MLPs: GP / LP Relationship Is Key

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.

Comments

[fireball:]

thank you elliot. easy to understand.

Oct 20 12:45 PM

[Smackdown:]

EPB has a very compelling story. GP is El Paso. They have a couple billion in carry forward losses and billions in drop down worthy assets. Makes for a perfect scenario. EPB just crossed into the 15% IDR split with the recent impressive distribution hike. With its expansion plans and the aggressive distribution plans, I would not be surprised to see them quickly surpass the 25% threshold and shoot for the 50% mark. Plus the business is the most stable type of FERC regulated assets in any MLP.

Good explanation Elliott! I hold your commentaries in a league above the usual misinformed and unprofessional Seeking Alpha blather regarding MLPs.

Oct 21 09:25 AM

[J. Stack:]

Elliot, thanks for an easy to understand article; however, when I started to read, I assumed you were going to explain why an investor would choose either a GP or the LP. For instance, as I am 76 years old, I am interested in dividend income.
In the case of WMB, the yield is 2.2% vs. WPZ which distributes about 10%. Question: why would anyone looking for income choose the GP with the lower yield?

Oct 21 09:26 AM

[Elliott Gue:]

Thanks, that's actually a complex question. The first point to note is that WMB isn't really a pure-play GP though it does control the GP of WPZ.

There are some publicly traded pure-play GPs out there. (To add to the complexity, the publicly traded GPs are actually structured as LPs for tax purposes). An example of a publicly traded GP would be Enterprise GP Holdings (NYSE: EPE), the GP for Enterprise Products partners (NYSE: EPD). EPE receives IDRs from Enterprise therefore its cash flows are derived from the IDR structure I outlined above and indirectly from EPD's distributions. To make a long story short, you will find that the yield on most publicly traded GPs is lower than for their LPs but the potential growth rate in distributions is higher -- the GPs are more or less a leveraged play on distribution growth.

To answer your question specifically about WMB. WMB is primarily an exploration and production company. The types of assets it targets would be fields where it can produce production growth. This isn't really appropriate for the MLP structure because what you want with MLPs isn't high growth but steady cash flows that can back up big distributions.

The types of assets in WPZ are much slower-growing -- WMB's slower-growing cash cow assets. They're not interesting from a growth perspective but they can be from an income sustainability angle.

The MLP structure effectively allows WMB to focus on attracting growth investors while it carves out assets that appeal to more income-oriented players. Whether you find WMB or WPZ more interesting would depend entirely on whether your looking for capital gains or cash income.

On Oct 21 09:26 AM J. Stack wrote:

> Elliot, thanks for an easy to understand article; however, when I
> started to read, I assumed you were going to explain why an investor
> would choose either a GP or the LP. For instance, as I am 76 years
> old, I am interested in dividend income.
> In the case of WMB, the yield is 2.2% vs. WPZ which distributes about
> 10%. Question: why would anyone looking for income choose the GP
> with the lower yield?

Oct 21 10:03 AM

[J. Stack:]

Thanks again, Elliott. Stable income is my sole aim. Appreciate your reply. Regards, J. Stack


On Oct 21 10:03 AM Elliott Gue wrote:

> Thanks, that's actually a complex question. The first point to note
> is that WMB isn't really a pure-play GP though it does control the
> GP of WPZ.
>
> There are some publicly traded pure-play GPs out there. (To add to
> the complexity, the publicly traded GPs are actually structured as
> LPs for tax purposes). An example of a publicly traded GP would be
> Enterprise GP Holdings (NYSE: seekingalpha.com/symbo...),
> the GP for Enterprise Products partners (NYSE: seekingalpha.com/symbo...).
> EPE receives IDRs from Enterprise therefore its cash flows are derived
> from the IDR structure I outlined above and indirectly from EPD's
> distributions. To make a long story short, you will find that the
> yield on most publicly traded GPs is lower than for their LPs but
> the potential growth rate in distributions is higher -- the GPs are
> more or less a leveraged play on distribution growth.
>
> To answer your question specifically about WMB. WMB is primarily
> an exploration and production company. The types of assets it targets
> would be fields where it can produce production growth. This isn't
> really appropriate for the MLP structure because what you want with
> MLPs isn't high growth but steady cash flows that can back up big
> distributions.
>
> The types of assets in WPZ are much slower-growing -- WMB's slower-growing
> cash cow assets. They're not interesting from a growth perspective
> but they can be from an income sustainability angle.
>
> The MLP structure effectively allows WMB to focus on attracting growth
> investors while it carves out assets that appeal to more income-oriented
> players. Whether you find WMB or WPZ more interesting would depend
> entirely on whether your looking for capital gains or cash income.
>
>
> On Oct 21 09:26 AM J. Stack wrote:

Oct 21 10:52 AM

[elliot_mllr:]

I believe that the reason yields on GPs are lower than on the underlying LPs is because the GPs trade at a higher price (or lower yield) since their greater dollar return growth is higher and this makes them more attractive.

Oct 21 03:02 PM

[oldman:]

I'm hesitiant to buy MLP's for my retirement accounts as I know I might end up with UBTI and a K-1 for the IRA. also, I think there are tax benefits I can't use although the yield is good and what's the difference if I can't use tax benefits? I'd appreciate your comments on these issues. Would certain MLP's be better, if at all, for my IRA?

Thanks for the article.

Oct 21 03:13 PM

[Elliott Gue:]

Yes, generally you are better owning MLPs in a taxable account. One reason is UBTI, the other is simply it's best not to put a tax-advantaged investment in a tax-free account as you lose the benefit.

There are three ways around the issue. One is to buy a closed-end MLP fund; these funds report dividends on a normal 1099 so you have no UBTI issue. They also offer nice yields that are tax-advantaged in an IRA account.

Second, you can buy what's known as an i-unit. These are issued by MLPs but pay distributions in the form of additional units (the MLP equivalent of shares) rather than cash. Also, not subject to UBTI. There are only two publicly traded i-units, KMR and EEQ.

Third, there are some MLPs that are actually based overseas and have elected to be taxed as a corporation for US tax purposes. Therefore, they report on a 1099. Because they have no US assets, they're not subject to any tax so this is just a technicality. An example would by NMM.


On Oct 21 03:13 PM oldman wrote:

> I'm hesitiant to buy MLP's for my retirement accounts as I know I
> might end up with UBTI and a K-1 for the IRA. also, I think there
> are tax benefits I can't use although the yield is good and what's
> the difference if I can't use tax benefits? I'd appreciate your comments
> on these issues. Would certain MLP's be better, if at all, for my
> IRA?
>
> Thanks for the article.

Oct 21 03:41 PM

[oldman:]

Thank you for explaining this so clearly.

Oct 21 09:45 PM

[Smackdown:]

Elliott, I have to strongly disagree with you. UBTI is seldom an issue in IRA accounts. Most MLPs do not generate enough UBTI to cause an issue. I do believe the $1000 limit is per MLP and not cumulative. In addition, UBTI is not the distribution as many incorrectly assume. In conclusion, the IRA trustee is responsible for the UBTI excise if any so it is not the investors concern.

Your second point is totally off the mark. A good investment is a good investment. Period. Alerian MLP index is up almost sevenfold in 13 years. If I avoided MLPS in IRA accounts because they are "not suitable due to some tax advantage", I pissed away one of the best sector opportunities, bar none. The tax advantage is icing and not any reason to avoid them.

Question... Which would you buy in an IRA if limited to these two choices. 1 year corporate investment grade paper at 1.4% or 1 year muni paper with higher ratings and 1.5%? Even though the muni is tax free, it still nets more. For the record, I would not buy either, but you get the point.... ;)


On Oct 21 03:41 PM Elliott Gue wrote:

> Yes, generally you are better owning MLPs in a taxable account. One
> reason is UBTI, the other is simply it's best not to put a tax-advantaged
> investment in a tax-free account as you lose the benefit.
>
>

Oct 22 11:48 AM

[Elliott Gue:]

Thanks for the comment. But a couple of points are worth noting:

1. UBTI allowance of $1k is not per MLP but cumulative. Whether or not you exceed that limit depends on how large your holdings are.

