Public pension funds leading growth of MLPs

Institutional investors have been allocating more money to master limited partnerships over the past 12 months, attracted by the hefty cash distributions and inflation-hedging charms offered by the fast-growing market niche.

A number of investment consultants, with varying degrees of caution, are recommending these publicly listed vehicles — focused on natural resource investments in sectors such as midstream energy projects — to clients.

Public pension funds have been at the forefront of that trend. That's because they are able to avoid some of the tax issues that would affect corporate funds and endowments and foundations, noted Andrew Junkin, a managing director with Santa Monica, Calif.-based investment consultant Wilshire Associates Inc.

In recent months, pension funds extending mandates to MLPs or preparing to do so include:

• $222 million Tulsa County (Okla.) Employees' Retirement System, which in June invested $6 million each with Chickasaw Capital Management LLC and Pinnacle Investment Advisors;
• $620 million St. Louis City Employees' Retirement System, whose board voted in May to add a strategic 7.5% allocation to MLPs;
• $23.3 billion Iowa Public Employees' Retirement System, Des Moines, which made its first MLP allocation in April, hiring Harvest Fund Advisors to run $150 million; and
• $19.8 billion Alaska Retirement Management Board, Juneau, whose board voted in April to invest $100 million to $200 million in MLPs.

“Inflation-plus” revenue arrangements for a number of energy and infrastructure projects have helped spark interest in MLPs “as a component of an inflation-protection strategy,” Mr. Junkin said in a recent interview.

Neil Rue, a Portland, Ore.-based managing director with Pension Consulting Alliance Inc., said MLPs can play a role in diversifying an inflation hedge, especially if a client's investment policy includes limits on private equity investments.

Meanwhile, the requirement that MLPs distribute the bulk of their earnings to investors is another attraction, which has become more prominent as fixed-income yields have sunk to historic lows.

That fact that defined benefit plans are “starved for yield” has focused attention on the relatively high cash distributions by MLPs, even as their properties as an inflation hedge have continued to drive the trend of increasing institutional allocations, said Mark Andersen, a senior vice president with the independent adviser group of Callan Associates Inc., San Francisco.

Alan Kosan, a Darien, Conn.-based managing director and head of alpha investment research with investment consultant Segal Rogerscasey, said in an interview that year-to-date, annualized cash distributions by MLPs have come to 7%, lifting the total returns on investments in those vehicles to around 11%.

In an environment where institutional investors have struggled to achieve return targets of 8% to 9%, returns such as those have provided a tail wind as investors look to diversify exposure to upstream energy sectors, such as oil production, with midstream exposure to parts of the market such as pipelines, Mr. Kosan said.

While the inflation-hedging charms of MLPs are a main draw, the fact that investors get paid while they wait for inflation is an added attraction, noted the chief investment officer of one multibillion-dollar public pension system with allocations to MLPs, who declined to be named.

MLP allocations by high-net-worth investors have increased more dramatically over the past year or two, attracted by the tax-advantaged structure of the investment vehicle, but conversations with Segal Rogerscasey's institutional clients are picking up as well, Mr. Kosan said.

If interest is picking up, investment consultants see limits to how quickly institutional investors can, or should, allocate to what consultants say is the $300 billion MLP market.

On the negative side, even with what amounts to very attractive fixed-income-like yield, MLPs have equity-like volatility, accentuated by heavy retail participation in the market and daily trading volume of less than $600 million, consultants said.

Moreover, while there are 85 to 90 publicly traded MLPs, the five largest account for a big chunk of the total, so institutional investors looking to allocate more than 5% of their portfolios to the market segment would have to grapple with concentration issues, Wilshire's Mr. Junkin noted.

For now, while recent returns have been attractive and the vehicle provides some protection in an inflationary environment, the MLP space remains “too narrow and concentrated” to justify considering it as a “stand-alone asset category,” noted Erik Knutzen, chief investment officer of Cambridge, Mass.-based investment consulting firm NEPC LLC.

Another concern: After 10 years during which MLPs have outperformed major equity benchmarks, there's no guarantee of continued outperformance. Investors opting to favor those vehicles as an inflation hedge now on the strength of that past performance could be better served by direct investments in the energy infrastructure sector, Mr. Knutzen said.