IDRs In Moderation

In January, equity research analysts at Tudor, Pickering, Holt & Co. Securities Inc. noted that Kinder Morgan Inc. (KMI) chairman Rich Kinder bought some $500 million more shares of KMI in November. "We'll have what he's having," they quipped.

KMI is the general partner (GP) of Kinder Morgan Energy Partners LP (KMP), one of the largest U.S. master limited partnerships (MLP). It's one of several examples of GP-MLP relationships that investors don't mind and, often, don't understand—except that they make money.

At one point in explaining KMP's distribution change-up for 2012, which is from a paid basis to a declared basis, Rich Kinder said in a 2011 year-end results conference call, "If that doesn't confuse you, I don't know what will. But at any rate, it's a very positive story and exceeded what we promised you in the IPO (initial public offering) about 11 months ago."

Here's the positive story: "Back when we did the IPO (in February 2011), we anticipated that we would have cash available to pay dividends for the year 2011 of $820 million and then we would use that to pay $1.16 in dividends. In fact, on a paid basis, we had $835 million in cash available for dividends and we paid $1.18."

For 2012, he expects KMI to pay dividends of $1.35 a share, a 13% increase from 2011. "If you look at it on a paid basis, our anticipated dividend for 2012 would be $1.30, which is 12% above the 2011 budgeted amount."

Meanwhile, some 98% of KMI's cash comes from distributions from KMP, "which is the driving force in the Kinder Morgan story" and, until KMI closes its acquisition of El Paso Corp., it is the only Kinder Morgan story. KMP paid $4.61 in distributions in 2011, up 5% from 2010.

However, Hinds Howard, who manages portfolios of MLP investments for individuals and institutions, has been investing in MLPs since 1995 and blogs as "MLP Guy," does understand all of this, including why investors in MLPs don't mind that some of their potential distribution-income growth goes to the GP in the form of IDRs or incentive distribution rights.

"The MLP will IPO with IDRs to a GP because they don't get credit at the IPO for not having IDRs. During the first two years of the public MLP, those IDRs aren't dragging on cash flow. It takes a while for an MLP to build up enough cash flow to hit the higher IDR tiers—up to 50%. The IDRs start at 2% and then they grow," says Howard, managing partner at MLP-focused, Austin, Texas-based adviser Guzman Investment Strategies.

"So, on Day One, the investment bankers will tell the MLP's management team—the GP—there's no reason for you to get rid of these IDRs because you're not going to get any more value at the IPO for it. You might as well just hold onto the IDRs and, later on, if it becomes an issue, you can always have the MLP buy them from you.

"Almost all of the past 20 or so midstream MLPs that have gone public have GPs with IDRs in their structure."

In 2004, a midstream MLP went public without a GP and its accompanying IDR obligations. In this case, Copano Energy came out as an LLC with a message to the IPO market: Its cost of capital would be lower than a GP-run MLP.

Howard says, "I don't think they've gotten much credit over the years for doing that. Copano has been successful, but I don't see them getting much preference from investors than MLPs that have GPs with IDRs."

In fact, investors want more shares in GPs and units of MLPs. "It's a way to invest alongside someone as successful as Rich Kinder," Howard notes.

The flexible GP

A native Texan, Howard made his way to the Northeast U.S. financial sector for undergraduate school at Boston University and grad school at Babson College. He found his way soon to Lehman Brothers in its investment-banking division and then to its Lehman Brothers MLP Partners, a hedge fund that was within Lehman's private-equity unit. At press time, he was returning to Texas—specifically, to launch the Austin office of Guzman.

The IDR method of incenting a general partner's effort in making a subsidiary MLP successful is evolving—particularly as each entity's need changes—Howard notes.

"IDRs are a promote—a preferential payment—to encourage the GP to grow the underlying MLP's distributions. That incentive is a good thing early on, and it certainly works, but what happens is that it works too well. You have a situation then where, after years of sustained distribution growth, the general-partner IDRs are 50% of each marginal distribution dollar paid to the MLP investors, and 40%-plus of the total cash distributed."

That can make for a greater drag on the MLP's cash flow, reducing returns to MLP unitholders and, as a result, makes the MLP's prospect for return on capital less with each bolt-on acquisition it considers.

"It forces the MLP to bid less for an asset than an MLP with no IDRs. In other words, mature MLPs that are paying out large percentages of their distributions to their general partner have a higher cost of capital—all else being equal—than MLPs with no IDRs."

