MLPs: GP / LP Relationship Is Key

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Includes: EPD, WMB, WPZ
by: Elliott Gue

Answering several dozen e-mails each week from subscribers can certainly be time-consuming, but it’s an invaluable way to determine what investors are thinking and what trends are most compelling. Master limited partnerships (MLP), a group I cover in MLP Profits with by co-editor Roger Conrad, remain a common source of queries.

As I’ve noted here, MLPs offer investors a simple value proposition: double-digit, tax-advantaged yields and strong recession-resistant growth potential. Although the group has seen a nice run-up in recent months, most MLPs continue to trade at significant discounts to historical norms in terms of yields relative to other income producing groups such as high-yield bonds and real estate investment trusts (REIT).

Even better, MLPs offer investors shelter from coming tax increases to dividends and income that are likely when the Obama administration allows the so-called Bush tax cuts to expire. The group allows investors to defer much of their personal income tax liability for years into the future or, in many cases, indefinitely.

And the group isn’t subject to America’s 39.25 percent corporate tax rate, among the highest such rates of any nation in the world. The government has made no moves to change the taxation of MLPs; in fact, Congress actually broadened the scope of the industry late in 2008, allowing MLPs to participate in the renewable fuels industry.

An MLP is really a combination of two different entities, a general partner (GP) and a limited partner (LP). When you purchase the MLP, you’re typically buying a LP interest, entitling you to cash distributions that represent your share of the cash flows produced by the MLP.

But the LP holders don’t actually manage the day-to-day business of the MLP; this function is performed by the GP. In exchange the GP receives a fee known as an incentive distribution right (IDR) for its services.

One of the most common questions I’m asked about MLPs is how fair is the relationship between the GP and LP; in other words, how can we be sure that the GP is acting in the best interest of LP unitholders? The GP/LP relationship is extremely important, and investors should take a hard look at the GP for every MLP in which they invest.

The IDR Incentive

Incentive distributions are typically based on the quarterly distribution paid to LP unitholders. The exact formula differs from MLP to MLP. For instance, with Enterprise Products Partners LP (NYSE: EPD), one of the largest publicly traded MLPs, the incentives paid to the GP are based on the following formula applied to each quarterly distribution:

  • Tier 1: 2 percent of each quarterly distribution under 25.3 cents;
  • Tier 2: 15 percent of each quarterly distribution of between 25.3 cents and 30.85 cents;
  • Tier 3: 25 percent of each quarterly distribution totaling more than 30.85 cents per unit.

Because Enterprise Products Partners pays out 54.5 cents per quarter in distributions at this time, its incentive distributions exceed the Tier 3 level; Enterprise pays what’s known as the high split to its GP.

Don’t make the mistake of assuming that this means that Enterprise’s GP is taking 25 percent of all cash flows earned by the MLP. This is a common fallacy. Here’s how the IDRs are actually computed:

  • Tier 1: The first 25.3 cents paid to the LP unitholder represents 98 percent of the actual total distribution. That means that the total Tier 1 payout is 25.816 cents (25.3 divided by 0.98). This consists of 25.3 cents for the LP holder and about half of 1 cent for the GP.
  • Tier 2: The next 5.55 cents (30.85 cents minus 25.3 cents) paid to the LP is 85 percent of the total distribution. That means the total payout is 6.53 cents (5.55 divided by 0.85). That’s 5.55 cents to the LP holders and roughly 1 cent to the GP.
  • Tier 3: The remaining 23.65 cents (54.5 cents minus 30.85 cents) paid to LP unitholders represents 75 percent of the total payout. That means the total payout is 31.53 cents (23.65 divided by 0.75). That’s 23.65 cents to the LP unitholders and 7.88 cents to the GP.

In total, each LP unitholder received 54.5 cents in distributions, while the GP received a little less than 9.38 cents per outstanding unit in incentive distributions this quarter. Thus of the total 63.88 cents paid out by the MLP, about 14.7 percent went to the GP as an IDR and a little over 85 percent went to the LP unitholders--that’s those of us who own Enterprise Products Partners.

The effect of the incentive distribution formula is that the higher the quarterly distributions paid to LP unitholders (investors in the MLP), the higher the management fee paid to the GP. The idea behind this is that the GP has an incentive to try to boost distributions; there's an incentive to pursue income-accretive acquisitions and organic growth projects.

The effect of this is also that relatively new, “young” MLPs pay little or no incentive distribution to GPs. As cash flows and distributions rise over time, incentive distributions rise as well.

Incentive distributions are an important consideration when investing in MLPs; each MLP has a different formula for calculating splits. For example, while Enterprise has a maximum split of 25 percent, it’s common for GPs to demand a 50 percent high split.

Obviously, the higher the split the less cash there is to pay distributions to investors in the MLP. High splits also reduce the amount of cash available to service debt, make acquisitions and for general capital expenditures. High splits to GPs can make it more expensive for an MLP to borrow money to fund expansion.

Meanwhile, some younger MLPs structure their incentive distributions so that incentive distributions will be small for the first few years of the MLP’s existence. This gives the MLP room to grow. Others start taking a higher cut earlier on. The structure of incentive distributions can make a big difference for unitholders.

It’s also worth noting that MLPs are the most common type of publicly traded partnership (PTP) in the US. However, some firms are structured as limited liability companies (LLC). These firms offer the same basic tax and yield advantages as MLPs; however, LLCs don’t have a separate GP and LP but are run more like normal corporations.

Another absolutely key consideration: how willing and able is the GP to aid the LP’s growth and financial stability.

The best scenario is a GP backed by a strong sponsor firm. For example, some MLPs with midstream energy assets--pipelines and storage facilities--have exploration and production (E&P) firms as GPs. For example, Williams LP’s (NYSE: WPZ) general partner is Williams Companies (NYSE: WMB).

Williams Companies has billions worth of midstream energy assets suitable for drop-down to Williams LP. That means it can essentially sell those assets to the LP. In such a transaction, known as a “drop-down”, the LP would typically buy the assets for a price that would immediately be accretive to its distributable cash flow. In other words, it would immediately make it possible for the LP to boost cash distributions.

Drop-downs benefit both sponsor and LP. Williams is a corporation and profits are taxed at corporate rates; by dropping down assets to an MLP, it’s sheltering them from tax.

In addition, Williams raises an immediate lump sum it can use to finance growth-oriented capital spending such as a stepped up drilling program.

Finally, Williams continues to benefit from the asset’s cash flows via IDRs paid to the GP. The LP, in turn, benefits from the cash flows provided by the asset via higher cash distributions.

Another key consideration: When times are tough, the GP can help. Some GPs have actually suspended or eliminated IDRs for a period of time to help shore up the LP’s cash flows and allow it to maintain distributions. Other GPs have actually helped finance their LPs when capital market conditions were weak.

There’s no fixed formula or metric for this assessment; rather it’s necessary to look at GP/LP relationships on a case-by-case basis. This key relationship has literally been the difference between a cut in distributions and continued growth for several MLPs over the past year.