Saturday, November 15, 2014

The Structure of MLPs

The structure of Master Limited Partnerships can vary to some extent, but the basic structure is this: There exists a General Partner (GP), that consists of the management team, and Limited Partners (LPs), that contribute capital. Often the entity that holds the GP also holds some LP units.
Limited Partners contribute capital by buying units of the MLP. (They’re called units rather than shares.) These LP units can then be traded on an exchange. In return, the LPs receive distributions from the operations, which are like dividends.
The GP often has Incentive Distribution Rights (IDRs) that are set forth in the founding of the partnership. The IDRs give the GP a ton of incentive to raise the distribution over time for the units that the LPs hold. These partnerships, therefore, are specifically designed for distribution growth.
A typical IDR structure starts off with the GP receiving 2% of the cash flow from the MLP, while the LPs receive the other 98%. For example, the MLP may start off by paying $0.25 per quarter to each LP unit as a distribution, with the GP only receiving a small sum. There will then be pre-defined tiers for which the GP starts getting paid a bigger share. In this example, the structure may be that once the per-unit distributions reach $0.35, the GP begins receiving 15% of the cash flow above that point, with the LPs receiving the other 85%. And then if the distribution reaches $0.45, the GP begins receiving 25% of the cash flow above that point, with the LPs receiving the other 75%. And then finally, if the distribution reaches $0.55 or above, the GP receives a full 50% of the cash flow above that point, with the LPs receiving the other 50%.
It’s tiered, so management receives the pre-defined percentage of the total cash above that tier. So as an example, if the partnership reaches $0.39 in distributions per unit per quarter, that doesn’t mean the GP receives a full 15% of the cash. They receive 2% of the cash below the tier, and then 15% of the cash above $0.35. Kind of like tax brackets.
The purpose of IDRs is to align management interest with limited partner interest. As management increases the per-unit distributions to the LPs, their own share of the cash grows even more quickly. So while Limited Partners may not particularly enjoy giving a lot of money to the GP at later stages in the MLP, it would be hard for them to complain, because if they get to that point, they’ve likely outperformed most other investments. The agreement is designed to give incentive to the GP to raise quarterly distributions far beyond the final tier.
To grow the business, the General Partner will usually issue new units. This is the opposite of corporations, that if they are shareholder friendly, typically wish to avoid share dilution and even repurchase their own shares to reduce the number of shares outstanding. Since MLPs are tax-advantaged, however, if they can get more capital, they can generally provide good returns to all new and existing unitholders.

An Example

This can be demonstrated with a rather simple and clear example.
Suppose there exists an MLP that currently has 100 million units, and each unit costs $50 and pays out $3 in annual distributions for a 6% yield. The market capitalization of this MLP, therefore, is $5 billion, and it pays out $300 million in distributions per year out of the $330 million in total free cash flows that it generates.
The MLP is paying out most of its cash flow, and so there is little capital left to grow the business and the distribution.
However, management has a good growth opportunity: they can build a pipeline that connects from their network to a storage hub, and all of their research indicates that this will be a good investment. It will cost $2 billion to build, and will produce $300 million in annual cash flow that grows at least with inflation, and will have $100 million in annual capital expenditures and maintenance. In addition, they can finance part of the construction with $1 billion in debt at 5% interest, since the assets should produce very reliable cash flows. So for this investment, they’ll have to pay $1 billion in upfront costs, and they’ll receive $300 million in cash flows and have to pay $100 million for expenditures and maintenance and $50 million in interest, for a total remaining profitable cash flow of $150 million. This would be a 15% return on their $1 billion in upfront equity.
The MLP makes this investment by issuing 20 million new units at $50 per unit. So now, there are 120 million units, and the partnership is bringing in $480 in free cash flow (the original $330 million plus the new $150 million). Management calculates they can pay out $450 million as distributions, which divided up into 120 million units equals $3.75 per unit per year (paid quarterly), which is a 25% increase over the original distribution of $3. So they managed to pay higher distributions to more units. Pretty impressive.

Conclusion

That’s generally how MLPs grow. They continue to make new investments in the form of new construction or acquisitions funded by issuing units, and if management is good, they’ll make sure that the new investments that they issue new units for are beneficial to everyone.
In reality, the example would be a bit more complicated, because we’d have to factor in the incentive distribution rights to management. We can’t really expect a 6% distribution yield and continued 25% distribution growth, but it’s not unreasonable to expect mid-to-high single digit distribution yields and mid-to-high single digit distribution growth for total annual returns in the low double digits. As far as dividend stocks go, this is pretty good.
The main emphasis on MLPs is that their structure is beautiful for the general partner, and pretty good for the limited partners as well. The tax-advantaged structure allows for rapid new capital additions in the form of new units issued, and the IDRs of the general partner encourage this type of growth as much as possible.

This article was written by Dividend Monk. If you enjoyed this article, please subscribe to my feed [RSS]

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