Inside Master Limited Partnerships · 4 Investors, Universe and Vehicles MLP Investors In the 1980s and 1990s, individual retail investors were the primary MLP investors. Since MLPs

Knowledge. Experience. Integrity.

Master limited partnerships (MLPs) are attractive to retail and institutional investors seeking invest-

ment opportunities with yield and growth return streams, inflation-hedging characteristics and diver-

sification. Additionally, taxable investors may benefit from MLPs’ tax advantages. MLPs are typically

part of a real asset portfolio.

MLPs differ from other publicly traded securities in their legal structure, leading to varying income

and tax implications. The majority of MLPs are active in the energy and natural resources sectors,

including oil and gas.

The investable universe for MLPs has expanded since they were first created in the 1980s to ap-

proximately $240 billion as of 2011. The explosion of products, indices and vehicle types has opened

doors for institutional investment.

However, MLPs are not appropriate for all investors. Risks relate to the accessibility of capital, legis-

lative changes, liquidity and the potential impact of commodity prices.

IntroductionMaster limited partnerships (MLPs) are investment opportunities with different characteristics than stan-

dard publicly traded securities. Similar to stocks, they are traded on public securities exchanges. However,

they are typically structured as limited partnerships, which have different tax implications. Additionally, un-

like REITs and other publicly traded securities, MLPs are not included in the main indices, such as Russell

and Standard & Poor’s, and thus potentially offer diversification benefits. MLPs have recently garnered

attention given the current low rate environment and the looming threat of inflation. These vehicles offer

returns from both yield and growth, and their consistent growth of cash distributions over time has led to

an influx of investment flows. MLP market capitalization has increased nearly tenfold in the past decade

to reach around $240 billion in 2011.

In this primer, we introduce MLPs and examine the investable universe. We review some of the benefits

and risks of MLP ownership for both institutional and retail investors, and address performance and

benchmarking.

CALLAN INVESTMENTS INSTITUTE

Research

July 2012

Inside Master Limited Partnerships

A Primer

2

The Basics: Legal and Ownership StructuresLegal FoundationMLPs are considered an asset class focused on yield and growth, and are frequently bucketed with real

return strategies. Technically, they are a type of corporate structure (accounting partnership)1 that are

taxed at the partnership level. MLP units trade on exchanges, such as the NASDAQ and NYSE, as part-

nership interests and pay distributions to their investors. They are able to allocate a greater portion of their

cash flow directly to investors than other publicly traded companies because they are not corporations (or

C Corporations) and thus do not pay corporate-level taxes.

The tax code for MLPs applies only to certain business-

es, generally those engaged in natural resources and

commodity investments, and some real estate enter-

prises (see side box for details on what qualifies). The

U.S. government recently changed the list of assets

eligible within the MLP structure, indicating their sen-

sitivity to legislative changes. Energy policy can impact

the industry by expanding or contracting the number of

MLPs based on how “qualifying sources” of income are

defined.

Ownership StructureOne general partner (GP) manages the daily operations of the MLP and periodically pays multiple limited

partners (LPs), or investors, distributions. The GP typically has a 1% to 2% ownership stake in the part-

nership and is eligible to receive incentive distribution rights (IDRs). GPs are also liable for all debts and

obligations of the partnership. LPs provide capital to the partnership and own the majority of its assets.

They receive a higher portion of initial cash flows generated by the partnership, but do not participate

in management or operations. Furthermore, any liability attributed to the LPs is limited to the amount of

capital they have invested.

IDRs are established in the partnership agreement and outline the percentage of cash flow allocated be-

tween the GP and LP unit holders (Exhibit 1). These IDRs allow the GP to share in distributions and claim

an increasing percentage of quarterly cash flow as the distribution payments grow over specified levels.

IDRs are essentially a performance fee paid to the GP for growing the distribution.

Qualifying Sources of Income

To receive partnership tax treatment, MLPs must generate at least 90% of their in-

come from qualifying natural resources, including oil, gas, petroleum products, coal,

other minerals, timber and any other depletable resource. In 2008, the Emergency

Economic Stabilization Act expanded this definition to include industrial source car-

bon dioxide, ethanol, biodiesel and various other alternative fuels. Specifically, quali-

fying natural resource activities include exploration, development and production

(E&P), mining, gathering and processing (G&P), refining, compression, transporta-

tion (e.g., pipeline, ship, truck) storage, and marketing and distribution. Retail sales

(e.g., gas stations) do not qualify.

1 MLPs were created in the early 1980s. Congress created the current MLP structure with the “Tax Reform Act of 1986” and the “Revenue Act of 1987” legislation intended to define and limit publicly traded partnerships.

3Knowledge. Experience. Integrity.

Percent of Distribution Allocated to:Hypothetical Distribution Tiers LP GPTier 1 98% 2%

Tier 2 85% 15%

Tier 3 75% 25%

Tier 4 50% 50%

As IDRs enter into the high splits, the cost of equity capital increases, leading to a higher hurdle for po-

tential projects and/or acquisitions.

MLPs are most commonly structured as limited partnerships but are sometimes created as limited liability

corporations (LLCs). Limited partnerships and LLCs are both publicly traded partnerships that avoid cor-

porate level taxation. Exhibit 2 illustrates the differences among the various corporate structures.

