Since 1981, Master Limited Partnerships (MLPs) have provided an effective method for energy companies to generate private investment. MLPs are a type of business organization which acts as a publicly traded limited partnership with two classes of partners: General Partners (GPs) and Limited Partners (LPs). Under this structure, GPs are responsible for the day to day management of the MLP's operations while LPs are investors who provide the capital to help finance those operations. MLPs are advantageous because they offer the tax benefits of a partnership (can offer savings of more than $0.25 per dollar of income) with the liquidity of a publicly traded company. They are extremely popular in the energy industry because due to the long term service contracts common in the industry these businesses can offer attractive income yields which investors seeking safe high yield investments in a low interest rate environment often find very attractive.
An extremely common characteristic of MLPs in the energy industry are the establishment of Incentive Distribution Rights (IDRs). The easiest way to think of these is as a bonus to the GPs in a limited partnership. They are structured to increase the share in incremental distrubatable cash flows the MLP generates which goes to the GPs. IDRs are meant to incentivize the GPs to run the business effectively and efficiently and to increase distributions to the LPs. When properly structured, these can be powerful tools to align the interests of the managers and owners of the business, however all too often IDRs are structured to favor GPs at the cost of the limited partners. The problem lies in the fact that they are often structured in tiers starting at 2% and climbing to levels as high as 50%. At the lower levels, IDRs often do align GP and LP interests, but as they climb, GPs are incentivized to take on projects to increase cash flows (and in turn their own payouts) which are in the end harmful to LPs.
A strong case study which perfectly illustrates this point is the structure of IDRs for the MLP Kinder Morgan Energy Partners (KM). KM's breakdown of capital provided is 98% by the LPs and only 2% by the GPs. This would lead one to believe that the LPs would lay claim to the vast majority of the cash flows. Even relenting for the fact that GPs should be offered incentives to effectively run the business, it is hard to fathom the LPs claiming less than 85% of the distributable cash flows. However, this is not the case due to the structure of the IDRs. KM's IDRs are structured in the common tiered set up which gives the GP an increasing share of the total cash as distributions per share increase. The lowest tier for KM is 2%, but the tiers rapidly increase with the top tier of 50% phasing in right around $1.00 per share in annual distributions, which is quite low. This puts the LPs for KM at an extreme disadvantage. At the 50% tier, despite putting up 98% of the capital, the LP is only claiming half of the marginal cash flow projects generate. This means while at the highest tier, on a project which requires a $100 investment (for which the LPs would be contributing $98) which generates $5 of annual income, LPs would only receive $2.50, a 2.5% ROI, which hardly covers the cost of capital. The GPs ROI on the same project, 125%. Despite clearly not being a project which is beneficial for LPs, the GPs would be incentivized to invest in it anyway.
As mentioned before, IDRs can be a powerful tool to incentivize GPs to effectively run the business which undoubtedly benefits LPs. Much like many other compensation package structures however, when IDRs are structured in a way which unfairly skews the benefits in the interests of GPs, often times it is the LPs who pay the biggest price. To properly align GP and LP interests, IDRs must be kept at lower levels. When levels are under 20%, GP and LP's interests seem to be properly aligned. The IDR offers the GPs a strong enough incentive to run the business to the best of their ability, but doesn't skew compensation distributions so greatly that LPs are put at an extreme disadvantage. As levels increase a strong moral hazard is created. As evidenced by KM, GPs will have an incentive to invest in projects which are not in the LP's best interest. Optimally structured IDRs will prevent this from happening. In future blog posts, we will explore the best way to structure IDRs within MLPs and the governance necessary to ensure proper structure.
Sources Used:
https://www.scribd.com/document/47275190/Kinder-Morgan-Summary-Analysis
http://www.investopedia.com/terms/m/mlp.asp
http://www.investopedia.com/terms/i/incentive-distribution-rights.asp
An extremely common characteristic of MLPs in the energy industry are the establishment of Incentive Distribution Rights (IDRs). The easiest way to think of these is as a bonus to the GPs in a limited partnership. They are structured to increase the share in incremental distrubatable cash flows the MLP generates which goes to the GPs. IDRs are meant to incentivize the GPs to run the business effectively and efficiently and to increase distributions to the LPs. When properly structured, these can be powerful tools to align the interests of the managers and owners of the business, however all too often IDRs are structured to favor GPs at the cost of the limited partners. The problem lies in the fact that they are often structured in tiers starting at 2% and climbing to levels as high as 50%. At the lower levels, IDRs often do align GP and LP interests, but as they climb, GPs are incentivized to take on projects to increase cash flows (and in turn their own payouts) which are in the end harmful to LPs.
