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THE BROYHILL LETTER

Executive Summary
A successful society is characterized by a rising living standard for its population, increasing investment in factories and basic infrastructure, and the generation of additional surplus, which is invested in generating new discoveries in science and technology. Robert Trout, The Iron Man of Radio

Investing in Infrastructure
Oxford Dictionaries denes infrastructure as the basic physical and organizational structures and facilities (e.g. buildings, roads, power supplies) needed for the operation of a society. Broyhill characterizes an investment in the operation of a society as a safe bet amidst a hazardous macroeconomic backdrop. Providing access to essential natural resources required to uphold or improve standards of living are among the most fundamental of societal services. Sources trace the origin of the word infrastructure in the English language to 1927, but the military use of the term achieved prevalence after the formation of NATO in the 1940s, and was later adopted by urban planners in its modern sense around the 1970s. The term came to prominence in the United States in the 1980s following the publication of America in Ruins, which kicked off a public-policy discussion around the nations infrastructure crisis - instigated by decades of insufcient investment and inadequate maintenance of public works. Today, infrastructure may be owned and managed by governments or by private companies, but in the economic context of an extended debt deleveraging, policy makers can no longer resort to the Rooseveltian Recipes reliant on massive borrowing to fund infrastructure projects without regard for the long-term scal consequences of such policies. Even so, existing assets must still be maintained and repaired and new assets must be built, to ensure the continued competitiveness of the western world. Given that the required investment is enormous and the traditional provider of that capital government does not have the resources to do that anymore, private sector interest has grown considerably in recent years. According to Preqin, over $175 billion has been raised by banks and managers for private infrastructure funds since 2004 with pension funds the leading investors in the asset class. The OECD estimates that there will be a worldwide need for as much as $30 trillion of infrastructure investment in the next two decades. In other words, there is considerable room for additional capital ows considering that average allocations to the asset class only represent one percent of pension assets today. Interest is growing for obvious reasons - infrastructure is a natural t for large pensions and sovereign wealth funds with long-term liabilities. These institutional investors need to protect the value of their portfolio from the toxic consequence of currency debasement and ination, while minimizing volatility in order to maximize the recurrent cash ows to beneciaries. As a result, infrastructure is an ideal investment that provides tangible advantages: long duration real assets; high and growing distributions with natural ination hedges; and statistical diversication which reduces overall portfolio volatility.

Enter The Master Limited Partnership

Although long recognized as an attractive asset class for institutional investors, access to infrastructure investment has been historically difcult to achieve for individual investors, particularly in the United States, where the majority of infrastructure is government owned and controlled. Fortunately, a liquid alternative now exists. Domestic energy infrastructure assets are often organized as Master Limited Partnerships, or MLPs, which are listed companies that own, manage and operate qualifying assets. The MLP structure enables these rms to utilize the tax advantages of partnerships. Shares trade like a corporate stock, but only pay one level of federal income tax so they are not subject to the double taxation of public companies.

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MLPs provide investors with a direct pathway to infrastructure investment. Traditional MLP assets include intrastate pipeline systems that take products to storage, regulated interstate pipelines that go across state borders, and the gathering and processing systems that take natural resources from the wellhead to the distribution point. These pipelines typically collect steady fees with long-term contracts, regardless of the types of and prices for the commodities that pass through the pipes. Upstream exploration and production MLPs nd long-lived oil and gas assets after they have had a drop in production. These assets have a long tail, which means a slow decline in future production and steady cash ow. Downstream MLPs are the rening assets and chemical plants.

By conning 90% of their income to these specic qualifying activities, MLP units are able to trade on public securities exchanges without entity level taxation. As of March 31, 2012, there were 81 publicly traded MLPs with two classes of ownership - 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 shareholder of a publicly traded corporation.

