2012 09 nepc investing in mlps - risks and opportunities

7/31/2019 2012 09 Nepc Investing in Mlps - Risks and Opportunities

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NEPC believes ha he secular growh sory wihin he Norh American energy landscape creaes anumber o compelling invesmen opporuniies.MLPs represen a single and somewha narrowway o inves in his opporuniy, and we recom-

mend ha invesors consider hem wihin abroader energy inrasrucure invesing sraegy.

Execuive Summary

Maser Limied Parnerships (MLPs) haveatraced increased invesor ineres in recenyears. This ineres has been spurred by sronghisorical reurns, high levels o income yield, andconcenraion in he energy and naural resources

secor which benefi rom unique economic re-urn drivers. Ye MLPs remain, or many invesors,a relaively unknown segmen o he global capialmarkes. In his paper we describe he MLP seg-men, assess he relaive poenial benefis o in-vesing in MLPs along wih he associaed risks,and place hem wihin he broader opporuniyse o energy inrasrucure invesmens.

An MLP is a ype o legal srucure uilized by cer-ain businesses ha own or operae real or angi-ble asses and is especially prevalen in he ener-

gy and naural resources secors. MLP unis areexchange-raded public securiies ha are charac-erized by a high level o income disribued oinvesors. The complex parnership srucure al-lows or he higher disribuion levels bu resulsin more complex ax and accouning implicaions.As a resul, he MLP marke has hisorically beenreail invesor-dominaed.

Energy-ocused MLPs represen he larges com-ponen o he MLP universe and are primarilyconcenraed in he midsream secor o he en-ergy value chain. Insiuional ineres has primari-ly been in midsream energy MLPs, which ownand operae he inrasrucure necessary oranspor, refine, and sore oil and gas or endusers. These businesses generally generae sablecash flows rom ee-based revenues. The ocus ohis paper will be on energy-relaed MLPs, andmore specifically hose ha operae primarily inhe midsream secor.

Sepember 201

Andrew Bret, CAIA, Senior Research Analys, Privae Markes

Tim Bruce, Senior Research Consulan, Hedge Funds

INVESTING IN MASTER LIMITED PARTNERSHIPS:RISKS AND OPPORTUNITIES

Background

What is an MLP?

A Maser Limied Parnership (MLP) is a busi-ness ha operaes under a parnership srucureraher han as a ypical C-Corporaion (C-Corp)Equiy shares o hese parnerships are calledunis which are publicly raded on exchanges, juslike C-Corp securiies. MLPs are pass-hrougheniies ha are no axed a he corporae level;insead he ax burden is borne by individual MLPuni holders (limied parners or LPs). Cashpayous o MLP uni holders are called disribu-

ions insead o dividends.

An MLP is managed by a General Parner (GP)ha is responsible or overseeing he businessoperaions o he MLP on behal o LPs. GPs ypi-cally hold a small sake in he parnership(generally around 2%) as well as Incenive Disri-buion Righs (IDRs), which enile he GP o ahigher percenage o cash disribuions as cash

MLP UNITS ARE EXCHANGE-TRADED PUBLIC SECURITIES THATARE CHARACTERIZED BY A HIGHLEVEL OF INCOME DISTRIBUTEDTO INVESTORS.


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prevalen which is illusraed by he large markeshare o MLPs operaing midsream energy as-ses. This is because MLPs need sable revenuegeneraion o mee disribuion expecaions andregulaed or ee-based businesses are a good fior he MLP srucure. Overall, energy-relaedMLPs represen roughly 77% o publicly-radedparnerships (PTP) currenly lised on US Ex-changes. 6

How do MLPs Work?

MLPs disribue nearly all ree cash flow o uniholders, which requires hese parnerships o relyon capial markes o finance business growh. Toadd asses ha increase he value o an MLP, heGP can inves in new-build projecs or acquirenew asses. Acquisiions allow an MLP o increasehe value o he parnership while increasing dis-ribuions rom he addiion o operaional asses.

MLPS may also finance growh hrough new equi-y issuance or privae invesmen in public equiy(PIPEs). MLPs ypically seek o grow hroughacquisiions due o heir relaively lower cos ocapial.