A strong case study which perfectly illustrates this point is the structure of IDRs for the MLP Kinder Morgan Energy Partners (KM). KM's breakdown of capital provided is 98% by the LPs and only 2% by the GPs. This would lead one to believe that the LPs would lay claim to the vast majority of the cash flows. Even relenting for the fact that GPs should be offered incentives to effectively run the business, it is hard to fathom the LPs claiming less than 85% of the distributable cash flows. However, this is not the case due to the structure of the IDRs. KM's IDRs are structured in the common tiered set up which gives the GP an increasing share of the total cash as distributions per share increase. The lowest tier for KM is 2%, but the tiers rapidly increase with the top tier of 50% phasing in right around $1.00 per share in annual distributions, which is quite low. This puts the LPs for KM at an extreme disadvantage. At the 50% tier, despite putting up 98% of the capital, the LP is only claiming half of the marginal cash flow projects generate. This means while at the highest tier, on a project which requires a $100 investment (for which the LPs would be contributing $98) which generates $5 of annual income, LPs would only receive $2.50, a 2.5% ROI, which hardly covers the cost of capital. The GPs ROI on the same project, 125%. Despite clearly not being a project which is beneficial for LPs, the GPs would be incentivized to invest in it anyway.
As mentioned before, IDRs can be a powerful tool to incentivize GPs to effectively run the business which undoubtedly benefits LPs. Much like many other compensation package structures however, when IDRs are structured in a way which unfairly skews the benefits in the interests of GPs, often times it is the LPs who pay the biggest price. To properly align GP and LP interests, IDRs must be kept at lower levels. When levels are under 20%, GP and LP's interests seem to be properly aligned. The IDR offers the GPs a strong enough incentive to run the business to the best of their ability, but doesn't skew compensation distributions so greatly that LPs are put at an extreme disadvantage. As levels increase a strong moral hazard is created. As evidenced by KM, GPs will have an incentive to invest in projects which are not in the LP's best interest. Optimally structured IDRs will prevent this from happening. In future blog posts, we will explore the best way to structure IDRs within MLPs and the governance necessary to ensure proper structure.
Sources Used:
https://www.scribd.com/document/47275190/Kinder-Morgan-Summary-Analysis
http://www.investopedia.com/terms/m/mlp.asp
http://www.investopedia.com/terms/i/incentive-distribution-rights.asp
You are correct in your statement that incentive distribution rights (IDRs) are a powerful tool to urge general partners (GP) to run the business effectively and generate positive cash flows, which undoubtedly benefits limited partner (LP) unitholders. However, I politely disagree with your position that this structure poorly aligns with LP interests and only benefits the GP. Typically, a master limited partnership (MLP) comes to the market with a set of producing assets. The entity is cash flow positive from day one of the venture. The GP developed these assets through debt offerings, equity issuances or cash investments over the years prior to the MLP creation. The LP unitholders are buying an equity interest in these developed assets, with usually 98% of the equity sold to the market, not the enterprise value. The LP does not bear responsibility to 98% of the total capital of the MLP and therefore does not justify a strong percentage of cash distributions through the life of the MLP.
ReplyDeleteMLPs are very debt intensive financial structures so while the GP has a 2% equity issuance it also bares the existing and future debt obligations. The incentive distributions rights provide a financing vehicle for the GP to be rewarded for sound business practices and growth of assets through profitability sharing. As free cash flows increase, cash distributions increase. I emphasized “free cash flows” to demonstrate that project investments must be cash flow positive to enable increased distributions. The GP must satisfy all business obligations, including debt service, before distributing cash distributions to equity unitholders. This means that the GP is incentivized to pursue positive NPV projects or accretive acquisitions for the MLP, which benefits LP unitholders in the long run as their distributions continue to grow above their initial distribution targets through good business decisions, albeit a lower payout percentage.
Now once the GP reaches the 50% / 50% IDR threshold, the MLP structure does face difficulties in continuing to achieve ample cash distribution growth for the GP and LP as both share an equal distribution. For example, it is very difficult to achieve a 20% growth rate year-over-year for a 10% / 10% split in cash distributions. However, the IDRs do not create poor decision making as a result, but rather a realization that the MLP is in a mature stage where rapid growth is hard to attain. At this stage the MLP should restructure or cap the IDRs at a level that is viewed favorably by LP unitholders. This has been done successfully for the following companies after reaching high IDR splits:
• TC Pipelines
• Magellan Midstream Partners
• Buckeye Partners
• Enterprise Product Partners
• Genesis Energy
It is a great analysis overall. IDRs are definitely an important means in the energy industry to get private investment. This is in a sector which is plagued with getting hold of great initial capital investment with a significant risk of returns. You are right in stating that the 50% threshold for GPs does sound excessive, especially in KM’s case which has produced such a skewed distribution of benefits in favor of the GPs. There is a flaw in incentivizing cash flow and not profits as can be seen for KM. It has caused the GPs to invest in bad projects and pocket the marginal cash flows. It is interesting to note that Kinder Morgan began by purchasing a general partnership interest in the Enron Liquids Pipeline, which is almost poetic considering the fact that Enron is the biggest corporate accounting offender in the Energy industry.
