Why Financial Institutions Matter: The Case of Energy Infrastructure MLPs

Institutional investors entered the Master Limited Partnership (MLP) space in 2001 with the Kinder Morgan offering of I‐share units. In the ten years that have passed since then, the number of MLPs has quadrupled, and their total market capitalization has increased tenfold. When compared to the MLPs of the 1980s, today's MLP are more focused both in terms of operations and distribution policy. After its birth in 1981, the MLP spread to over 30 different industries. But thanks in large part to tax law changes in 1987 that have helped limit MLPs to natural resource sectors, companies adopting the MLP structure since then have been concentrated in energy, and especially in energy infrastructure. And whereas distribution policy varied considerably among the early MLPs, today's MLPs uniformly pay out a large majority of their distributable cash flow. But to maintain or expand existing energy infrastructure while paying out most of their cash from operations, many MLPs require significant amounts of new capital. To help meet this ongoing funding requirement, new kinds of institutional intermediaries such as closed‐end C‐Corporation investment companies have emerged to provide capital to MLPs in the form of direct placements that offer flexibility with regard to offer sizing and timing. Since 2004, the total value of such direct placements of MLP units has exceeded $15 billion. What's more, the rise of this MLP operating/C‐corporation investment company structure has resulted in a novel realignment of incentives and functions. In this innovative arrangement, the pass‐through operating vehicle (i.e., the MLP) avoids double taxation of dividends while effectively committing managers to distribute cash. At the same time, for those MLPs with large maintenance and other requirements for capital, the commitment to pay out cash effectively forces the operating companies to raise capital continuously and stay “close to the capital marketplace.” This unusual combination of operating and investment vehicles also means that C‐Corporation investment companies, unlike their pass‐through counterparts, must manage tax on their own books and disclose to their investors the after‐tax results of their portfolio trading as well as their capital gains “overhang.”