MLPs can be creaed by corporaions hroughspin-offs or hrough a public offering o a new en-iy. An MLP wih a paren C-Corp GP wih mid-sream asses can access organic growh i he

flows grow over ime.1 LPs own he majoriy o heshares in an MLP; however, LP uni holders haveno voing righs or managemen responsibiliies.MLP is he erm mos commonly used o reer oan energy-relaed publicly raded limied parner-ship or LLC.

History of MLPs

Congress esablished he modern MLP srucureo encourage invesmen in energy inrasrucureby passing he Tax Reorm Ac o 1986 and TheRevenue Ac o 1987. These acs defined he me-chanics o he pass-hrough parnership srucureand esablished he requiremens necessary or acompany o be eligible o operae as an MLP. Todo so, a business is required o generae a leas90% o is income rom qualified sources.2 Thismeans ha income mus be derived rom busi-ness operaions in he real esae, naural re-sources and minerals secors.3 Qualified income is

largely generaed hrough aciviies relaed o heexploraion and producion, developmen, mining,processing, refining, ransporaion, sorage ormarkeing o minerals or naural resources. 4

The adopion o he MLP srucure by real assebusinesses, especially in he energy secor, hasbecome more prevalen in recen years. MLPswih midsream energy asses are viewed as anespecially atracive par o he marke. Mid-sream businesses provide relaively sable reve-nues rom oll-like ee arrangemens, which mini-mize he impac o commodiy price volailiy onrevenues.5 These businesses ypically operae inindusries wih high barriers o enry and in regu-laed segmens o he energy value chain.

The composiion o he MLP segmen has evolvedover he years o become more concenraed inenergy-relaed operaions. The shif ino moresable, ee-based indusries has been especially

Invesing in Maser Limied Parnerships: Risks and Opporuniies

Exhibi 1: Energy Value Chain

ExploraionDrilling

Producion

TransporaionSorage

PipelinesGahering & Pro-

cessingShipping and Trucking

CommercialIndusrial

ResidenialRefinery

ReailSource: NEPC, Cushing Asse Managemen

Exhibi 2: MLP Indusry Composiion1990 vs. 2012 (numbero companies)

Oil & Gas Midsream 10% 44%Oil & Gas Exploraion & Produc-ion 21% 14%Propane and Refined Fuel Disri-buion 0% 7%O&G Marine Transporaion 1% 6%Coal Leasing or Producion 0% 6%Oher Minerals, Timber 5% 4%Real Esae Income Proper-ies 14% 3%Real Esae Developers, Home-builders 4% 0%Real Esae Morgage Securi-ies 13% 3%Hoels, Moels, Resaurans 12% 0%Invesmen or Financial 5% 10%Oher Businesses 15% 4%

Note: May not equal 100% due to roundingSource: Naional Associaion o Publicly Traded Parnerships


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each unis share o ne axable income. The neaxable income is adjused or deducions andgains and is payable even i an MLP does nomake a disribuion in a given period. Typically,MLPs are able o minimize he amoun o axableincome hrough he depreciaion, depleion, andamorizaion o asses. Ne axable income is gen-erally 10-20% o an MLPs oal disribuable cashflow, meaning ha invesors are effecively receiv-ing disribuions ha are 80-90% ax-deerred.

Disribuions o uni holders are classified as re-urn o principal and remain ax-deerred unil heunis are sold or he cos basis reaches zero.9Once a uni is sold or he cos-basis reaches zero,an invesor is responsible or he axes on he dis-ribuions ha have been deerred o his poin(cos basis minus adjused cos basis).1An invesoris also responsible or he axes on his porion ohe axable income once he uni is sold or hecos basis reaches zero.10 Any capial appreciaion

gain rom he sale o an MLP uni is axed a hesandard capial gains rae.

Direc invesors in MLPs also have o deal wihhe adminisraive burden o he IRS K-1 orms(insead o Form 1099) issued by each individualMLP. The K-1 includes inormaion regarding auni holders share o parnership ne income,gain, loss, and deducions. Invesors are requiredo file income ax reurns (and responsible or hepoenial ax burden) in each sae in which anMLP generaes income.

