Here is my second in the series on the basics of MLPs. This post describes distributions and IDRs, what they are and how conventional MLPs are structured.
MLP Ownership and Distributions
MLPs generally have two classes of owners: the general partner (GP) and the limited partners (LPs). The GP is typically owned by a major natural resources company, an investment fund, the direct management of the MLP or is an entity owned by a combination of such parties. The GP may be structured as a private or publicly-traded corporation, an entity that is treated as a flow-through for tax purposes or some other entity.
Management / Governance
The entity that owns the GP typically controls operations and management of the MLP through an up to 2% equity interest in the MLP plus, in many cases, ownership of common and subordinated units. LPs own the remainder of the partnership, through ownership of common units, and have a limited role in the MLP’s operations and management.
MLP common and subordinated units represent an equity ownership interest in a partnership, generally providing limited voting rights and entitling the holder to a share of the company’s success through distributions and/or capital appreciation. Unlike stockholders of a corporation, common and subordinated unitholders do not elect directors annually and generally have the right to vote only on certain significant events, such as mergers, a sale of all or substantially all of the assets, liquidation, removal of the general partner or material amendments to the partnership agreement.
Cash Distribution Basics
MLPs are generally required by their limited partnership agreements to distribute a large percentage of their current operating cash flow. As a matter of policy, MLPs generally distribute substantially all of their cash on hand, less reserves established by their general partners, on a periodic basis (generally quarterly). Unlike real estate investment trusts (REITs), which are legislatively required to distribute at least 90% of their ordinary income in order to avoid corporate-level taxation, MLPs are not required by applicable tax law to distribute a certain percentage of their income to maintain their tax status.
MLPs are typically structured such that common units and GP interests have first priority to receive quarterly cash distributions up to an established minimum amount (“minimum quarterly distribution” or “MQD”). Common and GP interests also generally accrue arrearages in distributions to the extent the MQD is not paid. Once common and GP interests have been paid, subordinated units receive distributions of up to the MQD (subordinated units do not accrue arrearages). Distributable cash in excess of the MQD paid to both common and subordinated units is distributed to both common and subordinated units on a pro rata basis.
Incentive Distribution Rights
The GP is also generally eligible to receive incentive distributions (“incentive distribution rights” or “IDRs”) if the GP operates the business in a manner which results in distributions paid per common unit surpassing specified target levels. As the GP increases cash distributions to the LPs, the GP receives an increasingly higher percentage of the incremental cash distributions.
A common arrangement provides that the GP can reach a tier where it receives 50% of every incremental dollar paid to common and subordinated unitholders. These IDRs encourage the GP to streamline costs, increase growth capital expenditures and acquire assets in order to increase the MLP’s cash flow and raise the quarterly cash distribution in order to reach higher tiers. Such results are generally expected to benefit all security holders of the MLP. A typical structure for an MLP’s IDRs is shown below.
There is not one standard for MLPs in terms of how many IDR tiers an MLP has, what percentage the top tier is, and at what per unit distribution each level begins. However (at least with the midstream MLPs), from late 2005 forward (starting with WPZ), a convention was adopted by new MLPs to have IDR tiers as outlined below, and 15 total MLPs have IDR structures following that convention. Before that switch, there was a wide range of IDR levels relative to the MQD, but the most common pre-WPZ is listed below as well, and there are 8 MLPs with that tier convention.
IDR tiers and the resulting total cash flow that a GP receives each quarter is important to consider whenever evaluating MLPs for investment, because too much cash paid out to the GP can drag on the return of LPs. In an effort to combat the drag on returns and growth that IDRs can create, several MLPs chose not to have IDRs from the beginning (CPNO being the most vocal of those), to eliminate the GP through a consolidation transaction (like MWE, SPH and MMP have done), or to reduce the top tier of the IDRs to 25% from 50% once the MLP reaches the top tier (EPD, NS and TCLP are examples).
Look for more on IDRs and how they affect cost of capital and valuation in a later post.