One of the best investments for income-focused investors is master limited partnerships. This is due to the fact that these companies typically boast relatively stable business models that generate high levels of cash flow and pay out a high percentage of this cash flow to their investors in the form of distributions. In addition, many of them have relatively strong forward growth potential, particularly in the current climate. With that said though, the sector has somewhat fallen out of favor among investors, which may be due to the thrashing that many of these companies took during the oil bear market in the middle of this decade. It might be difficult to construct a portfolio of these companies though, particularly if you do not have a large sum of money to invest. This is where closed-end funds come in as they offer investors a way to get exposure to a portfolio of these companies run by professionals in one easy trade. One such fund is the Kayne Anderson MLP/Midstream Investment Company (KYN), so let us take a look and see if this fund would be a good addition to your portfolio.
About The Fund
According to the fund’s web page, the Kayne Anderson MLP/Midstream Investment Company has the primary objective of generating a high level of after-tax return for its investors. It does this by investing at least 85% of its assets in master limited partnerships operating in the energy industry (which is most of them). The fund states that it prefers to invest in companies that are specifically operating in the midstream space, which is the part of the energy space that performs the processing and transportation of the resources that upstream companies pull out of the ground.
The fund’s largest positions will no doubt be familiar to investors that have any interest in the midstream space. In fact, many of them are companies that I have discussed numerous times in the past on this site. Here they are:
Source: Kayne Anderson Funds
The majority of these firms are quite large and very stable companies, which is the sort of thing that income-focused investors will likely appreciate. This stability comes from the fact that their business model simply consists of transporting resources and charging a fee for this service based on the volumes of resources transported. These companies perform this service under long-term contracts, which means that the midstream company will be receiving revenue over an extended period of time and these contracts include minimum volume commitments, which guarantee that the customer will have to pay a minimum amount of money regardless of the volume of transported resources. This guarantees a certain stability to their cash flows, which ultimately supports the distribution that they pay out.
As my regular readers on the topic of closed-end funds are likely well aware, I do not normally like to see any single positions account for more than 5% of a fund’s total assets. This is because this is approximately the level at which that asset begins to expose the fund to idiosyncratic risk. Idiosyncratic, or company-specific, risk is that risk that any financial asset possesses that is independent of the market as a whole. Thus, the concern here is that some event may occur that causes the stock price of one of these heavily-weighted assets to decline independently of the market and drag the value of the portfolio as a whole down with it. As we can see above, there are nine companies that individually account for more than 5% of the fund’s total assets, one of which, Enterprise Products Partners (EPD), accounts for more than double that 5% limit. Thus, the fund and by extension its investors appear to be heavily exposed to only a handful of assets.
One problem that many investors have with master limited partnerships is the fact that they issue Form K-1 to investors instead of 1099s like many other dividend-paying companies. These can be somewhat of an annoyance at tax time. In addition, the structure of master limited partnerships makes them somewhat difficult to include in an IRA or other tax-advantaged structure due to the risk of unrelated business taxable income, which can result in investors having tax liability even though they are invested in the partnership through their IRA. KYN provides a way for investors to avoid this risk due to the fact that it is actually structured as a corporation and not as a pass-through registered investment company like most funds. This results in the fund paying all taxes on received distributions on a fund level and then issuing a 1099 to its investors, although the need to pay corporate taxes does act somewhat as a drag on returns.
The fund’s corporate structure is required due to regulations limiting the percentage of a registered investment company’s assets that can be invested in partnerships. This limit is 25%, which as we can see is below what the fund actually has invested in master limited partnerships (71%):
Source: Kayne Anderson Funds
Despite the fact that the fund paying corporate taxes act as a drag on returns, the corporate structure will likely prove to be an advantage for individual investors. This comes from the fact that it makes it much easier to include in an IRA and simplifies filing at tax time.
Unfortunately, KYN has delivered something of a disappointing performance over its history. As we can see here, the share price and net asset value have generally declined over the past several years, although there were a few periods of strength:
Source: Kayne Anderson Funds
This is countered by the fact that the company has generally delivered rather impressive performance numbers when distributions are included:
Source: Kayne Anderson Funds
It is important to note though that essentially all of the disappointing performance came from general losses in the energy sector in 2015 and 2018. As some might be aware, 2015 was a particularly bad year for MLPs as the steep decline in oil prices in late 2014 that then persisted throughout 2015 forced many partnerships to either go out of business or change their business models like Kinder Morgan (KMI). A similar event happened in 2018, especially in the last quarter of the year, but the impact on these companies was nowhere near as severe. Apart from these two periods, KYN has enjoyed relative price and NAV stability over time, but the fund never managed to recover its losses from these two periods, which is certainly a negative thing for shareholders.
