Tortoise Energy Capital Corp (NYSE:TYY) recently sent out their 2010 3rd Quarter Report. Shareholders who own TYY for exposure to the Master Limited Partnership (“MLP”) asset class may be well served to actually read it. A huge structural inefficiency for TYY, along with its MLP-focused ETF, Mutual Fund, and Closed-End Fund peers is readily apparent:
At August 31, 2010, the balance sheet reflects a net deferred tax liability of approximately $83.7 million or $4.34 per share.
More than $83 million on $690,388,032 in Total Assets was offset by net deferred tax liability due to the product’s single security wrapper for the diversified MLP exposure being taxable as a C-Corporation. Such data is merely the symptom of the underlying structural inefficiency of using a single security for a diversified set of underlying MLP holding constituents. The cost of the inefficiency, as reflected by NAV, grows as the underlying assets appreciate. Such is true whether the TYY and its peers close positions or not.
TYY Structural Inefficiency
While better known as a Closed-End Fund, TYY is technically taxable as a C-Corporation. Like other MLP Focused Closed-End Funds, Mutual Funds, and even the ETF (NYSEARCA:AMLP), its Net Asset Value (“NAV”) should account for its tax burden. I previously documented one demonstration of the financial effect in Nuveen’s MLP & Strategic Equity Fund Inc (NYSE:MTP), upon it writing down its NAV by $1.05 per share overnight.
Chuck Epstein, an award-winning financial writer who has written by-lined articles for over 50 financial publications and clearly a proponent of progressive change in the asset management industry, also just covered the C-Corporation product phenomenon among other important MLP investing topics.
In short, the C-Corporation structure generally constrains NAV performance to about two-thirds of the long term performance of underlying securities, before expenses. So, assuming positive long term returns if the asset class proves to have investment merit over time, TYY’s NAV performance is highly likely to underperform even a random sample of MLP asset class constituents.
No Critique of TYY Portfolio Managers
I am not advocating the throwing of darts as there are numerous single security hazards in a sector cluttered with conflict of interest. Significant Incentive Distribution Rights (“IDRs”) to an MLP holdings’ General Partner may be a very concerning indicator of potentially conflicted interest.
Rather, the C-Corporation structure of an MLP focused single security investment wrapper is far less efficient than direct ownership. Therefore, in addition to inferior NAV returns, TYY may prove to be subject to insufficient market demand for its product shares and thus be assigned a wide discount by Mr. Market over time. I’m surely not advocating to own MLP ETNs (AMJ, MLPN, MLPI), which themselves have distribution challenges and in their manufacture, create new credit risk.
While I may not identify with whether a C-Corporation Structure for an MLP investment vehicle should ever exist, I am in no way blaming passing judgment on the management of TYY. There are some holdings in the portfolio which mirror my own direct holdings of MLP units, outside of a C-Corporation wrapper.
The people behind TYY very well may be great people. They have a great challenge in outperforming the asset class to such an extent to make up for the C-Corporation tax classification of the product wrapper. The same is also true of AMLP, the index ETF, and other MLP focused Mutual or Closed End Funds, of course.
Disclosure: No positions in securities mentioned. Author is long 16 MLPs directly in an account licensed to Covestor’s MLP Direct Ownership Model, and short one unreferenced MLP Focused Closed-End Fund in accounts licensed to Covestor’s Long/Short Opportunistic Model and Covestor’s Pure Short Opportunistic Model. Dan Plettner and Covestor are both cited in the work of journalist Chuck Epstein, to which this article refers. Covestor is a Registered Investment Advisor (“RIA”) licensing Dan Plettner's data to create models for its clients. In addition to receiving royalties from Covestor, Dan receives income for securities research. Dan is neither a Registered Investment Advisor, nor an employee of Covestor.