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Summary

  • TYY is trading a lower relative discount than the other two funds.
  • The combined fund will be raising the distribution and lowering the management fee.
  • TYY has an attractive long term performance record.

Master Limited Partnerships (NYSEARCA:MLPS) have been one of the best performing asset classes over the last decade, especially on a risk-adjusted basis. The Sharpe ratio for MLP's has been consistently higher than for most other asset classes. If you go back a year, many of the MLP closed-end funds were selling at premiums over NAV. But things have changed dramatically since then and most of the funds sell at attractive discounts to NAV now.

Last month, I attended a closed-end fund conference where issuers of MLP funds had a panel discussion to discuss the current difficulties they face in offering new closed-end funds. It is hard to convince investors to pay a 5% premium (the sales load) for a new fund, when so many existing funds sell at attractive discounts to NAV.

Back in January, Tortoise Capital Advisors announced a proposed merger of three of their MLP closed-end funds. Tortoise Energy Capital Corporation (NYSE:TYY) and Tortoise North American Energy Corporation (NYSE:TYN) will be merged into Tortoise Energy Infrastructure Corporation (NYSE:TYG). The annual shareholders meeting is May 28, 2014 where shareholders will vote on the mergers.

There are a number of potential benefits to the mergers:

- Positive potential impact to distributable cash flow. Tortoise management intends to recommend that the Board approve an increase in the distribution of the combined fund to at least $0.61 per TYG share from the current $0.58.

- Opportunity for enhanced trading liquidity (narrower bid-asked spread) for the combined TYG.

- Operating cost savings and reduced management fees. Management estimates cost savings of $1.5 million. Currently TYG, TYY and TYN have annual management fees of 0.95%, 0.95% and 1.00% respectively. The tiered fee schedule would result in reduced management fees of 0.95% up to $2.5 Billion, 0.90% between $2.5 Billion and $3.5 Billion and 0.85% above $3.5 Billion. Based on combined assets of about $3.7 Billion, the effective rate for the combined fund is estimated to be about 0.93%.

- The larger asset base of the combined fund may provide greater financial flexibility through a larger balance sheet, more attractive leverage terms and a wider range of leverage alternatives.

The fund exchange rates for the merger will be determined based on each fund's respective net asset value on the business day just prior to the closing of the merger. All three funds have net deferred tax liabilities attributable to realized and unrealized gains on investments. These liabilities are already included in each fund's NAV calculation under GAAP accounting and will be reflected in the exchange rates for the merger.

If the stockholder voting and other conditions to closing are satisfied, the mergers are expected to take place around June 20.

At the present time, I believe that TYY is the best way to play the upcoming merger since it currently trades at the largest discount to NAV. The number of shares of TYG that will be received by a TYY shareholder is computed as follows:

(TYY NAV / TYG NAV) * TYY Shares= TYG shares + cash for fractional shares

MLP CEFs that are organized as a corporation must book a deferred tax liability (DTL) against securities in their portfolio that have appreciated. (When securities depreciate in value, a deferred tax asset (DTA) occurs.) As portfolio values change, DTLs or DTAs will occur. But since MLPs have generally had strong asset performance since inception, most MLP CEFs that have been in existence for some time have generated significant DTLs.

DTAs and DTLs do not adversely affect the value of the fund's underlying investments, and are really no different than having unrealized capital gains or losses in a traditional closed-end fund. The deferred tax liability only affects "real" net asset value when there is a sale of the investment that generated the DTL.

For CEFs with a low turnover ratio, I use an "adjusted" NAV where you add back the deferred tax liability (DTL) to the reported NAV. This adjustment gives you a much more realistic NAV. But note that for purposes of the merger exchange ratios, the regular unadjusted NAV is used, not the adjusted NAV.

Tortoise Energy Capital Corp is a closed-end fund designed to provide an efficient vehicle to invest in a portfolio of publicly-traded master limited partnerships . It seeks to obtain a high level of total return with an emphasis on paying current distributions to shareholders.

When you use the adjusted NAV for TYY, it currently trades at a whopping discount of -32.8%.

NAV= 36.98 DTL= 14.92 Adjusted NAV= 51.80

Market price= 34.83

Under normal circumstances, the fund invests at least 80% of total assets in equity securities of energy companies and at least 80% in equity securities of MLPs in the energy infrastructure sector. Up to 50% of total assets can be in restricted securities, primarily through private placements. The fund may invest up to 20% in debt securities. This is the sector allocation as of Feb. 28, 2014:

TYY- Sector Allocation Breakdown

Crude/Refined Product Pipelines

45%

Natural Gas/Natural Gas Liquid Pipelines

37%

Natural Gas Gathering/Processing

18%

TYY has good long term NAV performance but with a lot of volatility. The one losing year was 2008 when the NAV lost 53.23%. Over the last five years, it has produced a 25.3% annualized return based on NAV. The five year return based on market price was +22.48% annualized. Here is the total return NAV full year performance for TYY since 2006:

2006

+27.61%

2007

+7.18%

2008

-53.23%

2009

+96.07%

2010

+30.67%

2011

+11.50%

2012

+3.39%

2013

+33.18%

YTD

+13.98%

TYY- Top 10 Equity Holdings (as of April 30, 2014)

PAA

9.0%

MMP

8.2%

SXL

7.8%

EPD

7.0%

BPL

6.2%

ETP

4.5%

ACMP

4.5%

SEP

4.4%

OKS

4.0%

WES

3.9%

Here are some summary statistics on TYY:

Tortoise Energy Capital Corp.

  1. Total Assets: 956 Million Total Common assets: 744 Million
  2. Inception Date: May 31, 2005
  3. Annual Distribution (Market) Rate= 4.93%
  4. Last Regular Quarterly Distribution= $0.4325 (Annual= $1.73)
  5. Fund Expense ratio: 1.74% (Management Fee= 0.95% on total assets)
  6. Discount to NAV= -5.81% (before DTL adjustment)
  7. Deferred Tax Liability (DTL)= 14.82
  8. Adjusted Discount to NAV= -32.8% (after adding DTL to NAV)
  9. Portfolio Turnover rate: 12.3%
  10. Effective Leverage: 24.4%
  11. Average Daily Volume (shares)= 47,000
  12. Average Dollar Volume = $1.55 Million

As of May 16, the CEF asset coverage ratio for preferreds was 392% where the minimum requirement is 225%. For debt, the asset coverage ratio was 487%, where only 300% is required.

TYY is reasonably liquid for smaller investments, but care must be used for larger purchases. The official NAV for TYY is only updated weekly by the fund, but approximations to the NAV can be made by looking at price changes in the underlying holdings.

The main negative for TYY is the high expense ratio. I believe management of most of the MLP closed-end funds are overpaid, given the "buy and hold" nature of the portfolios.

But because of the upcoming closed-end fund merger and the high adjusted discount to NAV, TYY appears to be a good opportunistic investment now for an IRA. By purchasing TYY now, you are essentially buying the combined TYG at about a 6% discount while TYG itself currently trades at around a 2% discount.

Disclosure: I am long TYY, TYN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Tortoise MLP Closed-End Fund Merger Provides Opportunities