Why Invest In Midstream Companies?
The midstream sector as a whole is one that offers a great opportunity for investors to profit off of the production growth in North America’s energy sector. As we can clearly see here, the upstream production of oil and natural gas in the United States is expected to double over the next ten years:
Source: International Energy Agency, Kinder Morgan
In order for this production growth to make any sense, the upstream companies that are actually producing it have a way to get the production to market. This is where midstream companies come in as they will be the entities actually providing this transportation. As already mentioned, the general business model of a midstream company results in rising cash flow as volume increases. We should see volume increase as production does due to the need to get the new incremental production to market.
Of course, pipelines and other midstream infrastructure have a finite capacity of resources that they can carry. This is the reason why most firms in the midstream space are actively constructing new infrastructure so that they can meet this need for more transportation. Fortunately, the companies are not doing this on a speculative basis as they already have contracts in place before constructing new infrastructure. This ensures that they will generate a positive return on their investment as well as that they are not spending a great deal of money constructing infrastructure that nobody wants to use. This is a smart way to derive growth, and overall, we should see solid growth amongst midstream companies in the coming years.
As midstream companies, particularly MLPs, are well-known for their relatively high yields, we might expect KYN to also boast a relatively high distribution yield. This is indeed the case as the fund boasts an 8.40% yield at the current price. While this may seem reasonably impressive, it is actually less than what several other MLP funds offer. For example, the First Trust Energy Income & Growth Fund (FEN) currently yields 10.27%. Thus, this seemingly impressive yield is not really anything to write home about.
Another thing that may concern potential investors is that a large percentage of KYN’s distributions are classified as return of capital. We can see this quite clearly here:
Source: Fidelity Investments
The reason why this may be concerning is that a return of capital distribution can be an indication that the fund is not bringing in enough money from its investments to cover the distributions being made to shareholders and is thus essentially returning an investor’s own money back to them. However, there are other things that can cause a distribution to be classified as return of capital. These things include the distribution of unrealized capital gains or the distribution of money received from a master limited partnership. As you might expect, this second cause is a great deal of the money that actually comes into the fund. The important thing is whether or not the distributions are destructive to the fund’s net asset value. As we saw earlier, there were two occurrences during the fund’s history when its net asset value declined and neither one was caused by the fund distributing more than it can afford. Thus, it does not appear that we have anything to worry about from these return of capital distributions.
As is always the case, it is critical for us to ensure that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to ensure that we generate sub-optimal returns off of that asset. In the case of a closed-end fund, the usual way to value it is by looking at the fund’s net asset value. Net asset value is the current market value of all of the fund’s assets minus any outstanding debt. It is, therefore, the amount that the fund’s investors would receive if all of the assets were sold off and the fund was completely liquidated.
Ideally, we want to purchase shares of a closed-end fund when we can get them at a price that is less than net asset value. This is because such a scenario essentially means that we are acquiring all of the assets of the fund for less than they are actually worth. Fortunately, that is the case right now. As of July 8, 2019 (the most recent date for which data was available), KYN had a net asset value of $17.38 per share. However, the fund’s shares only trade hands for $15.63. This represents a 10.07% discount to net asset value. This is certainly a reasonably appealing price at which to acquire shares of the fund.
In conclusion, the midstream sector, particularly MLPs, are attractive assets for yield-focused investors to have exposure to. The sector also has some strong growth potential due to surging oil and natural gas production. The Kayne Anderson MLP/Midstream Investment Company is one way for investors to easily acquire a portfolio of these companies in one easy trade. However, the fund has a lower distribution yield than other MLP funds, a somewhat checkered performance history, and somewhat high exposure to only a few companies. Thus, it is somewhat of a second drawer choice as far as I am concerned.
At Energy Profits in Dividends, we seek to generate a 7%+ income yield by investing in a portfolio of energy stocks while minimizing our risk of principal loss. By subscribing, you will get access to our best ideas earlier than they are released to the general public (and many of them are not released at all) as well as far more in-depth research than we make available to everybody. We are currently offering a two-week free trial for the service, so check us out!
Disclosure: I am/we are long FEN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.