Investment Strategy Rises From Obscurity

When the billionaire Carl C. Icahn took control of CVR Energy last year, critics thought the dog had finally caught the car.

Over the years, he has often threatened to buy companies but rarely followed through. Then in 2012, Mr. Icahn paid at least $2 billion for 82 percent of CVR, an oil refinery business, something he knew little about. When he then tried to sell the company quickly and failed, he appeared to be stuck with a company he did not want to own.

Yet this year, Mr. Icahn took advantage of an obscure but increasingly popular securities structure â€" the master limited partnership, or M.L.P. â€" and used the company to inflate his already enormous wealth.

In January, CVR, under Mr. Icahn’s direction, placed its refineries into a new company, CVR Refining. The new company is structured as an M.L.P., a publicly traded partnership that pays no corporate tax and distributes most profit to investors. Thanks to those generous distributions, stock market investors are valuing M.L.P.’s at a significant premium to traditional corporations, so there was a good chance CVR Refining would do well as a public company.

“We saw the added value of creating a M.L.P.,” Mr. Icahn said in an interview. “It’s tax-efficient, and it passes profits through to shareholders, which is great, especially in a low-interest-rate environment.”

When CVR Refining finally sold shares to the public in an initial public offering, it raised $600 million. Weeks later, Mr. Icahn used that money to pay himself a huge dividend, resulting in a personal gain of nearly $1 billion. Shares of both CVR Energy and CVR Refining, meanwhile, continued to trade up and pay additional distributions.

Between the dividends and the improved market value of both companies, Mr. Icahn’s $2 billion investment was up more than 150 percent. In less than a year, largely because of the creation of an M.L.P., Mr. Icahn had made a profit of about $2.5 billion, which he said was “right up there” with the best deals of his career.

“He’s made a lot of money,” said Paul Sankey, an analyst at Deutsche Bank. “It’s the biggest home run of the year.”

Mr. Icahn’s successful maneuvering with CVR illustrates both the enormous growth in M.L.P.’s over the last five years and their ability to create huge personal wealth.

Since the financial crisis, the popularity of M.L.P.’s has soared. In 2009, there were just 66 such companies, worth a combined $160 billion. Today there are more than 110, and their combined value tops $500 billion. At least 19 such partnerships have been created this year.

What’s more, they are outperforming the broader stock market. Over the last five years, the Alerian index, which tracks M.L.P. performance, is up 162 percent; the Standard & Poor’s 500-stock index is up 105 percent over the same period.

“This is no longer a small, esoteric retail product,” said Jeremy Michael, co-chief of global natural resources at Barclays. “It’s gotten so large that even big funds are forced to get involved.“

Like the real estate investment trust, another increasingly popular type of tax-efficient, dividend-paying corporation, M.L.P.’s are booming in popularity and hotly valued as institutional investors seek yield-oriented assets.

Yet as they become more prevalent, there is heightened concern that M.L.P.’s â€" which have traditionally owned stable energy-related assets like oil and gas pipelines â€" are growing to encompass a more volatile range of assets, including shipping companies, coal producers and makers of sand for hydraulic fracturing. There is even an M.L.P. that operates cemeteries, and one that operates theme parks. Not all have been successes.

“For some it works better than others,” said Mary Lyman, president of the National Association of Publicly Traded Partnerships, a trade group. “Time will tell if it will be good for everyone who is doing it.“

When the Internal Revenue Service clarified rules about M.L.P.’s in the mid-1980s, it was responding to what it saw as abuses in the system. Leading up to the Tax Reform Act of 1986, a growing number of traditional corporations had been restructuring themselves as public partnerships as a way to avoid taxes. Before the crackdown, even a basketball team, the Boston Celtics, was an M.L.P.

In revising the tax code, the I.R.S. stripped most companies of that privilege, but it identified three areas that still qualified for tax-free partnerships: oil, natural gas and coal companies; real estate groups; and financial firms that derive most of their income from dividends and capital gains.

Today, as the United States experiences a new energy boom, that provision is letting new companies in low-margin businesses â€" like transporting oil and gas from remote parts of the country â€" stay afloat, passing profits on to investors. If pipeline companies had to pay the full 35 percent corporate tax rate, industry advocates say, they would not survive.

“From a public policy perspective, the tax-efficient nature of M.L.P.’s is an important component of energy independence,” said Peter Bowden, global head of midstream energy at the investment bank Jefferies.

But the tax breaks offered to M.L.P.’s cost the government dearly. In February, the Joint Committee on Taxation, which is nonpartisan, significantly raised its estimate of lost tax revenue as a result of the structure, saying that by 2016, it would amount to $7 billion, and an additional $1.6 billion a year in the future.

Those lost billions in federal income mean publicly traded partnerships are a constant target for critics of corporate tax breaks.

So far, the I.R.S. seems content to uphold the status quo. But last year, Democrats proposed the End Polluter Welfare Act, which would end tax subsidies for most conventional energy companies, including M.L.P.’s. The bill had few supporters in Washington.

Yet another piece of proposed legislation, this one to expand the scope of M.L.P.’s to include renewable energy companies, has found advocates on both sides of the aisle. Given how much wealth M.L.P.’s have created in recent years, it seems more likely that they will continue their run.

Some of the biggest fortunes in recent decades are the result of M.L.P.’s, dwarfing even Mr. Icahn’s success at CVR.

Richard D. Kinder, founder of Kinder Morgan Energy Partners, an early pipeline M.L.P., is worth $10.2 billion, according to Forbes magazine. Mr. Kinder generated his vast wealth because of a unique clause in the structure of such partnerships.

When most M.L.P.’s are set up, they are actually structured as two entities â€" a limited partnership that sells shares to the public, and a general partnership, most of which is retained by the founders. Initially, the general partnership receives just 2 percent of the quarterly distributions paid out by the company. But if distributions increase, the general partnership can receive a greater percentage of the profits.

The founders of two other M.L.P.’s, Enterprise Products and Energy Transfer Partners, also became multibillionaires because of this structure.

But M.L.P.’s are not immune to the vagaries of the stock market. When the partnerships cut dividends, investors are apt to flee.

In November, CVR Refining cut its distribution. It would pay out just 30 cents a share, down from the previous quarter’s distribution of $1.35. Shares in CVR Energy and CVR Refining plunged, eating into Mr. Icahn’s profits.

Yet CVR has little cause to worry. Mr. Bowden of Jefferies said that even when distributions fall, M.L.P.’s remain appealing to certain investors because of the generous tax treatment they receive from the government, and the promise that they will one day pay out fortunes in dividends.

“These are hard vehicles to kill,” he said.