We have received several inquiries recently about investments in master limited partnerships (MLPs). It seems that, although the popularity of MLPs is growing, many investors still don’t understand exactly what an MLP is or the risks involved in investing in one.
An MLP is a kind of limited partnership that is publicly traded on an exchange. It is similar to any other limited partnership, in that, 1) the limited partners provide the capital to the entity in return for periodic distributions of income; and 2) it is run by a general partner who receives compensation in return for management services rendered.
What are some risks of MLPs?
- MLPs hold cash-generating assets and are generally focused on the exploration, development, mining, or processing of natural resources, such as oil and gas, or minerals. This concentration in one sector can make them sensitive to shifts in the price of the related commodity.
- MLPs begin with a sponsor, usually a public company, that contributes assets to the MLP (and therefore holds limited partnership interests), controls the MLP’s general partner, and appoints the general partner’s board of directors. An MLP does not have its own board of directors. This results in control over the MLP by its sponsor entity and is inherently a conflict of interest.
- Investors who purchase limited partnership “units” in the MLP are liable for the debts and obligations of the MLP, generally up to the amount of capital contributed.
- Most MLPs announce its expected minimum cash distribution for the following 12 month period. If an MLP is unable to maintain its distributions, the trading price of the limited partnership units may be negatively impacted. This can incentivize the sponsor to maintain the level of distributions even if it requires borrowing by the MLP.
- MLPs may have tax consequences for the limited partners. Typically, MLPs do not pay federal income taxes. Instead the limited partners generally report their share of the income, gains, losses and deductions for the MLP on their individual tax returns based on the amount of their individual investments and pay the applicable income taxes. Investors may also need to file state tax returns in the states where the MLP does business even though the investors do not live in those states. Before you invest in any MLP, you should discuss the potential tax consequences with your tax advisor.
As with any investment, discuss the pros and cons of investing in an MLP thoroughly with your investment professional and make sure you understand what you are getting into before turning over your hard earned money.