(Editorial note: This article has been edited with author consent upon the urging of Kayne Anderson. Nothing in the original article was untrue or misrepresented the opinion of the author. However, there was concern that the article could have better paid tribute to KMF’s intention to constrain the portfolio to 25% MLPs and qualify for Registered Investment Company tax treatment. Seeking Alpha and the author both intend to avoid the possibility of confusion to the lay-reader.)
On Tuesday evening November 23rd 2010, Kayne Anderson Midstream/Energy Fund (NYSE:KMF) announced the pricing of its Initial Public Offering (“IPO”). Closed End Fund IPOs are always priced at a premium to their Net Asset Value (“NAV”) so regardless how good or bad the investment is for its new shareholders, such an announcement always marks a particular marketing feat.
Paragraph one of the press release highlights the size of the offering:
Kayne Anderson Midstream/Energy Fund, Inc. (the “Fund”), a newly organized closed-end fund announced today the pricing of its initial public offering of common stock. The Fund agreed to sell a total of 19,000,000 shares at a price of $25.00 per share (not including 2,850,000 shares that the underwriters may purchase pursuant to a 45-day option to cover over-allotments). Shares will begin trading on November 24, 2010 on the New York Stock Exchange under the symbol “KMF.”
For those lacking mental calculatiors, 19 million shares times $25 of investor capital to acquire each would represent $475 million. It is my opinion that a $475 million marketing success would be unlikely for a Closed-End Fund IPO not sold by asset gatherers with a huge focus on the hot MLP asset class. Factually, MLPs must be constrained to 25% of the portfolio to achieve KMF’s intention to be taxed as a Registered Invesment Company (“RIC”), and not a C-Corporation like most single security instruments other than debt instruments understood by shareholders to be focused on the MLP asset class.
Paragraph two of the press release glances at the Fund’s ojective, without discussing structural (in)efficiencies (more on that later):
The Fund’s investment objective is to provide a high level of total return with an emphasis on making quarterly cash distributions to its stockholders. The Fund seeks to achieve its investment objective by investing at least 80% of its total assets in securities of companies in the Midstream/Energy Sector, consisting of (a) Midstream Master Limited Partnerships (“MLPs”), (b) Midstream Companies, (c) Other MLPs and (d) Other Energy Companies. Net proceeds from this offering will be used to make investments consistent with the Fund’s investment objective and investment policies.
Paragraph three and four of the press release demonstrate who got the management contracts and who what investment banks were compensated by floating the offering:
The Fund will be managed by KA Fund Advisors, LLC (“KAFA”), a subsidiary of Kayne Anderson Capital Advisors, L.P., a leading investor in MLPs. As of September 30, 2010, Kayne Anderson and its affiliates managed assets of approximately $9.9 billion, including $8.5 billion in the Midstream/Energy Sector.
UBS Investment Bank, BofA Merrill Lynch, Citi, Morgan Stanley and Wells Fargo Securities are acting as joint book-running managers. Ameriprise Financial Services, Inc., Baird, Barclays Capital, RBC Capital Markets and Stifel Nicolaus Weisel are acting as senior co-managers on the offering…
After providing the addresses of those five investment banks, a bit of useful information to potential investors is offered:
Investors may also obtain the prospectus free of charge from the Securities and Exchange Commission’s (“SEC”) website at www.sec.gov.
An investor should read the Fund’s prospectus carefully before investing. The prospectus contains important information about the Fund and its investment objective and policies, risks, charges and expenses.
More specifically, the most recent prospectus amendment is available here within the SEC website. Good luck to the novice trying to find the same independently. Those interested in what they might be investing in would benefit to actually read it. In addition to observing customary risks associated with leveraged Closed-End Funds and the asset class, and where the up front expenses goes, it may be appropriate to contemplate the prospects of taxation as a Regulated Investment Company and/or a C-Corporation.
Apparent Structural Inefficiency
For Wall Street to sell single-security portfolio instruments into the MLP hotbed, certain inefficiencies must be absorbed by the product. In the case of KMF, the intention is to constrain the portfolio to 25% MLPs. Such might be well understood by all shareholders. Kayne Anderson may be forever successful in avoiding the “C-Corporation” tax treatment.
(What follows below applies to CEFs that are taxable as C-Corporations - a treatment KMF may avoid if it can successfully constrain its portfolio to 25% MLPs):
Closed-End Funds marketed into the MLP hotbed are generally not constrained to 25% MLP allocations, and are generally taxable as C-Corporations. Same with mutual funds and the ALPS Alerian MLP ETF (NYSEARCA:AMLP) that invest in MLPs. Their Net Asset Value (“NAV”) generally account for a tax burden. KMF’s generally addresses such a possibility as a risk.
I 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 less than 70% of the long term performance of underlying securities. So, assuming positive long term returns if the asset class proves to have investment merit over time, KMF’s NAV performance is highly likely to underperform even a random sample of the MLP asset class constituent. 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, KMF 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 (JPMorgan Alerian MLP Index ETN (NYSEARCA:AMJ), Credit Suisse Cushing 30 MLP Index ETN (NYSEARCA:MLPN), UBS E-TRACS Alerian MLP Infrastructure Index ETN (NYSEARCA:MLPI)), which themselves have distribution challenges and in their manufacture create new credit risk.
I love Closed-End Funds generally, but Closed-End Funds investing in MLPs may prove upon widening discounts in addition to incomplete asset class participation even worse than AMLP. To be clear that is not a compliment to AMLP.
No Critique of KMF Portfolio Managers
Over time, there are paths to KMF being treated as a C-Corporation, or it may forever remain constrained to a 25% MLP allocation. While I may not identify with whether structurally compromised products should ever exist, I am in no way blaming passing judgment on the management of KMF. While there are some holdings in the portfolio which I personally find to be subject to conflict of interest risk with which I’m uncomfortable, I am sure they do their due diligence in portfolio selection. The pool of investable MLPs is not huge and perhaps they are open to some things I am not open to in desire of having more diversification than my own 16 Direct MLP holdings.
The people behind KMF very well may be great people; they have a great challenge in outperforming the asset class. The same is also true of AMLP, the index ETF, and other MLP focused Mutual or Closed End Funds of course. And ETNs have their own significant detriments too.