2023-08-15 16:50:44 ET
Summary
- Master limited partnerships, or MLPs, have been popular investments for high income, but they have tax and diversification challenges.
- Investing in a closed-end fund specializing in MLPs can provide tax advantages and diversification, with potential for higher yields.
- The Kayne Anderson NextGen Energy & Infrastructure closed-end fund focuses on renewable energy and traditional midstream MLPs, but has underperformed and struggled to cover its distributions.
- The fund is currently trading at an enormous discount on the net asset value, so the price is acceptable.
- If the fund cannot improve its performance, it may be forced to cut the distribution. It may be best to avoid buying it for now.
For many years now, master limited partnerships have been one of the favorite investments for anyone seeking to earn a high level of income from their portfolios. This makes a lot of sense, as most of these companies pay out much higher yields than just about anything else in the market and enjoy certain tax advantages. In the case of midstream partnerships, the company typically has remarkably stable cash flows as well, which provides a great deal of support for the distribution.
Unfortunately, there are a few problems with these assets. The biggest of these is that it is very difficult to include master limited partnerships, or MLPs, in a tax-advantaged account, such as most retirement accounts. This is due to tax rules about including tax-exempt entities in a retirement account (most master limited partnerships are tax-exempt on a corporate level). The second problem with them is that it can be very difficult to put together a diversified portfolio of master limited partnerships unless you have access to a considerable amount of capital, but the same can be said of most asset classes.
One good way to get around these problems is by purchasing shares of a closed-end fund that specializes in investing in the sector. These funds are almost always structured as corporations, so all tax problems are handled on a corporate level, allowing them to be included in a retirement account just like Apple (AAPL), Alphabet (GOOG) (GOOGL), or any other popular stock. In addition, these funds have sufficient capital to ensure proper diversification combined with a professional management team to enforce the portfolio composition. Finally, these funds are able to employ certain strategies that have the effect of boosting the effective portfolio yield to levels beyond that of any of the underlying assets. When we consider that the Alerian MLP Index (AMLP) has an 8.17% yield at the current price, that is certainly saying a lot about the income potential offered by these funds.
In this article, we will discuss the Kayne Anderson NextGen Energy & Infrastructure Fund (KMF), which yields an impressive 8.57% yield at the current price. While this is admittedly not as high of a yield as we might expect given the yield of the benchmark master limited partnership index, this fund contains things like renewable energy companies in addition to traditional midstream master limited partnerships. That could be appealing for anyone that wants to gain exposure to the emerging green energy growth industry without sacrificing the income potential available from traditional fossil fuel energy companies.
I have discussed this fund before, but a few months have passed since that time so naturally several things have changed. This article will therefore focus specifically on these changes as well as provide an updated analysis of the fund’s financial condition. Let us investigate and see if this fund could be a good addition to a portfolio today.
About The Fund
(A proposal was tendered back in April 2023 to merge this fund with the Kayne Anderson Energy Infrastructure Fund (KYN). This proposal was scheduled to be put to a shareholder vote in June 2023. There has been no update on this proposal since April from the fund sponsor. This article is therefore written with the assumption that the two funds will continue to remain separate.)
According to the fund’s webpage , the Kayne Anderson NextGen Energy & Infrastructure Fund has the objective of providing a high level of total return. This is not surprising considering that this is a common equity fund. As we can see here, the fund is nearly entirely invested in common equity right now, although it does have a small amount of exposure to fixed-income assets such as preferred stock and bonds:
CEF Connect
The fund’s focus on total return makes a lot of sense when we consider this. After all, common stock by its nature is a total return vehicle. After all, investors typically purchase common stock with the objective of earning an income via the dividends and distributions paid out by these securities. There is also the desire to benefit from capital gains as the issuing company grows and prospers with the passage of time. In the case of master limited partnerships, the majority of the returns are delivered through the distributions made to the shareholders. We can actually see this quite clearly by looking at the Alerian MLP Index. Over the past five years, the index has lost 26.38% in terms of price, but it has actually delivered a 14.72% total return:
This comes from the fact that the distributions paid out by the companies that comprise the index were sufficiently large to fully offset the price decline and still provide a positive return for the shareholders. The fact that the price decline even exists is further proof that investors value these companies based on their distribution yields. As we can see, it was the events of the pandemic that caused the price decline of the index. The index as a whole was reasonably flat prior to that event. When energy prices crashed during the lockdowns, some master limited partnerships cut their distributions despite their financial performance being completely unaffected. While some of them have started to increase their distributions once again, other partnerships like NuStar Energy (NS) have yet to do so. The market prices of those companies that failed to increase their distributions still trade at levels that are well below what they had in 2019, suppressing the price performance of the index. For example, NuStar Energy is down 45.69% over the past five years:
The company’s revenue was higher last year than it was in 2019 or 2020, and its operating cash flow was nearly identical to what it had in both years. Thus, the only real reason why the unit price never recovered is that NuStar Energy never restored its distribution to its pre-pandemic levels. This, therefore, provides clear evidence that these companies are valued based on the distributions that they pay out and not on their actual financial performance.
