- A tremendous amount of controversy and criticism regarding the structure of Kinder Morgan's general partner and limited partners’ relationship have reached a fever pitch.
- The issue some believe is the general partner, KMI, uses incentive distribution rights, or IDRs, to unfairly siphon distributable cash flow from the company’s limited partner.
- The numbers tell a different story. KMI has identified capital expansion opportunities for KMP which have increased distributions from $70 million to over $4 billion over the last 16 years.
I recently penned a piece regarding the fact I believe Kinder Morgan's general partner Kinder Morgan Inc. (NYSE:KMI) is an excellent investment for dividend investors. In the comments section of the article there was a barrage of comments related to what is perceived to be an unfair relationship between KMI, the general partner, and the limited partner, Kinder Morgan Energy Partners (NYSE:KMP), which is an MLP. At the center of the controversy are KMI's 50% incentive distribution rights, or IDRs, which are in essence payments that an MLP issues to its general partner once it hits previously agreed upon performance standards. Many believe these IDRs are unfair and represent a usurious cost of capital for the MLP. In the following sections I will do my best to discern realty from repartee and deconstruct the good, the bad and the ugly truth regarding the ensuing Kinder Morgan IDR drama.
The Good, The Bad, and The Ugly Truth Regarding IDRs
The complex, and as some describe, unfair nature of the IDRs has been a topic of debate for quite some time with regards to Kinder Morgan. The following is deconstruction of the dilemma from my perspective.
The IDR structure has provided proven results for decades
I see the relationship between the general partner and the limited partners as highly symbiotic. My thesis is underpinned by the stellar growth of distributable cash flow and dividend yields for decades. Time is the ultimate arbiter of truth. KMI and KMP have coexisted under this arrangement for nearly two decades without issue. Kinder Morgan has delivered consistent annualized distribution growth for nearly 20 years. KMP's performance is unquestionably been outstanding. KMP currently has a highly attractive total return yield of nearly 7% and a target distribution growth rate of 5% for the next three years. This is directly supported by organic expansion projects of nearly $14 billion expected to come on line over the next 5 years.
Furthermore, Kinder Morgan is now the largest midstream energy infrastructure company and the fourth-largest energy company in the world as of this writing. If there were some type of impropriety going on, I submit it would have reared its ugly head by now.
KMI has deferred IDR payments for major acquisitions
IDRs payments made by the limited partner to the general partner can overly burden the limited partner, in this case KMP, when it comes to major acquisitions. The problem is with a major acquisition is it takes time for the synergistic benefits of the transaction to take hold. This effectively means the augmented profits and distributable cash flows may not be seen for some time to come. This makes the cost of capital for the IDR payment from KMP to KMI appear extremely burdensome for KMP unitholders in the near term. For instance, take the Copano Energy purchase for $5 billion. KMI announced that it would waive IDRs on a sliding scale over time. Effectively, KMI will waive $120 million in IDRs in both 2014 and 2015. In 2016 the IDR payment reduction will amount to $110 million with $5 million in reductions per year after that. So it would seem KMI is steadfastly making the appropriate modifications to support growth. A change in this policy with regard to a new acquisition would be a huge red flag for KMP unitholders. CFO Kimberly Dang recently stated:
"In certain circumstances, the GP has demonstrated a willingness to give back. And we've done acquisitions where we have a ramp in the cash flow. And so, we have a very supportive GP. But all I can say is the structure is working today. If it did - if we've come to a point sometime in the future when it's not working - then we will look at ways to solve that and consider other options."
MLP unitholders left holding the bag
The notion that KMP unitholders have been left holding the bag was recently spotlighted by the filing of a lawsuit. KMP investor Jon Slotoroff initiated a class action suit against KMI. The underlying argument in the suit is that KMI, as general partner, allocated too little of KMP's capital spending to maintenance capital which reduces distributable cash flow, and too much to expansion capital, which typically is funded through equity issuance and debt. As a result, KMI set distribution rates to KMP unitholders too high and earned billions in IDRs for itself. Also, the equity and debt issues unfairly burdens and dilutes the holdings of KMP limited partner investors.
