In recent weeks, investor attention has increasingly focused on how master limited partnerships (MLPs) calculate their maintenance capital expenditures (capex). The interest in this seemingly minute detail was sparked by the Security and Exchange Commission’s (SEC’s) investigation into accounting practices at Linn Energy and an analyst research report suggesting that Kinder Morgan is underestimating its maintenance capex (and thereby overstating its distributable cash flow).

Though the focus on maintenance capex was initially prompted by controversies related to two MLPs in particular, the questions raised have significant meaning for investors in all MLPs. There are many issues but chief among them is the distinction between maintenance capex and growth capex. The former are expenses incurred for the purpose of sustaining operating or cash flow-generating capabilities, while the latter are expenses that serve to add productive capacity. The difference between these two types of expenses is ambiguous, complicated by the fact that maintenance capital is a non-GAAP measure lacking a clear definition.

Not a technicality

The difference between maintenance and growth capex is more than just an accounting technicality. Growth investments are typically financed with new debt and equity issuances while maintenance expenses are funded from distributed cash flow. Thus, the lower the maintenance expenses, the more cash that is available for payouts to unitholders.

As distributable cash flow (DCF) is the single most important metric underpinning MLP valuations, MLPs are theoretically incentivized to reduce their maintenance spending, perhaps to imprudent levels, or to reclassify maintenance expenses as growth expenses. By funding maintenance expenses via external sources rather than through DCF, an MLP could augment the cash available for payouts and thereby enhance its overall valuation.

The problem with this is that over the long-term, the new capital that is raised for the stated purpose of funding growth investments would also need to fund ventures that sustain but do not actually grow cash flows. This might remain unclear to investors until later on when expected distribution growth fails to materialize and as the partnership shows declining returns and significantly higher debt to EBITDA levels.

The fall-out from the SEC’s investigation into Linn Energy suggests that the possibility of overestimating maintenance expenditures is not just a theoretical concern. As a result of the investigation, Linn Energy bowed to SEC pressure, revised its accounting practices and will no longer employ estimates for maintenance capital to determine the cash available for distributions. The partnership will use a new metric, which it is calling “discretionary reductions for a portion of oil and natural gas development costs,” or DRPONGDC.

Linn acknowledges that if it were to have limited its total capex in 2012 to DRPONGDC, it would have been unable even to maintain production levels on its reserves, let alone grow them. Given that its pro form a 2102 DRPONGDC figure is the same as the number it previously used for its estimate for its 2012 maintenance capital needs, the company made a tacit admission that prior maintenance disclosures were too low. Analysts estimate that under the revised model, Linn’s payouts would have been 15% lower during the past three years.

While the situation with Linn Energy underscored the need for investor vigilance regarding MLP maintenance capex, the Kinder Morgan matter raised more questions than conclusions. In an analyst report, Kinder was called a mere “house of cards” that will “eventually collapse” due to several issues, principal of which was the amount of money that the partnership allocated to maintaining the pipeline assets that it acquired from El Paso.

Kinder Morgan responds

El Paso had spent $499 million (or $354 million depending on what is included in the calculations) in maintenance capital on the assets in 2011, whereas Kinder Morgan was budgeting that it would only need to spend $132 million to maintain those pipelines in 2013.

Was Kinder Morgan underestimating its maintenance requirements and hence overstating its distributable cash flow, similar to Linn Energy? In response to the questions, Kinder’s management team hosted a one-hour conference call and provided very granular details regarding how the partnership differs from El Paso in how it conceives of and allocates maintenance versus expansion capital, addressing the $367 million variance.

Unfortunately, there is no clear way to ascertain from public financial documents whether an MLP is appropriately accounting for its maintenance capital needs. Investors may look at maintenance capex as a percentage of either EBITDA or depreciation and amortization for one gauge and anomalies on this metric from one MLP to another could be scrutinized. But this has limited usefulness due to the wide variations among MLPs in their assets’ age, condition, size and location.

While outside auditors will review MLPs’ GAAP financial statements, the most important metric for MLP valuation is DCF, whose calculation includes items that are not universally defined or even verifiable. Going forward, we can expect more questions to arise on the subjectivity inherent in this and other non-GAAP measures with investors seeking to probe the soundness of MLP distributions and their articulated growth rates.