Structure Comparison LP LLC C CorporationTaxable at Entity Level No No Yes

Tax Shield on Distributions Yes Yes No

Tax Reporting K-1 K-1 1099

General Partner Yes No No

Incentive Distribution Rights Yes No No

Management Incentive Interests No Yes No

Voting Rights No Yes Yes

Exhibit 2

Comparison of Investable Business Entities

Exhibit 1

Sample Incentive Distribution Rights Tiers

● The primary difference is that LLCs do not have a GP and thus do not pay out IDRs to the GP. Because LLCs do not distribute IDRs, they typically enjoy a lower cost of capital.

● LLCs have members rather than partners and management owns the same membership interest as unit holders.

● Unit holders of LLCs have voting rights whereas MLP unit holders do not.

● Typically the IDR split structure starts with the GP receiving 2% of the distributions. ● As distributions grow and targets are achieved, GPs garner a greater share of the payout. ● Most IDR agreements reach a tier in which the GP receives 50% of each incremental dollar paid to the LP unit holders. This 50/50 tier (Tier 4) is often referred to as the “high splits” tier.

Source: Wells Fargo Securities

Source: Morgan Stanley Research

4

Investors, Universe and VehiclesMLP InvestorsIn the 1980s and 1990s, individual retail investors were the primary MLP investors. Since MLPs are pass-

through entities, retail investors are attracted to MLPs’ tax-deferred stream of income. A large portion of

the distributions is treated as a return of capital, which reduces the investor’s tax basis. However, in the

past decade, the percentage of institutional investors grew from 10% to over 30% (Exhibit 3).

Public pension funds have more recently taken an interest in MLPs. Historically, public funds shied

away from MLPs because of the issues surrounding the treatment of unrelated business taxable income

(UBTI). UBTI is earned from business activities unrelated to the organization’s tax-exempt purpose. Tax-

exempt entities that receive more than $1,000 in UBTI may be held liable for the tax on that income. A

number of public organizations have argued that one sovereign entity cannot tax another, and therefore

they are not subject to any UBTI associated with MLPs. This stance has led to increased investment

flows from this sector of the institutional investment community.2

MLPs are attractive to institutional investors because of their infrastructure growth opportunities,3 the

potential inflation-hedging characteristics and a broadening opportunity set. Additionally, both institutional

and retail investors have included modest allocations to MLPs as part of a real asset allocation, since

MLPs own physical assets that produce cash flow, which has historically outpaced inflation.

0%

5%

10%

15%

20%

25%

30%

35%

40%

2011201020092008200720062005200420032002

9%

28%

15%

33%36%

28%25%

16%

31%

10%

Exhibit 3

Percent of MLP Universe Owned by Institutional Investors

2 This commentary should not be viewed as tax advice. Investors should consult with a tax professional regarding any tax-related questions.

3 The Interstate Natural Gas Association of America (INGAA) estimates that $205 billion in new natural gas infrastructure investment will be needed in the next 25 years, $100 billion of which is projected in the next 10 years. MLPs are a natural candidate to participate in the build out of midstream energy assets.

Source: Morgan Stanley, Barclays, FactSet


The MLP market, as measured by the Alerian MLP Index, grew from $12 billion in 1999 to more than $240

billion at the end of 2011 (Exhibit 4). MLPs have likewise grown in number from 17 in 1999 to 80 in 2011.

Daily volumes have increased with market size and product availability. Greater institutional presence has

also helped to improve market liquidity, but the market is still subject to liquidity-induced volatility.

Investment VehiclesAs capital has poured into the space and asset managers have brought more products to market, inves-

tors interested in MLPs now have more options. Aside from direct ownership, new products and pooled

vehicles (e.g., closed-end funds (CEFs), open-end mutual funds (MFs), exchange-traded funds (ETFs),

exchange-traded notes (ETNs) and limited partnerships) have expanded rapidly. Since 2009, 24 new

products were introduced and another five are in various stages of registration with the SEC. A complete

list of the pooled vehicles available as of year-end 2011 can be found in the Appendix.

In addition to the various pooled vehicles available, investors can own MLPs directly by purchasing in-

dividual securities or through a professionally managed separate account. The most appropriate invest-

ment structure varies depending on the investor’s unique needs. Exhibit 5 highlights relevant areas of the

different vehicles that investors should consider.

Exhibit 4

Market Capitalization and MLP Growth

Source: Alerian, NAPTP, Wells Fargo Securities

Market Capitalization # Energy-Related MLPs

Bill

ions

$0

$50

$100

$150

$200

$250

2011201020092008200720062005200420032002200120001999

$206.5

$80.3

$14.5$11.6

$138.4

$65.2$51.4

$27.2$25.4

$240.6

$123.1

$102.2

$41.0

0

20

40

60

80

100

# Energy-R

elated MLP

s

6

Passive Strategies Active StrategiesExchange

Traded Note (ETN)