MLPs are likely o generae unrelaed businessaxable income (UBTI), which is income earnedrom business aciviies unrelaed o an invesingeniys ax-exemp purpose. I a ax-exemp or-ganizaion generaes UBTI in excess o $1,000 peryear, he organizaion is required o documenhis wih he IRS and may be required o pay ax-es on UBTI in excess o his amoun. This can be ahurdle or insiuions ha are unwilling o under-

ake he adminisraive burden and bearhe coss o incurring UBTI. Larger insi-uions may be well equipped o handleUBTI issues wih experience rom oherinvesmens or an abiliy o offse UBTIrom oher areas.11

Tax-exemp insiuional invesors areno responsible or axes on capial gainsonce a uni is sold. There are differingopinions as o wheher ax-exemp or-ganizaions are responsible or he de-

paren company is willing o drop down assesino he MLP on a ransparen schedule. This al-lows he marke o have visibiliy ino an MLPsgrowh plan while he GP can avoid more compe-iive acquisiion processes or risky new-build pro-jecs. The paren C-Corp benefis rom he saleby moneizing lower reurning midsream asseso reinves in higher reurning projecs. The par-en company will ypically own 49% o he LP uniineress as well as a 2% GP share ha becomesmore valuable as disribuions grow. MLPs aregenerally valued a a premium relaive o C-Corpsbecause ne income a he parnership level is pre-ax income.

MLPs pay ou a high percenage o income o LPs(generally around 90%) in he orm o quarerlydisribuions. Unlike REITs, MLPs are no requiredo pay ou a cerain percenage o income; how-ever he wo srucures are similar in ha heycan pay ou higher disribuions because hey do

no pay corporae axes.7 Addiionally, uni hold-ers can deer axes on MLP disribuions or anumber o years. The high percenage o reve-nues disribued o uni holders means ha heseparnerships ypically have litle available cashand mus access capial markes o aciliaegrowh hrough new build projecs or acquisiions.

Tax Treatment8:

An MLP srucure appeals o many naural re-source-relaed businesses because o he axshield which provides higher ne income a heparnership level. This means ha disribuionsare higher; however, he ax burden has beenshifed o he invesor. The adminisraive burdenand poenially conusing naure o he unique axreamen is he main reason insiuional inves-ors have hisorically no invesed in he space.

MLP disribuions are ax-deerred bu MLP in-vesors are responsible or he axes allocaed o


Structure Comparison MLP LLC C-Corp

Non-axable eniy Yes Yes NoTax burden flow hrough o invesors Yes Yes NoDisribuion Tax Shield (o invesors) Yes Yes NoTax Reporing K-1 K-1 1099General Parner (GP) Yes No NoIncenive Disribuion Righs (IDRs) Yes No NoVoing Righs No Yes Yes

Exhibi 3: Public Parnership and C-Corp Srucure Comparison

Source: Morgan Sanley Research, Wells Fargo Securiies, LLC, Credi Suisse, Na-ional Associaion o Publicly Traded Parnerships (NAPTP)


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Performance

MLPs hisorical perormance is asignifican driver o curren iner-es in he invesmen caegory. Inhis secion, we evaluae MLPperormance, risk (as measuredby volailiy and drawdown), andcorrelaions wih oher asse ca-

egories. As we discuss in a laersecion, here are many differenMLP indices bu or he purpos-es o simpliciy and presenaion,

he Alerian MLP Index will serve as he proxy oran invesmen in MLPs or he ollowing analyses.

As shown in Exhibi 10, he Alerian MLP index hasexceeded he S&P 500 in every calendar year or

he pas decade.

Indeed, one o he mos compelling elemens oMLPs or many invesors is ha hey have gener-aed srong reurns or an exended period o

in periods o unexpeced inflaion. As Exhibi 8shows, disribuion growh has oupaced inflaionin recen years; however, we believe his haslargely been he resul o herapid expansion experienced inhe indusry, raher han rominflaion-linked drivers.

Yield:

In a depressed ineres raeenvironmen, MLPs offeratracive yields. As Exhibi 9illusraes MLPs have genera-ed higher yields han 10 YearTreasury noes, invesmengrade corporae bonds, andhe S&P 500. High Yield bondshave offered a higher yield his-orically, alhough he spread wih MLPs has igh-ened in recen years. O course dividends andcoupons are only one porion o he oal reurnequaion. MLPs are more volaile han High Yieldor Invesmen Grade deb and are subjec o eq-uiy-like price flucuaions.


