By Connie Hsu, CFA and Jason Stevens
The Alerian MLP Index sold off nearly 7% in mid-November after the presidential election, as concerns about the fiscal cliff, budget deficit, and changes to favorable tax regulations took hold. Beyond marketwide concerns about pending dividend and capital gains tax increases, master limited partnership investors seemed concerned that MLPs may be subject to corporate taxes and new carried interest rules. These threats--which have existed for years--have been amplified lately by fears regarding the drastic measures needed to resolve the federal government's budgetary woes. MLPs, which do not pay taxes at the entity level, look to be an easy revenue target, but we believe it is highly improbable that they will see any major changes to their tax-favored status. In the unlikely event that MLPs became subject to corporate taxation, however, we'd expect only a modest impact on valuations.
Removal of Congressional Support Unlikely
Master limited partnerships have enjoyed pass-through tax status since the Tax Reform Act of 1986, which was designed to encourage private investment through a lower cost of capital. MLPs pass through their income to unitholders, who then pay taxes on that income at their own marginal tax rates often only when the units are sold. MLP income is therefore taxed only once, in contrast to the double taxation that happens when corporations pay entity-level taxes on income and shareholders pay a second layer of taxes on dividends received.
MLP investors therefore pay less tax overall, but the difference is not significant enough for the government to pursue, in our view. In early 2012, Congress estimated that taxing energy MLPs (with a combined market capitalization of more than $300 billion) at the corporate tax rate of 35% would generate only $300 million in annual revenue. The low tax yield is largely due to the nature of midstream businesses (which constitute the majority of MLPs); they employ heavy fixed assets that garner a large depreciation deduction in the calculation of taxable income. Because the gain is trivial relative to other potential tax revenue sources, we do not believe Congress will pursue this route.
Moreover, additional taxation would jeopardize private investment in the development of domestic energy resources and potentially force even costlier public investment over the long term. MLPs have gained bipartisan support, as they have proved very successful in financing and building out energy infrastructure over the years, in line with many political agendas that seek lower energy costs for consumers, domestic energy independence, and jobs growth. In recent congressional testimony, the National Association of Publicly Traded Partnerships, the industry lobbying body, noted that MLPs supported an estimated 323,000 jobs in the midstream energy sector and invested an estimated $17 billion in domestic energy infrastructure during 2011.
To this end, the most recent changes to MLP tax rules have actually expanded the potential base for MLP qualifying income to include transportation and storage of biofuels and other liquids, in support of their development. Likewise, the latest MLP proposal (the Master Limited Partnerships Parity Act introduced this past June) targets further expansion of the MLP umbrella to include renewable energy activities, while the latest fiscal cliff deal (the American Taxpayer Relief Act) extends and increases tax subsidies worth an estimated $12 billion over 10 years to wind energy companies.
What Could Change in the Short Term?
Of all tax reforms, the two most likely are changes to the treatment of dividends/capital gains and carried interest.
The just-passed American Taxpayer Relief Act increases the dividends/capital gains tax rate for high earners (annual household income of greater than $450,000) to 20% from 15%. Over time, this higher tax rate could apply to a larger population if the income threshold is lowered to the originally proposed $250,000. Broadly speaking, the higher the dividend taxes, the more attractive the tax-deferred status of MLPs appears to investors, when compared with corporations. Because distributions are not taxed as dividends, MLP investors pay less in total taxes on net income.
We do not believe treatment of carried interest in publicly traded partnerships will affect energy MLPs at all, as the proposal targets financial services firms that are structured as publicly traded partnerships. Carried interest refers to the share of profits that partners receive for profitable investments, which under partnership taxation rules is taxed at the long-term capital gains rate. It's been an issue lately because hedge fund and private equity managers, who receive much of their compensation through this carried interest, effectively pay only lower capital gains taxes on this compensation, rather than higher ordinary income taxes.
Proposed legislation seeks to treat the carried interest of financial services firms as ordinary income. Though this does not affect MLPs generally, it could have some impact on publicly traded general partnerships, as incentive distribution rights could become taxable as compensation and hence be subject to ordinary income taxes. However, the language of the current bill specifies these changes for financial services firms, so energy MLPs would be excluded. Additionally, MLP unitholders already pay taxes at full ordinary income tax rates. Hence the potential revenue gain for the government from corporate taxes comes at the expense of losing the taxes that partnership unitholders currently pay. This is another reason the incremental gain of taxing MLPs is less than expected at first glance.
What Could Change Over the Long Term?
Over the long term, we believe a greater overhaul of tax policy is fully possible. Potential changes could take several very different flavors, affecting both corporations and MLPs. There are several proposals that we believe would significantly affect MLP investors, including shareholder credits for corporate taxes paid; corporate deductions for dividends paid; shareholder exemptions for dividends received; rate alignment (investor tax rates on dividends and capital gains on sales of corporate stock would be reduced as a partial offset to the additional tax at the entity level); and lowering the maximum corporate tax rate while broadening the tax base applicable to the tax.
While we cannot precisely show the impact of each proposal, we note that overall these efforts seek to eliminate or reduce the double taxation of corporate profits at the entity level and shareholder level. Should such reforms pass, the tax revenues from MLPs and corporations would therefore be much more comparable.
Valuation Impact to Morningstar's MLP Coverage
Though we view the probability as remote, it is possible that the MLP structure could be eliminated. It is difficult to precisely forecast the impact to the sector without knowing the specifics, but to get a sense of how valuations and structures could change, we make a few simplifying assumptions to generate a worst-case scenario.
