Kayne Anderson MLP Investment (KYN) recently provided their 2010 3rd Quarter Report which in financial statements discloses $262,227, or more than 10% of its $ 2,493,902 Total Assets in “Deferred Tax Liability”.
It is my opinion that this data demonstrates the huge structural inefficiency for KYN along with its MLP-focused ETF, Mutual Fund, and Closed-End Fund peers. MLP focused funds (those whose portfolio constituents are more than 25% MLPs) are subject to C-Corporation tax treatment at the investment company level. In short, the “wrapper” applied to the MLP constituents can make a great Net Asset Value (“NAV”) sacrifice of the constituents’ market value performance even before expenses. Proportionally, the structural sacrifice appears to be about one-third of the underlying constituents’ performance, accounting for C-Corporation Tax Liability.
The specific “Deferred Tax Liability” data here 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 KYN and its peers close positions or not.
Kayne Anderson Raising Assets Under Management
Although shareholders of Closed-End Funds generally lack an ability to redeem to their shares, Kayne Anderson has been very successful increasing Assets Under Management (“AUM”) in the current environment. Investors are generally familiar with the possible expiration or limited extension of the Bush Tax Cuts and Asset Gatherers who appeal to hands-off people have the public highly conscious of K-1 processing efforts. It’s a dangerous situation when the public understands the tax efficiency of MLP investing generally, but doesn’t understand the specifics associated with MLP investing vehicles.
Further examination of the shareholder reports may provide a useful glimpse as to the assets being raised, which although not generally subjected to commissions in issuance will be subject to perpetual management fees. Page one and two of the KYN 2010 3rd Quarter Report highlight its own marketing success in recent asset new share issuance, sometimes simultaneous with KYN investing in units of interest to the same new investors.
Private Placements. On June 10, 2010 and June 15, 2010, we completed two private placements of unregistered common stock to members of senior management of Magellan Midstream Partners, L.P. (“MMP”) and Inergy Holdings, L.P. (“NRGP”), respectively. The Company issued a total of 1.5 million shares at an average price of $23.90 per share. Simultaneous with the issuance of the Company’s common stock, the Company purchased $35 million of NRGP common units and $9.9 million of MMP common units owned by such members of senior management.
Common Share Offering. On August 11, 2010, we completed a public offering of 7.3 million shares of common stock at a price of $26.30 per share (the offering price represented a 4% premium to our net asset value at such time). Net proceeds from the offering of $182.9 million were used to make additional portfolio investments. These new investments were consistent with our investment strategy and were predominately made in equity securities of midstream MLPs. On September 9, 2010, we issued 793,877 shares of common stock at a price of $26.30 per share as part of the over-allotment option in connection with the August offering.
KYN has not been the only Closed-End Fund vehicle which has driven the managers’ AUM of late. I recently wrote about Kayne Anderson Midstream / Energy Fund (KMF), which raised $475 Million in new investor capital on November 23rd, 2010. That particular fund intends to constrain its MLP investments to not surpass a 25% threshold and it is certainly possible that all 19 million IPO shares were allocated to investors who understand that constraint. My original words were edited (with my consent) following Kayne Anderson’s urging.
Whether my opinion is critical of the products, or whether I’m skeptical as to the clarity about the products’ sacrifices and inefficiencies apparent to the public is incidental. One thing is clear. Kayne Anderson has been successful raising assets in marketing its products
KYN Structural Inefficiency
While better known as a Closed-End Fund, KYN is technically taxable as a C-Corporation. Like other MLP Focused Closed-End Funds, Mutual Funds, and even the ETF (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 (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, KYN’s NAV performance is highly likely to underperform even a random sample of MLP asset class constituents.
No Critique of KYN 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, KYN 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 KYN. 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 KYN 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.