An oft-debated component of the partnership agreement between the General Partner and Limited Partner is the role and impact of Incentive Distribution Rights. The IDR schedule dictates how incremental distributable cash flow generated by the LP will be allocated to the General Partner. The cumulative IDR payment to the GP increases if the LP distribution rate is increased and/or more LP units are issued to raise capital. At first glance, the IDR burden would suggest that partnership agreements which incorporate such a structure would have a much higher burden to increase distributable cash flow in order to increase distributions to LP units.
In the midstream sector of over 60 MLPs, only five partnership agreements do not have an existing IDR clause. These units are Enterprise Product Partners (NYSE:EPD), Buckeye Partners LP (NYSE:BPL), MarkWest Energy Partners LP (NYSE:MWE), Magellan Midstream Partners (NYSE:MMP) and Genesis Energy LP (NYSE:GEL). Some investors expect units which have a proven management team, healthy assets and low leverage should produce higher distributable cash flow growth over units burdened with an IDR, particularly at the high split rate of 50%.
We considered such expectations and developed a peer group to compare midstream units for those that have IDRs against the minority group which do not have IDRs. The key comparative metrics are yield, coverage ratios, 3-year DCF CAGR growth and Trailing Twelve-Month returns, which would provide us with a snapshot to compare growth and total return performance.
The two charts show the comparison between IDR units and those without IDRs:
The short list of IDR free units consist of those with superior metrics, each with a history of steady distribution growth and strong returns for unitholders. This minority group of units offer yield vs. forecast distribution CAGRs that plot into the middle of the range available from the full list of midstream MLPs. The plot below of units indicate that both peer groups offer high CAGR growth rates and commensurate yields. On the chart below, the no-IDR units are indicated by circles.
IDR Impact on Growth Capital
Capital to fund growth projects is often raised from issuance of new LP units and debt. The cost of capital is a proportional rate of the LPs' interest paid on debt and the distribution yield on the units. If IDRs are applicable, the equity cost will include the IDR payments on the newly issued partnership units.
The effect of IDR payments depend on the current LP unit yield and the quarterly distribution rate compared to the IDR tier structure. Two examples are used to illustrate:
Access Midstream Partners LP (NYSE:ACMP) yields 3.9%, based on the current $0.56 quarterly distribution. ACMP's top 50% IDR split is paid on the distribution above $0.50625. Calculating IDR costs using all of the tier percentages results in an equity cost of capital for ACMP of 4.31%. The IDR payments add 0.41% for ACMP at the current distribution yield. Stated another way, for every $.01 that ACMP raises the distribution for LP units, the actual distributions it makes is $.02, with the other $.01 being paid to the GP. Access Midstream Partners is a high-growth MLP, and IDR costs have had a negligible effect on the unit's ability to finance its growth, in part due to the minimal difference between the distribution rate and the high split tier. As the distribution grows over time, this cost of capital will increase as the 50% split paid to the GP increases and the cumulative effect is realized.
Kinder Morgan Energy Partners LP (NYSE:KMP) yields 7% with the recent $1.36 distribution. The KMP 50% IDR split is on distributions above $0.23375 per quarter, subjecting $1.13 of the current quarterly distribution to the high split rate. The high distribution rate in relation to the top split rate make IDR payments a significant factor in the cost of equity capital for Kinder Morgan Partners.
If the market decides that an MLP should trade at a higher yield due to lower growth, coverage, or leverage concerns, the resulting decline in the unit price can disrupt the cycle of growth for the partnership. For example, KMP at $77 and a 7% yield must issue 17% more LP units to raise the same amount of capital than at a $90 unit price and under 6% yield. More importantly, distributions and IDRs must be paid on all of those additional units. If DCF estimates for a project were based on the $90 figure, the accretive DCF to increase the distribution rate will be lower if KMP ends up issuing units at the lower price, making it more challenging for the company to meets its distribution growth forecasts.
Factors such as a higher DCF coverage ratio - which allows the unit to fund growth without issuing more debt/equity - or a temporary waiver of IDR payments can help the LP balance the impact of a declining unit price when it needs to raise capital. However, if a higher cost of capital does lead to lower distribution growth, the growth cycle will slow, making it difficult for an MLP to find highly accretive projects which can propel distribution growth.
How are IDR Units able to maintain high growth rates?
The IDR model is most effective when the GP/Sponsor has inventory, or access to assets with long-term EBITDA cash flows which can generate a premium when dropped from a Sponsor C-Corp into an MLP structure. When this occurs, an independent auditor assigns a fair value to the assets being sold from the GP Sponsor to the LP. If necessary, the LP finances the purchase with available cash, revolver credit, debt and/or equity issuance. After such financing and maintenance capex expenses, the EBITDA cash flows are accretive to the LP unitholders, and the GP participates in that accretion with the IDR split. Therefore, the key relationship is between the fair value transaction price and implied cost of capital. These factors are balanced with the incentive to generate accretive cash flows which benefit both the GP and the LP.
Evidence suggests that a broad set of MLPs with IDRs have been, and are forecast to, generate double-digit DCF growth numbers, similar to units without IDRs. Motivated GPs who are able and willing to drop assets into the LP can often offset the IDR burden for a period of time. Therefore, when analyzing an LP for investment, one should understand the GP's assets, EBITDA inventory, and motivation for supporting the LP units to gain confidence in the long-term DCF growth rates, the dominant factor for total return.
Data and Charts provided by MLPData.com
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.