We assume the MLP structure dissolves, businesses convert to corporations, and income is subsequently subject to corporate taxes at the 35% statutory rate. However, the C-corps under our midstream coverage realize an average effective tax rate of 25%, and hence we use a 25% effective tax rate in this scenario. We assume Congress provides a grace period, comparable to historical precedent of three to four years (depending on when the legislation is passed), so corporate taxation begins in 2016.
This higher tax rate is somewhat offset by the lower implied weighted average cost of capital. The taxes paid now reflect an interest tax shield previously unrealizable for MLPs. We maintain the capital structure mix of about 50% debt financing and 50% equity financing in this WACC assumption and in our financial forecasts through 2016. Realistically, we'd expect companies to shift toward greater use of debt financing over time, but for our simplified scenario, we maintain the current mix.
In our discounted cash flow models, we reduced terminal enterprise value/EBITDA multiples by 2 full turns to reflect the average premium at which midstream MLPs currently trade to midstream C-corps. We attribute the premium primarily to the structural tax and capital cost differences between MLPs and corporations, which we extract in this scenario.
We assume that general partners of MLPs dissolve as soon as administratively possible, probably before corporate taxes begin in 2016. This could happen in several ways--through the conversion of GP units to LP units, a cash buyout of the GP, or vice versa. For our worst-case scenario, we assume the first option, that GP units convert to LP units at revised fair value estimates after applying taxes in perpetuity and a lower WACC. In reality, this unit conversion may not take place at fair values, but instead at a discount to market pricing upon announcement. This therefore implies that publicly traded general partners dissolve after receiving LP units as compensation. In our coverage universe, this applies to NuStar GP Holdings (NSH) and Energy Transfer Equity (ETE).
Assuming a gradual shift to corporate status, we'd expect distributions to be cut dramatically, as capital structures shift to reduce reliance on the capital markets for growth financing (a hallmark of the MLP model). With lower expected free cash flow, firms would probably slow expansion and hold on to more free cash flow in order to internally finance growth, rather than routinely issue follow-on equity, in particular. This would curb growth expectations (from current average annual growth rates of about 5%) making these former MLPs less attractive to yield investors.
Our worst-case scenario does not incorporate these growth factors, as we believe they are strategy changes that are likely to vary significantly, depending on company-specific considerations such as existing capital structures and growth prospects.
Given our simplification of the MLP transition process, our estimates should be taken with a large heap of salt. However, we still find the exercise interesting for a few reasons. In particular, we were able to derive some general observations about what types of MLPs would see the most impact and the least, which provides some insight into current capital costs across our coverage universe. This type of comparison is not easily observed because of the different MLP structures in existence, given the range of general partner incentive distribution rights, international taxes, subordinated unit issuances with particular rights, and excess cash flow cushions. In particular, this taxation exercise effectively removes a major difference in capital structures (general partner incentives) and puts capital costs on a more level (albeit still uneven) playing field.
In this tax-affected scenario, the impact is significant but not devastating by any means. Our fair value estimates fall an average 14% as a result of corporate taxation, and we observe a few trends.
A lower weighted average cost of capital benefited all companies modestly, adding an average 4% to fair value estimates. On average, our WACCs decreased by 70 basis points, to 7.3%, thanks to the inclusion of tax shield benefits.
Raising the effective tax rate by 25% hurt valuations by an average 18% across the board, as a result of lower free cash flow in perpetuity. This makes intuitive sense, since for our coverage approximately 80% of discounted cash flows lie in the perpetuity. As our exercise does not apply taxes to cash flows generated through 2015, we'd expect less than a 25% hit to valuations.
For the MLPs with general partners, eliminating the GP burden generally improved valuations, as some of the tax hit was absorbed by lower GP stake valuations.
Historical Precedents Offer Clues
Though we cannot forecast firm or market reactions to tax changes with much certainty, there is some historical precedent regarding how similar tax legislation changes affected business organizations and the subsequent market reaction. First, in 1987, the United States created more stringent rules on what types of businesses qualified for the tax benefits of MLPs. Then in 2006, Canada removed the tax benefits of a royalty trust, a structure akin to a U.S. MLP.
In 1987, following a proliferation of publicly traded partnerships, the U.S. specified the types of businesses that qualified for MLP tax-deferred status. PTPs that did not qualify had 10 years to meet the requirements or switch to corporate status. In 1997, these partnerships were given a further option of paying 3.5% tax on gross income, which some elected to do.
In 2006, Canada changed its energy trust rules (which previously provided for little or no corporate taxes), so that they would be subject to the statutory tax rate of 28% beginning in 2011. Share prices of Canadian energy trusts immediately dropped 30% after the announcement, but gradually recovered. Over the next few years, most trusts merged or liquidated and eventually converted to tax-paying corporations. For the most part, former trusts have fared poorly since the new tax rules took hold in 2011, but we attribute this largely to business mismanagement rather than any direct impact of paying taxes. In particular, many ex-trusts attempted to pay yields similar to those of the past era--despite a lack of favorable tax treatment--while dealing with unfavorable business conditions, which strained cash flows and balance sheets at the same time. Several former trusts, such as Enerplus (ERF) and Pengrowth (PGH), eventually succumbed to prevailing conditions and halved their dividends in 2012. However, their shares still suffered (share prices are down roughly 60% since their corporate conversions).
That said, it's important to note that in contrast to the volatile cash flows of the Canadian energy trusts (which were exploration and production firms), most MLPs operate in the midstream energy sector, which by design offers less commodity exposure, steadier profits, and more highly visible cash flows available for distribution. A tax code change should therefore be easier to manage in terms of having fewer moving parts. However, we believe the Canadian energy trust example both demonstrates the downside risk for MLPs in a corporate tax scenario and highlights how pivotal a role management can play in navigating industrywide shifts.
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