The Competitive Landscape

A number of forces affect the competitive environment for businesses today, but these forces are not of equal importance. We believe one is clearly more important than the others - Barriers to Entry. If there are barriers, it is difcult for new rms to enter the market and challenging for existing companies to expand. Put simply, no other feature has as much inuence on a companys success as where it stands in regard to these barriers. Measured by potency and durability, economies of scale, when combined with some customer captivity, provide the strongest and most durable moats. Pipelines earn high grades on both counts. Although it may seem counterintuitive, most competitive advantages based on economies of scale are found in local and niche markets, where either geographical or product spaces are limited and xed costs remain substantial. An attractive niche should be characterized by customer captivity, small size relative to the level of xed costs and the absence of vigilant dominant competitors. In fact, companies can build quasi-monopolies in markets that are only large enough to support one company protably, because it makes no economic sense for a new entrant to spend the necessary capital to enter the markets.
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Infrastructure rms provide an extraordinary example of niche domination. MLPs have high barriers to entry due to capital requirements and geographical monopolies. A business in the midstream is a toll collector that takes products from one point to another. Many have monopolistic characteristics as building a pipeline requires clearing multiple regulatory hurdles which can be challenging to overcome given ongoing environmental concerns. Furthermore, when there is not enough demand between two points to protably support multiple pipelines, a single pipeline enjoys niche economics and can charge the maximum allowable rates. Those rates can be quite attractive for owners as pipelines have a somewhat looser regulatory regime than utilities.

Our Investment Thesis

Thematically, MLPs represent an investment in the buildout of our domestic energy infrastructure over the next few decades. Nearly all other infrastructure is contingent upon pipelines and other energy assets to provide the lifeblood of our economy. These businesses operate toll-road business models supported by long-life real assets, with ination hedges built into long-term contracts, regional monopolistic footprints, and relatively inelastic long-term energy demand growth. The resulting operating fundamentals allowed MLPs to generate predictable cash ows and pay consistent and growing quarterly cash distributions over the past few decades, which translate into very attractive investment characteristics: long-term stability and low volatility, attractive risk-adjusted returns, diversication via low correlation with other asset classes, and the potential for an effective ination hedge. The two most comparable asset classes to MLPs are Utilities and Real Estate Investment Trusts (REITs). Both Utilities and MLPs benet 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 Energy Regulatory 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 are hard assets with associated permanent value. The useful life of MLP income-producing assets is typically over fty years. REIT rental income tends to uctuate with macro-economic conditions and market demand; whereas MLPs benet from inelastic energy demand and inationadjusted tariffs. Meaningful new infrastructure investment requires capital, and both are needed to efciently connect growing areas of energy demand with new areas of supply. Pipeline and related infrastructure assets are expected to support growing population centers and facilitate the transportation of natural gas and crude oil across North America, creating a compelling investment opportunity in the coming decades. 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 $130 to $210 billion of additional capital expenditures will need to be spent on natural gas infrastructure development to meet growing and shifting energy demands.
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On the acquisition front, we 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. Longer-term, we believe new midstream infrastructure development represents a highly sustainable secular growth story, with MLPs the natural structure to undertake the vast majority of such investment. Put simply, we are likely on the verge of the largest energy infrastructure build-out since World War II.

Cash Flow & Tax Advantages

Fundamentally, the return on the stock market is derived from the cash ows generated by the underlying companies. This could be further simplied by analyzing dividends rather than cash ows, as dividends are an essential component of return. Since 1871, on a one-year time horizon, nearly 80% of the markets return has been generated by uctuations in valuation. However, as the time horizon is extended, fundamentals play an increasing role in return generation, such that, at a ve-year horizon, dividend yield and dividend growth account for almost 80% of the return. On average, over the very long term, dividends have accounted for some 90% of the total return to the stock market. We highlight this historic factoid to put the cash ows generated by MLPs in perspective. A substantial portion of MLP total return is yield. This income is far from xed. Since June 1, 2006 until March 31, 2012, the average yield on the Alerian MLP Index has been roughly 7.2%. And over the past ve years, MLPs have increased distributions at a ve-year compound annual growth rate of 7.9%.

MLP cash distributions and annual increases in cash distributions have been among the highest for any asset class since the inception of modern-day MLPs in the mid-1980s. In todays yield-starved environment, they continue to stand out with high distributions and stable business models. Generally speaking, we think businesses that pay investors more this year than they did last year, are a good place to be in a low-interest rate environment.

