Frequently Asked Questions

30 April 2013

Alerian
1717 McKinney Avenue
Suite 1450
Dallas, TX 75202
www.alerian.com

table of

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Master Limited Partnership (MLP) Basics

What are Master Limited Partnerships (MLPs)?
How many energy MLPs are there?
How are MLPs structured?
How is an MLP different than a C corporation?
What are incentive distribution rights (IDRs)?
What are the tax advantages of owning MLPs?
How can the cash distributions from MLPs be tax-deferred?
Are MLP distributions guaranteed? Is there a minimum amount
of distributions that must be paid?
Merits of Master Limited Partnerships
Why own energy MLPs?
How do energy MLPs compare to other asset classes?
What is the growth trajectory of the MLP asset class?
How have MLPs performed historically?
What have MLPs yielded on a historical basis?
What has been the historical distribution growth?
How correlated are MLPs to the broader market?
Can you explain the sharp pullbacks in MLP prices during 20072009 and during August 2011?
Investing in Master Limited Partnerships
Can MLPs be held in an IRA?
Can MLPs be held by foreign investors?
Are institutions such as pensions invested in the space?
Does an MLP unitholder have to pay state taxes in every state
where the MLP operates?
Is there a way to gain exposure to MLPs but avoid filing K-1s
and state taxes?
Can MLPs be used as an estate tax planning tool?
Where can I find more information on MLPs?
Evaluating Master Limited Partnerships
How are MLPs generally valued?
What is Distributable Cash Flow (DCF) and how is it calculated?
Why are earnings per unit (EPU) or P/E negative for many MLPs?
What is the difference between maintenance and growth
capital expenditures?

Pooled Investments in Master Limited Partnerships

How can I invest in Alerian indices like the AMZ, AMZI, and
ANGI?
What is the difference between an MLP exchange traded fund
(ETF) and exchange traded note (ETN)?
What active management MLP products are available?
Master Limited Partnership Risks
Legislative: What is the likelihood that Congress would abolish
the preferential tax treatment afforded to MLPs?
Commodity Price: How correlated are MLPs to movements in
crude or natural gas prices?
Interest Rates: How have MLPs performed during periods of
inflationary environments?
Regulatory: What sort of governing bodies regulate MLPs?
Industry: Is hydraulic fracking safe? How will that impact MLPs?
Environmental Risks: How safe are natural gas and crude oil
pipelines? What has been the historical safety record of MLPs?
Alerian and the Alerian Index Series
How do I buy the Alerian fund?
How did the Alerian MLP Index (AMZ) become the benchmark
for the MLP asset class?
In general, what is the difference between Alerians Index Series
and other MLP indices?
When was Alerian formed?
Where did the name Alerian come from?
How can I get in contact with Alerian?

frequently asked

questions
MASTER LIMITED PARTNERSHIP (MLP) BASICS

What are Master Limited Partnerships?

Master Limited Partnerships, or MLPs, are engaged in the
transportation, storage, processing, refining, marketing, exploration,
production, and mining of minerals or natural resources. By
confining 90% of their income to these specific qualifying activities,
their units are able to trade on public securities exchanges exactly
like the shares of a corporation, without entity level taxation. Most
MLPs trade on the New York Stock Exchange (NYSE), NASDAQ, or
other public exchanges.

What are the tax advantages of owning MLPs?

A unitholders basis is adjusted upward by the amount of partnership
income allocated and adjusted downward by the amount of cash
distributions received. For most MLPs, cash distributions received
exceeds allocated income. The difference between distributed cash
and allocated income will be treated as return of capital to the
unitholder and reduces the unitholders basis in the units. Typically,
70-100% of MLP distributions are tax-deferred, with the remaining
portion taxed at ordinary income rates in the current year.

How many energy MLPs are there?

As of April 30, 2013, there are 102 publicly traded energy MLPs with
a combined market capitalization of approximately $400 billion.

As long as the investors adjusted basis remains above zero, taxes

on the return of capital portion of the distribution are deferred
until sale of units. If an investors basis reaches zero, then future
cash distributions will be taxed as capital gains in the current year.
Upon sale of the MLP, the gain resulting from basis reductions is
recaptured and taxed at ordinary income rates and any remaining
gain is taxed at capital gain rates for investments held greater than
one year.