Exchange Traded Fund

(ETF)Closed-end Mutual Fund

Open-end Mutual Fund*

Limited Partnership

Fund

Separately Managed Account

Liquidity Daily Daily Daily DailyTypically

monthly or quarterly

Daily

Tax Reporting 1099 1099 1099 1099 Consolidated

K-1 Multiple K-1s

Investment Tax Status Taxable Note Taxable

C CorporationTaxable

C CorporationTaxable

C Corporation

Partnership Pass-thru Tax

Status

Partnership Pass-thru Tax

Status

Generates UBTI No No No No Yes Yes

Size of the Universe $4.8 billion $2.8 billion $15.5 billion $3 billion n/a n/a

# of Products 8 1 17 9 n/a n/a

Typical Fee 0.85% 0.85%High: 9.7%

Median: 2.4% Low: 1.2%

High: 1.5% Median: 1.25%

Low: 0.85%n/a

High: 1.25%Median: 0.70%

Low: 0.50%

Pros

Suitable for retirement accounts;

simplified tax reporting; little tracking error;

reasonable fees


simplified tax reporting;

no credit risk


simplified tax reporting


simplified tax reporting; daily liquidity at NAV

Consolidated K-1

Direct ownership;

transparency

ConsTax inefficient; credit risk of ETN issuer

Potential tracking error

Higher fees associated with the use of leverage;

corporate tax drag

Corporate tax drag

Not suitable for retirement

accounts

Not suitable for retirement

accounts; multiple K-1s

Exhibit 5

MLP Vehicle Options

as of March 13, 2012

* If the open-end fund is structured as a regulated investment company, MLP investments are limited to 25% of assets.

Source: SEC EDGAR Filings, Morningstar, eVestment Alliance


MLP SubsectorsThe majority of the 100 MLPs available today operate in the energy and natural resource sectors. These

can be broken down into two major categories based on the type of product the MLP is associated with

and its location in the value chain: upstream, which refers to exploration and production (or E&P), and

midstream. Downstream activities, which refer to the distribution and sale of products after they are re-

fined or processed, do not qualify as MLPs.

Upstream activities, comprised of the E&P of oil and gas from the wellhead, are approximately 13% of the

current investable universe. Specifically, the E&P sector focuses on the exploration, development and ac-

quisition of oil and natural gas producing properties. Most MLPs in this sector do not participate in explor-

atory drilling and typically own and operate assets in mature basins. Risks include declining commodity

prices, inability to hedge commodity exposure at reasonable costs and lack of acquisition opportunities.

Most hedge 70% to 90% of expected production for one to three years.

Midstream denotes the gathering, treating, processing and transportation or storage of crude oil, natural

gas, natural gas liquids (NGLs) and/or refined petroleum products after they are produced but before they

are distributed for consumption. The majority of MLPs (57%) fall into the midstream segment, which is

broadly divided into four main categories described below:

1. Natural gas, crude and refined product pipelines and storage terminals. These assets generally have

stable and predictable fee-based cash flows and minimal exposure to direct commodity price risk.

However, they can be exposed to indirect, volumetric risk if higher commodity prices squeeze de-

mand, leading to less product flowing through the pipes. Volumetric risk is higher for crude and re-

fined product pipelines than for natural gas pipelines.

Other 4%Financial Services 10%

Real Estate 6%

Other Natural Resources 4%

Coal 6%

Marine Transport 6%

Propane & Refined Fuel 7%E&P 13%

Pipelines, G&P, Storage and Refining

44%

Exhibit 6

MLP Universe by Subsector

as of December 31, 2011

Source: National Association of Publicly Traded Partnerships

8

2. Gathering and processing (G&P) MLPs collect gas from multiple wells and transport the commodity

through a system of pipelines to a processing facility. In general, the G&P sector is exposed to the

greatest commodity and volumetric risk within the midstream category. Commodity price sensitivity

for the processors varies depending on the type of contract that exists between the processor and the

producer of the commodity. G&P MLPs with commodity price exposure typically engage in hedging

to reduce their sensitivity to price swings.

3. Propane MLPs distribute propane via trucks to residential, commercial, industrial and agricultural

customers. Commodity price sensitivity is low as these MLPs can typically pass on price increases to

customers. The majority of revenue is generated during the winter heating season.

4. Shipping MLPs transport energy products primarily via tankers or barges. Long-term contracts pro-

vide these MLPs with some cash flow stability. Shipping MLPs have little exposure to commodity

prices but are dependent on sustained energy demand. A drop in global demand may cause a de-

crease in the amount of resources shipped.

The impact of commodity prices on MLP cash flow varies depending on the types of assets the MLP owns

and which subsector it operates within. Generally, the closer an MLP’s assets are to the wellhead (i.e., the

further upstream), the greater their commodity price exposure if operating unhedged.

Benchmarks and Historical Performance Given the recent popularity of the MLP sector, the number of new MLP indices has grown considerably.

The creation of products that track these indices has also kept stride. Despite the proliferation of new

indices and products, the Alerian MLP Index is widely viewed as

the industry standard.

Many of the newer indices generally conform to the Alerian MLP

Index with slight differences. For example, Tortoise Capital Advisors

launched the Tortoise MLP Index in December 2009. It is also capi-

talization weighted, but limits single name exposure to 10% and

carries more names (75 as of March 12, 2012). In contrast, Swank

Capital’s Cushing 30 MLP Index is an equal-weighted index of 30

MLPs that uses formula-based valuation methodology to rank the

MLPs for inclusion in the Index. It emphasizes fundamental factors

such as cash flow, cash distributions and other operational metrics

rather than market capitalization.

In terms of performance, the Alerian trounced the broader equity market over the 10 years ended

December 31, 2011, gaining 15.5% versus 2.9% for the S&P 500 with comparable volatility. Over the

same time period, the Alerian outshined other yield-oriented asset classes as well, besting indices repre-

senting REITs, utilities, high yield and commodities (Exhibit 7).

