The Not-So-Obvious Advantage for These High-Yield Investments Will Help Make You Rich

A graphic representation of incentive distribution rights. Source: Flickr/Images Money.

It's no secret that Enterprise Products Partners (NYSE: EPD  ) and Magellan Midstream Partners (NYSE: MMP  ) pay fantastic distribution yields better than 3%. One thing that may not be as commonly known is that these two master limited partnerships have one distinct difference that will probably make them better long-term investments: their ownership structure. Let's take a look at what makes Enterprise Products Partners and Magellan Midstream Partners so unique and the advantages it gives them long term.

Incentive distribution rights: It's more than just talk
One rather difficult aspect to wrap your head around when it comes to investing in MLPs is the corporate structure. Things like general partners and incentive distribution rights have a large effect on how the company hands out distributions but also how it runs its business. To many, limited partnerships that pay as much as 50% of its distribution to the general partner in the form of incentive distribution rights both hurts shareholders and makes investment back into the business challenging. But there are those who think that it actually helps to have this structure. As one MLP-focused hedge fund manager said in a recent article in Bloomberg:

I always hear this argument from analysts and those who don't like how the system has been set up, all you have to do is look at the growth in the last 15 years and you start to realize that's just talk.

I'm sorry, but Enterprise Products Partners and Magellan Midstream Partners seem to prove otherwise. 

Both Magellan and Enterprise are among a small set of MLPs that don't have a general partner so they do not pay incentive distribution rights. What this means, most directly, is that these limited partnerships have a lower cost of capital. With this in mind, it should not be surprising that these two companies far outpace many of their peers in two key data points for MLPs: distribution coverage ratio and S&P investment ratings. The distribution coverage ratio describes how much cash the company generates after paying for operations and maintenance in relation to how much it pays out to its unitholders. S&P investment ratings are pretty self-explanatory, but better grades mean they can secure debt at lower interest rates than others.

Let's compare Enterprise and Magellan to two other prominent players in the MLP space: Kinder Morgan Energy Partners (NYSE: KMP  ) and Energy Transfer Partners (NYSE: ETP  ) . 

Company Investment Grade Rating From S&P Distribution Coverage Ratio (Full-Year 2013)
Enterprise Products Partners BBB+ 1.48
Magellan Midstream Partners BBB+ 1.35
Energy Transfer Partners BBB- 0.96
Kinder Morgan Energy Partners BBB 1.01

Source: Company press releases and Standard & Poor's.

While several factors will play into how a partnership is able to generate distributable cash flow, it's probably not a coincidence that the only two MLPs with a BBB+ rating from Standard & Poor's -- the highest of any MLP -- also happen to be ones that don't have incentive distribution rights. There is also proof in the performance. Here is the total return of these companies over the five years prior to both Magellan and Enterprise buying out their general partners.

EPD Total Return Price Chart

EPD Total Return Price data. Source: YCharts.

And here is their performance after buying out the general partners in 2010:

EPD Total Return Price Chart

EPD Total Return Price data. Source: YCharts.

If not having to pay incentive distribution rights is just talk, then Magellan and Enterprise are talking very loudly.

The ripple effect
It's one thing to say that performance like this is attributed to not having to pay incentive distribution rights, but its another to explain why this is possible without them. Having and not having incentive distribution rights can actually have a strong effect on the decisions of management. Incentive distribution rights are basically a management fee, and those fees are based on management's ability to grow the distribution. Remember, there is a clear distinction between growing the distribution and growing the business. While growing the business can grow the distribution, distribution increases are ultimately a management decision and can be unrelated to the performance of the business sometimes. So as MLPs that are managed by general partners with incentive distribution rights, it's expected that Kinder Morgan Energy Partners and Energy Transfer Partners are going to pay out the absolute maximum payment and look to grow that distribution.

For Enterprise and Magellan, though, there is less pressure to maximize the distribution payment. Sure, both have steadily increased their distributions over several years, but they have done so while leaving cash on the books to fund some some of its growth rather than relying exclusively on debt and equity issuance like others do. This gives management more flexibility on how to allocate capital.

What a Fool believes
There were already reasons aplenty to like MLPs as investments, but the small distinction of paying incentive distribution rights or not can go a long way in determining the success of a well-run MLP. Enterprise Products Partners and Magellan Midstream Partners prove that, and investors should look for the types of fees certain partnerships pay before making an investment decision.

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Related Tickers

8/28/2015 4:02 PM
EPD $28.62 Up +0.16 +0.56%
Enterprise Product… CAPS Rating: *****
MMP $71.94 Up +0.75 +1.05%
Magellan Midstream… CAPS Rating: *****
ETP $49.56 Up +0.95 +1.95%
Energy Transfer Pa… CAPS Rating: *****
KMP $0.00 Down +0.00 +0.00%
Kinder Morgan Ener… CAPS Rating: *****