How are MLPs structured?

MLPs have two classes of ownership, which are general partners (GPs)
and limited partners (LPs). GPs manage the partnerships operations,
receive incentive distribution rights (IDRs), and generally maintain
a 2% economic stake in the partnership. LPs are not involved in the
operations of the partnership and have limited liability, much like
the shareholders of a publicly traded corporation.
How is an MLP different than a C corporation?
Unlike regular corporations, MLPs do not pay corporate-level
tax. And whereas investors that own shares in a corporation are
considered shareholders, MLP investors are considered unitholders
that own interests (or units) in the MLP. Since the MLP itself does not
pay corporate-level tax, income and deductions are passed through
to the holders of their partnership interests. Instead of receiving a
Form 1099 detailing dividends and distributions, an MLP investor is
responsible for filing a partnership tax information return known as
a Schedule K-1.
What are incentive distribution rights (IDRs)?
IDRs incentivize GPs to grow LP distributions by entitling GPs to
receive a higher percentage of incremental cash distributions when
the distribution to LP unitholders reaches certain thresholds.

From an estate planning perspective, if units are passed along to

heirs, upon death of the unitholder, the basis is stepped up to the
fair market value of units on the date of death and prior distributions
are not taxed.
Are MLP distributions guaranteed? Is there a minimum amount
of distributions that must be paid?
MLP cash distributions are not guaranteed and depend on each
partnerships ability to generate adequate cash flow. Unlike Real
Estate Investment Trusts (REITs) that must distribute a certain
percentage of their cash flow each quarter, the partnership
agreements of individual MLPs determine how cash distributions
will be made to general partners and limited partners. Generally
speaking, partnership agreements mandate that the MLP distribute
100% of its distributable cash flow (DCF), less a discretionary reserve
determined by the GP, to unitholders within 45 days after the end
of a quarter.

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MERITS OF MASTER LIMITED PARTNERSHIPS

Why own energy MLPs?

Thematically, MLPs represent an investment in the build-out of
U.S. energy infrastructure over the next few decades. Energy
infrastructure MLPs operate toll-road business models that benefit
from inflation hedges built into their contracts, regional monopoly
footprints, and inelastic long-term energy demand growth. Such
business models allow MLPs to generate predictable cash flows and
pay consistent and growing quarterly cash distributions. In addition,
MLP returns have historically exhibited low correlation with the
broader equities market.
How do energy MLPs compare to other asset classes?
The two most comparable asset classes to MLPs are Utilities and
Real Estate Investment Trusts (REITs). Both Utilities and MLPs benefit
from inelastic long-term energy demand growth. However, Utilities
are subject to a more local and highly scrutinized regulatory body
focused on returning cost savings to their constituents. The interstate
pipelines owned by MLPs, on the other hand, are predominantly
regulated at the federal level by the Federal Regulatory Energy
Commission (FERC), where infrastructure assets are viewed as
critical to energy security.
The commercial buildings held inside REITs are viewed as hard
assets with inherent tangible value. Similarly, the steel pipelines and
storage tanks that transport and store the nations energy, including
that which heats and cools those buildings, are hard assets with
associated permanent value. REIT rental income, however, tends
to fluctuate with economic conditions and market demand, while
MLPs benefit from inelastic energy demand and inflation-adjusted
tariffs.
What is the growth trajectory of the MLP asset class?
Growth in the asset class will stem from additional organic projects,
asset acquisitions from integrated majors, as well as the monetization
of assets held in private hands. According to the Interstate Natural
Gas Association of America, over the next two decades, roughly
$200 billion will need to be spent on U.S. natural gas infrastructure
development to meet growing and shifting energy demands. On the
acquisition front, industry analysts estimate that at least $200 billion
of midstream assets are housed at public and private corporate
structures, all of which could eventually be acquired by MLPs.

How have MLPs performed historically?

