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Opportunity Knocking In MLPs

|About: Kayne Anderson MLP/Midstream Investment Company (KYN), Includes: KED, KMF, KYE

Summary

KYN (Kayne Anderson MLP) is the largest CEF in the MLP sector

It offers an attractive 11.4% yield which can be tax-advantaged

Recent selling pressure has created a significant and rare price discount

The fund's NAV has potential to add 11.5% if corporate tax rates are lowered

For readers not already familiar with closed-end funds - and specifically MLP closed-end funds - here's a quick primer:

Closed-end funds (BATS:CEFS) are actively managed fund products, similar to mutual funds, which have a "closed" (i.e., fixed) number of shares issued - much like a company's stock.  Unlike mutual funds and ETFs which can expand and contract assets continuously by allowing investors to contribute new capital or redeem existing capital, closed-end funds cannot.  

Since interest in CEFs waxes and wanes like any other investment product, prices of a closed-end fund tend to rise above or fall below underlying fair value (referred to as the NAV) of a fund.  

One of the more popular uses of the CEF structure is as a vehicle to invest in master limited partnerships (NYSEARCA:MLPS), without the inconvenience of a K-1 or UBTI.  MLP funds account for about 5% of the CEF marketplace and, in my opinion, are among the best applications of the CEF structure.  

The largest fund in the sector, Kayne Anderson MLP (KYN) manages over $1.8B in net assets and has been in operation since 2004.  The fund offers an attractive distribution rate of 11.98% (source: Morningstar) which has the added benefit of being 100% return of capital, which makes it tax-free at time of distribution (important note: this lowers cost basis and may add to capital gains upon sale) which can make this a nice way for long-term holders to defer taxes.  Side note: in some cases, return of capital is concerning to investors because it looks as though a fund isn't earning its distribution.  MLP funds with ROC do not fit into this "bad ROC" category, in my view.  

Over the past several weeks, Kayne Anderson MLP (KYN) has gone on sale.  Experienced CEF investors will note that the fund is currently at a Z-score of -2.4 (1 year) and an amazing -3.3 (3 month) (source: cefconnect.com).  This is a shorthand way of expressing that KYN is selling at a discount which is on the far-left tail of the recent historical range (i.e., it's historically cheap).  This makes the fund an attractive opportunity on a purely statistical basis.

However, there's a tax reform kicker which I haven't seen others discuss.  Please follow me into the tax weeds...  Due to its long tenure (13+ years) and entity structure (C-Corp), KYN has on its balance sheet a very large deferred tax liability ("DTL") which as of Oct 31st was $4.40 per share. 

I'll spare readers the long version of how GAAP accounting works for C-corp MLP funds, but the short version is that the fund's NAV (currently reported as $16.33) is presented net of the deferred tax liability of $4.40.  In other words, the NAV before DTL adjustment is $20.73.  The discount to unadjusted NAV (ie $20.73) is a whopping 23.5%!

GAAP is extremely conservative in treatment of DTLs, essentially presuming that 100% of that tax bill is due today, which is not the case.  Investors have historically partially backed out the DTL for purposes of determining what price they'll pay for such a fund.  The DTL isn't treated as $0, but neither is it treated as its full balance sheet amount, in the eyes of investors.  The fund's true discount is somewhere wider than 3% but less than 23.5%, depending on how you choose to discount the DTL.  

Now for the kicker.  This DTL is carried on the balance sheet at the prevailing tax rate, which I believe is 35% in this case.  If corporate rates were to be lowered, the fund would be able to recalculate this DTL at that future (lower) rate, lessening the DTL and "magically" increasing the reported NAV.

Back-of-envelope math: if rates dropped from 35% to 20%, the DTL would drop to $2.51, and the NAV would rise to $18.21 - an 11.5% bump in NAV!  This would place current market price at a 13% discount on this new NAV, not considering whatever discount factor investors decide to apply to the remaining DTL.  

Please do your own diligence on all of the above.  Tax matters can be nuanced.  However, in my view, KYN represents a compelling - and not yet recognized - opportunity.  

Disclosure: I am/we are long KYN.