2. It's true that a good investment is a good investment and most individual investors focus too much attention on taxes relative to just picking good stocks. But, the question/choice you propose in your comment isn't the question I was asked.

The choice I was responding to in my prior comment wasn't whether someone should buy MLPs in an IRA or not at all. It was whether MLPs should be purchased in an IRA or in a taxable account. If you have the choice of playing them in a taxable account that would be preferable in my view.

If you do want to hold some in an IRA, the names I mentioned are simply a way of avoiding UBTI issues at all. In addition KMR and EEQ might make sense in an IRA where monies are going to be held for a long period of time as these i-units are somewhat akin to a distribution reinvestment plan.


On Oct 22 11:48 AM Smackdown wrote:

> Elliott, I have to strongly disagree with you. UBTI is seldom
> an issue in IRA accounts. Most MLPs do not generate enough UBTI
> to cause an issue. I do believe the $1000 limit is per MLP and
> not cumulative. In addition, UBTI is not the distribution as many
> incorrectly assume. In conclusion, the IRA trustee is responsible
> for the UBTI excise if any so it is not the investors concern.<br/>
>
> Your second point is totally off the mark. A good investment is
> a good investment. Period. Alerian MLP index is up almost sevenfold
> in 13 years. If I avoided MLPS in IRA accounts because they are
> "not suitable due to some tax advantage", I pissed away one of the
> best sector opportunities, bar none. The tax advantage is icing
> and not any reason to avoid them.
>
> Question... Which would you buy in an IRA if limited to these two
> choices. 1 year corporate investment grade paper at 1.4% or 1
> year muni paper with higher ratings and 1.5%? Even though the
> muni is tax free, it still nets more. For the record, I would
> not buy either, but you get the point.... ;)

Oct 22 01:19 PM

[Smackdown:]

We need to further explore the UBTI issue..... This from the recent NAPTP conference in September. Please note the part about UBTI being calculated on a per partnership basis. Based on my extensive experience in the sector, and with historical IRA UBTI due, I agree that it must be per partnership. Let's keep this friendly since we are on the same side!!

"b) Tim Fenn (a tax lawyer specializing in MLPs) of Vinson Elkins stated the following on UBTI (I hope I heard these right):

> filing of the 990T is the trustee's responsibility, as has been speculated on this board

> there is some confusion about the $1,000 UBTI limit for IRAs...you would only OWE TAX on $1,000 or more of NET UBTI, but the trustee is supposed to file on GROSS UBTI of $1,000...so there are some things apparently that can be netted against the GROSS UBTI so just because there is a filing doesn't mean you owe money; marginal tax rates for UBTI in IRAs start at 15% today; UBTI is calculated per partnership, and is not to be 'netted out' across multiple MLPs"

Oct 22 04:56 PM

[Smackdown:]

I just got off the phone with investor relations of a large MLP. They indeed confirmed that I am correct and that the UBTI does not net out across multiple holdings. It is MLP specific. For example, you own 10 MLPS in an IRA that each have $900 in UBTI. It is not added up. No tax is due.

Hope this helps.

Oct 22 05:08 PM

[Elliott Gue:]

Thanks for the follow-up comments. I did not intend for my earlier reply to seem unfriendly.

I agree that most of the time UBTI may not be a major issue as certainly not all of income you receive from an MLP is considered UBTI. It is also definitely true that it's the trustee's responsibility to file a form 990T.

However, I have read several reports that suggest that the UBTI is added up across all MLPs owned. In particular, check out IRS Publication 598. This publication discusses tax-exempt organizations that is specifically stated to include IRAs. Each organization is required to report income from all its unrelated businesses on a single 990T. Here's the link to that publication:
www.irs.gov/pub/irs-pd...

Also, check out several of the MLP guides posted on the NAPTP's own website at naptp.org.


