Everywhere you look, investors are talking about what a great deal master limited partnerships (MLPs) are. What's not to like? High dividend yields, a booming energy industry, partially tax free income. A great article on Seeking Alpha entitled MLP Master: A Conversation with Elliott Gue describes much of the upside in this space. Let's look at the five biggest risks to MLPs that people are ignoring.
1. Share Creep, aka share dilution: MLPs must pay out most of their income so how can they grow? By offering new shares. So if there are a million shares outstanding and you own one share, you own one one millionth of the company. If management has a secondary offering and issues more shares, you just got diluted. Almost all MLPs are always offering new shares. An article about BreitBurn Energy (NASDAQ:BBEP) written just a few days ago discusses how a secondary offering affected its share price.
2. Access to credit markets: A second issue that goes part and parcel with secondary offerings is the issuance of debt. MLPs must issue bonds for new capital and growth. However, interest rates are at all-time lows. As time goes on, MLPs will have to pay more in interest. This will take a bite out of net income, which will lessen dividend payment to investors.
As you can guess by looking at the balance sheets of MLPs, they are highly levered and have lots of debt. Bond king Bill Gross of Pimco and manager of Pimco Total Return (PTTRX) thinks that there is a bubble building in high-yield bonds. In his March 2013 Investment Outlook, Gross quotes Fed Governor Jeremy Stein as saying on a scale of one to 10; we are at a six in terms of irrational exuberance.
3. Competition: If all of these MLPs are going public and being spun off from oil majors, did anyone think about all of the added competition? There is only so much oil, natural gas, and natural gas liquids to be moved to and from the refinery. All of this new competition could potentially mean lower income and lower dividends for MLPs as contracts come up for renewal. How many new issues have come since Kinder Morgan (NYSE:KMP) and Magellan Midstream (NYSE:MMP)?
4. Hedging and derivatives: If you read the annual reports of MLPs, almost all have some type of hedge in place. It could be to hedge the price of oil or natural gas or a rise in interest rates. One of the many risks in hedging is counter-party risk. What bank or hedge fund is the counter-party? What if it goes under? Is the government going to continue to bail out these entities? Why would anyone offer a hedge against a rise in interest rates? To directly quote Amerigas Partners' (NYSE:APU) Annual Report, "The Partnership is exposed to credit loss in the event of nonperformance by counter parties to derivative financial and commodity instruments". Reading the Risks section of any annual report actually can give you the real risks of an investment.
5. General Partner relationship: The fifth risk is the relationship of the MLP with its general partner (GP). So many MLPs have different agreements that it is difficult to lay out one risk. Some GPs get an incentive based upon distributions. Some have poison pills in place to thwart takeovers. Are there conflicts of interest between the GP and MLP of new opportunities? Many GPs are publicly traded and by law, have to have their own agenda.
Conversely, the relationship between the GP and MLP can also help. Look at Access Midstream's (NYSE:ACMP) GP -- Williams (NYSE:WPZ) and Global Infrastructure Partners, which has a tie-in with Chesapeake (NYSE:CHK). You can bet the GP will be pushing business their way.
Conclusion: I don't mean to pooh-pooh MLPs. They have been great over the last few years. It's just that when every Tom Dick and Harry begins to talk about them, I get a little concerned. Any serious MLP investor will tell you not to just look at yield.