The Alerian is a market capitalization-weighted and float-adjusted com-posite of the 50 most prominent energy MLPs, including E&P companies, and represents more than $240 billion in market cap. To be included in the Index, a company must be a publicly traded partnership or LLC that is engaged in the transportation, storage, processing or production of energy commodities. MLPs must also meet other liquidity and capi-tal requirements. Since the Alerian is market cap-weighted and does not limit individual security representation, it exhibits a bias toward larger companies. The largest 10 names represent 59% of the Index; the top two account for 25%. In stark contrast, the smallest 10 constituents ac-count for less than 3% of Index exposure.4 These figures are based on the adjusted market cap weightings, which take into consideration the common units available for investment and exclude non-common units, locked-up units and insider-owned units that are not freely tradable.

4 As of the December 16, 2011 quarterly rebalancing.


The Alerian surpassed the other indices in all time periods except the most recent trailing one-year period,

when the DJ Utilities Index outperformed.

Exhibit 8 reveals the Alerian’s wide range of annual returns. In 1999 the Alerian MLP Index lost 7.8%,

followed by a surge of over 40% in 2000 and 2001. In 2002, the market again turned and the Index slid

3.4%. During the credit crisis, investors grew wary of MLPs’ ability to access capital; limited liquidity ex-

acerbated a sell-off as prices nosedived. From October 31, 2007, to December 8, 2008, the MLP market

experienced a dramatic peak-to-trough decline of 42%. A sharp recovery followed in 2009 (+76.4%), as

MLPs regained access to equity and debt capital at enticing rates.

Exhibit 8

Alerian MLP Index Calendar Year Returns

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

10 YearsFive YearsThree YearsOne YearLast Quarter4.4%

2.1%

13.9%

14.1%

8.3%

6.2%

11.8%

19.7%

16.3%

7.3%

8.6%

2.9%

15.5%

-2.2%

4.2%7.3%

-0.3%

8.7%

14.2%

9.4%

20.5%

12.8%

23.7%

14.1%

39.8%

Alerian MLP IndexS&P 500

Dow Jones Utilities Index

Merrill Lynch High Yield Master IINAREIT Composite Index

Ret

urns

9.0%

-1.2%

-2.8%

5.6%

6.9%

GS Commodity Index

Exhibit 7

Index Returns

Periods ended December 31, 2011

-40%

-20%

0%

20%

40%

60%

80%

201120102009200820072006200520042003200220012000199919981997

35.9%

76.4%

-36.9%

12.7%

6.3%

45.7%

-3.0%

13.9%

26.2%

16.7%

-7.8%

26.1%

43.7% 44.5%

-3.4%

Ret

urns

Source: Alerian

10

However, two key risks—volatility and liquidity—accompany potentially strong performance in this niche

market. Exhibit 9 illustrates the rolling three-year standard deviation for various indices. Over the most

recent 10-year period the Alerian had similar volatility to the S&P 500.

Benefits of MLP InvestingA growing opportunity set and increasing liquidity have recently made the MLP market accessible to more

investors, both retail and institutional. Key considerations for investors include:

● Attractive yields for investors seeking income

● A potential hedge against inflation

● Benefits attributable to estate planning and tax efficiency for taxable investors

YieldsThe current low rate environment and investors’ quest for yield have partially driven the recent surge in

popularity of MLPs. While MLPs are not considered fixed income securities, they offer investors an ap-

pealing tax-advantaged income distribution in addition to potential growth of this distribution. MLPs com-

pare favorably to other yield-oriented securities such as investment grade or high yield credit, Treasuries,

municipal bonds and REITs (Exhibit 10).

Exhibit 9

Rolling Three-Year Standard Deviation

as of December 31, 2011

GS Commodity Index

DJ Utilities Index

NAREIT Composite Index

ML U.S. High Yield Master II

S&P 500

Alerian MLP Index

20112010200920082007200620052004200320022001200019990

15

20

25

30

35

45

10

5

40

Sta

ndar

d D

evia

ion


MLPs have been able to grow their distributions consistently through acquisition and/or expansion, of-

fering a desirable value proposition of current yield plus growth of the distribution, further differentiating

them from other income-oriented investments. Broadly, MLP yields span 4% to 15% for the underlying

companies, with expected distribution growth rates ranging from 3% to 15%, depending on the subsector

within which they operate. Based on the yield plus growth model, using Barclays’ average yield (7.0%)

and their expected three-year average growth projections (6.1%), investors can expect a return of 13.1%

from MLPs over the next 12 months. Using historical growth rates rather than forecasted data, return

expectations are in the high single to low double-digits.

As of December 31, 2011, the Alerian yield was 6.1%, and its trailing three-year average distribution

growth rate was 4.2%, summing to an expected total return of 10.3% in 2012. The growth component is

underpinned by healthy fundamentals as well as the need for additional infrastructure investments.5

Inflation HedgeMLPs have also sparked the attention of investors interested in hedging inflation for three main reasons,

including:

● Most interstate pipelines have contracts that adjust annually based on some measure of inflation,

often the producer price index (PPI) plus some spread (e.g., PPI +1.5%). This builds an automatic

escalator into the contracts that is tied directly to one measure of inflation.

● MLPs involved in E&P and G&P are more sensitive to commodity price movements than others,

depending on the type of processing contract in place. They potentially offer an inflation hedge when

commodity prices increase.

Exhibit 10

Yields Across Asset Classes as of December 31, 2011

0%

2%

4%

6%

8%

10%

10-YearU.S.

