Over the past few months, Kinder Morgan Energy Partners (NYSE:KMP) has been no stranger to controversy. The stock has been a battleground between bulls and bears with questions about its growth prospects, the distribution, cap-ex accounting, and its relationship with the General Partner ("GP"), Kinder Morgan Inc. (NYSE:KMI). This past week, there was a thought provoking article published in Pensions & Investments that questions the protections limited partners are afforded in Master Limited Partnerships ("MLP"). I recommend reading the viewpoint, which is available here. It is worth asking whether investors should own MLPs like KMP or avoid them because of structural flaws. I believe the answer is yes, MLPs can be wise investments, and will discuss the unique MLP structure as well as its problems and counterbalancing safeguards in this article.
At its core, an MLP is analogous to a hedge fund. Limited partners put up the equity, but the general partner manages the assets for a fee. In a hedge fund, investors give cash towards a partnership and someone like John Paulson manages the money. In an MLP, an investors buys units, like KMP, and the general partner, KMI, runs the partnership, by operating the pipelines and finding growth projects. There is concern that the general partner has been ignoring the interests of limited partners, thereby making MLPs like KMP risky investments.
A reason for this is a lack of fiduciary duty. Management of a typical corporation, say Bank of America (NYSE:BAC), owes shareholders a fiduciary duty. In other words, they must always and exclusively put shareholders' interest first. They cannot act in a way that betters themselves or a third party at the expense of shareholders. This provision protects shareholders' interests, and managers can be personally liable for breaching this duty. Now, it is important to note that fiduciary duty does not protect shareholders from honest, good faith mistakes. No individual is infallible, and so long as management believes, and has a rational basis for believing, it is acting in accordance with shareholders' interests, they are satisfying the fiduciary duty requirement. In a sense, fiduciary duty protects shareholders from a malicious management but not one that makes an honest make.
An MLP, though, is not a corporation; it is a partnership. The LP is just a collection of assets, but the GP makes the business decisions. However, most general partners have no fiduciary duty to limited partners. KMP states, "Our limited partnership agreement contains provisions that prohibit the limited partners from advancing claims arising from conduct by our general partner that might otherwise raise issues as to compliance with fiduciary duties or applicable law. For example, our limited partnership agreement permits the general partner of the partnership to make a number of decisions in its "sole discretion." This entitles the general partner to consider only the interests and factors it desires, and it has no duty or obligation to give any consideration to any interest of, or factors affecting, us, our affiliates or any limited partner."
At first glance, this appears very problematic as KMI has the legal ability to essentially act contrary to KMP's interest, and KMP unitholders have little if any recourse. Should this concern investors? To me, the answer is both "yes" and "no." Yes, investors should be concerned about weak governance, but this is true for every investment they make. Perhaps, MLPs require closer scrutiny than typical corporations. However, the concern is not great enough to permanently avoid KMP, and there is an important safeguard in place that essentially protects KMP's interests.
It is also worth noting that KMP is up 84% over the past 10 years, and it has grown its quarterly distribution from $0.71 to $1.38 during this time. Clearly, KMP investors have done well, and KMI has not massively defrauded them. Still, the fact the structure has not caused problems in the past is not proof that problems will not arise in the future. History provides context, which is important but not a be-all and end-all.
The safeguard is in how KMI is compensated for its work as GP. KMP pays Kinder Morgan incentive distribution rights ("IDR"), which is a proportion of incremental cash flow. This provides incentive for the GP to find growth projects, and it seems to be working well given the current $14 billion backlog of growth projects (financial and operating data available here). Going forward, KMI gets 50% of incremental cash flow, even though it does not help fund the projects. No doubt, this is a hefty sum. In a perfect world, I wish it were a lower percentage; I am sure most KMP holders feel the same. However, this arrangement has worked well, with KMP consistently growing the distribution thanks to a very expansionary GP.
KMI now gets 43% of KMP's distributable cash flow. As KMP can pay out more to investors, KMI gets paid more. Conversely if KMP faces problems and has to cut its distribution, KMI will get paid less. As such, its incentives are aligned with KMP investors. The better KMP investors do; the better KMI will do. While there is a weaker legal requirement than at a typical corporation, the IDR structure provides tremendous economic incentives for KMI to act in KMP's best interest.
Now, this IDR structure does have a potential pitfall. A GP may in theory expand the LP's asset base too quickly to grow the near term cash payout but leave the LP with an unsustainable debt burden. The LP would eventually need to issue a lot of equity to pay down the debt, crushing the value of LP units. KMI has maintained a disciplined approach with KMP funding growth projects 50% in equity and 50% in debt. If this balance was suddenly abandoned in favor of 80-100% debt funding, that would be a major red flag. However, so long as this ratio remains roughly in place, investors can be sure expansion activities are being done in a financially sustainable way.
As you can see, the MLP structure is a bit complicated as investors need to follow the actions of the general partner to understand the value of their limited partnership interest. Governance is an important issue that needs to followed and debated closely. While investors in KMP and other MLPS may lack some legal safeguards, the payment structure incentivizes GPs like KMI to act in a fashion that is profitable for LP investors. The MLP structure is not anti-investor, and there are no structural problems that make MLPs un-investable. MLPs can continue to play a critical role in your portfolio. In particular, KMP works well for income oriented investors with a solid 7.3% distribution yield. With this yield, KMP continues to work as an income investment.
Disclosure: I am long KMP. 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.