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MLP cash distributions depend on each partnerships ability to generate adequate cash ow. Unlike Real Estate Investment Trusts (REITs) that must distribute a certain percentage of their cash ow, each MLPs partnership agreement determines 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 ow (DCF) to unitholders. As previously discussed, MLPs do not pay corporate-level tax like regular corporations. Instead, they pass through the majority of their income (and deductions) to the holders of their limited partnership, resulting in higher distributable cash ow to investors. Since the MLP itself does not pay corporate-level tax, the income, deductions, and tax attributes from the MLP are passed through to their limited partnership unitholders. One of the appeals of an investment in MLPs is the tax-deferred treatment of quarterly cash distributions. A portion of these distributions are a return of capital and a reduction to the cost basis and thus, not taxed when received. Furthermore, MLPs can create a tax shield through required allocations of depreciation, depletion and special tax basis adjustments for investors. Instead of receiving a Form 1099 detailing cash distributions paid, an MLP investor will receive a Schedule K-1. We think this distinction is important in understanding the lack of institutional ownership in the past, but recent developments (more on this below) have created a compelling opportunity for MLPs to gain sponsorship in the future. It is notable that a number of pensions and endowments, with long-time horizons, have started to develop an interest in the asset class, particularly in 2011. Examples include the Missouri Teachers Association and the UT Investment Company (University of Texas at Austin).

Long Term Upside In Valuation

After two years of substantial outperformance, MLPs have taken a breather in 2012, providing investors with an attractive entry point. Recent underperformance has been a function of mean reversion (valuations appeared relatively full going into a year where high risk assets have performed best), mixed fundamentals in certain sub-sectors (i.e. natural gas), and a heavy issue calendar (MLPs have raised $14.3 billion of equity this year). We believe this near term consolidation has laid the foundation for MLPs next leg of outperformance. Looking forward, we expect a gradual rerating of the sector based upon increased institutional sponsorship, overall industry maturation, improved liquidity, and the ongoing search for alternative sources of income in a slow-growth and low-yield world.
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The most common metrics and methods by which MLPs are valued include Price-to-Distributable Cash Flow (P/DCF), Enterprise Value-to-EBITDA (EV/EBITDA), Yield Spread to the 10-year Treasury, and the Dividend Discount Model. Similar to how REITs dene their cash ow from operations as Funds From Operations (FFO), MLPs use Distributable Cash Flow (DCF) as a measure of cash available to distribute to unitholders or to fund growth. Although P/DCF and EV/EBITDA multiples screen roughly in line with historical averages, we believe attractive yields will be the overriding investment consideration in this environment and expect robust yields to continue to attract investment in a low interest rate environment. MLPs currently have a median yield of 7% which we think compares quite favorably to yields below 2% on both the S&P 500 Index and Ten Year Treasury Bond.

While there has been considerable healing in the credit markets since the nancial crisis, spreads continue to remain above historical averages. The historical spread to the Ten Year Treasury is roughly 340 basis points compared to a much juicier 550 basis point spread today. Essentially, treasury rates have collapsed in Japanese fashion, but many interest-ratesensitive securities have not followed suit. So spreads are attractive, but investors continue to fret that those spreads are sitting on top of articially depressed treasury yields. In our view, this is precisely where the opportunity lies. With clarity on interest rates now through mid-2015 (at the earliest), we believe the yield trade should continue to propel MLPs higher as long as we are stuck at the zero bound (dont hold your breath). Given scarcity of yield alternatives in the current low interest rate environment and continued global economic uncertainty, we expect MLPs to see a renewed bid as investors gravitate to the sectors relative stability and secular cash ow growth story one largely uncorrelated to macroeconomic conditions. Moreover, low interest rates are highly accommodative of large capital funding needs required for MLPs to satisfy midstream infrastructure investment required over the coming decades.

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Corporate bonds offer another point of comparison. While MLP yields have typically traded at discounts (i.e. higher yields) to investment grade bonds, given that MLPs can and have historically grown their coupon (distribution), it follows, that a fair valuation for MLP distribution yields may have them lower than their bond counterparts in the future. The current spread to investment grade bonds is approaching 250 basis points, and also remains well above the ve and ten year historical averages.