Exhibi 8: Alerian Index Disribuion Growh vs. Consumer Price Index

Source: Alerian, Bureau o Labor Saisics

Exhibi 9: Yield Comparison rom January 1996 o June 2012 17

Source: Bloomberg, Barclays, Alerian, NAREIT, Federal Reserve Economic Daa

Exhibi 10: Calendar Year Reurns

Alerian MLP IndexTR -3.4% 44.5% 16.7% 6.3% 26.1% 12.7% -36.9% 76.5% 35.9% 13.9%

S&P 500 TR -22.1% 28.7% 10.9% 4.9% 15.8% 5.5% -37.0% 26.5% 15.1% 2.1%Russell 2000 IndexTR -20.5% 47.3% 18.3% 4.6% 18.4% -1.6% -33.8% 27.2% 26.9% -4.2%HFRI Equiy Hedge(Toal) Index -4.7% 20.5% 7.7% 10.6% 11.7% 10.5% -26.7% 24.6% 10.5% -8.4%GSCI CommodiyIndex 32.1% 20.7% 17.3% 25.6% -15.1% 32.7% -46.5% 13.5% 9.0% -1.2%FTSE NAREITEquiy REIT (TR) 3.8% 37.1% 31.6% 12.2% 35.1% -15.7% -37.7% 28.0% 28.0% 8.3%

Source: NEPC, Alerian, HFRI, Perrac, Bloomberg


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Volatility and Drawdown:

Invesors considering an invesmen in MLPsshould be aware o poenial or high volailiy andlarge drawdowns in-line wih equiies and com-modiies. Despie he high volailiy and equiy-like drawdown poenial, MLPs have sill genera-ed reurns wih a higher Sharpe raio han oherasse classes. When considering he poenial orlarge drawdowns alongside oher asse classes, i

ime. Exhibi 11 shows railing annualized peror-mance o he Alerian MLP Index relaive o equi-y, commodiy, and REIT indices.

This ouperormance over common ime periodsis shown graphically in Exhibi 12, illusraing hesrong perormance o he Alerian MLP index rel-aive o US equiy benchmarks, equiy hedgeunds, commodiies, and REITs.


Alerian MLP In-dex TR 7.8% 27.0% 9.9% 13.0% 16.7%S&P 500 TR 5.4% 16.4% 0.2% 4.1% 5.3%Russell 2000 -2.1% 17.8% 0.5% 4.6% 7.0%HFRI EquiyHedge (Toal)

Index-7.4% 4.7% -0.7% 3.4% 4.9%

GSCI CommodiyIndex -10.7% 2.1% -5.5% -4.3% 3.4%FTSE NAREITEquiy REIT (TR) 12.9% 32.4% 2.6% 6.2% 10.3%

Exhibi 11: Annualized Reurns (as o June 30, 2012)


Exhibi 12: Cumulaive Reurn rom January 1996 o June 2012


Alerian MLP Index TR 16.0% 15.8% 0.81 -41.1%S&P 500 TR 6.9% 16.2% 0.28 -50.9%Russell 2000 Index TR 7.2% 21.1% 0.27% -52.9%HFRI Equiy Hedge (Toal) Index 9.4% 9.8% 0.62 -30.6%GSCI Commodiy Index 3.3% 23.4% 0.11 -67.6%FTSE NAREIT Equiy REIT (TR) 11.0% 21.6% 0.44 -68.3%

Exhibi 13: Risk/Reward Comparison (January 1996 o June 2012)



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he relaively limied inflaion-hedging characeris-ics o he MLP segmen.

Imporanly, he correlaion o MLPs o oher riskasses including socks and commodiies in-creased during 2008. Invesors should be cogni-zan o his and have an expecaion o increasedcorrelaions during periods o sress in he mar-ke.

MLP Benchmarking:

There are a limied number o MLP benchmarksavailable. In Exhibi 16 we highligh he characer-isics o he various indices.

While hese indices are he mos commonly usedamongs MLP invesors, here are a number ocusom indices uilized by managers in he seg-men as well. Invesors should also noe ha heabove indicies also include upsream and oherenergy-relaed MLPs, including publicly raded

GPs, in he invesable universe. There are dedi-

should be noed ha he MLP segmen rebound-ed o pre-financial crisis levels a a aser pacehan oher securiy ypes.

Exhibi 14 displays he risk and reurn o MLPsand he comparaive benchmarks. Over his imeperiod, he MLP index has generaed very srongmonhly reurns bu wih significan volailiy.

