Master Limited partnerships, or MLPs, have traditionally been governed using the sponsored MLP governance model. Nevertheless, confusion over IDRs has given rise to new governance models. The new models eliminate the use of IDRs and more closely resemble traditional publicly traded corporations. A number of MLPs have recently formed or have restructured into meaningfully dissimilar governance models than the traditional sponsored MLP governance model. Enterprise Products Partners, L.P. (NYSE:EPD) did so in 2010, for example, essentially taking the general partnership's interests private. After my latest article regarding an in depth review of the pros and cons of Kinder Morgan Inc. (NYSE:KMI) restructuring to a model that resembles the model employed by LinnCo. (LNCO) and Linn (LINE), which are limited liability companies, I received numerous requests to give my two cents regarding whether it's a good idea for Kinder to restructure itself using the Enterprise Products Partners, L.P. model. The following is my response.
A polemical deconstruction of the sponsored MLP governance model
MLPs are complex and confusing investment vehicles. The governance models utilized by MLPs are much more intricate and multifaceted than simply owning stock in a corporation.
This has given rise to much confusion regarding the IDR (Incentive Distribution Rights) facet of the traditional sponsored governance model. The sponsored MLP Governance model is the governance model of choice presently for Kinder Morgan. Kinder Morgan, Inc. owns the general partner interest of Kinder Morgan Energy Partners, L.P. (NYSE:KMP) and El Paso Pipeline Partners, L.P. (NYSE:EPB), along with limited partner interests in KMP, Kinder Morgan Management, LLC (NYSE:KMR) and EPB.
It may seem by the recent tumult over IDRs the sponsored MLP governance model is out of the ordinary. Nonetheless, this couldn't be further from the truth. Presently, a majority of midstream MLPs operate under a sponsored MLP governance model. The provisions for the model are provided by the Delaware Revised Uniform Limited Partnership Act ("DRULPA").
The governance provisions for sponsored MLPs are comprised of copious contract requirements intended to align the interests of the common unitholders of the MLP limited partners, KMP and EPB, with the general partner KMI. The general partner is compensated by IDRs from the MLP's distributable cash flow. Kinder's IDR rate has reached the upper limit of 50% presently. In turn, KMI seeks out large midstream energy assets that the company feels will substantially cover the cost of capital and increase distributable cash flow. Sometimes assets are then dropped down to the MLPs.
Example drop down transaction
For instance, EPB recently announced the company will acquire from KMI 50% interest in Ruby Pipeline, 50% interest in Gulf LNG and 47.5% interest in Young Gas Storage. The transaction value is approximately $2 billion, including $1 billion of proportionate debt at Ruby and Gulf LNG, resulting in an equity purchase price of $972 million. This allows KMI to reduce outstanding debt while allowing the company to continue to participate in the cash flows through the limited partnership agreement.
The MLPs, KMP and EPB, are obligated to distribute 100% of "available cash" as prescribed within the partnership agreement. Available cash is defined as all cash on hand at the end of the quarter less reserves established for the operation of the MLP, compliance with applicable laws and any debt instruments or other agreements with the MLP. KMI, as the general partner, makes all the decisions while KMP and EPB unitholders basically have no say in the decision-making of the company. The benefit of this is a tax preferred status regarding distributions. Some investors believe this is onerous on the MLP unitholders pointing to the fact other entities such as EPD and Enterprise Products Holdings LLC, the current general partner of EPD, provide a better structure by effectively eliminating IDRs. In the following sections, we will take a look at the pros and cons of this model as compared to the traditional sponsored MLP governance model.
Enterprise Products Partners 2010 Restructuring Arrangements and current status overview
Enterprise Products Partners, L.P. acquired Enterprise GP Holdings LP, the owner of the general partner of Enterprise, in November of 2010 resulting in the cancellation of the IDRs and the conversion of the general partnership interests into units of the MLP. Ownership of the general partner interest was transferred to Enterprise's sponsor Enterprise Products Holdings LLC, a private company which continues to maintain sole control of EPD's general partnership interests giving the LLC control over the election of the board of directors. While the general partner's interest is no longer financially incentivized by IDRs, the LLC maintains the same governance rights as it held previously.
The arrangement closely mimics the characteristics of the sponsored MLP governance model by having the sponsor maintain firm control of governance in the form of a non-economic GP. Even so, the financial incentive structure no longer exists.
Nonetheless, the Board of Directors of the LLC and its affiliates still owe EPD and its unitholders fiduciary duties. This governance model appears to have several benefits. The benefits of this structure are a potentially lower cost of capital and a simple and more easily understood structure. EPD has one of the highest credit ratings in the MLP industry at - Baa1 / BBB+ and no IDRs.
The one huge catch
With the financial incentives of the IDRs removed, it is very prudent to keep abreast of the LLC and its affiliates' ownership interest in EPD, which currently stands at 36.4%. This 36.4% interest adequately aligns EPD's common unitholders and EBCO and its affiliates' interests. If EBCO takes any action that disadvantages EPD, it would basically be harming itself by virtue of its significant stake in the MLP. So this makes EBCO's ownership interest in EPD a very important metric. If there is a significant reduction in the ownership interest, this could be a huge red flag.
Kinder Morgan has delivered consistent annualized distribution growth for nearly 20 years. KMP's performance has 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. The company is doing an outstanding job of exceeding growth estimates and recently boosted guidance.
The sponsored governance model is not the exception, it is the rule. Only a handful of midstream energy companies operate in a different fashion. Furthermore, KMI's 50% IDRs do not appear unreasonable with KMI providing a substantial backlog of $14 billion and the IDRs are used specifically for this reason.
The symbiotic nature of the Sponsored or Traditional MLP governance model can be plainly seen. With Kinder Morgan currently enjoying a good credit rating, I see no reason for a change other than the fact the structure appears to be less investor-friendly due to confusion regarding the arrangements of the structure.
Kinder Morgan's Ace in the Hole
Kinder currently enjoys a good credit rating as it stands. If Kinder's credit rating is downgraded at some point in the future, it may be time to consider restructuring the company as EPD has done. If any sort of credit issues arise from the current structure, Kinder can reorganize at that time, effectively giving Kinder Morgan an Ace in the hole. Unwittingly or not, the brouhaha over the IDRs has created a tremendous buying opportunity in KMI shares as compared to EPD.
My conclusion is there is nothing out of the ordinary or wrong regarding the payment of IDRs or the sponsored MLP governance model that Kinder employs. Even so, I would layer in to any position to reduce risk.