MLPs, as measured by the Alerian MLP index (NYSE: AMZ), a
composite of the 50 most prominent energy MLPs calculated using a
float-adjusted, capitalization-weighted methodology, have returned
16.3% annualized on a total return basis from index inception (June
1, 2006) through April 30, 2013. One may not directly invest in an
index.
What have MLPs yielded on a historical basis?
Since June 1, 2006 until April 30, 2013, the average yield on the AMZ
was 7.1%. In 2012, the average yield on the AMZ was 6.3%.
What has been the historical distribution growth?
Weighted average distribution growth from June 1, 2006 until April
30, 2013 was 7%. annualized.
How correlated* are MLPs to the broader market?
From June 1, 2006 until April 30, 2013, MLPs exhibited a relatively
weak 0.5 correlation to the S&P 500 Index, which is an index of
500 stocks chosen for market size, liquidity and industry grouping,
among other factors. This compares to a correlation of 0.8 for REITs
and 0.6 for the Utilities sector. One may not invest directly in an
index.
Can you explain the sharp pullbacks in MLP prices during 20072009 and during August 2011?
While MLPs have historically had a weak correlation to the broader
markets, they are still equity securities and are not entirely immune
to market forces. During 2007-2009, access to capital essentially
froze as the financial crisis was unfolding. Since MLPs pay out a
majority of their cash flow as distributions and primarily depend on
the capital markets for the funding of new projects, MLP equities
suffered. Even so, the majority of MLPs were able to maintain their
distributions, some even growing.
During August 2011, the pullback was primarily attributable to
broader equity selling pressure from the United States government
credit downgrade, and for a brief period, investor fears regarding
the continuation of current MLP tax policy/status.

*Correlation - a statistical measure of how two securities move in relation to each other

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INVESTING IN MASTER LIMITED PARTNERSHIPS

Can MLPs be held in an IRA?

MLPs can be held directly in an IRA. However, partnership income
not cash distributions may be considered unrelated business
taxable income (UBTI) subject to unrelated business income tax
(UBIT) if UBTI exceeds $1,000 in a year. The custodian of the IRA
is responsible for filing IRS Form 990T and paying the taxes. More
information can be found in IRS Publication 598, Tax on Unrelated
Business Income of Exempt Organizations, or in the Internal Revenue
Code, Section 512: Unrelated Business Taxable Income.

Is there a way to gain exposure to MLPs but avoid filing K-1s and
state taxes?
There are several publicly traded pooled investment products that
handle the K-1s and state tax filings for the investor, and in return,
distribute a Form 1099 to investors. Passively managed MLP products
that track indices include exchange-traded funds and exchangetraded notes. A list of products that track the Alerian Index Series
can be found at www.alerian.com. Actively managed MLP products
include open-end funds and closed-end funds.

Can MLPs be held by foreign investors?

Foreign investors are required to file federal tax returns to report
their share of an MLPs income, gains, losses, and deductions.
Federal income taxes are paid at regular rates on their share of
the MLPs net income. Additionally, taxes must be withheld at the
highest applicable effective tax rate on MLP quarterly distributions.
An investor can get credit back on excess withholdings by filing a
U.S. federal tax return.

Can MLPs be used as an estate tax planning tool?

Yes. Upon death, the cost basis of a unitholders MLP investment is
reset (stepped up) to the price of the units on the date of transfer,
thereby eliminating a taxable liability associated with the reduction
in the original unitholders cost basis. As always, investors should
consult a tax or estate planning tax professional for advice.

Are institutions such as pensions invested in the space?

Pensions and endowments have started to develop an interest in the
asset class. Examples include the Missouri Teachers Association and
the UT Investment Company (University of Texas at Austin). Pensions
and endowments typically make an investment in MLPs as part of
their asset allocation strategy (as opposed to a trading strategy) and
tend to be longer-term investors.

Where can I find more information on MLPs?

The National Association of Publically Traded Partnerships (www.
naptp.org) is the trade organization for MLPs. Their website
includes several primers from sell-side research analysts and buyside institutions. Similar to Alerian, the NAPTP does not provide
investment research on specific MLPs.

