Using a Broader Approach in MLP and Energy Infrastructure Investment
JAMES J. CUNNANE JR., with 21 years of investment experience, is Managing Director and Chief Investment Officer of Advisory Research, Inc.’s MLP & Energy Infrastructure team — formerly FAMCO MLP. He oversees the firm’s MLP and energy infrastructure product lines and chairs the risk-management committee. He joined the MLP team in 1996 and currently serves as a portfolio manager for three publicly traded closed-end mutual funds: the Fiduciary/Claymore MLP Opportunity Fund (FMO), the Nuveen All Cap Energy MLP Opportunities Fund (JMLP) and the Nuveen Energy MLP Total Return Fund (JMF). He also serves as a portfolio manager for the Advisory Research MLP & Energy Income Fund (INFIX), an open-end mutual fund, as well as a privately offered open-end mutual fund. Mr. Cunnane holds a B.S. in finance from Indiana University and is a chartered financial analyst charterholder. He serves on the finance council and investment committee of the Archdiocese of St. Louis, and on the board of directors of St. Patrick’s Center.
QUINN T. KILEY, with 13 years of investment experience, is Managing Director and Senior Portfolio Manager of Advisory Research, Inc.’s MLP & Energy Infrastructure team — formerly FAMCO MLP. His responsibilities include portfolio management of various energy infrastructure assets and oversight of the energy-infrastructure research process. He joined the MLP team in 2005. Mr. Kiley serves as a portfolio manager for three publicly traded closed-end mutual funds: the Fiduciary/Claymore MLP Opportunity Fund, the Nuveen All Cap Energy MLP Opportunities Fund and the Nuveen Energy MLP Total Return Fund. He also serves as a portfolio manager for the Advisory Research MLP & Energy Income Fund, an open-end mutual fund, as well as a privately offered open-end mutual fund. Prior to joining the MLP team, Mr. Kiley served as Vice President of corporate and investment banking at Banc of America Securities in New York. He was responsible for executing strategic advisory and financing transactions for clients in the energy and power sectors. Mr. Kiley holds a B.S. with honors in geology from Washington and Lee University, an M.S. in geology from the University of Montana, a JD from Indiana University School of Law and an MBA from the Kelley School of Business at Indiana University. He has been admitted to the New York State Bar.
M O N E Y M A N A G E R I N T E R V I E W
SECTOR — GENERAL INVESTING
TWST: Please start with some background information on Advisory Research Investment Management — a bit about the firm’s history and an overview of your business.
Mr. Cunnane: Advisory Research, Inc. is an institutional investment manager that provides U.S., international, global, and MLP and energy infrastructure strategies for sophisticated investors. Importantly for this particular conversation, Advisory Research has a dedicated MLP & Energy Infrastructure team located in St. Louis. The St. Louis group is a 13-person team that’s been managing MLPs and energy infrastructure for over 18 years. We are currently managing a
little over $5 billion in MLP and energy infrastructure assets, and have two strategies, one of which is an MLP-dedicated strategy, and the other is an MLP and energy infrastructure strategy that seeks to find the best energy infrastructure assets in the U.S. and invest in them either via MLPs, equity tied to corporations or debt.
TWST: Of those two strategies, is there one you’d prefer to focus on?
Mr. Cunnane: I think both of them are interesting. The MLP-dedicated strategy is something that I talked to The Wall Street Transcript about a couple of years ago. The MLP and energy infrastructure strategy — the newer strategy — has done very well, and we think is particularly
interesting as we look forward to the next 10 years and the opportunity set that’s going to be in front of us. The other differentiator is that the MLP-dedicated strategy is available only in separate accounts and in closed-end funds, whereas the MLP and energy infrastructure strategy is available via an open-end fund, which has been a very quickly growing part of the MLP universe recently.
TWST: Would you give us a snapshot of that fund then and discuss its overall investment approach?
Mr. Kiley: The concept is that what drives MLPs generally is the businesses they operate, not the structure of their equity or the tax treatment. Energy infrastructure is a real asset-based business that has strong fundamental demand for the services they provide, which allows them to have long-term visibility on cash flow, which allows them to pay out a yield and to service their debt, etc. And because they are capital-intensive businesses, you have a lot of offerings on the equity and the debt side.
So our thought process was, let’s have an approach that’s a little broader than MLPs only, a slightly broader universe that’s going to give us the ability to have a best-ideas approach in energy infrastructure. We think that approach over time is going to give an MLP-like return, but do it with
better liquidity because it’s a broader universe, do it with less volatility in part because we are going to own some fixed income, and if implemented in an open-end fund structure, it’s going to provide simple 1099 tax reporting instead of the K-1s you get buying MLPs directly. We think it really solved some issues of how people perceive MLPs, which are, it’s a small asset class, it’s a little illiquid, it’s somewhat more volatile than other yielding asset classes and could be hard to own. This fund, we think, addresses all of those issues.