ReplyDeleteHowever, I also agree with Christopher that you make the GPs sound very draconian. LPs are not material participants, therefore, they cannot control the company’s daily operation or make legally binding decisions. They are compensated with their limited liability. Also, they do have some authority. Some states even allow LPs to vote on the partnership structure, remove GPs and sell the company’s assets. There will always be a tradeoff in carrying limited liability with less powers. The GPs are bound to satisfying business debts and even liable to legal proceedings. Also, the primary motivation for IDRs is to increase distributions to the LPs. So, it is fulfilling that purpose.
It will be interesting to see how you address the moral hazard created by higher levels of IDR. Would you recommend changes in the tier structure, or capping the percentage split in cash distributions? You have mentioned a 20% level. How did you come at that percentage? Also, what do you mean by the governance required to ensure a proper structure?
I am fascinated by the above discussion, and having read the Kinder Morgan source and Christopher’s response, I am doing my best to assess the validity of both arguments. I believe that the topic in Ronnie’s post is an interesting question worth analysis and seeks to identify optimal incentive distribution configurations for given arrangements of master limited partnerships. On the other hand, Christopher’s post enlightened me that MLPs first come to the market as a cash flow positive entity and that LPs in the arrangement are buying equity interest and not exposed to the debt and other liabilities of the GP. There seems to be an agreeance that as 50%/50% IDR levels are reached between the GP and LP that the attractiveness of a venture diminishes for the LP as their capital could be best allocated elsewhere. I have no knowledge on how quickly Kinger Morgan IDRs move toward this ratio, and if it is not long enough for the MLP to truly reach a mature stage then the validity of Ronnie’s post increases.
ReplyDeleteFor context, Kinder Morgan is one of the largest names in petroleum product transportation in the United States with 55% of its $7.7 billion in earnings before depreciation and amortization coming from natural gas pipelines. I agree that in general MLP IDR’s structured to benefit the GP generally do not lead to bad decision making, but the question I have becomes weather this practice is sustainable in all industries. The paper described Kinder Morgan’s business structure as nefarious and comparable to a Ponzi scheme. Perhaps this is not a conscious attempt but is the result of MLPs attempting to retain growth in the volatile, finite petroleum distribution business. In that sense, Kinder Morgan needs to continue growing in a swim or sink scenario.
The company has lots of growth on the horizon with the majority of the $12 billion projects going to natural gas pipelines and an LNG export terminal. They have a 49% partner in the LNG project and 20 years of contracts with Royal Dutch Shell guaranteeing “cash flow.” Are these net present value positive projects or do the cash flows enable the MLP to continue with current IDR structures while kicking the restructuring of the business model further down the road. Is it necessary for large infrastructure development firms to take on this structure so that projects with large capital requirements are able to be financed without a large NPV? Or perhaps this process is unsustainable and causes companies and institutions to push for project developments where there is not a true market need in some sort of nefarious fashion? I have no knowledge of how Kinder Morgan has restructured or capped IDRs in the past, but your team’s future analysis in the topic could seek to understand how these business agreements vary across industries (different between pipeline and E&P companies).
Source:
https://www.fool.com/investing/2017/03/31/how-kinder-morgan-inc-makes-most-of-its-money.aspx
Great start. I look forward to learning about your improvements to the structure that KMI started. One suggestion is to tell us something about how prevalent this structure is. Have newer MLPs been moving away from it? Also, I’m not sure that you have the IDR structure just right. I’ll elaborate in class. Specifically, you may be missing the fact that the total distribution given to each unit holder is a (complex) *average* of the various tiers. No unit holder literally gets the marginal distribution. For example, if distributions per unit are $2, and the threshold is $1, and the sharing is 98% / 2% for 0 to $1, and 50/50 for $1 and above, then the LP unit holder gets 0.98 + 0.50 = $1.48. Your example suggests otherwise, I think? You should also remember that when the MLP issues new units, they issue them into a market. Naturally, the market price reflects where the current distribution is, relative to the tiering scheme. The units will trade for less, the more the GP is getting, relative to being father away from when the GP’s distributions are deep in the money. So the new unit holders go into their investments with eyes wide open. The existing unit holders? They bought the units years ago, and realized what the cash flows look like. Of course, they wouldn’t give their 98% of the money if the cash flows weren’t worth it. Is everything copasetic, therefore? Not necessarily. The GP has the incentive to make investments that increase the size of distributions, not investments that have NPV>0. So there is a very real sense in which existing unit holders can get “diluted.” This problem is different than a “problem” with a complex cash-flow sharing scheme. The latter isn’t necessarily problematic as long as everyone understands the cash flows and they priced “fairly,” a big assumption, perhaps, but different than overpaying for new projects in order to increase GP distributions.
ReplyDeleteGrading Rubric (badly formatted because comments don’t allow formatting)
Possible “grades:” Excellent (E), Very Good (VG), Good (G), Could be Better(CBB)
Takes a clear position: VG
Substantiates the position: G
Informs the casual reader: VG
Clarity/quality of exposition: VG