Saturday, November 22, 2014

What to Look for in a MLP

There are a few key areas where MLPs can be fairly attractive for individual investors alongside other investments like dividend stocks.
First, unless you’re a particularly interested and savvy investor, I’d propose sticking to fairly stable businesses. The fairly stable MLPs tend to be pipeline businesses and other very reliable cash-generating assets.
Second, there are three key areas for MLPs I look for. They are: MLPs on the low side of the IDR payouts, publicly traded General Partners, and MLPs with no General Partner.

1) MLPs on the Low Side of the IDR Payouts

As previously mentioned, the MLP typically starts out with very low Incentive Distribution Rights (IDRs) payments to the General Partner. This means that the cost of capital is low, and limited partners receive almost all of it. Over time, if management is good, the partnership will grow considerably and the distributions per unit will grow considerably. At this point, the GP is getting a big share of the total cash flows.
This can be somewhat problematic at this point, since future growth relies on continued issuance of new units for construction or acquisitions. If a considerable portion of the cash from these new investments goes to the GP, then it can be difficult to find investments that allow the MLP to raise the distribution for all Limited Partner units. This isn’t necessarily an insurmountable problem; there have been established and large MLPs that continue to make good investments for unitholders despite being on the high end of their IDR targets. But they may be an exception to the rule.
So when you’re investing in an MLP as a Limited Partner, make sure you’re aware of what the IDR agreement is, and where the distributions currently stand in relation to the target distributions. Investing in young MLPs means Limited Partners receive a big share of the cash, and there is plenty of incentive to the General Partner to grow the partnership and increase the distributions. These young MLPs can potentially produce a rather good rate of return for a number of years, and potentially a lot longer than that.

2) Publicly Traded General Partners

Sometimes, the General Partner is itself wrapped in a partnership structure and traded on an exchange. This means that investors can benefit from the growth of the General Partner and the IDRs. Investors in a General Partner can be on the receiving side of the IDRs rather than the paying side.
Astute readers have noticed two things by now:
1) The GP benefits when it raises distributions per unit, since they reach their IDR targets and start getting a bigger percentage of the total cash.
2) Since their IDR agreements allow the General Partner to take a percentage of the total cash flow, they also benefit when the partnership as a whole, issues more units and grows, since there will be more total cash flow, and they get a pre-defined percentage of total cash flow.
In other words, the General Partner benefits both in the sense that it gets a greater share of the total cash pie as it performs well, and also that it grows the size of the cash pie. The General Partner, therefore, wants to issue as many units as possible to grow the MLP as big as possible, while also ensuring that all of those investments allow them to grow the per-unit distributions to the Limited Partners, so that they can reach and surpass the highest tier of their IDR distribution agreements. This is why MLPs are so good at building infrastructure like wildfire: management benefits insanely from profitable growth and has tons of incentive to collect as much new capital for investment and growth as possible.
So the General Partner starts out receiving approximately 2% of a small MLP cash flow, and if they manage the partnership skillfully, they end up receiving perhaps 20% or 30% or more of a much, much larger MLP cash flow. The total returns can be rather incredible for the GP, and some of them are publicly traded.
These publicly traded GPs sometimes exist as independent investments, where investors receive distribution payments that hopefully grow strongly. Other times, the GP is held by a larger company, so the investor benefits from their wholly owned operations, as well as their GP interest in a partnership.
I find General Partners to be a great investment for the most part, because investors can generally expect significant distribution growth, and they benefit both from increased distributions and an increase in the number of LP units due to issues of new units, but they are not without drawbacks.
Firstly, there aren’t too many pure publicly traded GPs anymore, since a lot of them have been bought out (which can be good for the holders of those GPs, and for the potential of existing holders of GPs). So pickings are limited. There are still some, and above that, there are many companies that include a GP interest in with the rest of their assets.
Secondly, along with increased reward, comes increased risk. The limited partners have a fairly straightforward risk profile: their partnership generates cash, and they get some of it. If the partnership generates less cash, the distribution will likely have to be cut. But for a general partner, this can be more dramatic, because if the distribution is cut, it will likely fall lower in the IDR tier structure, and they’ll receive a smaller percentage of the now-smaller total cash flow until they can increase the distribution again. So in the event of a problem, the General Partner has more downside risk than the Limited Partners. They’re leveraged on the performance of the whole partnership; then things are good, they do great, but when things are bad, they do worse. This is partially mitigated by the aforementioned companies that hold their own assets as well as a GP interest in a partnership.

3) MLPs with no GP or Low IDR Caps

As previously mentioned, at high levels, the IDRs can sometimes be a limit on growth, since it basically increases the cost of capital and makes it more difficult to find investments that benefit both the GP and the LPs. Investments only make sense from the perspective of the Limited Partners if, even after IDR payouts to the GP, they can still raise LP distributions. The higher the incentive distribution payouts become, the harder this is to do.
MLPs typically solve this problem in one of three ways:
1) Management is excellent, and is able to continually find these investments.
2) The partnership buys out the General Partner. The GP benefits because they receive a good buyout, and LPs benefit because from this point forward, there are no Incentive Distribution Rights to pay out anymore, and so they have a much lower cost of capital for new investments to increase the partnership and the distributions.
3) The partnership solves this problem from the beginning, and caps IDR payouts to 25% of total capital rather than 50%. Up to 25% or so is rather sustainable; the GP benefits, but they never get so much that it hurts the partnership’s ability to find good investments.
Finding partnerships that either no longer have to pay any IDRs, or finding partnerships that only have to pay small IDR payments, can make for a fairly attractive investment.

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


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