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March 10, 2018

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Incentive Distribution Rights Revisited

More than once in the last month, I’ve been asked to review how incentive distribution rights (IDRs) works, and how they impact an MLP.  In the earliest days of the blog, I wrote some pieces on the basics of MLPs, including one on IDRs published in December 2009 that you can read here.

Unfortunately, not much has changed in the structure of MLP IDRs.  There has been little innovation in the structure and no other midstream MLP IPO since Copano in 2005 that has elected to go public without IDRs (not counting upstream MLPs or variable distribution MLPs).  We have had plenty of opportunities for innovation, considering the 78 MLP IPOs since that post in 2009.

Today, there are 54 MLPs with IDRs by my count, out of 85 MLPs that I track.  Among non-shipping midstream MLPs, just 42 have IDRs.  By market cap, those 54 MLPs represent approximately 43% of the MLP market and 23% of the Midstream market, as discussed in this week’s post.

IDR Math Revisited

My original post on IDRs showed the conventional tier set up, but to understand their impact, you need to see them in action.  Below are two charts based on a hypothetical MLP with standard IDR tiers that starts out at $1.00/unit distribution and grows that distribution to the 50% tier in 3 years, then grows 8% each year thereafter.

10 years into the MLP’s life, the G.P. is receiving over 30% of the MLP’s distributed cash flow.  The L.P. unitholders have realized strong growth in their distributions of 157% from IPO, but the G.P. has seen its cash flow grow by 5,875% from $2mm to almost $120mm.  That’s a great deal for the G.P., especially if they can structure a drop-down MLP that enables the creation of that return just by moving assets from one bucket they control to another.

How do IDRs Impact an MLP’s Ability to Grow?

The other thing to note when it comes to escalating G.P. payouts is they become a big burden on the MLP’s ability to grow cash flow per unit as time goes on.  The lack of retained cash drags on cash flow such that coverage becomes a serious problem.

In the charts below, I have set up a model for a pretend MLP with a standard IDR structure, $100mm in annual EBITDA and no debt.  That MLP invests $100mm in growth projects at 8x EBITDA multiple every year, funded 50/50 with debt and equity (at 5% yield), and grows its distribution by 5% annually.

What happens over time is growth in DCF/L.P. unit begins to fade and then turns negative, because 8x EBITDA returns are no longer able to provide sufficient return to cover the MLP’s growing cost of capital, and value is destroyed with each equity issuance and capital deployment.

If that MLP continues to deploy capital and grow distributions by 5%, eventually coverage falls well below 1.0x and the uncovered distribution payment and IDRs result in a downward spiral.

The ways to avoid such a spiral include: (1) not having IDRs at IPO (which we have seen is not an option at IPO), (2) eliminating IDRs along the way (hopefully in a manner that avoids a distribution reset), or (3) finding opportunities to deploy capital at increasingly high returns that exceed a constantly increasing cost of capital.

Many MLPs were able to pursue option 3 for many years when there was less competition for M&A and for infrastructure development, ready equity capital markets and declining cost of debt.

The midstream world has evolved, and the structure is evolving, but as generalist investors look to get involved in the sector, it makes sense to flag some IDR basics, even if IDRs eventually are destined to be eliminated across the space.

Hopefully, we are all on the same page that IDRs impair MLPs to the benefit of their GPs in an accelerating way as an MLP is successful in growing its distribution.  The success tax is too high to ensure future success.