with other investment products, come with significant risk and potential for volatility. Reasons to research carefully and proceed with caution before investing in MLPs include:

• Price fluctuations: MLPs are historically highly sensitive to commodity price fluctuations, which can impact their performance and potential investment returns. 
• Regulatory risk: Regulatory changes can have a significant impact on MLPs. For example, tax code modifications or increased government oversight could reduce advantages or cut into profits. 
• Liquidity risk: MLPs can have lower trading volumes compared to traditional stocks, potentially affecting the ease of buying or selling MLP units. While still considered a liquid asset, they offer lower liquidity when you need to sell quickly than some other investment options. 

Differentiating MLPs from other Investment Vehicles

Here are the key differences between MLPs and traditional corporations, real estate investment trusts (REITs) and other partnership structures. 

• MLPs vs. limited partnerships: MLPs are publicly traded, while limited partnerships are not.
• MLPs vs. corporations: MLPs are taxed as partnerships, not corporations. That means they are not subject to double taxation. Corporations pay corporate tax, and then the shareholders must pay personal taxes on the holdings' income. For this reason, MLPs are considered a more favorable structure for tax advantages. 
• MLPs vs. REITs: REITs are corporations with regular shareholders, whereas MLPs are partnerships with so-called unitholders. Both offer similar liquidity and are publicly traded. Both may pay dividends. But REITs face the same double taxation issue as other corporations. 

Master limited partnerships, with pass-through taxation, dividends and growth opportunities, may be more suitable for income-focused investors interested in the energy industry. With the vast array of MLPs available, you can choose what interests you — from oil and gas to solar or natural gas. 

Investing in MLPs

Whether considering additional diversification for retirement account investments or driving growth for medium-term goals, the combination of liquidity and tax benefits can make MLPs an attractive option. Consider the 25 best-yielding MLPs or stay on top of master limited partnership fund news to continue researching opportunities. For further diversification, consider REITs or ETFs.

Frequently Asked Questions