Treasury

S&P500

BarclaysAggregate

BarclaysMuni

Index*

BarclaysBBB

Corporate

FTSENAREITAll REITs

AlerianMLPIndex

BarclaysCorporate

HY Cash Pay

1.9%2.2%2.2%

4.3%4.3%

4.9%

6.1%

8.3%

Yiel

d

5 INGAA estimates that $205 billion in new natural gas infrastructure investment will be needed in the next 25 years, $100 billion of which is projected in the next 10 years.

*Tax equivalent yield at 35%.

12

● MLPs own real, physical assets (e.g., pipelines and storage facilities) that produce cash flow, which

is ultimately distributed to the limited partners. Historically, MLPs have produced distributions at a

rate that exceeds inflation, even during times of economic and market weakness, such as 2008

(Exhibit 11). The trailing three-year average annual distribution growth rate as of December 31,

2011 was 4.2%, compared to the trailing three-year average rate of inflation at 2.4%. During the

credit crisis of 2008, the MLP sector suffered a sharp price decline, but MLPs were able to maintain

and, in many cases, increase their distributions due to the fundamental strength of the underlying

businesses. Even if MLP distribution growth does not return to the double-digit rates of 2006 to 2008,

industry experts conservatively project MLP distribution growth from 4% to 6% over the next three

to five years.

Potential Tax BenefitsFor taxable investors, MLPs offer benefits attributable to estate planning and tax efficiency. When MLPs

make distributions, the majority of the distribution is treated as a return of capital. The cost basis associ-

ated with the investment is reduced by the portion of the distribution that was treated as a return of capital.

Similar to other investments, upon death of the MLP holder, the holder’s estate is able to step up the cost

basis, thus eliminating any tax liability associated with reducing the holder’s original cost basis. However,

the advantage of MLPs is that they generate high tax-advantaged income now, providing a very meaning-

ful financial and estate planning instrument.6

6 This commentary should not be viewed as tax advice. Investors should consult with a tax professional regarding any tax-related questions.

0%

2%

4%

6%

8%

10%

12%

20112010200920082007200620052004200320022001200019991998

5%

4%

3%

10%10%

5%

4%4%

9%

1%

11%

4%

6%

5%

Median Distribution Growth Change in CPIExhibit 11

MLPs Median Distribution Growth vs. Change in Inflation

Source: Wells Fargo, Bureau of Labor Statistics


In addition to providing investors with appealing yields, inflation-hedging properties and tax benefits,

MLPs can also help to diversify a real assets portfolio. However, MLPs carry unique risks that investors

should consider within the context of their overall portfolio holding and investment goals.

Risks of MLP Investing Multiple risks are associated with owning MLPs. We highlight four that potential investors should consider:

● Access to capital markets

● Regulatory risk

● Liquidity

● The impact of commodity pricing

Access to Capital MarketsMLPs are highly dependent on access to debt and equity financing to fund their growth, since they pay

most of their cash flow to underlying investors in the form of distributions. When the capital markets

contracted in 2008, it became difficult for many MLPs to fund capital projects already underway. Many of

the larger, more stable MLPs with healthier balance sheets were still able to access the debt and equity

markets, though at higher costs. As a result, many of the projects broke even or, worse, went from positive

cash flow generation to negative. Furthermore, a higher cost of capital raises the hurdle rate necessary

for companies to justify a project, which might lead to less capital deployed. Ultimately, MLPs that cannot

access capital markets at a reasonable cost will not survive.

Regulatory Risk MLPs enjoy a favorable tax treatment that allows them to operate as a pass-through entity. Although there

is currently no legislation aimed at altering the tax treatment, changes to the status quo could negatively

alter investors’ returns and rattle the MLP market. Numerous proposals to tax pass-through entities have

arisen in the past two years. The Obama administration recently proposed a plan to make pass-through

entities pay corporate income taxes rather than allowing them to pass tax liabilities through to individual

unit holders. Given the government’s recent focus on U.S. energy independence along with job creation,

changes to the current favorable tax treatment face some political headwinds.

LiquidityMLPs are a relatively small investment sector and as such, liquidity is limited. The market cap of the

Alerian MLP Index stood at around $240 billion at the end of 2011. To put this in perspective, the market

cap of Exxon Mobil is approximately $400 billion. Average daily trading volume has dramatically improved

over the last few years. In 2006, average trading volume totaled $200 million per day, but has increased

fourfold averaging more than $800 million per day at the end of 2011.7 Even with the improvement in

liquidity, the market is still susceptible to sharp swings and technical dislocations when supply/demand

dynamics are out of sync.

7 Source: Barclays

14

The Impact of Commodity PricingMLPs can experience price volatility correlated to sharp movements in commodity prices, but this is often

due more to investor behavior and a perceived exposure to commodity prices than business fundamen-

tals. The rolling three-year correlations of MLPs to other asset classes in Exhibit 12 reveal that MLPs are

generally most correlated with high yield credit and equities and have the lowest correlations to oil and

natural gas.

A spectrum of commodity price sensitivity exists within the universe of MLPs. The MLP subsectors with

the greatest sensitivity to commodity price movements are E&P and G&P companies. E&P companies

have the most direct exposure as their revenues, derived from oil and natural gas production, are tied

closely to commodity prices. The G&P subsector also exhibits commodity price sensitivity due to the na-

ture of their contracts, which vary their exposure to the underlying commodity. Most E&P MLPs maintain

some sort of hedging program to help mitigate their exposure.