On Oct 22 05:08 PM Smackdown wrote:

> I just got off the phone with investor relations of a large MLP.
> They indeed confirmed that I am correct and that the UBTI does not
> net out across multiple holdings. It is MLP specific. For example,
> you own 10 MLPS in an IRA that each have $900 in UBTI. It is not
> added up. No tax is due.
>
> Hope this helps.

Oct 23 12:00 AM

[scoots:]

What about MTP? Is this a true ETF in the MLP area? If so, could it be useful instead of woning MLPs themselves.

Scooter

Oct 23 02:04 AM

[Smackdown:]

Elliott,

I did some more research and you indeed are correct. (tail between legs). UBTI is combined for a $1000 total. However, you do get to deduct depreciation and other expenses against it. Furthermore, there is a very good case to be made to allow netting gains and losses from one MLP to another, as long as 469 (k) limitiations do not apply. If this is true, then this would be a very good thing. Netting passive losses against the UBTI.......

More coming!!

Keep up the good work btw.

Oct 23 03:22 PM

[Elliott Gue:]

MTP is a closed-end fund that buys primarily MLPs. At this time, it trades at around a 6 percent premium to its net asset value (NAV), the value of all the stocks in its portfolio.

Closed-end funds are fine though they tend to be heavily weighted toward a few big names and usually own the good, the bad and the ugly of the MLP space. I think funds can be part of an MLP strategy but investors willing to buy individual names can outperform.


On Oct 23 02:04 AM scoots wrote:

> What about MTP? Is this a true ETF in the MLP area? If so, could
> it be useful instead of woning MLPs themselves.
>
> Scooter

Oct 23 03:26 PM

[Elliott Gue:]

Thanks for the update and kind words.

I think conversation/debate in the Seeking Alpha comments section is among the most useful aspects of the website. It certainly drives me to dig deeper on certain issues.


On Oct 23 03:22 PM Smackdown wrote:

> Elliott,
>
> I did some more research and you indeed are correct. (tail between
> legs). UBTI is combined for a $1000 total. However, you do get
> to deduct depreciation and other expenses against it. Furthermore,
> there is a very good case to be made to allow netting gains and losses
> from one MLP to another, as long as 469 (k) limitiations do not apply.
> If this is true, then this would be a very good thing. Netting
> passive losses against the UBTI.......
>
> More coming!!
>
> Keep up the good work btw.

Oct 23 03:31 PM

[Augustus:]

It would be much better if you would check with the IRS. The UBTI check is for a TOTAL number of $1,000. Buy KMR as it is selling at a discount anyway. Maybe AMJ if you can tolerate the ETN problem.


On Oct 22 05:08 PM Smackdown wrote:

> I just got off the phone with investor relations of a large MLP.
> They indeed confirmed that I am correct and that the UBTI does not
> net out across multiple holdings. It is MLP specific. For example,
> you own 10 MLPS in an IRA that each have $900 in UBTI. It is not
> added up. No tax is due.
>
> Hope this helps.

Nov 13 11:49 PM

[Augustus:]

As noted, MTP is a closed end fund and entails a management fee. There is nothing particularly illegitimate about that, just something to be aware of. I very much like the sector and believe that it is mispriced as it does not have much immediate momentum juice at any particular time. They just keep sawing logs and adding to the woodpile.

A good approach would be to follow MTP and try to buy it when at a discount to NAV. that will also probably happen when the sector is well out of favor. Considering that they are for the most part simply toll collectors it is a pretty safe income generator.


On Oct 23 02:04 AM scoots wrote:

> What about MTP? Is this a true ETF in the MLP area? If so, could
> it be useful instead of woning MLPs themselves.
>
> Scooter

Nov 14 12:05 AM

[lowdrawdown:]

What if interest rates go up? MLP capital structures are generally 50% debt/50% equity. While pipelines have some pricing power (inflation indexed tariffs), rising interest rates would definitely increase debt service costs and lower earnings for distributions. Also, MLP yields would have to go up too to remain competitive.... double whammy> lower income + higher yields = big price drop... any way to hedge?

Nov 21 02:35 AM