Does an MLP unitholder have to pay state taxes in every state

where the MLP operates?
Yes. An MLP unitholder is responsible for paying state income
taxes on the portion of income allocated to the unitholder for each
individual state. In most cases, however, unless the unitholder owns
a large position, the share of allocable income is small and the
unitholder may not have to file in certain states due to minimum
income limits. Additionally, some states in which MLPs operate do
not have state income taxes, such as Texas and Wyoming.

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frequently asked

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EVALUATING MASTER LIMITED PARTNERSHIPS

How are MLPs generally valued?

The most common valuation metrics for MLPs are Price-toDistributable Cash Flow (P/DCF), Enterprise Value-to-EBITDA (EV/
EBITDA), Yield Spread to the 10-year Treasury, and the Dividend
Discount Model. Generally, Price-to-Earnings (P/E) is not used, as it
tends not to be the best representation of cash flow.
What is Distributable Cash Flow (DCF) and how is it calculated?
Similar to how REITs define their cash flow from operations as Funds
From Operations (FFO), MLPs use Distributable Cash Flow (DCF) as
the primary measure of cash available to distribute to unitholders
or to fund growth.
Distributable cash flow is considered a non-GAAP financial measure,
or not a Generally Accepted Accounting Principle (GAAP) measure
of liquidity or financial performance with set standards. Investors
should understand that the definition and calculation of DCF may
vary among partnerships, as ultimately, each MLP determines its
definition of DCF in its partnership agreement. The calculation
of DCF is typically net income, (+) depreciation, depletion, and
amortization, (-) cash interest expense, (-) maintenance capital
expenditures, (+/-) other non-cash items.

Why are earnings per unit (EPU) or P/E negative for some MLPs?
Due to accounting standards, there can be wide differences
between an MLPs earnings per unit (EPU) and distribution per
unit (DPU). In most cases, EPU tends to be less than DPU, due to
non-cash items. Typical non-cash items include depreciation and
amortization expenses, non-cash mark-to-market adjustments for
derivative positions, equity income versus cash distributions from
unconsolidated affiliates, and non-cash amortization of interest
financing charges.
What is the difference between maintenance and growth capital
expenditures?
In general, maintenance capital expenditures are expenditures
spent to maintain long-term operating capacity or revenue levels,
such as integrity spending, replacing compressors or valves, and
general repairs. Growth capital expenditures are expenditures that
increase capacity or generate new income opportunities.

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POOLED INVESTMENTS IN MLPS

How can I invest in Alerian indices like the AMZ, AMZI, and ANGI?
An investor cannot invest directly in an index. Several companies have
investable products, such as exchange-traded funds or exchangetraded notes, which are designed to track Alerian indices. An investor
should consider the vehicle that most appropriately fits his or her
needs and risk tolerance. For more information about such products,
please visit www.alerian.com.
What is the difference between an MLP exchange-traded fund
(ETF) and exchange-traded note (ETN)?
ETNs and ETFs are passively managed options designed to track
the performance of an underlying index. Some, but not all, of the
differences are listed below.
IRA / 401k Eligibility. The ETF is IRA and 401(k) eligible and
does not generate unrelated business taxable income (UBTI).
The ETN can be invested in IRAs and 401(k)s; however, no
should-tax opinion (or official stance) has been obtained from
a tax counsel by any of the current ETN issuers, meaning IRA
and 401(k) eligibility has neither been confirmed nor denied.
Credit Risk. An ETN is a senior unsecured obligation of the issuing
bank, thereby exposing the investor to credit risk. Although the
maturity of the available MLP ETNs is currently over ten years,
credit exposure is limited to a one-week rolling basis. The minimum
repurchase amount is 50,000 notes, and repurchases are available
on at least a weekly basis. The ETF does not carry the credit risk of
the product issuer, but similar to any equity investment, the ETF
does carry the credit risk of the underlying companies.

C Corporation Tax Election. Unlike a typical equity or bond mutual
fund, which is treated as a Regulated Investment Company (RIC) for
tax purposes, an MLP ETF is taxed as a C corporation. Equity and
bond mutual funds are allowed to make the RIC election because
the securities in which they invest (stocks and bonds) are taxable
entities. Because MLPs themselves have no entity-level tax, the IRS
requires any open-end or closed-end fund that invests more than
25% of its assets in MLPs to be taxed as a C corporation.