However, most MLPs, particularly in the midstream sector, are not directly exposed to commodity price

risk. MLPs are generally sheltered from direct commodity price movements because they do not take

ownership of the underlying commodity. Rather, MLPs own the assets that are used to transport, process

and store natural resources, rendering them susceptible to throughput and volumetric risk, which are

indirectly tied to commodity prices. For example, if the price of oil rises from $75 to $100 per barrel, con-

sumers may reduce consumption and the pipelines may transport less volume. However, the pipeline is

not directly exposed to the volatility of oil prices. Additionally, most contracts are long-term and fee-based

rather than volume-based, which mitigates throughput risk linked to a drop in demand.

Investors concerned about commodity price movements can construct a portfolio that excludes those

MLPs that are most sensitive to it.

Natural GasOil

GS Commodity IndexNAREIT Composite Index

DJ Utilities IndexML U.S. High Yield Master IIS&P 500

-0.1

0.2

0.3

0.4

0.5

0.6

0.8

0.1

0.0

0.7

2011201020092008200720062005200420032002200120001999

Cor

rela

tion

‘12

Exhibit 12

Rolling Three-Year Correlations Relative to the Alerian MLP Index

as of March 31, 2012

Source: Bloomberg


ConclusionMLPs are a niche strategy within the publicly traded securities arena. Popular with retail investors for

around 20 years, they have rapidly gained traction with institutional investors over the past decade.

They are typically included within the real return portion of a portfolio due to their yield and growth return

sources, and the tangible nature of their underlying assets.

The size of the MLP universe, both in number of MLPs and market capitalization, has increased dramati-

cally in the past decade. An influx of new indices, strategies and vehicles has accompanied growth. The

expanding opportunity set has made MLPs accessible to a wider variety of investors, many of which are

drawn to this asset class for the attractive yields, possible inflation hedge, diversification benefits and, for

taxable investors, potential advantages in estate planning and tax efficiency. However, investors consid-

ering MLP investment should be aware of the risks related to capital market access, potential legislative

changes, liquidity and commodity pricing shocks. Cash flow volatility and commodity price sensitivity also

vary within the different MLP sectors.

16

General Glossary/Key Terms for MLP Investments:

Downstream: Generally refers to retail or wholesale end users and, in the scope of oil, refineries where

crude oil is delivered.

Dropdown: The sale of an asset from a parent company (or sponsor company) to the underlying partner-

ship. Dropdowns generally occur at multiples that are immediately accretive to the partnership and ulti-

mately beneficial to the sponsor. Dropdowns from the sponsor enable the MLP to grow their distributions

without internal growth projects or a third-party acquisition.

Fracturing: A process employed in the production of natural gas that typically involves the pumping of

water (at very high pressures) to create an extensive crack in the rock formation. The crack in the rock

exposes an increased surface area that allows a greater amount of natural gas to be produced.

Fractionation: The process that involves the separation of the NGLs into discrete NGL purity products

(i.e., ethane, propane, normal butane, isobutane and natural gasoline).

Frac spread: The difference between the sales price of natural gas liquids (the processing output) and

the cost of natural gas (the processing input). Depending on the types of contracts in place, the frac

spread can impact the profitability of the processing facility.

Hydrocarbon: An organic compound made of carbon and hydrogen atoms used as sources of energy,

including natural gas, coal and crude oil.

Interstate pipelines: A pipeline that transports product across state lines. Interstate pipelines are regu-

lated by the FERC.

Intrastate pipelines: A pipeline that operates within one state. Intrastate pipelines are regulated by state,

provincial, or local jurisdictions.

Incentive distribution rights (IDRs): IDRs typically allow the GP to receive an increasing percentage

of quarterly distributions after the minimum quarterly distribution and target distribution thresholds have

been achieved. In most partnerships, IDRs can reach a tier wherein the GP is receiving 50% of every

incremental dollar paid to the LP unit holders. This is known as the 50/50, or “high splits,” tier.

K-1 statement: The statement that an MLP investor receives each year from the partnership that shows

his or her share of the partnership’s income, gain, loss, deductions and credits. A K-1 is similar to Form

1099 received by shareholders of a corporation.

Limited partner (LP): (1) provides capital, (2) has no role in the MLPs’ operations or management, and

(3) receives cash distributions.


Master limited partnership (MLP): Limited partnership investment vehicles consisting of units (rather

than shares) that are traded on public exchanges. MLPs consist of a general partner and limited partners;

also known as “publicly traded partnerships.”

Midstream: Gathering, treating, processing, transportation or storage of a product after it is produced

from the wellhead, but before it is distributed to the end use market for consumption.

Natural gas liquids (NGLs): NGLs are extracted from the raw natural gas stream into a liquid mix (con-

sisting of ethane, propane, butane, isobutane and natural gasoline). The NGLs are then typically trans-

ported via pipelines to fractionation facilities.

Publicly traded partnership (PTP): A master limited partnership (MLP) or a limited liability company that

has chosen to be taxed as a partnership, which is publicly traded.

Refined petroleum products: Crude oil refineries process and refine oil into refined petroleum products.

These products are primarily used as fuels by consumers (gasoline, diesel, jet fuel, kerosene and heating

oil).

Unrelated business taxable income (UBTI): MLP income received by a tax-exempt entity (e.g., pension

accounts, 401(k)s and endowment funds) is considered “income earned from business activities unre-

lated to the entity’s tax-exempt purpose,” or UBTI. A tax-exempt entity that receives more than $1,000 per

year of UBTI may be held liable for the tax on the UBTI.

Upstream: The production of oil and natural gas from the wellhead (also known as exploration and

production).