On a day-to-day basis, there is generally no correlation between interest rates and MLP yields. But over the past three decades, MLPs have certainly beneted from the general trend of declining interest rates. We think the sectors robust yields will continue to attract investment in a low interest rate environment. And based on the outlook for the global economy and the Federal Reserves continued accommodative stance, we expect interest rates to remain low for the foreseeable future. In addition, given investors income requirements, we continue to believe MLPs will be an increasingly attractive investment option for investors searching for yield. MLPs continue to offer among the most attractive yields in the market, especially on a risk-adjusted basis, in our view.

Investment Vehicles For Everyone

Direct investment in publically traded MLPs is a suitable option for many investors, but others may prefer additional diversication or less of an administrative burden. In this case, there are a number of closed-end funds and exchange traded products which provide an efcient alternative and can simplify the tax aspect for individuals. We think these funds also help the liquidity and overall sustainability of MLPs as an asset class, ultimately driving new cash ows into the sector. Unlike a typical equity or bond mutual fund, which is treated as a Regulated Investment Company (RIC) for tax purposes, MLP ETFs and closed-end funds are taxed as a C corporation, eliminating the need to le a K-1. Because MLPs themselves have no entity-level tax, the IRS requires any open-ended or closed-ended fund that invests more than 25% of its assets in MLPs to be taxed as a C corporation. And because the fund is a corporation, it can pass through 100% of dividends and the character of that distribution stays the same. In other words, distributions from these funds may be classied as a return of capital.

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This creates a unique situation for a number of MLP funds in that the C corporations must accrue deferred income taxes for any future tax liability associated with (1) the portion of MLP distributions considered to be a tax-deferred return of capital and (2) capital appreciation or depreciation of the underlying securities. Accordingly, the net asset value of the fund will be reduced (or enhanced) by this deferred tax liability (or asset) and performance will be affected in a similar manner meaning investors will generally give up some of the upside in the underlying index in exchange for a buffer on the downside. This is a trade-off we are generally happy to make, particularly when it is accompanied by ease-of-use in terms of tax reporting. ETNs, which also issue a 1099 for income paid out each year, are not subject to corporate taxes, but neither are they tax advantaged; unlike ETFs, they expose investors to the credit risk of the issuer. This is generally not a trade-off we are willing to make given the size and opacity of bank balance sheets today. Because the quarterly distribution for an ETF will typically be similar to that of its underlying companies (i.e. a return of capital), after-tax ETF distributions will generally be signicantly greater than the after-tax ETN distribution

Bottom Line
The evidence of slower trend growth in the aftermath of debt-induced nancial crises is well-rehearsed even by the most consensus, institutionalized investment managers at this point. However, we still think the majority are missing the most important point. The average low in interest rates in many of these academic studies occurred almost fourteen years after the initial panic and even twenty years later, long-term yields were still very depressed. In other words, baby boomers and future retirees are likely to remain starving for yield for the foreseeable future. Portfolio theory would suggest that investors should focus on total return, rather than exclusively on yield. But most investors still face a difcult choice ahead: take more risk or accept less income. Fortunately, we have uncovered a number of compelling alternatives to replace more traditional sources of cash ow. It is entirely possible to create a high yielding portfolio with dampened volatility by combining an allocation to MLPs with high yielding segments of the xed income market to provide the most yield at an acceptable level of risk. An investors allocation to MLPs in a portfolio depends on investment objectives and risk tolerance, but in general, our investment ranges from 5% to 10% of assets under management today. Periodic spikes in interest rates, as weve experienced in each year of the current economic recovery, come as no surprise to investors. Market driven rates simply do not move in a straight line. But the trend is clear. And as such, we remain constructive on the long term potential for MLP performance given the following factors: (1) Growth in domestic production of oil and gas should continue to drive demand for energy infrastructure, supporting monopolistic, visible, fee-based and long-term growth opportunities for the sector; (2) MLPs currently trade in-line with ve and ten-year historical valuation metrics and we expect a gradual rerating of the sector; Finally, (3) robust yields, and growing distributions should continue to attract capital in a low interest rate environment, while real assets provide a natural ination hedge and portfolio diversication - Christopher R. Pavese, CFA The views expressed here are the current opinions of the author but not necessarily those of Broyhill Asset Management. The authors opinions are subject to change without notice. This letter is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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