GPs confronted with this have taken different paths to solving toward having an MLP that can continue to make competitive bids for acquisitions. Tactics have included reducing the IDR the GP may earn, temporarily reducing the IDR or having the MLP buy the GP's IDRs, thus eliminating the IDRs.

Enterprise Products Partners LP, which is the largest MLP, reduced its GP's maximum IDR earnings in 2002 from 50% to 25%. "Several others have reduced their top distribution tier, including Nustar (Energy LP) and most recently Sunoco Logistics (Partners LP)," Howard notes.

Meanwhile, Kinder Morgan Inc. has taken a temporary reduction in its IDR take to make a transaction work for its MLP.

IDR elimination

Some general partners have eliminated their IDRs altogether—via having the MLP buy them. Those include Buckeye Partners LP, Magellan Midstream Partners LP, Penn Virginia Resource Partners LP, Natural Resource Partners LP and Inergy LP. Howard adds, "Often this is done when the GP is a public company."

While investor perception from a cursory look may be that the IDR structure is on its way out, careful review shows that it's as strong as ever among IPOs of midstream MLPs, while used less often in the E&P MLP space—that is, oil and gas exploration and production companies.

"These are more likely to not have IDRs. The largest E&P MLP, Linn Energy LLC, has no IDRs and didn't from the start," Howard notes.

The difference in business model is most apparent when these MLPs or LLCs are in the market for bolt-on assets. For example, while midstream MLPs compete with virtually only each other for assets on the market—and have similar IDR structures—the E&P MLPs are competing with each other as well as with traditional C-corp E&Ps, which can outspend their cash flow to make deals and drill assets.

"There are a few LLCs that are E&P MLPs—with Pioneer Southwest (Energy Partners LP) being the biggest. The E&P space is more varied than the midstream space in terms of structure, but IDRs are less common."

For example, private-equity-backed E&P MLPs include QR Energy LP, which went public in 2010, and Memorial Production Partners LP, which went public a few months ago. "These and others have IDRs that go up to 25% or they'll have special management-incentive units."

Performance

So, are midstream MLP investors finding more value in units of the GP than of the MLP? It seems that they are. "Public GPs have outperformed MLPs handily over the last five years. That is the benefit derived from understanding the nature of GP cash flows," explains Howard.

And, on their face, the purpose of investing in one or the other can be made different when it comes to the investor's tax preference.

Mark Maki, president of Enbridge Energy Management LLC (EEQ), which runs Enbridge Energy Partners LP (EEP), said, when reporting the company's 2011 year-end results, that EEQ "is a little bit different way of investing (directly) in Enbridge Energy Partners, if you don't want the (K-1) complexities that occasionally come with a partnership. It's not that hard for those who have TurboTax or go to a tax professional, but it is a little bit different than investing in your traditional C-corp."

Instead of getting a cash distribution and an annual 1099, EEQ shareholders get a distribution of additional shares and an annual K-1. "There are only two structures like this in the MLP space—ours, and Kinder Morgan has the other," Maki notes. "But this is a way for you to invest in EEP and, provided you meet the holding-period requirements, you can cash in those dividends and receive capital gains treatment for them as you monetize your shares. Both methods—the advantage of the partnership structure and the EEQ—are a tax-effective way to get a good yield."

So has the demise of IDRs in the midstream MLP space been greatly exaggerated? "I think so," Howard says. "It is true that some mature MLPs have taken their IDRs off the table, but I think that, if they went public today, they would still go public with IDRs.

"I don't think IDRs would go away because investors refused to buy MLPs that had IDRs in them. I just don't think that, at the IPO, people are focused on this. It's not going to impact them for several years. I do think that management teams would withdraw the IDRs if they saw the business model struggling.

"You might see more midstream MLPs go out like Copano did. But right now, MLPs are able to go out and buy assets and build plants and systems at returns that are high enough to justify having the IDRs."

Howard notes, "MLP general partners have outperformed consistently in recent years. The value of the general partner interest—and IDRs, in particular—seems to be continually undervalued, and can even be hidden in the shadow of a larger company that has other assets, as was the case with Sunoco (Inc.), El Paso (Corp.), Williams (Cos.) et al. before those companies spun off other parts of their businesses."

With such an ongoing dearth in price-appreciation and income-producing equities in the public markets—while many non-energy industries remain sideways—the MLPs remain popular, he concludes. "Yes, people are not unhappy with MLPs and the yields they're getting. It's still a very attractive asset class.