Wellhead: The equipment at the surface of a crude oil or natural gas well used to control the pressure of

the well. The wellhead is also the point at which natural gas or crude oil emerges from the ground to the

surface.

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Appendix: List of Publicly Traded Partnerships

Pipelines and Other Midstream Operations, CompressingAmerican Midstream Partners, LP NYSE AMIDAtlas Pipeline Partners, L.P. NYSE APLBlueknight Energy Partners, L.P. NASDAQ BKEPBoardwalk Pipeline Partners, LP NYSE BWPBuckeye Partners, L.P. NYSE BPLCalumet Specialty Products Partners, L.P. NASDAQ CLMTCentral Energy Partners, L.P. OTC ENGY.PKCheniere Energy Partners AMEX CQPChesapeake Midstream Partners, L.P. NYSE CHKMCompressco Partners, L.P. NASDAQ GSJKCopano Energy, L.L.C. NASDAQ CPNOCrestwood Midstream Partners LP NYSE CMLPCrosstex Energy, L.P. NASDAQ XTEXDCP Midstream Partners, LP NYSE DPMEagle Rock Energy Partners, L.P. NASDAQ EROCEl Paso Pipeline Partners, L.P. NYSE EPBEnbridge Energy Partners, L.P. NYSE EEPEnergy Transfer Partners, L.P. NYSE ETPEnergy Transfer Equity, L.P. NYSE ETEEnterprise Products Partners L.P. NYSE EPDExterran Partners, L.P. NASDAQ EXLPGenesis Energy, L.P. NYSE GELHolly Energy Partners, L.P. NYSE HEPInergy Midstream, L.P. NYSE NRGMKinder Morgan Energy Partners, L.P. NYSE KMP Magellan Midstream Partners, L.P. NYSE MMP MarkWest Energy Partners, L.P. AMEX MWE Niska Gas Storage Partners, L.P. NYSE NKANuStar Energy L.P. NYSE NSNuStar GP Holdings, LLC NYSE NSHOiltanking Partners, L.P. NYSE OILTONEOK Partners, L.P. NYSE OKSPAA Natural Gas Storage, L.P. NYSE PNGPlains All American Pipeline, L.P. NYSE PAARegency Energy Partners LP NYSE RGPRose Rock Midstream, L.P. NYSE RRMSSpectra Energy Partners, LP NYSE SEPSunoco Logistics Partners L.P. NYSE SXLTarga Resources Partners LP NASDAQ NGLSTC PipeLines, LP NYSE TCPTesoro Logistics LP NYSE TLLPTransmontaigne Partners L.P. NYSE TLPWestern Gas Partners, LP NYSE WESWilliams Partners L.P. NYSE WPZ

Exploration and ProductionAtlas Energy, L.P. NYSE ATLSBreitBurn Energy Partners L.P. NASDAQ BBEPConstellation Energy Partners LLC NYSE CEPDorchester Minerals, L.P. NASDAQ DMLPEV Energy Partners, L.P. NASDAQ EVEPLegacy Reserves LP NASDAQ LGCYLinn Energy, LLC NASDAQ LINELRR Energy, L.P. NYSE LREMemorial Production Partners LP NASDAQ MEMPMid-Con Energy Partners, LP NASDAQ MCEPPioneer Southwest Energy Partners, L.P. NYSE PSEQR Energy, LP NYSE QREVanguard Natural Resources, LLC NYSE Arca VNR

Propane and Refined Fuel DistributionAmeriGas Partners, L.P. NYSE APUFerrellgas Partners, L.P. NYSE FGPGlobal Partners LP NYSE GLPInergy, L.P. NASDAQ NRGYNGL Energy Partners LP NYSE NGLStar Gas Partners, L.P. NYSE SGUSuburban Propane Partners, L.P. NYSE SPH

Marine TransportationCapital Product Partners L.P.[1] NASDAQ CPLPGolar LNG Partners LP1 NASDAQ GMLPMartin Midstream Partners L.P. NASDAQ MMLP Navios Maritime Partners L.P. 1 NYSE NMM Teekay LNG Partners L.P. NYSE TGPTeekay Offshore Partners L.P.1 NYSE TOO

Natural Resources: Coal, Other Minerals and TimberAlliance Resource Partners, L.P. NASDAQ ARLPAlliance Holdings GP, L.P. NASDAQ AHGPCVR Partners, LP NYSE UANNatural Resource Partners L.P. NYSE NRP, NSPOxford Resource Partners LP NYSE OXFPenn Virginia Resource Partners, L.P. NYSE PVRRentech Nitrogen Partners, L.P. NYSE RNFRhino Resource Partners LP NYSE RNOPope Resources NASDAQ POPEZTerra Nitrogen Company, L.P. NYSE TNH

Real Estate PropertiesNew England Realty Associates, L.P. AMEX NENNTS Realty, Ltd. AMEX NLPW. P. Carey & Co. LLC NYSE WPC

Real Estate Mortgage SecuritiesAmerica First Tax Exempt Investors NASDAQ ATAXEllington Financial LLC NYSE EFCMunicipal Mortgage and Equity, LLC OTC MMAB.PK

Investment / Financial ManagementAlliance Bernstein, L.P. NYSE ABApollo Global Management, LLC NYAE APOThe Blackstone Group L.P. NYSE BXCompass Diversified Holdings LLC NASDAQFortress Investment Group NYSE FIGIcahn Enterprises, L.P NYSE IEPKKR & Co. L.P. NYSE KKRKKR Financial Holdings LLC NYSE KFNLazard Ltd. NYSE LAZOch-Ziff /Capital Management Group LLC NYSE OZMSource: National Association of Publicly Traded Partnerships (NAPTP)