Corporate Taxes and Tracking Error. An MLP ETF must accrue

deferred income taxes for any future tax liability associated with
(1) the portion of MLP distributions from underlying securities
considered to be a tax-deferred return of capital and (2) capital
appreciation or depreciation of the underlying securities. The net
asset value (NAV) of the fund will be reduced (or enhanced) by
this deferred tax liability (or asset). An MLP ETN is not subject to
corporate taxes.
Taxation of Quarterly Distributions. The quarterly distribution
for an ETN is treated as a coupon and taxed at ordinary income
rates. The quarterly distribution for an ETF will typically be similar
to that of its underlying companies, or 70%-100% return of capital.
The remaining taxable portion of the distribution will be taxed at
qualified dividend rates.
Treatment at Sale. As an aside, upon sale of securities, a direct
investment in an MLP would require an investor to recapture the
portion of distributions considered tax-deferred return of capital
at ordinary income rates. In an MLP ETF, the entire deferred portion
will be taxed at capital gain rates. Separately, ETNs are treated as
prepaid forward or executory contracts for US federal income tax
purposes. Gains or losses are recognized upon the sale, redemption,
or maturity of the ETN and are treated as capital gains or losses.
What active management MLP products are available?
Actively managed products include MLP mutual funds and closedend funds. When making an investment decision between an MLP
closed-end fund or mutual fund, it is important to consider the
investment team, their track record, and total fees of the fund. Both
are IRA and 401(k) eligible; however, the shares of a closed-end fund
trade throughout the day, whereas mutual funds only trade at the
end of the day. Some MLP mutual funds may choose to employ
leverage, whereas others may not. The benefits of leverage include
higher returns in an upward market; however, leverage also increases
overall volatility to the net asset value of the fund.

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RISKS

Legislative: What is the likelihood that Congress will abolish the

preferential tax treatment afforded to MLPs?
Most MLP industry analysts view a change in MLP tax status
as unlikely, as MLPs are an integral part of domestic energy
infrastructure. Moreover, MLPs have already experienced tax reform.
In 1987, Congress created Section 7704 in the tax code to define and
limit publicly traded partnerships to those with specific qualifying
income sources, mitigating the probability that something similar to
Halloween 2006 for Canadian Income Trusts will occur. On February
1, 2013, the staff of the Congressional Joint Committee on Taxation
(JCT) released its annual list of tax expenditures. For energy and
natural resource publicly traded partnerships, the total revenue loss
over five years (2012-2016) is estimated to be $7 billion, equating to
$1.4 billion per year. This amount, if collected, would likely have a de
minimis impact on the trillion-plus dollar U.S. deficit.
Commodity Price: How correlated are MLP unit prices to
movements in natural gas prices?
Since MLPs typically do not take ownership of the commodity that
is being transported, MLPs have historically had a low correlation to
commodity prices. Over the past 15 years, the correlation between
MLPs and both crude oil and natural gas has been statistically
insignificant. However, external factors related to commodity price
movements may indirectly affect MLPs, such as producers shutting
in natural gas production due to oversupply. Another indirect
fundamental risk may be from demand destruction given high
commodity prices or the proliferation of alternative energy sources.
Despite these risks, the demand for petroleum products and natural
gas is largely inelastic in the near term.
Interest Rates: How have MLPs performed during inflationary
periods?
On a day-to-day basis, there is generally no correlation between
interest rates and MLP yields. Over the past three decades, MLPs
have benefited from a trend of declining interest rates. However,
there have been three notable periods in which drastic interest
rate movements (1994, 1999, and 2004) have resulted in shortterm weakness in the asset class. The most notable surge in interest
rates occurred in 1994 when the Federal Reserve began tightening
monetary policy after three years of relatively low interest rates,
raising the federal funds rate from 3.25% to 5.5% in the span of
less than a year, thereby causing 10-Year Treasury rates to increase
dramatically. During this period, MLP prices traded downwards and
exhibited a strong inverse correlation with interest rates.

Regulatory: What sort of governing bodies regulate MLPs?

