One of the most important and overlooked topics for investors in master limited partnerships, or MLPs, is incentive distribution rights, or IDR, granted to the general partners. These payouts have been the focus of media and analyst scrutiny over the last year and have led to double-digit price declines in some partnerships.
Watch for partnerships that restructure their distribution agreements to make sure that your rights are being protected.
Incentive distribution rights: Profiteering of the MLP universe
Master limited partnerships own the energy infrastructure and issue units, but most technically have no employees. A general partner manages the day-to-day operations and holds a 2% stake in the partnership. Beyond the 2% stake, the general partner also has the right to a sliding scale of the cash distributed from the partnership through the IDR. As the cash distribution from the partnership increases, the general partner gets a larger slice of the cash pie. Below is an example of the IDR structure for Tallgrass Energy Partners (NYSE: TEP).
With the current distribution at $1.30 per share, the general partner is taking 15% of cash returned to unitholders. The distribution has more than doubled since last year and would need to increase by just a third from here for the general partner to start taking half of the distribution.
As U.S. energy production booms and distributions rise for many partnerships, analysts worry that these IDR structures might create a conflict of interest. The fear is that not only do higher distributions mean the general partner takes a higher percentage of the payout, but that the general partner may neglect capital expenditures to unsustainably push distributable cash flow higher.
While IDRs motivate the general partner to increase the distribution, putting more money in unitholders' pockets, they also create this conflict between the two owners. Over the longer term, increasing the distribution can also increase the partnership's cost of equity by forcing it to raise more money through debt or unit issuance.
Partnerships looking after your rights
Several partnerships are acknowledging the conflict and have restructured their IDR schedules. Some partnerships have capped the percentage that can go to the general partner, limiting the conflict and the incentive to increase the distribution. Other partnerships have bought back the shares of the general partner, effectively eliminating the whole issue.
TC Pipelines (TCP) has capped the IDR for its general partner, TransCanada (TRP 0.33%), at 25% of the distribution. The partnership owns natural gas pipelines along the U.S. northern border and should continue to benefit as the general partner drops more assets down to the partnership. Units pay a 6.6% yield with an annualized increase of 2.5% over the last three years.
Magellan Midstream Partners (MMP) in 2009 became one of the first MLPs to buy out its general partner. The partnership operates pipelines and storage terminals in the central and eastern United States. Magellan's 9,600 miles of refined products pipeline is the largest network in the country, connecting it to 40% of U.S. refinery capacity. The partnership also owns storage and distribution terminals across the southeast and Gulf Coast, with major hubs in Cushing, Okla., and Houston. Units pay a 3% yield with an annualized increase of 16.6% over the last three years.
Natural Resource Partners (NRP 1.23%) eliminated its IDRs but allowed its general partner to maintain its 2% equity interest in the partnership. The company is primarily a coal producer, but has diversified assets in oil and natural gas operations. Thirty-five percent of first-quarter revenue came from operations outside of coal, up from 17% in the same period last year. While recent EPA proposals and low natural gas prices have driven investors out of coal stocks, it is still the fastest-growing fuel source in the world and accounts for 39% of U.S. electricity production. The partnership offers one of the highest distributions, with a yield of 8.75%, though the amount has been cut over the past year to protect growth.
While investors still need to consider growth in distributable cash flow and other metrics behind MLP investing, partnerships that protect your right to the distribution are a good place to start. Watch the tier levels for your MLP investments, especially when the distribution approaches the next higher level.