Correlation:

Correlaion o MLP reurns o US equiies andequiy hedge unds are modes, bu posiive. AsExhibi 15 shows, he correlaion o he AlerianMLP index o he represenaive equiy indicesand equiy hedge unds has been less han 0.4over he period since incepion. MLPs also exhibia modes correlaion o REITs, anoher ype o axshelered and yield-oriened invesmen opion.O noe, MLPs are less correlaed wih commodi-ies (even he energy-heavy, GSCI CommodiyIndex) han hey are wih equiies. This highlighs


Exhibi 14: Annual Average Reurn and Sandard Deviaion (Jan 1996 o June 2012)


Alerian MLP Index TR

AMZX 1.00S&P 500 TR 0.38 1.00

Russell 2000 Index 0.39 0.81 1.00HFRI Equiy Hedge 0.39 0.76 0.84 1.00GSCI Commodiy 0.29 0.26 0.31 0.44 1.00

FTSE NAREIT Equiy 0.39 0.58 0.66 0.45 0.21 1.00

Exhibi 15: Correlaions rom January 1996 o June 2012



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o he marke has experienced remendousgrowh as insiuions have increased he amouno capial flowing ino he space. While currenMLP yield levels do no indicae ha he segmenis over-valued and he undamenal growh driv-ers appear o be srong, such susained hisoricalouperormance ofen creaes significan overval-uaion and he possibiliy o a regression o per-ormance oward long-erm averages or compa-rable-risk asses.

Volatility and Drawdown:An invesmen in he MLP segmen has he poen-ial o generae reurns ha are highly volailewih large drawdowns ha are in-line wih equi-ies and commodiies, as illusraed in Exhibi 12.

caed midsream or inrasrucure MLP indexeswihin hese universes; however hey are evenmore concenraed in a smaller number o hold-ings.

For he purpose o he perormance analyses inhe preceding secions, we used he marke capi-alizaion-weighed Alerian MLP index. Imporangoals o benchmarking are represening he in-vesable universe o capure he opporuniy seavailable o invesmen managers in he segmen.

While he marke-capializaion weighed mehod-ology may skew he reurns due o he large con-cenraion in a small number o names, i remainsrepresenaive o he opporuniy se. Theweighing o he Alerian biases he reurns o-wards a handul o large MLPs, as illusraed inExhibi 17.

Risks of MLP Invesing

Valuation and PerformanceRegression to the Mean:

As shown in Exhibi 10, heAlerian MLP Index has gen-eraed annualized reurnsha have ouperormedequiy, equiy-linked hedgeund and commodiy indi-ces or all railing periodsup o en years. As Exhibis4 and 6 illusrae, he size


Number o Consiuens 50 65 55

Index Weighing Floa-Adjused MarkeCap Floa-Adjused Marke Cap

Floa-Adjused Marke CapNo MLP can be more han 15% o he Index

All socks wih a weigh above 4.5% canno col-lecively represen greaer han 45% o he inde

Rebalancing Quarerly Quarerly Annually (July)

Marke Cap Requiremen >$500 million floa-adjused

>$200 million, avg. marke cap;mus remain above $175 mil-

lion or 30 day minimum prioro evaluaion o say in index >$300 million floa-adjused

Liquidiy Requiremens Median daily radingvolume or railing sixmonhs o 25,000 unis None

3 monh average daily value raded above $2million (preerred)

Disribuion Sabiliy Re-quiremen

Disribuion level main-ained or grown quar-er over quarer or

None NoneIncepion Dae 12/29/1995 12/31/1989 7/20/2001

Exhibi 16: MLP Index Comparison

Source: NEPC, Alerian, Wells Fargo, Standard and Poors

Enerprise Producs Parners LP19 EPD $42.5 $26.4 15.5%Kinder Morgan Energy Parners LP KMP $18.4 $16.4 9.6%Plains All American Pipeline LP PAA $12.4 $11.4 6.7%Energy Transer Equiy LP ETE $11.3 $8.2 4.8%Magellan Midsream Parners LP MMP $7.6 $7.6 4.4%Energy Transer Parners LP ETP $10.0 $7.6 4.4%Linn Energy LLC LINE $7.1 $7.0 4.1%ONEOK Parners LP OKS $11.6 $6.6 3.8%Kinder Morgan Managemen LLC KMR $7.1 $6.4 3.7%Enbridge Energy Parners LP EEP $7.2 $5.5 3.2%

Exhibi 17: Alerian Index Top 10 Holdings (as o June 15, 2012 quarerly rebalancing)

Source: Alerian


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nesses; however, a change o he ee srucure orhese businesses remains a remoe risk. Drillingaciviy could poenially decline as a resul oenvironmenal regulaions enaced on racking,which is increasingly being viewed in a negaiveligh by environmenaliss.

