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Kinder Morgan Energy Partners LP (NYSE: KMP), the second-largest master limited partnership (MLP) by market value, has boosted its quarterly distribution 48 times since CEO Richard Kinder took over in 1997. Over the past five years alone, the publicly traded partnership has grown its payout by more than one-third, contributing to a total return of almost 100 percent over this period.

Despite this stellar track record, the partnership has encountered criticism from Hedgeye Risk Management, which reportedly issued a press release entitled "Best New Idea: Short Kinder Morgan."

My colleague Roger Conrad took a closer look at Kinder Morgan Energy Partners' carbon dioxide segment, which supplies this gas to other upstream operators and its own enhanced-oil-recovery operations in the Permian Basin. Hedgeye has highlighted this business line as a potential liability, noting that this segment involves exposure to commodity prices and questioning the minimal maintenance-related capital expenditures associated with this operation. You can read Roger's take on this criticism in Kinder Morgan Energy Partners LP: Not a House of Cards.

This article examines another common criticism of Kinder Morgan Energy Partners that Hedgeye has trotted out to support its short thesis: That the MLP's general partner, Kinder Morgan Inc. (NYSE: KMI), enriches itself and its shareholders at the expense of Kinder Morgan Energy Partners' unitholders. More specifically, the bears claim that Kinder Morgan Inc.'s hefty incentive distribution rights (IDR) impede Kinder Morgan Energy Partners' ability to grow its distribution over time.

Although Kinder Morgan Inc.'s IDRs entitle the firm to a sizable percentage of Kinder Morgan Energy Partners' cash flow, the bearish case exaggerates the challenges that this arrangement poses to the limited partner's distribution growth.

As we explained in The Lowdown on MLP IDRs: Incentive or Impediment, an MLP often consists of 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 IDRs 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.

(click to enlarge)
Source: Company Reports

Kinder Morgan Energy Partners pays a quarterly distribution of $1.32 per unit, putting the MLP well into the high splits - the level at which the general partner receives its maximum share of the limited partner's incremental distributable cash flow. Check out this table breaking down the Kinder Morgan Energy Partners' quarterly payout to LP unitholders and the incentive distribution received by Kinder Morgan Inc.

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Source: Company Reports, Energy & Income Advisor

According to these calculations, Kinder Morgan Inc. receives 45.74 percent of Kinder Morgan Energy Partners' total quarterly payout. Bearish commentators frequently cite the general partner's disproportionate take of Kinder Morgan Energy Partners' distributable cash flow as the primary reason to avoid the stock.

Kinder Morgan Energy Partners' quarterly IDR obligation as a percentage of its total payout is the highest of the 10 largest publicly traded partnerships by market capitalization (see graph) and the 50 names that make up the Alerian MLP Index.

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Source: Bloomberg, Energy & Income Advisor

Three of the 10 largest MLPs - Enterprise Products Partners LP (NYSE: EPD), Magellan Midstream Partners LP (NYSE: MMP) and MarkWest Energy Partners LP (NYSE: MWE) - have eliminated their IDRs since 2008. Enterprise Products Partners LP, for example, in November 2010 acquired its general partner, Enterprise GP Holdings LP, for about $10 billion. Although the MLP issued additional units to fund this transaction, management emphasized that the deal would simplify the partnership's structure, lower its cost of capital and support long-term growth in distributions.

Comparing the two largest MLPs by market capitalization reveals the extent to which IDRs eventually can inhibit distribution growth.

For Kinder Morgan Energy Partners to grow its quarterly payout by 10 percent, the MLP would need to generate an additional $0.26 per unit in cash flow ($0.13 per unit for the GP and $0.13 unit for investors in the LP) to maintain its current distribution coverage. Enterprise Products Partners, on the other hand, would need to increase its distributable cash flow by $0.07 per unit to support a 10 percent increase to its quarterly payout. (Note that these calculations assume that the number of outstanding units remains the same.)

What does this mean in actual dollar terms? With 308 million outstanding units, Kinder Morgan Energy Partners would need to generate an additional $80 million in distributable cash flow to fund a 10 percent increase to its payout. There's no question that IDRs become a significant burden when an MLP enters the high splits.

