Many MLPs have an agreement between the General Partner and Limited Partners that determines how the total percentage of cash distributions will be allocated between the GP and LP unitholders. In some cases, there is a mechanism called the “incentive distribution right” or IDR that allows the GP to receive an incrementally larger percentage of distributions as the amount distributed increases. For example, for Targa Resources (NGLS) the IDRs are structured as in the table above.
To better demonstrate how IDRs work, let us use a fictional MLP with the following distribution schedule and assume that there are 98 LP units and 2 GP units outstanding (as economic ownership between the LP and GP is usually split 98%/2%). Let us assume that this quarter, the declared LP distribution is $5.00.
As the distribution escalates into higher tiers, more and more incremental cash is going to pay the GP unitholders. This affects the “cost of equity”, or how much return unitholders demand. If the price of an LP unit of our fictional MLP is $250/unit, and the current distribution is $5.00/unit as shown above, it seems that the cost of equity is ($5.00 * 4) / $250 or 8% (we multiply by 4 to annualize the quarterly distribution). However, the total amount of cash paid was actually $541.96 over 98 LP units and 2 GP units, so $5.42 was required for every unit. The adjusted cost of equity for the fictional MLP is actually ($5.42 * 4) / $250 or 8.7%.
Not all MLPs have IDRs. For example, MarkWest Energy (MWE), Genesis Energy (GEL), and Enterprise Products Partners (EPD) do not have IDRs. In some cases, management chose to restructure the companies as to reduce the equity cost of capital.
So, what exactly do IDRs mean for the MLP investor? Let’s say an MLP has the IDR structure, has reached the higher tier splits, and would like to grow its distributions to LP unitholders by 5%. The IDR structure means that the MLP must grow its distributable cash flow by more than 5%, because the GP owners will be taking a disproportionate amount of the incremental cash flow growth. That is, if an MLP announces that it expects distributable cash flow growth of 5% for a period, it does not necessarily mean that distributions will grow at the same rate. Before buying an MLP stock, an investor may want to first research the IDR structure of the stock. This information can be found in company filings such as the prospectus supplement for new equity issuance. Additionally, investors should be aware that most of the companies in the Alerian MLP ETF (AMLP) have IDRs in their structure.