OtherBrookfield Infrastructure Partners, L.P. NYSE BIPCedar Fair, L.P. NYSE FUNML Macadamia Orchards, L.P. NYSE NUTStoneMor Partners L.P. NASDAQ STON


MLP Closed-End Funds TickerIPODate

IPO Proceeds

($mm)

Proceeds Raised in 2010-2011

($mm)

Total Assets ($mm)*

Total Net Assets ($mm)**

Effective Leverage^

Total Expense Ratio^^

Tortoise Energy Infrastructure TYG 2/24/04 $301 $81 $1,745 $1,029 25.1% 3.47%Fiduciary Energy Income and Growth FEN 6/24/04 $140 $54 $553 $415 24.9% 2.41%Kayne Anderson MLP Investment Company KYN 9/27/04 $819 $327 $3,239 $2,204 32.0% 9.70%Fiduciary/Claymore MLP Opportunity Fund FMO 12/22/04 $362 $79 $718 $528 26.5% 9.38%Tortoise Energy Capital Corp. TYY 5/26/05 $384 $34 $686 $483 22.1% 3.93%Kayne Anderson Energy Total Return KYE 6/27/05 $808 - $1,398 $977 30.1% 4.30%Tortoise North American Energy Corp. TYN 10/27/05 $125 - $201 $168 16.5% 2.00%Kayne Anderson Energy Development Company KED 9/21/06 $269 - $340 $262 22.7% 3.90%MLP & Strategic Equity Fund MTP 6/27/07 $291 - $281 $281 - 1.20%Cushing MLP Total Return Fund SRV 8/27/07 $185 $88 $392 $266 21.3% 3.39%Clearbridge Energy MLP Fund CEM 6/25/10 $1,210 $1,210 $1,913 $1,493 21.9% 1.71%Tortoise MLP Fund NTG 7/27/10 $1,160 $1,160 $1,585 $1,197 24.5% 1.43%Kayne Anderson Midstream/Energy Fund KMF 11/23/10 $475 $475 $834 $639 23.4% 1.60%Nuveen Energy MLP Total Return Fund JMF 2/24/11 $450 $443 $600 $440 26.7% 1.78%Salient MLP and Energy Infrastructure Fund SMF 5/31/11 $150 $140 $195 $157 19.5% N/AClearbridge Energy MLP Opportunity Fund EMO 6/10/11 $540 $540 $558 $558 - N/ATortoise Pipeline & Energy TTP 10/27/11 $250 $250 $305 $265 13.3% 1.77%

Appendix: MLP Pooled Vehicle Options

MLP Mutual Funds, ETNs and ETFs Ticker Vehicle LaunchMarket Cap

($MM)^Expense Ratio^^

J.P. Morgan - Alerian MLP Index AMJ ETN 4/2/09 $4,162 0.85%E-TRACS UBS Alerian MLP Infrastructure Index MLPI ETN 3/31/10 $250 0.85%Credit Suisse Cushing 30 MLPN ETN 4/13/10 $239 0.85%E-TRACS 2x Leveraged Long Alerian MLP Infrastructure Index MLPL ETN 7/6/10 $101 0.85%E-TRACS Alerain Natural Gas MLP Index MLPG ETN 7/13/10 $16 0.85%E-TRACS 1x Short Alerian MLP Infrastructure Index MLPS ETN 9/28/10 $7 0.85%UBS E-TRACS Wells Fargo MLP Index MLPW ETN 10/29/10 $20 0.85%Morgan Stanley Cushing MLP Hi Income ETN MLPY ETN 3/16/11 $20 0.85%Alerian MLP ETF AMLP ETF 8/25/10 $2,810 0.85%SteelPath MLP Alpha MLPOX MF 3/30/10 $703 1.25%SteelPath MLP Income MLPZX MF 3/30/10 $354 1.10%SteelPath MLP Select 40 MLPFX MF 3/30/10 $888 0.85%FAMCO MLP & Energy Infrastructure Fund MLPPX MF 9/9/10 $26 1.00%Cushing MLP Premier Income Fund CSHZX MF 10/19/10 $288 1.40%FAMCO MLP & Energy Income INFIX MF 12/27/10 $78 1.25%Center Coast MLP Focus CCCNX MF 12/31/10 $504 1.25%MainGate MLP IMLPX MF 2/17/11 $63 1.50%Tortoise MLP & Pipeline Fund TORIX MF 5/31/11 $81 1.10%

Source: Morgan Stanley, CEF Connect, SEC Filings* Morningstar as of 3/14/2012; Total assets includes leverage** Morningstar as of 3/14/2012; Total common assets net of leverage^ Morningstar as of 3/14/2012; some funds do not update leverage regularly; calculations are based on last reported leverage amount^^ Morningstar; expense ratios are as reported by the fund for its most recent fiscal year and include management fees and interest expense from leverage

Source: Morgan Stanley, SEC Filings, Morningstar^ 3/13/2012 Morningstar, Company Website^^ Institutional Share Class used for MF Expense Ratio

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Inside Master Limited Partnerships · 4 Investors, Universe and Vehicles MLP Investors In the 1980s and 1990s, individual retail investors were the primary MLP investors. Since MLPs

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