Alma Recurrent Energy Infrastructure Income Fund

Market Review and Outlook

Since 2018, Wall Street has modelled Midstream as a low-growth / no-growth industry – but growth has persisted
As Midstream experienced a painful multi-year downturn from 2014 through 2020, many analysts’ cash flow growth forecasts began to reflect the painful downturn in stock prices. During and even after COVID, Wall Street forecasts for Midstream EBITDA growth have been anemic – reflecting concerns about lower Shale productivity and the impact of the Energy Transition on oil and gas demand. This “lack of growth” has been reflected in valuation multiples which remain well below pre-COVID levels. Interestingly, actual financial results have dramatically exceeded expectations in the past 5 years, reflecting an industry that has achieved meaningful operating leverage and margin expansion from assets which only became recently operational.

On a cumulative basis, Midstream industry EBITDA has expanded by $31bn, or nearly 50% – approximating $100bn on an annual basis today. If we were to look at the cumulative expectations for year-over-year EBITDA growth published by Wall Street analysts over that time, we would see $9bn of cumulative EBITDA growth. In other words, actual cumulative EBITDA growth has more than tripled analyst expectations over the past 5 years.

A skeptical reader might ask, “Aren’t Wall Street estimates made to be beaten?” – but there’s more to the story
We appreciate the skepticism that comes with midstream and energy investing, especially as the sector remains largely out of favor among investors. A possible reply might be, “They beat analyst estimates – so what?” And that question is fair in anticipating the fact that growth isn’t noteworthy simply because it exceeded Wall Street’s forecast – it’s only noteworthy if the growth is generated in a capital-efficient way. And here again, we see that Midstream is outperforming expectations – while EBITDA is sometimes subject to “sandbagging,” management teams generally do not sandbag capital expenditures. And we see again that Midstream is beating Wall Street capex estimates even while growing cash flow.

Midstream was exceeding capex forecasts – effectively running over budget on growth projects – by billions of dollars annually during 2018-2020. The result was a free cash flow outlook that consistently disappointed. Since 2021, Midstream industry capex has met or fallen below forecasts, with over $2bn in excess free cash flow coming from YTD 2023 capital discipline alone.

Even with large-cap Canadian midstream names outspending, most growth is being supported by near-maintenance capex
We noted two months ago that Canadian large cap midstream companies had maintained high capex business models, and their stock performance has suffered considerably as a result. But even with significant Canadian capex burdens, the Midstream sector broadly remains highly disciplined. Below, we take Wall Street forecasts out of the equation and compare the companies to themselves. As recently as 2018, Midstream capex was 2.7x greater than book depreciation. As spending has dropped by >$20bn in the last 5 years, capex today approximates 125-135% of book depreciation, despite meaningful economy-wide cost inflation in the last 3 years.

In our recent white paper, we noted that midstream earnings yields were double-digit, and meaningfully above REIT or utility earnings yields. Importantly, with midstream capex approximating book depreciation levels, this means that Midstream free cash flow yields are also likely to be double-digit – compared to a sector-wide dividend payout that remains approximately 6% to 7% today. With double-digit free cash yields and persistent EBITDA growth (even in a lower capex environment), Midstream continues to defy forecasts of obsolescence and decline even despite valuations that reflect a thus-far illusory terminal value risk.

Fund

With strong midstream performance YTD, investors should have little to complain about. But one factor – fund-level tax expenses – have reduced after-tax returns for some MLP fund and ETF investors by >$1bn in the last 12 months. In December 2022, we detailed how COVID-era tax assets were nearly depleted across many MLP funds, exposing billions of dollars of midstream AUM to rising tax bills in 2023 and beyond. These fund-level taxes impact NAV, so they diminish returns even for tax-exempt investors. Since 2022, 11 taxable “C-corp” funds (representing >$20bn or 2/3 of all midstream fund AUM) have exhausted tax assets, incurring >$1bn in corporate tax! Another $0.5bn was possibly incurred YTD 2024 given strong performance. While Recurrent cannot ever guarantee future performance, we can assure investors that none of our funds or SMAs incur an additional layer of fund-level corporate tax expense.

Please reach out for Recurrent’s new midstream white paper, which explores midstream’s excess (and growing) yield vs. fixes income, and white paper on the long-term relationship between inflation and capex.

Performance review

During the month of March 2024, the Alma Recurrent Energy Infrastructure Income Fund for the I USD C Share Class generated net returns of +7.71%, leading the Alerian MLP Index’s (AMZ) +4.53% return by +3.18%.

Investment discussion

Since our Dec 2022 note, over two-thirds of midstream/MLP funds have returned to incurring significant corporate taxes

In December 2022, we noted how the depletion of the AMLP’s net operating losses (NOLs) was likely a harbinger of higher tax bills to come for investors in many competitor midstream/MLP funds and ETFs. Long-time readers likely are familiar with the unique history of taxable MLP fund products, which we’ve recounted in more detail elsewhere. But for today’s purposes, we’ll simply remind our readers that many of the midstream funds and ETFs we compete against (>$20bn, or roughly 2/3 of the midstream fund market) incur corporate tax at the fund level, up to a 21% statutory corporate tax rate, regardless of whether the holder is tax-exempt.

Over a decade ago, when the sector was almost entirely comprised of MLPs, this unpleasant layer of corporate tax was viewed as a necessary evil for investors seeking to avoid K1s. Then, during 2015-2020, most midstream market cap restructured away from the MLP structure, but significant losses across midstream funds meant that no funds were required to pay corporate taxes, rendering the question of fund structure temporarily moot. Since 2022, a majority of midstream fund AUM has returned to paying corporate taxes.

We believe investors have incurred $1bn in unnecessary fund-level taxes since 2022 – a trend unlikely to reverse
The magnitude of tax expenses paid by midstream funds subject to corporate taxation is meaningful. In the last 2 years, $20bn of fund AUM has incurred over $1bn of tax expense. Given strong Q1 2024 returns, we believe that these same funds have incurred approximately $0.5bn of tax expense in Q1 2024 alone (these tax expense numbers won’t be public until after mid-year, given mutual fund SEC filing timing).

Roughly one-seventh of all pretax gains in fiscal year 2023 were negated by corporate taxation. This 13.43% tax drag (which we define as tax expense / pretax returns) compares to 1.47% and 8.08% tax drags in FY 2021 and FY 2022. Understandably, in 2021, this 1.47% drag hardly registered. Given strong absolute performance in 2022 and 2023, investors may not have been focused on this growing performance drag.

It is hard to justify a (growing) layer of tax that is effectively optional for the end investor. There are many fund and ETF vehicles today with similar investment propositions and similar yield profiles that do not incur this layer of corporate tax.

As investors, we are always worrying – but we are happy to not worry about growing fund-level taxes in any of our investment vehicles

The eye-watering pre-2015 expense ratios dropped significantly as funds incurred significant NOLs. While the Trump-era TCJA reduction in corporate taxes mitigated some of the tax expenses in 2022 and 2023, the average expense ratio has returned to levels that are rarely-seen in today’s fee-conscious investment landscape.

Readers can examine the composition of the increasing average tax drag – almost all taxable funds have seen a meaningful increase as NOLs/tax assets have been depleted by the rally of the last 4 years. The overall tax expense (as a % of pretax total returns) is likely to increase as funds that have only recently exhausted NOLs remain well below the 21% statutory corporate tax rate. As those funds continue to appreciate and further deplete remaining NOLs, we expect that these funds’ overall tax bills will move towards 21%.