For its part, the Kayne Anderson NextGen Energy & Infrastructure Fund appears to recognize this. The fund specifically states that it aims to provide the majority of its total return in the form of direct payments to the shareholders. From the webpage:
“[The fund’s investment objective is] to provide a high level of total return with an emphasis on making cash distributions. KMF intends to achieve this objective by investing at least 80% of its total assets in securities of energy companies and infrastructure companies.”
Thus, the fund certainly realizes that the overwhelming majority of the investment returns that it receives will be distributions from the companies in the portfolio. It will, in turn, distribute the money that it receives to its own shareholders, resulting in its own high yield.
As long-time readers are no doubt well aware, I have devoted a considerable amount of time and effort over the past ten years or so to discussing midstream companies and master limited partnerships on Seeking Alpha and here at Energy Profits in Dividends. As such, the largest positions in the fund’s portfolio will probably be familiar to most readers. Here they are:
Kayne Anderson
I have discussed the majority of these companies at one point or another over the years. In fact, the only two that I have never published articles on are Plains GP Holdings (PAGP) and Atlantica Sustainable Infrastructure (AY). However, Plains GP Holdings is simply the general partner for Plains All American Pipeline (PAA), which I have discussed numerous times. As such, many readers are probably familiar with it.
One thing that we do see here is a focus on natural gas, as opposed to crude oil. The Williams Companies (WMB), Energy Transfer (ET), and MPLX (MPLX) all operate some of the largest natural gas midstream infrastructure networks in the United States. We also see Targa Resources (TRGP), which is mostly active in the natural gas liquids space, and Cheniere Energy (LNG), which is the largest producer of natural gas in the United States. Sempra Energy (SRE) is also a presence in the natural gas space, although it is mostly involved in utility distribution as opposed to midstream. This is not surprising, as the fund’s name implies that it is focusing on investing in companies that are “facilitating the energy transition.”
As I have explained in numerous previous articles, natural gas is likely to be a huge part of that energy transition because it serves as a supplement for unreliable renewable energy sources like wind and solar. As such, the demand for natural gas globally is likely to grow over the coming years and these companies should see increasing business as the story plays out.
There have been surprisingly few changes since the last time that we discussed this fund. In fact, the only major change is that Brookfield Renewable Partners (BEP) was removed from the fund’s largest positions and replaced with Sempra Energy. This is not necessarily a bad change as Brookfield Renewable Partners has been arguably overpriced for a while, but it is still one of the best companies in the renewable energy space. Other than this change, there have been some changes in the weightings of the various assets in the fund’s portfolio, but this could be due to one asset outperforming another in the market. It is not necessarily a sign that the fund has been actively trading its assets in order to change the weightings.
This could lead us to assume that this fund has a relatively low annual turnover. That is certainly true, as the fund’s 16.00% annual turnover last year is substantially lower than nearly every other equity closed-end fund in the market. It is certainly lower than the majority of energy infrastructure funds. The reason that this could be beneficial is that it costs money to trade stocks or other assets, and these expenses are billed directly to the fund’s shareholders. That creates a drag on the portfolio’s performance and makes management’s job much more difficult. After all, the fund’s managers need to earn sufficient returns to both cover these extra expenses and still have enough left over to satisfy the shareholders. That is a difficult task that very few management teams manage to accomplish on a consistent basis. This is one of the reasons why many actively-managed funds fail to outperform a comparable benchmark index.