Similar to Utilities, though not to the same extent, MLPs are
regulated by several organizations. Interstate pipelines are regulated
by the Federal Energy Regulatory Commission (FERC). Pipeline
safety is overseen by the Pipeline and Hazardous Materials Safety
Administration (PHMSA). Intrastate pipelines are regulated at the
state level by organizations such as the Texas Railroad Commission.
Any material change in regulatory requirements or standards could
impact MLPs and their assets.
Industry: Is hydraulic fracking safe? How will that impact MLPs?
Hydraulic fracturing takes place via cement-sealed pipelines well
below the water table. Environmentalists express concerns about
drinking water contamination while industry experts cite a 62year history of commercial use of hydraulic fracturing in the United
States without a major environmental incident. The Environmental
Protection Agency, an objective third party, is completing a focused
study on the issue, and expects to release a draft report of results in
late 2014.
The development of hydraulic fracturing in the US shale plays
increases the volumes transported on MLP-owned pipelines.
However, as MLPs do not participate in the actual fracturing process,
their exposure to increased fracturing regulation remains limited.
Environmental Risks: How safe are natural gas and crude oil
pipelines? What has been the historical safety record of MLPs?
Natural gas and crude oil pipelines have averaged 250-300 significant
incidents each year for the past 20 years, according to the Pipeline
and Hazardous Materials Safety Administration. However, a 2009
study by the American Petroleum Institute shows that the number
of spills per 1,000 miles has dropped by 60% in the previous 10 years
and the number of barrels released per 1,000 miles has dropped
42% in the same time period. The falling number of incidents per
pipeline mile is due to increased maintenance and technology that
enables more accurate and frequent monitoring of pipelines. For
instance, the use of smart pipeline integrity guides (PIGs) to monitor
any degradation in pipeline materials has become more and more
widespread.

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frequently asked

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ALERIAN AND THE ALERIAN INDEX SERIES

How do I buy the Alerian fund?

Alerian is an indexing company and does not own a fund. We are in
the business of creating indices that are most relevant to a variety
of stakeholders. In turn, we license our indices to various companies
that create investable products, such as exchange-traded funds and
exchange-traded notes. For more information about such products,
please visit www.alerian.com.

How did the Alerian MLP Index (AMZ) become the benchmark
for the MLP asset class?
The AMZ was launched on June 1, 2006 as the sectors first real- time
benchmark. We have been very fortunate to enjoy the continued
support of the sectors various stakeholders, including the MLPs
themselves, research analysts, buy-side asset managers, and
national media, among others.

In general, what is the difference between the Alerian Index

Series and other MLP indices?

When was Alerian formed?

Alerian was formed in 2004. Alerians original offices were in the Big
Apple (New York, NY) until we moved to the Big D (Dallas, Texas) in
2007.

Transparency. Alerian aims to provide unbiased MLP benchmarks

that are both investable and replicable for stakeholders. Alerian
does not use a black box system to select constituents, instead
preferring a rules-based methodology. Alerian believes that it
is important for the methodology that stands behind each of
its indices to be completely transparent and available so that
stakeholders can replicate the process used to design, construct,
and maintain each of the indices. Alerian uses only publicly
available data (press releases, SEC filings, etc.) to create the indices
and all of the methodology guides are available on our website.

Consistent Methodology. Methodology is consistently and
uniformly applied for special and quarterly rebalancings.

Where did the name Alerian come from?

Alerian is the name of our founders friend. We wish we had a more
interesting story to tell than that.
How can I get in contact with Alerian?
Please e-mail index@alerian.com or feel free to call us at
972.957.7700.

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disclaimers
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While Alerian believes that the information provided in this
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Research May Not Be Current.
This document has been prepared solely for informational purposes
based on information generally available to the public from
sources believed to be reliable. Alerian makes no representation
as to the accuracy or completeness of this document, the content
of which may change without notice. Alerian expressly disclaims
any obligation to update the contents of this document to reflect
developments in the energy MLP sector. The methodology involves
rebalancings and maintenance of indices that are made periodically
throughout the year and may not, therefore, reflect real-time
information.
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Analytic services and products provided by Alerian are the result
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