Energy Sector Risk:

MLPs have commodiy price risk, which can havea direc impac on businesses operaing in he oiland naural gas producion, gahering and pro-cessing, and coal secors. Commodiy priceswings can also impac he businesses o MLPsha do no own he acual commodiies by affec-ing demand which in urn has an impac on vol-umes.

Furhermore, he expeced growh in he MLPmidsream secor is predicaed on he coninuedgrowh in drilling aciviy, a decline in which could

affec volume and revenues or midsream energybusinesses. A decline in drilling aciviy could oc-cur as a resul o regulaory acion or rom find-ings ha deermine original esimaes o shalereserves are oversaed. Eiher scenario wouldresul in a shorall versus projeced hydrocarbonproducion which would seriously impair mid-sream revenues and growh expeced rom newprojecs.

The segmen is also prone o business execuionrisk. Operaional issues may occur as a resul o abad invesmen in a non-accreive asse or could

arise as a resul o a weaher even or oher dis-rupive occurrence inheren in he hard asse seg-men (such as an acciden or a pipe breaking).Such an occurrence would negaively affec re-urns or he MLP in quesion. The recen rendhas seen variable disribuion MLPs ener hemarke. These businesses have less sable cashflows bu have atraced he atenion o invesorsdue o heir ofen iniial high iniial yields. Thesebusinesses may seem atracive in he shor-ermbu could sruggle in poor economic condiions.

Capital Market Risk:

MLPs are also heavily dependen on capial mar-kes o aciliae coninued growh because o hehigh percenage o revenues ha are paid oueach quarer o uni holders. The abiliy o energyMLPs o coninue o access deb rom he capialmarkes and reain srong credi raings is crucialor coninued growh. A severe economic down-urn could negaively impac MLPs abiliy o ac-

Liquidity:

While he rading volume and he marke capiali-zaion o he MLP universe has grown dramaical-ly, i remains a very small segmen relaive o oh-er asse classes. Liquidiy becomes a greaer con-cern i rading volumes drop dramaically duringperiods o sress and an invesor holds posiionsin smaller MLPs wih limied rading volumes. Im-

poranly, MLPs are sill primarily owned by reailinvesors. Srong recen perormance and highyields raise concerns o more shor-erm inves-ors enering he space. This invesor composiioncould lead o elevaed selling pressure in heeven o negaive news or poor shor-erm peror-mance.

Concentration and Diversification:

As Exhibi 17 illusraes, he en larges MLPsmake up more han 60% o he invesable uni-

verse capured by he Alerian MLP Index. Thisresuls in perormance being driven by a smallnumber o MLPS and limis he abiliy o diversiywihin he segmen.

Correlation with Equities:

MLPs have a modes posiive correlaion obroader equiy markes ha has averaged ap-proximaely 0.40. This correlaion is expeced oincrease dramaically during periods o markesress.

Idiosyncratic Risks:The individual parnerships wihin he MLP op-poruniy se have diverse businesses wih risksassociaed wih individual issuers. As such, hereare a number o addiional risks o MLP business-es, as deailed below.

Regulatory and Legislative Risk:

The poenial or regulaory or legislaive changesha could eliminae he ax benefis enjoyed byMLPs remains a significan risk o he segmen.

This risk is miigaed somewha by he suppor orincreasing domesic energy producion rom bohhe Presiden and Congress. The Federal EnergyRegulaory Commission (FERC) is he independ-en agency ha regulaes inersae ranspora-ion o naural gas, crude oil and elecriciy as wellas naural gas and hydropower projecs. The high-ly regulaed naure o he business creaes hepercepion o revenue sabiliy or hese busi-



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a poenial conflic on acquisiion price. This rep-resens one o he ways an MLP could be misman-aged by a GP, which may be more concerned wihoher business aspecs o he company o hederimen o he MLP.

MLP Invesmen Approaches

There are a number o ways or insiuional inves-

ors o access he MLP segmen. There are inves-men managers ha can acively manage a poro-lio o MLPs as well as passive sraegies ha willclosely rack seleced MLP benchmarks. Exhibi18 liss hese approaches.