Slotoroff states in a lawsuit KMI is taking almost 50% of the allocations leaving KMP essentially holding the bag with regard to maintenance of the pipeline systems. The complaint states:
"Kinder Morgan Inc. has used its control over Kinder Morgan Energy Partners to allocate cash flow for distributions in bad faith, taking $3.2 billion improperly since 2010, and causing the operating entity to incur unnecessary debt. Kinder Morgan Inc. has ensured that, quarter after quarter, hundreds of millions of dollars exit Kinder Morgan Energy Partners and are thereafter not available for needed maintenance."
Case in point, the complaint refers to a 2004 spill of diesel fuel which promoted the U.S. Department of Transportation to order safety improvements which increased the MLP's maintenance costs.
KMI's head of media relations, Larry Pierce, addressed the complaint by stating:
"While we don't typically comment on pending litigation, we believe the claims in this lawsuit are without merit and the company plans to defend itself vigorously."
The potential dilution of KMP unitholders down the road
Some suggest the relationship between KMI and KMP may lead to KMI unfairly burdening KMP unitholders with unmanageable liabilities by making asset purchases vis-à-vis debt. This would effectively load KMP's balance sheet up with debt, while KMI shareholders siphon half the distributable cash flow from the assets off for themselves. At some point, hypothetically, KMP will have to issue equity to relieve itself of the debt encumbrance, in essence, diluting unitholders in the MLP greatly. Not good news. Yet, we haven't seen evidence of anything like this occurring as of yet.
Kinder Morgan's structure does leave KMI, the general partner, in the driver's seat, of this I have no doubt. The KMP 10-K states various downsides regarding the GP/LP structure, yet I submit this is the primary one to be concerned with. The 10-K states:
"The interests of KMI may differ from our interests and the interests of our unitholders. KMI indirectly owns all of the common stock of our general partner and elects all of its directors. Our general partner owns all of KMR's voting shares and elects all of its directors. Furthermore, some of KMR's and our general partner's directors and officers are also directors and officers of KMI and its other subsidiaries, including EPB, and have fiduciary duties to manage the businesses of KMI and its other subsidiaries in a manner that may not be in the best interests of our unitholders. KMI has a number of interests that differ from the interests of our unitholders. As a result, there is a risk that important business decisions will not be made in the best interests of our unitholders."
This skews the risk/reward ratio in favor of the general partner in my eyes. What further underpins my position on this is the fact that, coincidentally, a majority of Richard Kinder's stake is concentrated in KMI. According to the 10-Ks Kinder owns less than 1% of KMP, Kinder Morgan Management, LLC (NYSE:KMR) and El Paso Pipeline Partners, L.P. (NYSE:EPB). On the other hand, Kinder owns a 23.3% stake in KMI according to the annual proxy statement. So it would seem there must be some reason for this lopsided allocation and inquiring minds would like to know want that is.
The Bottom Line
The fact is KMP is up 84% over the past 10 years and grown its quarterly distribution from $0.71 to $1.38 over this period, enriching the MLP's unitholders greatly. Furthermore, the IDR split is not onerous at 50-50 between KMI and KMP. KMI has shown itself to be very flexible with regard to waiving IDR payments at the onset of large acquisitions in order to lighten the initial burden for KMP until profitability gains traction. Finally, the company has the potential for remarkable organic growth due to a profound revitalization of North American oil and gas production. This fact is evidenced by the $14 billion backlog of future projects due to be implemented within the next five years.
In conclusion, I think everything is in order at present and don't see a reason to be concerned regarding the IDR relationship. Nonetheless, keep watch for red flags and it will be interesting to see how the lawsuit progresses. If you are ultimately still concerned, sell out of KMP and buy KMI or sell out completely and buy a different MLP. It's as simple as that, problem solved.