Unfortunately, this fund does not appear to be an exception to that rule. As we can see here, the Kayne Anderson NextGen Energy & Infrastructure Fund underperformed the Alerian MLP Index on a total return basis over the past five years:
The same underperformance trend exists over the one-year, three-year, and ten-year periods. Indeed, the ten-year period is particularly atrocious because the index actually delivered a 5.45% total return over the period, but the Kayne Anderson fund delivered a 42.94% total loss.
This is certainly a very poor showing for the closed-end fund, but it is worth noting that its investment strategy has changed somewhat over the time period. In particular, the fund has started focusing more on the energy transition than it once did. This also results in the Alerian MLP Index not being a perfect benchmark for it. The index consists of fourteen master limited partnerships and the Energy Select Sector SPDR ETF (XLE). Of these fourteen partnerships, thirteen are midstream companies and one is a liquefied natural gas producer. Thus, it entirely consists of fossil fuel companies. However, the Kayne Anderson NextGen Energy & Infrastructure Fund is a bit different:
Kayne Anderson
As we can see here, only 48% of the fund is invested in midstream companies. The fund also has natural gas and liquefied natural gas producers, renewable energy infrastructure companies, and utility firms. The latter two comprise 24% of the portfolio but are not present at all in the index. This can be expected to give this fund a very different total return profile than the index. For example, we can all recall back in 2020 when renewable energy companies skyrocketed in price but fossil fuel producers did not.
In fact, in October 2020, NextEra Energy (NEE) actually briefly surpassed Exxon Mobil (XOM) in market cap. This fund would be better situated to be able to take advantage of such events than the index. With that said though, on a purely fundamental basis, fossil fuel energy companies should outperform renewable energy ones for the next few years as crude oil and natural gas prices are likely to rise and there are no technologies on the horizon that can solve the reliability and cost problems of renewable energy.
Leverage
In the introduction to this article, I stated that closed-end funds such as the Kayne Anderson Energy & Infrastructure Fund have the ability to employ certain strategies that can effectively boost their portfolio yields well beyond that of any of the underlying assets. One of these strategies is the use of leverage. In short, the fund borrows money and then uses that borrowed money to purchase partnership units of master limited partnerships, as well as shares issued by midstream and renewable energy corporations. As long as the purchased assets deliver a higher total return than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio.
This fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates. As such, this will usually be the case. It is important to note though that this strategy is not as profitable today with rates at 6% as it was eighteen months ago when the borrowing rate was basically zero. This is because the difference between the borrowing rate and the yield that can be obtained by purchasing the common units of a midstream partnership is not as great as it once was.
Unfortunately, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not using too much debt because that would expose us to an excessive amount of risk. I generally do not like to see a fund’s leverage exceed a third as a percentage of its assets for this reason. Fortunately, this fund satisfies that criterion as its levered assets currently comprise 22.76% of the portfolio. As such, this fund appears to be striking a reasonable balance between risk and reward. We should not have to worry too much about the fund’s leverage as investors.
Distribution Analysis
One of the primary reasons why investors purchase midstream corporations and master limited partnerships is because they tend to have substantially higher yields than just about anything else in the market. As of the time of writing, the Alerian MLP Index yields 8.17%, which is substantially higher than the 1.46% yield of the S&P 500 Index (SP500). The Kayne Anderson NextGen Energy & Infrastructure Fund purchases the equity of these companies, although it does not exclusively buy such high-yielding entities. The fund then applies a layer of leverage to the position in order to boost the effective yield of the portfolio. It then aims to distribute most to all of its received distributions and capital gains to its own investors.
As such, we might assume that this fund would have a very high yield itself. This is certainly the case, as the fund pays a quarterly distribution of $0.16 per share ($0.64 per share annually), which gives it an 8.57% yield at the current price. The fund has, unfortunately, not been particularly consistent with its distribution over the years:
This lack of consistency is likely to reduce the fund’s appeal in the eyes of those investors that are seeking a safe and secure source of income to pay their bills or finance their lifestyles. However, it is quite understandable. As mentioned earlier in this article, there were a few widely-held master limited partnerships that reduced their distributions in 2020 following the imposition of the COVID-19 lockdowns. They did not have to do this as most of their cash flows held up fine, but the crash in energy prices made the market quite hostile towards these companies and it made sense to conserve capital and strengthen their balance sheets. This naturally reduced the fund’s income, and it also saw its asset value decline due to the market sell-off. As such, the fund had to cut its distributions to better correlate with the returns that it was actually generating in order to ensure its own long-term survival.
