Master limited partnerships ((MLPs) usually comprise two entities: an operating limited partnership (LP) and a general partner (GP) that usually owns a 2 percent stake in the LP and receives compensation for managing the operating partnership's assets.
Not only does the general partner receive a regular distribution from any common units that it owns, but in many cases the GP also holds incentive distribution rights (IDR) that entitle it to a higher proportion of the LP's quarterly distribution. An MLP's IDR schedule is usually structured in a manner that encourages the GP to drive distribution growth at the LP level. In general, the GP receives an increasingly higher percentage of the LP's incremental cash flow once the payout on the common units reaches certain predetermined targets.
The relationship between GP and LP is of fundamental importance to prospective investors in an MLP. Because each MLP's IDR structure differs, you need to understand how much the general partner receives in incentive payments and the extent to which this promotes or inhibits distribution growth at the LP level.
A real-world example is the best way to illustrate these concepts. Let's start with Williams Partners LP (NYSE: WPZ), an MLP that owns an extensive portfolio of midstream assets, including natural-gas pipelines, gathering systems, gas-processing plants and storage facilities. Williams Companies (NYSE: WMB), which formed Williams Partners in 2005, holds about 64 percent of the partnership's outstanding units and owns a general-partner interest in the partnership.
Williams Partners pays incentive distributions to its GP according to the following tier structure.
(click to enlarge)Source: Williams Partners LP 2012 10-K, Filed Feb. 27, 2013
This IDR schedule was established in Williams Partners' partnership agreement and disclosed in a registration statement filed with the US Securities and Exchange Commission prior to the initial public offering. This document sets Williams Partners' minimum quarterly distribution at $0.35 per unit; the LP can disburse less than $0.35 per unit if its cash flow falls short, but any arrearage must be paid up in subsequent quarters.
But this safeguard has never proved to be necessary. Williams Partners has never paid a distribution less than its quarterly minimum since going public. In the most recent quarter, Williams Partners disbursed $0.8625 per common unit. Based on this payout and tier structure, we can calculate how much Williams Companies should receive in IDR payments. (Note that these calculations don't reflect the $200 million waiver that the GP recently granted Williams Partners after the explosion at its olefins plant in Geismar, La.)
(click to enlarge)
Source: Williams Partners LP 2012 10-K, Energy & Income Advisor
- Minimum Quarterly Distribution: At this initial rung on the IDR ladder, holders of Williams Partners' common stock receive $0.35 per unit. For its general-partner interest, Williams Companies' receives a separate disbursement equivalent to 2 percent of this amount. In other words, the total quarterly payout would amount to $0.3571 per unit; LP investors would receive $0.35 per unit, while the GP would rake in $0.0071 ($0.35 divided by 0.98) for each outstanding LP unit.
- Tier 1: When Williams Partners' quarterly distribution reaches $0.4025 per unit, the general partner is entitled to a separate disbursement equivalent to 2 percent of this $0.0525 per unit increase ($0.4025 minus $0.35). In this scenario, investors would receive $0.0525 per common unit, while Williams Companies would receive $0.0011 for each LP unit. These amounts are on top of the minimum quarterly distribution.
- Tier 2: When Williams Partners' quarterly distribution hits $0.4375 per unit, the general partners' incentive distribution jumps to 15 percent of this $0.035 per unit increase. That is, Williams Companies would receive $0.0062 per unit on top of its minimum and Tier 1 incentive distributions.
- Tier 3: When Williams Partners' quarterly distribution hits $0.525 per unit, the GP's incentive distribution ticks up to 25 percent of the $.0875 increase accruing to LP unitholders. In this situation, Williams Companies would receive about $0.029 per outstanding LP unit on top of the minimum, Tier 1 and Tier 2 distributions.
- Tier 4: When Williams Partners' quarterly distribution is equal to or greater than $0.525 per unit, the MLP and the GP split any incremental distribution growth equally. The publicly traded partnership disbursed a second-quarter payout of $0.8625 per unit, meaning that the general partner and the LP investors each collected $0.3775 per unit. That's on top of the payouts associated with the previous tiers. This equates to a total second quarter payout of about $1.244 per unit-$0.8625 for the LP unitholders and the remaining $0.381 for the general partner.