Mr. Cunnane: MLPs are a very popular investment class right now, but what we think investors are really investing in when they buy MLPs is the growth in U.S. energy infrastructure that we have seen over the last couple of years and are going to see for the next couple of years. We believe that while investing in MLPs is going to be very productive over the next few years, we also believe that a broader, more opportunistic strategy that invests in the best energy infrastructure assets, and in different types of securities to get at those underlying assets, is also going to be a very exciting and productive strategy that potentially provides a lot more opportunity to add value for a team like ours.
TWST: That expansion is clearly the big one, but I was going to ask what themes or trends you are seeing in the industry that are affecting the investment market in general and your investment decisions in particular.
Mr. Cunnane: The highest-level trend that we are seeing is that U.S. production of oil and natural gas continues to expand, and every time we see an update on energy production, it’s higher than what the marketplace, and ourselves, would have projected six months earlier. This has been occurring for approximately eight years now, following a very long period of declining production. That increase in production is
leading to an incredible opportunity to build out infrastructure to support the delivery of that production to market, whether that market is domestic or foreign. Also, a lot of the production and the growth of production is in areas that historically didn’t have substantial production, and so they are underserved by infrastructure. It’s a real opportunity for the growth of U.S. energy infrastructure, particularly midstream energy infrastructure, and that’s where we are investing.
Mr. Kiley: I think infrastructure is often overlooked as a way to play the energy story because the flashier or sexier names are often the large E&P companies. But one of our overall themes is that, while we have this increased production of oil and gas, we think there is likelihood — we have seen it, and we think it’s going to continue — that there will be some negative pressure on U.S. prices of these commodities. And so if you were to buy into the energy boom and buy it with commodity price exposure, you might be not getting what you signed up for. The infrastructure play allows you to experience the growth of the energy business and limit your commodity price exposure. We think it gives you a really interesting return stream, while being exposed to a pretty obvious — and becoming more and more popular — growth story.
TWST: Mr. Kiley, you mentioned earlier the perception of this being a small asset class and market, but it certainly has grown significantly in recent years. I believe last year was a record year for MLP IPOs. Is the investor interest there to support that, and do you expect that level of activity to continue this year?
Mr. Kiley: It’s an interesting time in the market. We are hitting all-time highs on various indices; we are having record IPO activity. It’s hard to say we expect more of the same, but we do think this space is going to continue to expand. We think there is an interesting market dynamic for MLPs right now. MLPs have done well, and they are more discovered today than maybe they were in the past. The MLP story is based on this infrastructure boom, and we think there is a long-term growth story there.
We think there is investor appetite for the equity of MLPs and energy infrastructure generally because they tend to be yielding securities, and this is a low-yield market, and it tends to be growing yield. The distributions and dividends grow over time, and this is a low-growth market. When you can provide yield and low-growth in one asset class, it can be very attractive. So we think we have a little bit of a Goldilocks environment for MLPs right now. We think rates are going to stay relatively low for the next year or two and that economic growth is going to stay relatively low; in that environment, MLPs are pretty well-positioned if you’re looking for a place to put money today.
Mr. Cunnane: One of the opportunities given this large number of IPOs is that we’ve seen a great distinction in both the quality and the growth prospects of some of the new issues. As we move forward here for the next couple of years, we think higher quality, higher growth from an investment strategy standpoint is where you are going to want to
Highlights
James J. Cunnane Jr. and Quinn T. Kiley discuss the Advisory Research MLP & Energy Infrastructure team and strategies. Using a broader, best-ideas approach, they are able to invest in energy infrastructure, gaining better liquidity while still obtaining MLP-like returns. Mr. Cunnane and Mr. Kiley believe the strength of their approach is being able to find and access assets in the most beneficial way for investors, whether through the MLP itself, parent company equity or debt.
Companies discussed: Energy Transfer Equity, L.P. (ETE); Williams Companies (WMB) and Chesapeake Energy Corporation (CHK).
be, and so we’ve really focused in these new opportunities to identify higher quality, higher growth MLPs — or even corporations that own energy infrastructure — as where we want to invest our next dollars.
TWST: What are some of your favorite investment ideas or top holdings right now, and why?
Mr. Cunnane: I think this is a good opportunity for us to talk about some MLP ideas, and also talk about scenarios where maybe the corporate parent or the debt is a more attractive alternative to owning the MLP. We can illustrate both the strength of an MLP strategy and then illustrate the strength of a broader strategy that allows us to own the parent companies of MLPs and/or the debt as well. I’ll let Quinn jump off and start with one or two of those.
