Many midstream companies -- the businesses that transport and process oil and natural gas -- are structured as mastered limited partnerships. Set up in a tax-advantaged manner, the MLP structure allows profit to flow through the partnership, straight to the unit holder, untaxed. The unit holder is then required to pay taxes on his share of the MLP's income. In the end, it means a little extra paperwork for investors, but it can very much be worth it. For a more thorough look at the tax implications of MLP investing, check out fellow Fool Dan Caplinger's insightful write-up.
Of course, there are advantages on the business side as well. Most MLPs are run by a general partner, or GP. To put it simply, the MLP holds all the assets and the GP makes all the decisions and collects all the money. GPs almost always hold a general partner stake in the MLP of about 2%, and a significant number of limited partner units in an MLP (the same kind investors can buy), and what are called incentive distribution rights, or IDRs. When an MLP's productivity outperforms a certain level previously agreed upon by management, a corresponding percentage of the extra cash also goes to the GP in the form of IDRs.
There's more than one way to skin a cat, and investors interested in the energy MLP space will notice that not all MLPs are set up the same way. With that in mind, let's look at three different models with which energy businesses are using the MLP structure.
Model 1: The publicly traded general partner
Rich Kinder brought Kinder Morgan (NYSE:KMI) back into the public realm in the spring of 2011. It's the general partner of Kinder Morgan Energy Partners (UNKNOWN:KMP.DL) and El Paso Pipeline Partners (UNKNOWN:EPB.DL). One of the reasons I like Kinder Morgan is the option to buy into one of the biggest players in the midstream industry without having to worry about a K-1 on April 15.
KMI's general partner stake in KMP and El Paso Pipeline breaks down as so:
- It has approximately 11% of total limited partner interests in KMP.
- It has approximately 42% of total limited partner interests in EPB.
- It receives incentive distributions from both KMP and EPB.
Through the first nine months of 2012, KMI waived $19 million in incentive distributions from KMP as part of a prior agreement regarding the acquisition of the KinderHawk system.
There are obviously plenty of good reasons to buy an MLP like Kinder Morgan Energy Partners -- a 6.4% yield, for one -- but I like the flexibility that comes with a publicly traded general partner like KMI.
Model 2: The privately held general partner
Plains All American Pipeline (NYSE:PAA) is a master limited partnership with a privately held general partner, which means the MLP is the only vehicle for individual investors and there is no way to buy into Plains without some extra paperwork come tax time. This is a relatively common structure, so let's take a closer look.
Public unit holders own about 92% of the limited partner interest in PAA. The privately held GP has a 6% limited partner interest, and a 2% GP interest, as well as IDRs. Plains has been decreasing its incentive distributions to the GP over the past few years, which is good news for investors who would like to see more money in their pockets, or watch the partnership spend it on developing its assets.
For example, after its acquisition of BP's (NYSE:BP) Canadian NGL business, Plains committed to reducing its IDR payments by $15 million per year for the first two years after the close, and $10 million per year after that. Through the first six months of this year, IDRs paid to the general partner totaled about $134 million.
Model 3: No general partner
In 2010, Enterprise Products Partners (NYSE:EPD) merged with its general partner. Though it still technically exists internally, the partnership no longer pays out the 2% GP interest or any IDRs. When Enterprise made the announcement two years ago, it listed several key reasons that merging with its GP was advantageous, including:
- Lowering EPD's long-term cost of capital by eliminating IDRs, which allows EPD to enhance cash accretion from organic growth and acquisitions.
- Simplifying EPD's structure, providing greater transparency for equity and debt investors alike.
- Reducing costs by about $6 million a year just by eliminating public company expenses tied to the old GP.
Absent the burden of incentive distribution rights, Enterprise is able to hang on to more cash than many of its MLP peers does. In this era of midstream infrastructure growth, that extra cash provides invaluable flexibility.
High-yielding master limited partnerships are pretty tempting options for investors right now, but not all MLPs are created equal. Interested investors should research an MLP's structure to develop a better understanding of which investment is right for them.