As I have pointed out numerous times in the past though, anyone buying today will receive the current distribution at the current yield. As such, they are completely unaffected by the fund’s actions with respect to its distribution in the past. The most important thing is the fund’s ability to sustain its distribution at the current level. Therefore, let us investigate this.
Fortunately, we have a very recent document that we can consult for that purpose. The fund’s most recent financial report corresponds to the six-month period that ended on May 31, 2023. This is one of the most recent financial reports available for any closed-end fund on the market. It is very nice because the market has generally been stronger so far this year than it was last year, and the fund may have been able to take advantage of this. We should see this reflected in the report. With that said, the energy sector was pretty strong in 2022 as well, so the performance differential between the two periods is probably not going to be as great as it would be for companies in many other sectors.
During the six-month period, the Kayne Anderson NextGen Energy & Infrastructure Fund received $14.425 million in dividends and distributions along with $142,000 in interest from the assets in its portfolio. However, a significant portion of this money came from master limited partnerships, so it is not considered to be income for tax purposes. As such, the fund only reported a total investment income of $7.176 million during the six-month period. It paid its expenses out of this amount, which left it with a $159,000 net investment loss. This was obviously not enough to cover any distributions, but the fund still paid out $15.103 million to its shareholders. At first glance, this is likely to be concerning as the fund is clearly failing to cover its distributions out of its net investment income.
However, a fund like this has a number of other methods that can be employed in order to obtain the money that it needs to cover the distribution. For example, it received $7.313 million from master limited partnerships during the period that was not included in the fund’s net investment income. It also might have been able to get some money through capital gains that can be paid out to the shareholders. Unfortunately, it generally failed at that task as it reported net realized gains of $8.016 million but this was more than offset by $67.524 million net unrealized losses.
Overall, the fund’s net assets declined by $74.770 million after accounting for all inflows and outflows during the period. This is quite disappointing as the fund failed to cover its distributions over the period. It also failed to cover the distributions over the trailing eighteen-month period. On December 1, 2021, the fund had net assets of $414.844 million but this declined to $388.850 million on May 31, 2023. Unless the fund manages to generate some strong gains in the second half of this year, it may be forced to cut the payout.
Valuation
It is always critical that we do not overpay for any assets in our portfolios. This is because overpaying for any asset is a surefire way to earn a suboptimal return on that asset. In the case of a closed-end fund like the Kayne Anderson NextGen Energy & Infrastructure Fund, the usual way to value it is by looking at the fund’s net asset value. The net asset value is the total current market value of all of the fund’s assets minus any outstanding debt. It is therefore the amount that the shareholders would receive if the fund were immediately shut down and liquidated.
Ideally, we want to purchase shares of a fund when we can obtain them at a price that is less than the net asset value. This is because such a scenario implies that we are purchasing the fund’s assets for less than they are actually worth. This is, fortunately, the case with this fund today. As of August 14, 2023 (the most recent date for which data is available as of the time of writing), the Kayne Anderson NextGen Energy & Infrastructure Fund has a net asset value of $8.74 per share but the shares currently trade for $7.40 each. This gives the fund’s shares a 15.33% discount on net asset value at today’s price. That is an incredibly large discount that is quite a bit better than the 14.90% discount that the shares have averaged over the past year. As such, the current price appears to be quite a reasonable price to pay for this fund.
Conclusion
In conclusion, master limited partnerships are in theory an ideal asset for retirees due to their incredibly stable cash flows and high distribution yields. Unfortunately, they can be difficult to include in a retirement account due to tax laws. The Kayne Anderson NextGen Energy & Infrastructure Fund offers a way to put these companies into your retirement portfolio, and it pairs them alongside renewable energy companies in an attempt to offer a “best of both worlds” portfolio. Unfortunately, the fund is something of an underperformer relative to the Alerian MLP Index and it failed to cover its distribution over the past eighteen months. While the current valuation is quite reasonable, it might be best to look elsewhere.
For further details see:
KMF: Good Price, But Underperformance And Declining NAV Real Problems