Moreover, whenever Kinder Morgan Energy Partners raises capital by issuing additional units, the total incentive distribution to Kinder Morgan Inc. increases even if the rate remains the same. Let's consider what would happen if Kinder Morgan Energy Partners raised $790 million in capital by issuing 10 million new units. With a current quarterly distribution of $1.32 per unit, the MLP would need to disburse an additional $13.2 million to LP unitholders and $11.1 million in incremental IDR payments to Kinder Morgan Inc. This translates to an annual cost of about 12.7 percent.

Let's apply the same situation to Enterprise Products Partners. To raise $790 million, the MLP would need to issue 13.6 million units, which would increase its quarterly distribution to unitholders by $9.25 million. Annualizing this incremental increase yields an annual cost of capital of about 4.7 percent - far superior to Kinder Morgan Energy Partners.

At first blush, Kinder Morgan Energy Partners' IDR obligations to Kinder Morgan Inc. appear to be a major headwind for the MLP. However, investors shouldn't overlook several mitigating factors.

For one, Kinder Morgan Energy Partners' size makes it easier for the firm to raise capital. Consider that the MLP would need to generate about $80 million per quarter and $320 million per year in distributable cash flow to support a 10 percent hike in its payout. (This assumes that the MLP doesn't issue additional units to fund the projects or acquisitions driving this uptick in cash flow.)

Investors should keep in mind that this $320 million in incremental cash flow represents 0.6 percent of Kinder Morgan Energy Partners' $55 billion enterprise value. Viewed in this light, the MLP doesn't appear as disadvantaged relative to its peers.

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Source: Bloomberg, Energy & Income Advisor

Although Kinder Morgan Energy Partners still has a higher cost of capital than the three MLPs without IDRs, the partnership is in the middle of the pack for large-cap publicly traded partnerships.

Moreover, Kinder Morgan Energy Partners' size and reputation for excellence enable the MLP to raise low-cost capital in the bond market. For example, the MLP on Aug. 5 raised about $800 million by issuing bonds that mature in 2019 and yield about 3 percent and bonds that mature in 2024 and yield of about 4.3 percent.

Bearish commentators also ignore the fact that the MLP's general partner repeatedly has waived a portion of its IDR payment to support acquisitions and organic growth projects at the LP level.

For instance, to help pay for Kinder Morgan Energy Partners' $5 billion acquisition of Copano Energy LLC, Kinder Morgan Inc. agreed to forego more than $60 million worth of IDR fees in 2013, $120 million in 2014 and 2015, and $110 million in 2016. Thereafter, these waivers decline by $5 million each year. Likewise, the general partner voluntarily relinquished $11 million worth of incentive distributions in 2010, $28 million in 2011 and $27 million in 2012 to support the acquisition of KinderHawk Field Services. And in 2010, the general partner refused about $170 million in IDR payments that stemmed from capital transactions rather than cash flow from operations.

This long history of waiving IDR obligations to support Kinder Morgan Energy Partners' growth suggests that Kinder Morgan Inc. would move aggressively if the LP's distribution coverage were called into question or threatened.

One potential step would be to reset the target levels on the MLP's IDR schedule. Such a move wouldn't be unprecedented in the MLP universe: Enterprise Products Partners' former general partner in 2002 reduced the top-tier split to 25 percent from 50 percent. The MLP didn't pay anything to its GP for this relief.

Even a relatively modest reduction in Kinder Morgan Inc.'s IDR take would save Kinder Morgan Energy Partners significant sums. Consider the $120 million worth of IDR obligations that the general partner waived for 2014 amounts to $0.39 per LP unit outstanding.

Such a move would quickly alleviate concerns about the Kinder Morgan Energy Partners' ability to grow its distribution and kick the legs out from underneath any short sellers who have followed Hedgeye's advice. Nevertheless, we prefer other MLPs to Kinder Morgan Energy Partners. On Sept. 23, Roger Conrad and I will host a free webinar on our top three publicly traded partnerships for 2014 and beyond.

Disclosure: I am long EPD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Kinder Morgan Energy Partners LP: Reality Vs. Hyperbole