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The benefits Master Limited Partnerships, or MLPs, offer to your portfolio are obvious: They provide income, they have a relatively low correlation to stocks and a tendency to outperform the S&P 500, all while maintaining beneficial tax treatment. On the other hand, the dangers may require some digging to find. One of the major factors that can impact your returns is the MLP's business structure. Although MLPs are publicly traded, they are structured as partnerships. For the most part, MLPs operate under the direction of a General Partner (GP) which, in many cases, owns a special class of equity in the MLP called General Partner Interest (GP Interest). This may sound innocent enough, but the General Partner Interest may entitle the GP to what are known as Incentive Distribution Rights, or IDRs.

IDRs are similar to performance fees for hedge funds. The managing GP receives an extra share of the profit for exceeding a certain measure of performance. Unlike hedge fund performance fees, IDRs only apply to distributions (dividends) and are based on a series of distribution targets instead of a benchmark rate or index. Some people consider this to be positive. They believe it will incent managers to increase distributable cash flow and align manager interests with investor interests. Disproportionate payments to the GP are irrelevant as long as the Limited Partners are receiving increased distributions as a result.

Others believe this to be negative. IDRs may constitute a moral hazard. The owners of IDRs receive a disproportionate benefit from outperformance while their downside risk is similar to that of investors. This may encourage risky behavior as the GP's payoffs are disproportionate to their risk. Instead, if the GP received distributions in line with their GP Interest, pro rata, they would receive the same potential benefits and risks as investors as a result of their performance. This may be considered a better alignment of interests between managers and investors than issuing IDRs.

To find out whether an MLP pays IDRs may take some detective work. It should be available in an MLP's annual 10-k report. For example, in the Energy Transfer Partners (NYSE:ETP) 10-k the following diagram can be found which neatly outlines the business structure.

Click to enlarge:

ETP Business Structure

As shown here, ETP's General Partner maintains a 1.5% GP Interest in ETP, however in most reports, a chart like this will not exist. Instead, a 10-k will have brief statements regarding IDRs, Incentive Distributions, General Partner distributions, etc. These statements can come in many forms. Looking at the ETP 10-k report again, we find the following excerpt in the section titled "Cash Distribution Policy."

Distributions of Available Cash from Operating Surplus

We are required to make distributions of Available Cash from operating surplus for any quarter in the following manner:

First, 100% to all Common and Class E Unitholders and the General Partner, in accordance with their percentage interests, until each Common Unit has received $0.25 per unit for such quarter (the "minimum quarterly distribution");

Second, 100% to all Common and Class E Unitholders and the General Partner, in accordance with their percentage interests, until each Common Unit has received $0.275 per unit for such quarter (the "first target cash distribution");

Third, 87% to all Common and Class E Unitholders and the General Partner, in accordance with their percentage interests, and 13% to the holders of Incentive Distribution Rights, pro rata, until each Common Unit has received at least $0.3175 per unit for such quarter (the "second target cash distribution");

Fourth, 77% to all Common and Class E Unitholders and the General Partner, in accordance with their percentage interests, and 23% to the holders of Incentive Distribution Rights, pro rata, until each Common Unit has received at least $0.4125 per unit for such quarter (the "third target cash distribution"); and

Fifth, thereafter, 52% to all Common and Class E Unitholders and the General Partner, in accordance with their percentage interests, and 48% to the holders of Incentive Distribution Rights, pro rata.

This is a common example of how IDRs are executed. Once the Limited Partners receive a certain level of distribution payment, anything above and beyond that amount is paid to the General Partner in greater proportion. In a sense, it functions similar to marginal tax rates. It should be noted that ETP's recent distribution payments have been 89 cents. This is more than twice the highest target distribution, above which, the holder of the IDRs (the GP) receives 48% of all distributed cash. This is in addition to distributions received from their 1.5% equity interest.

Another example of how payments to a General Partner can affect cash distribution can be found in the following statement from Kinder Morgan Energy Partners' (NYSE:KMP) 10-k Annual Report:

KMI and its consolidated subsidiaries owned... an approximate 12.4% interest in us... Including both its general and limited partner interests in us, at the 2011 distribution level, KMI received approximately 50% of all quarterly distributions of available cash from us.

KMP pays 50% of all distributions to 12.4% of the ownership. While there is no doubt that KMP is large, well-diversified, and well-managed, questions need to be raised whether this type of distribution policy is justified given its past performance and future prospects.

Ultimately, the decision as to whether the General Partners performance justifies the pay of IDRs is up to you, but with a little work, IDRs may still be avoided. According to the diagram of ETP's business structure, its GP is owned by Energy Transfer Equity (NYSE:ETE). ETE also owns a significant portion of the ETP common units, so if you like ETP's business, but aren't interested in paying the IDRs, perhaps you could buy ETE and be on the receiving end of those IDR payments. Alliance Holdings GP (NASDAQ:AHGP) and Alliance Resource Partners (NASDAQ:ARLP) have a similar relationship. AHGP owns the IDRs to ARLP.

Another way to avoid paying IDRs would be to select MLPs that don't issue them. While they are less common, there are still plenty to choose from, the largest of which is Enterprise Product Partners (NYSE:EPD). Still, it's important to remember that you're buying the underlying business. It makes no sense to purchase interest in a poor company because it does not issue IDRs. In the end, fundamentally sound businesses make the best investments.

Source: IDRs Can Threaten Your MLP Returns