Seven Partnerships with Appealing Incentive Distribution Rights to Consider

For investors looking for fairly safe high yields, Master Limited Partnerships can potentially be a good choice. They offer fairly high distribution yields that are typically well-supported by cash flows from stable toll-booth type businesses. Since most of the cash flow is paid out as distributions, growth usually comes from issuing new units. This dilutes unitholder ownership but if the numbers work out, it adds value to all parties involved.

One of the primary aspects of an MLP is the Incentive Distribution Rights (IDRs) payout that the partnership pays to the General Partner (GP). The thing that makes MLPs particularly appealing for dividend investors, is that the whole structure is centered around the distribution payout, rather than allowing the payout to be an optional use of cash like in a typical corporation. Put simply, IDRs are structured as follows: the general partner is entitled to a percentage of the total cash flow of the partnership, and this percentage is based on the current size of their quarterly distribution payout to limited partners. So if management does a good job of growing the per-unit value of the partnership (and correspondingly the per-unit distribution to limited partners) over time, then the holders of the general partner benefit even more, but everyone should be pleased with substantial returns.

A potential problem arises, however, if those incentive distribution payouts get too large. Many MLPs IDR agreements allow the payout to the general partner to approach 50% of total cash flow. If the payout gets quite high, it typically means that both the limited partners and the holders of the general partner have done quite nicely in terms of returns up to this point (since these payouts were explicitly determined based on quarterly distribution growth), but going forward, the general partner has a lot more value to look forward to than the limited partners.

This is because the effective cost of capital becomes so high. Since the partnership has to issue new units and debt in order to make acquisitions or grow organically, and upwards of 30+% or more of the free operating cash can go to the general partner due to IDRs at later stages, it ends up leaving little money for distribution growth for limited partners. The general partner still benefits, however, because their payouts grow both when they raise the quarterly distribution to limited partners and when they increase the total number of partnership units (and more specifically, the total size of the partnership cash flows). In the early stage of a partnership, it doesn’t directly benefit the GP to increase the number of units, because they get only at small percentage of total cash flow anyway. But once they are entitled to such a large percentage of the total cash flow of the partnership, then their cash flow can grow primarily from increasing the number of units and correspondingly, the total cash flows of the partnership. Limited partner unit distribution growth can slow or stall.

There are, however, several ways to invest in MLPs and avoid this problem. Presented below is a solid but non-exhaustive list of seven partnership investments that put investors on the right side of the IDRs.

Energy Transfer Equity (ETE)

The most straightforward way of avoiding problematic IDRs is to be on the receiving side of them rather than the paying side of them, which means owning a stake in a General Partner. This list, therefore, begins with 4 different publicly traded general partners, starting with Energy Transfer Equity. Energy Transfer Equity (ETE) owns the general partners and IDRs of both Energy Transfer Partners (ETP) and Regency Energy Partners (RGP). As a whole, ETE and its partnerships constitute one of the largest partnerships in the U.S., and they own natural gas pipeline systems across much of the United States.

Energy Transfer Equity also represents a good example of a partnership that has run into issues due to IDRs. ETP has been unable to grow its quarterly distribution for a few years now, while the general partner, ETE, has been able to grow its own quarterly distribution. The downside to general partners is that their distribution yields are not typically as high as those of limited partners, but the total yield + growth tends to be higher. ETE currently has a 6.23% yield.

My analysis of ETE is a bit dated and could use an update, but if you’re interested in learning more about general partners or IDRs, this ETE analysis provides a far more quantitative overview of how general partners benefit disproportionally after a certain point: Energy Transfer Equity Analysis

Brookfield Asset Management (BAM)

Brookfield Asset Management owns IDRs to a few partnerships, with exposure to real estate, renewable energy, and global infrastructure assets. Further, their payments from IDRs are set to max out at 25% rather than 50%, so they should never run into the issue of being weighed down in heavy cost of capital due to IDR payouts, and they’re on the appealing side of the IDRs anyway (the receiving side). They also receive lucrative management fees that scale in a similar fashion to their IDRs. BAM unfortunately offers the lowest yield on this list, at under 2%, but I believe that perhaps due in part to the highly complex structure of the partnership, they’re currently attractively priced.

Kinder Morgan Inc. (KMI)

Kinder Morgan Inc is the general partner of Kinder Morgan Energy Partners (KMP). It’s structured as a corporation, so investors can get MLP exposure without the associated tax complexity that typically comes with owning an MLP. The yield is modest, at only around 3.5%, but the dividend growth rate should exceed the growth rate of KMP. KMP, however, is a solid counter-example of a partnership that despite reaching high levels of IDR payouts, continues to be able to modestly increase the distribution to the limited partners.

Oneok, Inc. (OKE)

Oneok holds numerous investments, and one of them is a stake in the Oneok Partners LP (OKS). The business gathers, processes, stores, transports, and distributes natural gas and natural gas liquids around the country. Interestingly, Oneok provides some diversification alongside other partnerships, because while partnerships tend to be centralized around the Gulf of Mexico, Oneok’s primary infrastructure hub is farther north in Oklahoma and Kansas, and stretches around the country from the Gulf, to the Great Lakes, to Canada. While OKS provides a 4.56% yield, OKE currently provides only a 2.89% yield, albeit with greater growth.

Brookfield Infrastructure Partners (BIP)

Owning general partners isn’t the only way around the IDR problem. Brookfield Asset Management, which was previously described, is structured slightly differently than many other partnerships. Most relevant for this discussion is that their total allowance of the cash flows from IDRs maxes out at 25% rather than 50%. This means in practice, their payout will not exceed the upper-teens or the low-20s in terms of total percentage of partnership cash flows, rather than the 30+% that MLPs can get to. BAM receives IDRs from multiple partnerships, and one of those is Brookfield Infrastructure Partners (BIP). The partnership owns a diversified set of assets on multiple continents, including coal terminals and railroads in Australia, timberlands in North America, shipping ports in Europe, electric transmission lines in Chile, and a number of other assets around the world including natural gas pipelines. Personally, I’d look for dips below $30 to snag units with a 5+% yield.

My full analysis of the partnership is available here: Brookfield Infrastructure Partners Analysis

Buckeye Partners (BPL)

The third way here to avoid being on the wrong side of high IDR payouts is to own partnerships that no longer have to pay IDRs. Buckeye bought out its general partner a couple of years ago, and no longer has any IDR payouts to pay. This lowers the effective cost of capital for the limited partners, and allows distributions to grow more quickly. Buckeye currently offers the highest yield on this list, with a 7.35% yield, and was able to raise distributions every quarter straight through the financial crisis and recession, but currently doesn’t cover the distributions as strongly with cash flow as many others on this list.

Enterprise Products Partners (EPD)

Enterprise Products Partners is another large partnership that bought out its general partner and cancelled its IDRs. No longer burdened by these payments, EPD can give more cash to unitholders. The partnership currently offers a 4.86% distribution yield, and has raised the distribution for more than 30 consecutive quarters. EPD has 21,000+ miles of natural gas pipelines, 17,000+ miles of NGL and petrochemical pipelines, 6,000+ miles of crude oil pipelines, 190 million barrels worth of liquids storage capacity, 14 billion cubic feet of natural gas storage capacity, 24 natural gas processing plants, 20 NGL and propylene fractionation facilities, and 6 offshore hub platforms.

I published a report on EPD earlier this week, and it can be found here: Enterprise Products Partners Analysis

Full Disclosure: I am long ETE and BIP at the time of this writing.
You can see my portfolio here.

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