With the possible exception of hedge funds, it’s hard to find a more attractive business model than being the general partner (GP) of a publicly traded master limited partnership (MLP). In return for putting up just 2% of the capital, you not only get to control all the management decisions of the partnership, you get paid to do it with lucrative incentive distribution rights (IDRs) that can grow to 50% of all funds distributed.
The partnership structure is attractive to investors because it eliminates corporate income taxes. Instead of paying taxes at a corporate level, MLPs pass through the gains and losses of the partnership to the unit holders in proportion to their share of their ownership to report on their own tax returns and avoids double taxation of dividends.
These payments arrive in the form of “distributions” which look like dividends are technically different. These are not reported on the unit holder’s taxes as dividends but rather on the K-1 tax form along with the owner’s share of any gains or losses in the partnership. Since depreciation is high in infrastructure based MLPs, the partnership will report a loss rather than a gain so the distributions become a return of capital rather than taxable income so no taxes are due until the investment is sold.. This combination of high yields and tax deferment makes MLPs attractive to retail investors to yield conscious investors.
So what is better than a high yield, tax–deferred investment in a limited partnership? Well how about owning the general partner instead. The GP gets the same pro-rata unit distribution on its 2% ownership of the MLP as the limited partners get, but much more importantly, it also gets an IDR payment, the secret sauce of MLP investing, for growing the MLP.
IDR’s are birthed in the founding prospectus of a MLP to motivate the general partner to grow the MLP by rewarding the GP annually with incentive payments over certain distribution thresholds. As these targets are reached, the GP receives an ever increasing percentage of the growth until eventually half of the incremental gain is committed to the GP by the IDR. If that doesn’t sound rich enough for the GP, it gets even better (or worse, if you are a limited partner). As the partnership sell more LP units to fund the purchase of more assets, the GP gets to collect IDR payments from an ever increasing number of units. While limited partners only gain when their distribution is increased, the GP gains not only by increasing the distribution per unit, but from the increasing the number of units as well.
Since IDRs are so valuable, most publically traded MLP’s are arranged to have one partnership that owns the business assets and a second partnership or C-Corp that owns the General Partner of the first MLP. This lets Wall Street separate the usually higher yielding, but slower growing distributions of the LP, from the lower yielding, but faster growing distributions of the GP.
The problem with IDR’s is that eventually, too much of a good thing can cook the golden goose Once 50% of all future distribution growth is allocated to the GP, it can be difficult to find accretive acquisitions to grow the LP. This past fall Kinder Morgan collapsed its limited partnerships back into a new C-Corp (KMI) to deal with just this problem. Other companies, such as Magellan Midstream have dealt with this by having the LP’s buy out the GP, but however it happens, the GP gets compensated for giving up the IDR.
By this time, it may have occurred to the reader that GP’s are leveraged investments to the LP and that leverage is the eight deadly sin. Yes, GPs are levered to the success of the limited partner’s MLP they manage, and furthermore purchasing the GP of a bad LP is certainly not going to turn out well. But I’m not sold that GP’s are inherently risky. In my opinion, the way to manage this risk isn’t to necessarily pick the “non-leveraged” LP over the “leveraged” GP, but to pick a safer MLP in the first place.
The MLP business model works best for stable, long-life assets under multi-year contracts. Unlike tax paying corporations, partnerships can’t save up capital for a rainy day as they are required to distribute their excess cash as it comes in. This is not a problem for a MLP with valuable interstate pipelines shipping product owned by others under long term contracts. Stable contracts, no commodity risk and high deprecation makes for an excellent MLP candidate. However, a MLP created from a single cyclical commodity chemical plant run on a series of short term contracts, the MLP structure is a recipe for disaster. Because, an MLP has no reserves to draw on, all it takes is for the weak MLP to suffer, is to need to raise fresh capital in a down cycle forcing it into unfavorable asset sales or highly dilutive secondary share offerings.
With the current decline in oil prices, many energy MLP’s are being sold off, some wisely but some indiscriminately since different MLPs are more affected by commodity prices than others. At the top rung in MLP quality in the energy space are long-haul interstate pipeline companies like Plains All America, PAA. Since these companies have stable prospects and no commodity exposure, they should not be affected in the long-run by changes in commodity prices.
In the middle tier are the midstream players that gather gas and oil from the wellhead and process the liquids out of the gas before sending it on to the interstate pipelines. These companies to get involved in a little hedging of the natural gas liquids in their processing facilities since they are often paid by taking a percentage of the profits for their processing, but this risk is relatively small. The larger risk for midstream players is more the general health and future prospects of the basins where they operate. Midstream operators in a high cost basin would not see much if any growth in a low oil price environment. Should an E&P with plans to drill 1000 wells in a basin, decide to scale back their plans after drilling just 25 wells, the midstream processing plant will never be fully loaded and will not achieve its initial targets. A smart operator is aware of this risk and manages plant expansion and minimum commitments accordingly, but in boom times people write silly contracts.
At the least desirable end of the risk profile are the oil and gas producing MLP’s. Because oil and gas production naturally declines with time, MLP’s which purchase oil and gas producing properties and fighting an uphill battle with the almighty decline curve to maintain their distributions. Oil producing MLPs must not only generate enough cash to pay their distributions but they must fund the purchase of new producing properties at the same time to ensure future cash generation as well. Companies like LINN energy try to remove the risk of commodity swings by hedging future oil production, and in the process they will give up the upside of higher prices in in exchange for a lower prices with less volatility. This hedging allows them to project future earnings for two to three years out, but it doesn’t protect them from long term declines in oil prices. Like California home buyers in the 90’s, these operators think prices only go up and trouble awaits in the odd year that it doesn’t.
Eagle Rock Partners (EROC) is an example of an oil and gas producing MLP that is mostly hedged through 2016. So it may be unfairly marked down in price if the current oil price drop is temporary what if oil prices are still low in 2016 when they need to write new hedges? If you know the answer to that question, you could make money on Eagle Rock, but if you could answer that, I’d bet you could make more money trading oil futures on the NYMEX.
Next up, I will review some MLP GPs to put on your watch list…