Is Your MLP Paying Out Too Much Cash?

Investors love master limited partnerships because of their lucrative distributions, but the former can often be second-class citizens when it comes to these payouts because the partnership must also shell out cash to its general partner in the form of incentive distribution rights, or IDRs. Today, we're going to look at how cash gets doled out at Plains All American Pipeline (PAA -0.22%), Energy Transfer Partners (ETP), and Buckeye Partners (BPL).

What are IDRs?
In theory, a general partner's role at an MLP is to drop down assets, issue debt for an acquisition, or otherwise trigger growth in return for an ever-increasing slice of incremental cash flow. That slice is an incentive distribution right payment, and it gets paid on a quarterly basis. It is important to note that this payment is separate from any distributions a general partner collects if it owns any common units.

New MLPs usually don't pay much in IDRs at first, but as it grows its distribution over time, the percentage of cash owed to the general partner grows in preapproved increments. The split between cash owed to the limited partners and cash owed to the general partner typically falls within three or four tiers. The specific distribution amount associated with each tier will vary from MLP to MLP, but the percentage breakdown is very similar and often looks like this:

Tier 3 is what's referred to as the "high splits," indicating that the MLP's distributions have reached a previously agreed upon amount and the general partner is due 50% of incremental cash flow going forward. If you want to quickly check the IDR splits on any MLP, I recommend using the "DCF Financials" research tool at MLPdata.com. Again, you'll want to double-check the site's numbers against an SEC filing before making an investment decision, but it's a handy tool nevertheless.

Real-world examples
Let's take a look at IDRs using some actual data. Through the first nine months of the year, here's how distributions break down at our three MLPs:

Source: Company SEC filings.

Both Plains All American and Energy Transfer Partners are currently in the high splits for IDRs. These charts give us an important reminder, however, that IDR payments do not comprise a certain percentage of all cash flow, just incremental distributable cash flow, which refers to distributable cash flow earned on new projects.

And then we have Buckeye Partners, which has no general partner and therefore pays no incentive distribution rights. It sends all of its distributable cash flow to limited partner unitholders, minus what it elects to keep on hand to maintain the partnership.

So what?
Master limited partnerships are complicated entities with a lot of layers. Clearly, IDRs are not the only factor investors need to consider before buying, but they do matter. Incentive distribution rights increase an MLPs cost of capital, which can have a big impact on growth, ultimately affecting distributions down the road. Cost of capital can also affect the competitiveness of an MLP, something that will become even more important as mergers and acquisitions ramp up in the space going forward.