Yesterday afternoon, a lawsuit (article available here) seeking damages against Kinder Morgan (NYSE:KMI) was made public, which could have major implications for the company as well as the master limited partnership ("MLP") it manages, Kinder Morgan Energy Partners (NYSE:KMP). Investors should also note that as a consequence Kinder Morgan Management (NYSE:KMR) is involved as it is an LLC that solely owns KMP units and automatically reinvests dividends. In essence, this lawsuit is driven by some of the criticism by bearish analyst Kevin Kaiser of Hedgeye. While the eventual result of this case is obviously unknown, it is important for investors to understand what has been alleged and how that impacts both KMI and KMP. As you can see from the following chart, neither firm has performed well over the past twelve months, which could be a reason why this investor felt compelled to launch the suit.
First, we must understand the relationship that KMI and KMP have to each other. KMP is a limited partnership, and when you buy KMP for your portfolio, you are buying a limited interest. This means that you hold equity in the partnership but don't have the authority to make any decisions. Instead, the General Partner ("GP") runs the limited partnership, and KMI is KMP's general partner. The best way to understand this structure can be through a hedge fund, which is typically a limited partnership. If you invest in David Einhorn's hedge fund, you have equity in that fund (the value of your investment), but you don't make any of the investing decisions. Instead, you delegate that responsibility to the GP, in this case David Einhorn. In exchange, the GP takes some sort of a fee; for most hedge funds that is 2% of assets and 20% of performance.
At its core, KMP is structured the same way. Investors in KMP own the pipelines and all of its assets, but KMI operates those assets. KMI receives compensation through something called Incentive Distribution Rights ("IDR"), which essentially entitle KMI to a portion of the cash flow that KMP generates. As KMP generates more cash, KMI gets a bigger payment. This system provides an incentive for KMI to operate the partnership well and find accretive expansion projects. However, there is further incentive for KMI to ensure KMP performs well because the IDRs are not a constant rate. Instead, as KMP pays a higher distribution, KMI gets a higher share of each incremental dollar generated. In other words, there is a progressive IDR scale.
Since CEO Richard Kinder took over in 1997, KMP has performed exceptionally well, and it is now in the top IDR bracket of 50%. As a consequence if KMP increased its pre-IDR distributable cash flow ("DCF") per unit by $1.00, KMI would be entitled to $0.50 while KMP investors would get the other $0.50. Now, some investors are not fans of this structure as they believe KMI is now getting paid too much for KMP's incremental growth. This is a fair criticism, and investors can choose to invest elsewhere if they feel this way. The partnership agreement between KMI and KMP is already in place, so no investor should feel blindsided by this structure. Thanks to Mr. Kinder's leadership, KMP has consistently grown its distribution. Over the past ten years, its distribution has doubled to a $1.36 quarterly pace, so the results are hard to argue with.
Now in this lawsuit, Mr. Jon Slotoroff who is an investor in KMP, alleges that KMI is taking too high of an IDR from KMP. If we look at KMP's full 2013 results (available here), it paid an IDR to KMI totaling $1.708 billion. For comparison, KMP generated DCF for limited partners of $2.244 billion. As you can see, KMP pays a significant amount to its general partner. This payout to KMI accounted for 43% of KMP pre-IDR distributable cash flow, so there is a lot of money at stake.
As KMI gets more money as DCF increases, it has an incentive to increase DCF, which KMP investors want. However, Mr. Slotoroff is alleging KMI is doing this in a fraudulent way. At its core, distributable cash flow is essentially calculated by taking operating cash flow and subtracting sustaining (often called maintenance) capital expenditures. Expenditures on growth capital expenditures like a new pipeline are not subtracted as they are funded by new equity and debt issuance rather than cash flow. The lawsuit says that KMI is understating maintenance cap-ex, which in turn increases its IDR payment. Essentially, if maintenance cap-ex is under-allocated by $100 million, KMI would get a $50 million undeserved IDR payment and KMP unitholders would receive $50 million in a higher distribution. However, KMP holders would be hurt by $100 million in additional debt and equity issuance to fund this cap-ex, diluting their stake.
Mr. Slotoroff alleges that since 2010, KMI has taken $3.2 billion unjustly from KMP through fraudulent IDRs. Now, this lawsuit comes after a year in which maintenance cap-ex came under scrutiny at KMP and Linn Energy (NASDAQ:LINE) as Kevin Kaiser railed against their accounting practices. In fact, the SEC even opened an inquiry into LINE, though it has taken no action and permitted its takeover of Berry Petroleum. It is important to recognize that distributable cash flow is a non-GAAP number, so there are no ironclad legal standards for its accounting like there are for GAAP income statements. Generally though, maintenance cap-ex is seen as the cash required to maintain operations at the current rate. This lawsuit accuses KMI of launching a massive fraud. Given $3.2 billion in unfair IDRs, that means it is understating KMP's maintenance cap-ex by $6.4 billion over a four year period.
For perspective, KMP spent $327 million on sustaining cap-ex in 2013. This lawsuit alleges KMP understated its total by over 83%. In 2013, maintenance cap-ex was 1.2% of PP&E, which is in-line with industry standards. Moreover, KMP has been aggressively expanding its network, so its pipelines have a young average life, meaning they have even lower cap-ex requirements. As a percentage of EBITDA, KMP's maintenance cap-ex spending is well within industry norms. This lawsuit implies that the annual maintenance expenditure for its pipeline network should be closer to 7% of PP&E. Most pipelines are fully operational for over 33 years, so a 7% maintenance rate is absurd. Even if there were an accounting issue, and there is no reason to believe there is, it would be significantly lower than this lawsuit alleges.
It is true that since the end of 2010, KMP has added $8.4 billion in debt and $9.6 billion in equity, but this is because KMP has been very acquisitive and is spending over $3 billion annually to expand its pipeline network to profit from the natural gas revolution. After all, the partnership's assets have doubled to $41.7 billion in this time frame. Increased debt is a sign of KMP's expansion rather than understated maintenance expense. Moreover, the company is planning on spending $438 million on sustaining cap-ex in 2014, which is up 34% year over year. That is not the action of a GP looking to pillage the partnership.
It should be noted that this lawsuit would be far more damaging to KMI than KMP as KMI would have received wrongful payments and would be forced to return cash to KMP. While KMP would get a cash infusion, higher maintenance cap-ex would lead to a lower distribution, which would hurt its price. However, this lower distribution would also lead to a smaller IDR, cutting deeply into KMI's cash flow. Still with KMP reporting reasonable maintenance figures that are growing with its larger asset base, this case looks like it lacks merit. Put simply, KMI is not scamming KMP.
While this lawsuit should not have a long-term impact on shares, investors should obviously follow any and all progress in the case. Moreover, it provides a good opportunity for all investors to re-examine the GP-LP relationship and KMP's financials. Some investors may be uncomfortable with the IDR structure and choose to invest elsewhere as any change in the KMP partnership agreement is exceedingly unlikely. Still, there is a difference between finding an investment unattractive and suggesting fraud. KMP has a strong though not perfect safety record, and its pipelines are not in disarray. Increased debt is from expansions and acquisitions not the funding of maintenance. The MLP sector would benefit from an industry-wide discussion of sustaining cap-ex to simplify investing, but given what KMP spends in relationship to its assets and EBITDA, there are no signs of problems. While this lawsuit provides investors with an opportunity to do deeper due diligence, there is no reason to believe KMI is illegally raiding KMP. I for one will continue to stay long KMP.