Investors often assume that when an MLP reaches the high splits, the GP collects 50 percent of the MLP's distributable cash flow. This is demonstrably untrue: Williams Companies and Williams Partners evenly split the portion of the LP distribution that's above $0.525 per unit. In other words, LP unitholders receive about 69 percent of Williams Partners' total quarterly payout, while the general partner takes the remaining 31 percent.
IDRs aren't necessarily bad. In the early stages of an MLP's existence, the tier structure of IDRs incentivizes the GP to pursue policies that will drive distribution growth for LP unitholders. The higher the distributions to the LP unitholders, the greater the general partner's quarterly IDR.
Williams Partners' first two quarterly distributions paid in November 2005 and February 2006 were the minimum $0.35 per unit (the first distribution was prorated). Williams Companies received only 2 percent of the total payout at that tier level and had a strong incentive to boost distributions so that its share of quarterly cash flow would increase. Progress was rapid: Williams Partners hit its Tier 2 target with its November 2006 payout of $0.45 per unit and entered the high splits in August 2007.
Since Williams Partners went public, drop-down transactions from Williams Companies have fueled much of the MLP's cash flow and distribution growth. In these deals, the sponsor sells assets that generate qualifying income to the LP at prices that are immediately accretive to distributable cash flow and will enable the partnership to increase its quarterly payout.
For example, Williams Partners in 2006 purchased Four Corners LLC from Williams Companies for total consideration of about $1.6 billion. This deal netted the LP 3,500 miles of natural-gas gathering line in the San Juan Basin of New Mexico and Colorado as well as three processing and two treatment plants. Gas-processing plants separate natural gas liquids (NGL) - a heavier group of hydrocarbons that includes propane, ethane and butane - from the raw natural-gas stream, while treatment facilities remove carbon dioxide from the mix.
Although Williams Partners issued additional units to fund this acquisition, the cash flow generated by these assets more than offset this dilution and drove the MLP's distribution growth in its early years.
How can unitholders be assured that the LP receives a fair price on these drop-down transactions? IDRs help to incentivize this behavior, especially in the early stages of an MLP's existence. Careful analysis of a newly listed MLP's IDR schedule gives investors an idea of how quickly the MLP plans to grow its payout.
As an MLP matures, IDRs can impede distribution growth at the LP level. Williams Partners has almost 439 million outstanding common units, which translates into a quarterly obligation of about $380 million at the MLP's current distribution rate of $0.8625 per unit. However, the IDRs that Williams Partners pays to Williams Companies increase the MLP's quarterly obligation to almost $550 million.
For Williams Partners to grow its quarterly distribution to unitholders by 10 percent ($0.08625 per unit), the MLP would also need to disburse an incremental $0.08625 to Williams Companies to comply with its IDR schedule. Assuming that Williams Partners doesn't issue additional units to funds this growth, the MLP would need to increase its distributable cash flow by almost 14 percent to support a 10 percent increase in its quarterly payout to LP unitholders.
In other words, Williams Partners would need to generate an additional $75 million in cash flow to fund a 10 percent increase in its distribution. On an annualized basis, this amount of cash flow equates to about 1 percent of Williams Partners' enterprise value, a measure of the value of all of the MLP's outstanding units and net debt.
To alleviate the challenges associated with the high splits, Williams Companies in the past has foregone a portion of its IDRs to enable the LP to maintain its distribution or to stimulate growth. For example, after an explosion crippled Williams Partners' Geismar olefins production plant, the general partner temporarily waived $200 million in IDR payments.
However, investors shouldn't make the mistake of focusing solely on an MLP's IDR burden when deciding how to place their bets. Many mature MLPs have generated respectable distribution growth while in their high splits - on the other hand, some unencumbered names have generated only modest distribution growth because of the inferior quality of their asset bases. PVR Partners LP (NYSE: PVR), for example, has increased its distribution only modestly despite eliminating its IDRs entirely.
Nevertheless, understanding an MLP's IDR schedule can provide useful insight into its growth potential. We recently analyzed the IDR obligations of all 50 names in the Alerian MLP Index.
The table below highlights the five MLPs in our study that must grow their distributable cash flow by the highest proportion to increase their quarterly distribution by 10 percent.
This table spotlights the five MLPs that face the biggest hurdles to their quarterly distributions by 10 percent, a challenge that we quantified by comparing the requisite amount of incremental cash flow growth to each partnership's enterprise value.