NEPC does no recommend invesing direcly inindividual MLP unis bu raher o choose rom anumber o available opions ha provide diversi-fied exposure o he segmen. When consideringdifferen invesmen opions, invesors should beaware o he ype o he sraegy and coss asso-

cess he capial markes and could also lowerprofiabiliy by reducing energy demand. Addi-ionally, MLPs end o underperorm in a risingineres rae environmen as he cos o capialor acquisiions rises.

Ownership Structure Risk:

The GP/LP relaionship wihin an MLP srucure

creaes a siuaion where conflics o ineressmay arise. The IDRs increasingly avor he GP asdisribuions grow. This increases he cos o capi-al as each new asse acquired by he MLP musincrease reurns o mee IDR hurdles. This couldpoenially enice he GP o grow cash disribu-ions a an unsusainable rae or he purpose oincreasing heir share o disribuions. Such ac-ions may increase he perormance o an MLP inhe shor-erm bu may hreaen he business inhe long-erm. GPs may also sell paren companyasses o an MLP (drop down), which represens


Exhibi 18: Comparison o MLP Invesmen Approaches20

Fund Type SMA Parnership Closed-End Open-Ended Srucured NoeManagemenSyle Acive Acive Acive or Passive Passive PassivePublicly Trad-ed No No Yes Yes YesTax Saus Parnership Parnership Taxable C-Corp Taxable C-Corp Taxable Noe

Tax Reporing Muliple K1sMuliple or

ConsolidaedK-1s or Form Form 1099 Form 1099 Form 1099Leverage Possible Possible Yes No SomeimesLiquidiy Daily Typically Monhly Daily or Monhly Daily DailyDisribuionTreamen Typically Reurn oCapial Typically Reurn oCapial Typically Reurn oCapial Typically Reurn oCapial Ordinary IncomeUBTI Yes Typically yes, some

can block No No No

ManagemenFees

75-125 bps and couldinclude a perormance

ee~100 bps and could

include aperormance ee 95-150 bps ~85 bps ~85 bps

Number o

IndividualHoldings 20-35 20-35 20-60 Mached o an Index Mached o an Index

Benefis Clien-Direced AciveManagemen Acive Managemen Liquidiy in heorm o und shares Provides diversifica-ion and liquidiy

Provides diversificaionand liquidiy hroughsynheic exposure

ConsideraionsAdminisraive burden

and coss

Fees

Adminisraiveburden and coss

Shares ypicallyrade a a premiumor discoun o heNAV o he under-

lying holdings

Double axaion

Passive sraegy hamasks an index

Bank credi risk

Source: NEPC, Toroise Capial Advisors, Swank Capial


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12

advanaged srucure ha operaes in a simi-lar ashion o MLPs.

2. US Inernal Revenue Code Secion 7704

3. Qualified naural resources include crude oil,naural gas, peroleum producs, coal, oherminerals, imber and any oher resource hacan be depleed as defined in Secion 613 o

he US Inernal Revenue Code. Secion 7704was amended in 2008 o include indusrialsource carbon dioxide, ehanol, biodiesel andoher alernaive uels.

4. Oher sources o qualiying income were de-fined o include ineres, dividends, real prop-ery rens, income rom he sales o propery,gains rom he sale o asses, income rom hesale o sock, gains rom commodiies andcommodiy-relaed uures/opions. Reailoperaions are generally excluded excep in

he propane secor.5. Mos MLPs have muliple business lines and

any reerence o midsream energy MLPsmeans ha hese parnerships generae helarges porion o heir revenues rom opera-ions in he midsream energy secor.

6. Excludes oil and gas royaly russ in PTPorm, commodiy unds, open- and closed-endMLP unds, MLP ETFs and MLP Indexes.

7. MLPs se a Minimum Quarerly Disribuion

(MQD) requiremen or common equiyunis held by invesors. These unis will ypi-cally be backsopped by subordinaed unisheld by he paren company ha are used oreplace any shoralls in disribuions.

8. NEPC is no a ax advisor and his is no in-ended o consiue ax advice. The ax rea-men o an MLP invesmen is an imporanissue, which is why i is being addressed here.This discussion is inended o describe he axreamen as clearly as possible, bu does noaddress cerain nuances ha may occur in

some insances.