Mr. Kiley: If you look at our top 10 holdings of our MLP and energy infrastructure strategy, the thing that jumps out to me right away is that nine of the top 10 are general partners or own a general partner of an MLP. That’s a big theme for us. It’s a way to get exposure to that growth story that Jim was talking about, and a way to be biased in your holdings to even more growth.
The way general partners typically work is they are a large holder, typically the largest holder, of the underlying MLP. They also control the governance by owning the general partner. And they also have incentive distribution rights whereby they can get an incrementally larger piece of the cash flow that’s being paid out by the MLP as they grow the cash distribution per unit at the MLP, and so that aligns them to grow the distribution to LP unitholders. It gives them an increased piece of future growth, and that means that if you buy an underlying MLP that’s growing, the GP typically is going to grow faster.
And so one of the themes we clearly have in the strategy on the equity side is to own GPs because it gives us that better growth, and it’s a direct way to own an MLP interest but also have a better lever on that growth. Of the top 10, nine of them are in that theme. In all of those cases, we like the underlying MLPs as well; it’s just in this portfolio we have chosen to buy — more often than not — the general partner, if it is available to buy, as opposed to the underlying LP unit.
Our top holding in the strategy is Energy Transfer Equity
(ETE). It is the general partner of several MLPs, and is itself an MLP. But you might look at, say, the Williams Companies (WMB), which is another top 10 holding; it is the GP, also owns GP interests in a couple of MLPs, and it’s a C-Corp. If you’re buying straight MLPs in a typical MLP strategy, you might not get exposure to that general partner, even though clearly its main business is owning and operating MLP interests. So it gives us a way to get exposure there, and it’s not an MLP holding, so it’s a little differentiated from some of our other MLP-only accounts. These companies also issue debt.
One of the unique things in the energy infrastructure market is that a lot of pipelines, the actual asset itself is an issuer of bonds. And so we might buy the equity of one MLP and the bond of an underlying pipeline, and so we’re getting more exposure to that story, but specifically, the credit risk of a single pipeline. That’s an area that’s often overlooked by the market. They typically are high-yield, so they’re outside of the purview of investment-grade bond managers.
We think we can get some attractive returns there, even though I think there is a general market perception that fixed income is overpriced because the area in which we’re looking for opportunities tends to be a little overlooked. We’re getting some interesting opportunities on the bond side as well as the equity side, so that’s why we’re excited about the strategy. We get to broaden our opportunity set as compared to MLPs only, and we’re tending to traffic in areas that are a little less traveled than some others in the bond market and the equity market.
TWST: Is there another example you’d like to add? Mr. Kiley: Another example of how we look at the bond portfolio and the role it plays in the strategy: There are certain things in the energy market that we might want to take advantage of — for example, natural gas was really beaten up a couple of years ago. We had a view that it had bottomed and that it was going to recover, and obviously, that was helped by a really cold winter. But absent that cold winter, we thought natural gas prices were cheap and were going to
“The distributions and dividends grow over time, and this is a low-growth market. When
you can provide yield and growth in one asset class, it can be very attractive. So we think
we have a little bit of a Goldilocks environment for MLPs right now.”
1-Year Daily Chart of Energy Transfer Equity, L.P.
Chart provided by www.BigCharts.com
1-Year Daily Chart of Williams Companies
recover, but we thought it was a little risky to take equity risk to play that theme. What we did was buy of natural-gas-exposed E&P and infrastructure players, so we could participate in the improving credit story of a natural-gas-associated company but do it on the bond side, where we had capital protection, and where it wasn’t going to be as volatile as the equity side.
A name that I think jumps to people’s minds when you talk about that is Chesapeake Energy (CHK), which has been in the news and much maligned over the last several years, and fell onto hard times largely because of its natural gas exposure. We happen to love the underlying plays that they own and just thought the better way to play that was on the bond side. So we own some Chesapeake
bonds, and they’ve been great performers for us, and so we executed on the theme of natural gas recovering and did it through what we think is a safer, steadier, less volatile approach than owning the equity of a company like that.
Mr. Cunnane: I think one of the really interesting topics in today’s MLP and energy infrastructure market is: If you want to buy an MLP-dedicated or focused product, what are some of the trade-offs between the funds that you can purchase? One of the really nice things about the MLP and energy infrastructure strategy that we utilize is that it’s a really good fit for an open-end fund approach. It allows us to invest in the great story of U.S. energy infrastructure, to deliver investors a 1099, but not to be burdened with the tax liability that MLP funds that invest solely in MLPs are often burdened by.
