With: Greg Mason, Managing Director, Ares Management Portfolio Manager, Litman Gregory Masters High Income Alternatives Fund
Date: November 14, 2019
Greg Mason: Finally, our third main category that we invest in – in midstream energy – a lot of people historically have thought of this as MLPs. The MLP space is moving, where we’re seeing some C-Corp conversions. We actually don’t care; we’re agnostic whether it’s C-Corp or MLP structure.
We’re really focused on mid-stream energy. We want to invest in the pipes and the gathering systems and the processing plants. We don’t do any E&P (exploration and production) exposure. None of the producers in this. We’re really looking for more of the sustainable cashflows.
The MLP model is really evolving. If you go back before the energy crisis in ’15 and ’16, the MLP market was all about growth. Rapid dividend growth – rapid issuing equity to funds. Big capital-expenditure. Growth projects.
It really was an unsustainable model. It was dependent solely on the capital markets providing them capital.
Where the MLPs and the midstream energy space have moved today is, they’ve moved to where they’re retaining more capital. They’re funding their capital-growth expenditures with internally-generated capital. And they’re not issuing any equity today to fund their growth.
We think that that is a much more sustainable business model.
You can see at the top right-hand corner there of the distribution coverage. Those numbers are pretty small on the right-hand side, but we’re peaking out at about 160% dividend coverage. If you rewind that back to ’14 and ’15, when the MLPs were growing rapidly – there was about 110% dividend coverage.
That provides better and more-consistent dividends, as well as being able to retain that capital to grow their business.
What we’ve seen is energy is completely out of favor today. The E&P producer stocks are getting crushed. The midstream energy stocks have come under significant pressure. As you can see here, this at 9.30, we’re trading at 10.8-times enterprise value to cashflow. This number updated today is sub-10-times.
Midstream energy is trading at near-historical low valuations.
Actually in our portfolio, I’ll show you here – we’ve actually been underweight midstream energy. The pie chart in the middle shows our current asset breakdown, where we’re 34% BDCs currently, 13% midstream energy, 21% mortgage REITs (real estate investment trusts), 11% preferreds and 21% in cash today.
We’ve been materially underweight MLPs all year. However, given to what we’re seeing in terms of increased fundamental improvements in the space, as well as where the valuations are today, we think there’s probably a little bit more downside this year with some end of the year tax-loss selling. But we’re getting close to the point where we’re considering increasing our exposure to midstream energy.
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We cut our midstream energy in half back in May. The reasons for that, we thought, were what had been tailwinds in the MLP space of improving production volumes. Particularly in the Permian. As well as US becoming a trade-exporter, and seeing demand for exports. Those were tailwinds in 2018.
We thought those were shifting, for a couple of reasons.
Number 1, we thought that the trade dispute was going to have an impact on the export markets. We were seeing spreads between basins widen, and that was going to be more difficult for producers.
In addition, we’d been seeing this pressure on the producers to living within their cashflow means. We thought would reduce potential expectations for volume in this space.
So we cut our position in half on midstream energy.
Since May, the midstream energy space has traded off 25%. What’s interesting is, we’ve actually seen EBITDAs (earnings before interest, taxes, depreciation and amortization) continue to grow. So we just finished third-quarter EBITDAs. We saw EBITDA cashflows in the MLP space grow 7% year-over-year.
We’re seeing actually capital expenditures. We think 2019 is going to be the peak year for capital expenditures for MLPs. It’ll decline somewhat in ’20, and I think significantly in 2021, which I think will improve cashflows for the MLP space.
We’re seeing distribution-coverage ratios now going to 1.55-times, this recent quarter. We’re seeing those fundamentals increase while the market has been worried about the producers lowering their volumes.
The market has become negative on energy because of concerns about volume productions. We’re actually getting to the point where we think the market is worried too much about volume productions and not focused on that we’re still seeing EBITDA cashflows improve, and that capital expenditures are going to be lower in the next couple of years, which is actually going to help free cashflow.
At current valuations, we’d probably be inclined to pull the trigger now. But we’ve seen what’s happened in the equity markets, with stronger returns in the S&P (500). People naturally look for tax-loss selling, and the MLPs are a perfect spot for tax-loss selling this year, being down 20% in a year where the market’s up 20%.
We’re being a little tactical on when we decide to increase our exposure there to the MLPs.