9. MLPs are atracive or individual invesorsesae planning purposes because he cosbasis ges rese when ranserred o an heir.

10. Income shielded during he holding period isaxed as UBTI upon he sale o a uni or ax-exemp plans.

ciaed wih cerain approaches such as a long/shor sraegy. Some managers do offer soluionsha address adminisraive and ax issues associ-aed wih MLP invesing.

Conclusion

The need or increased invesmen in energy in-rasrucure in Norh America provides he oun-

daion or coninued growh o he MLP segmen.While recen MLP perormance has been srong,plan sponsors considering he segmen need obe aware o he poenial risks. Firs, volailiycomparable o equiies should be expeced. Ishould also be undersood ha MLPs have hisor-ically exhibied modes posiive correlaions obroader markes and hese correlaions have in-creased dramaically during periods o markesress. As a resul, MLPs canno be couned on oprovide diversificaion across all marke condi-ions. Finally, he degree o which MLPs provide a

hedge or inflaion is limied.

The businesses and perormance o MLPs arediverse which means here is he poenial oralpha generaion in he segmen, however hemarke is relaively small and highly concenraedwhich can limi he size and requency o alphaopporuniies. Manager and vehicle selecion is acriical aspec o meeing invesmen goals as wellas addressing any adminisraive burdens or aximplicaions unique o paricular plan sponsorypes.

As a resul o hese consideraions, we suggesha MLPs should no be viewed as a sandaloneasse class bu raher as one componen o a na-ural resources equiy or diversified real assesallocaion. In his ramework, a properly sizedMLP allocaion may play a role as par o a com-prehensive invesmen approach o he srongexpeced growh o he energy inrasrucure sec-or.

Endnoes

1. Incenive Disribuion Righs (IDRs) provideGPs wih an increased share o revenues asdisribuions grow, a schedule o which isspecified in MLP agreemens. A small numbero companies ha can be grouped ino heMLP classificaion or he purposes o hispaper are srucured as LLCs. LLCs do nohave a GP or IDRs, invesors are called mem-bers insead o parners, and all members aregraned voing righs; however, his is a ax



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Disclaimers and Disclosures

Pas perormance is no guaranee o uureresuls.

All invesmens carry some level o risk. Di-versificaion and oher asse allocaion ech-niques do no ensure profi or proec againslosses.

The inormaion in his repor has been ob-ained rom sources NEPC believes o be reli-able. While NEPC has exercised reasonableproessional care in preparing his repor, wecanno guaranee he accuracy o all sourceinormaion conained wihin.

This repor conains summary inormaionregarding he invesmen managemen ap-proaches described herein bu is no a com-plee descripion o he invesmen objec-

ives, porolio managemen and research hasuppors hese approaches. This analysisdoes no consiue a recommendaion o im-plemen any o he aoremenioned ap-proaches.

11. Some public pension plans have decided hahey do no have o pay axes on UBTI. MLPinvesmen managers can discuss differenapproaches o considering UBTI.

12. The INGAA Foundaion, Inc. Norh AmericanNaural Gas Midsream InrasrucureThrough 2035: A Secure Energy Fuure, June28, 2011

13. Morgan Sanley Research


15. MLP marke capializaion daa as o 12/31/11


17. The 10 Year US Treasury daa is couresy ohe Federal Reserve Economic Daa (FRED)daabase and is he US 10 Year Treasury Con-san Mauriy Index (No Seasonally Adjus-

ed, End o Period Daa). The BarCap USCredi and BarCap High Yield Indices uilizeyield o wors calculaions and assumpionsrom Bloomberg. The S&P 500 dividend yieldis he 12 monh cumulaive dividend dividedby he curren price index level, calculaed ona rolling monhly basis. The FTSE NAREIT Eq-uiy REIT yield is provided by Naional Associ-aion o Real Esae Invesmen Truss(NAREIT) and he Alerian MLP Index Yieldis calculaed by Alerian.

18. Adjused Marke Cap akes ino accoun non-common unis, lock-up common unis, insider-owned common unis and he GP-ownedunis.

19. Enerprise Producs Parners LP has been anNEPC clien since 2008.

20. There are also muual unds ha inves inMLPs ha are no included in his exhibi. Mu-ual unds canno be more han 25% allocaedo MLPs or own more han 10% o an MLP orhe vehicle will lose is ax-exemp saus

2012 09 nepc investing in mlps - risks and opportunities

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