This issue is very unique to MLP funds. In an effort to deliver a 1099, an MLP-dedicated fund may be subject to an extra layer of tax that can negatively impact NAV growth. Our strategy allows us to offer an open-ended approach that delivers that same 1099, we believe delivers the same exposure to the great U.S. energy infrastructure story and the attributes of MLPs that investors want, but does it in a much more tax-efficient manner because we’re not burdened by an extra layer of tax.
Mr. Kiley: I think, as with MLPs, there is a lot of nuance. When you look at individual names and stories, not all MLPs are the same. I think it’s attracted some investors who do it themselves, and get caught up and say, “I’ll just buy this yield because it’s an MLP, and I like the yield.” But the risk underlying it may be very different than another MLP. Because of the oddities of MLPs, the same is true of the investment vehicles you can put your money into. So it’s not just, do your homework if you’re going to buy an individual MLP, but do you homework if you’re going to buy a fund, because the simple approach of saying, “I like MLPs, I’ll buy an ETF” — you’re not buying something that’s going to track the index very well. If you buy an open-end fund, like Jim laid out, you might have certain issues like tax drag. This is a place that’s a little harder to get into, and we think really requires active management by somebody like us or our competitors that manage these professionally, because it is a different asset class than people may be used to looking at.
TWST: I was going to ask what sets your fund apart from others available to investors. Is there anything else you would add?
Mr. Cunnane: The strength of the approach is in the fact that we’re able to find great assets and access them — and that might be, again, the MLP, it might be the parent company equity, or it might be the debt — in the best way that we can for our investors. It’s a very
opportunistic approach. It’s an approach that delivers a high correlation to an MLP index, but does it with less volatility and more liquidity, and we think those are positive traits. Lastly, we’re able to deliver a significant yield, and we think that’s something that energy infrastructure and MLP investors like.
TWST: What do you use as a benchmark? How is your performance compared?
Mr. Cunnane: We use the Alerian MLP Index as a benchmark. We tell people that, over time, we believe that our approach will compete very well with the Alerian, and we think that the history to date bears that out. We also note that in any given year, because of our lower volatility strategy, we’re going to be likely to underperform the Alerian in years when Alerian does very well, and likewise, we should outperform in years when the Alerian is weaker. But over time, we compare ourselves to and believe we’ll beat the Alerian.
I’ll note that many of the MLP-dedicated funds don’t compare themselves to the Alerian Index, even though they are solely investing in MLPs, and I believe that’s because it’s difficult to own an MLP-dedicated portfolio, accrue and pay the taxes that you may be subject to in that kind of a strategy at the fund level, and compete with an index that’s not subject to those taxes. So again coming back to the tax issue, the MLP-dedicated funds on the open-end fund side — I believe — may have a difficult time competing with the Alerian Index over time and are therefore unlikely to compare themselves to it today.
TWST: Would you like to wrap up with some final thoughts or words of advice?
Mr. Kiley: Jim laid out why our strategy is different and unique. The way I look at it is: Long term, this is an approach that — if we do our job correctly — should perform relatively well in different parts of the cycle, not only when MLPs are hot and popular. We have an opportunity to allocate to equity, MLPs or fixed income, and if we do that the right way across the energy infrastructure universe, I think we should perform well in different environments over time. That’s one of the reasons why I think this is going to be a pretty interesting strategy over time, because we have some levers to pull that you can’t pull in an MLP-only portfolio.
Mr. Cunnane: I would just add that while a careful study of MLP structures is important when you invest in MLPs, to make sure you get into the right place, it’s also very, very important — we believe — that investors own MLPs and energy infrastructure as part of their overall asset mix. Because we do believe that, regardless of
“One of the really nice things about the MLP and energy infrastructure strategy that we
utilize is that it’s a really good fit for an open-end fund approach. It allows us to invest in the
great story of U.S. energy infrastructure, to deliver investors a 1099, but not to be burdened
with the tax liability that MLP funds that invest solely in MLPs are often burdened by.”
structure, it’s going to be an asset class that’s going to provide a unique set of attributes and has a fundamental backdrop of growth that’s going to support those attributes — both growth and income — very well. We think it’s a strong asset class to be invested in over the next couple of years, and we encourage people to do their homework on how to get their investment in a way that’s going to deliver what they expect.
TWST: Thank you. (MN)
© 2014 The Wall Street Transcript, 622 3rd Avenue, New York, NY 10 017 Tel: (212) 952-740 0 • Fax: (212) 668-9842 • Website: www.twst.com
JAMES J. CUNNANE JR.
Managing Director & CIO of MLP & Energy
Infrastructure
QUINN T. KILEY
Managing Director & Senior PM of MLP & Energy
Infrastructure
Advisory Research, Inc.
180 N. Stetson Ave.
Suite 5500
Chicago, IL 60601
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