Why master limited partnerships rely on external capital
Master limited partnerships are a specially structure entity, and they don’t pay corporate-level taxes. This tax benefit allows MLPs to be valued at a higher multiple on their before-tax cash flows and earnings power, which also helps lower the cost of capital for these entities. However, not every company is able to structure itself as an MLP. Master limited partnerships must meet certain requirements, such as operating in certain industries (including energy) and distributing a certain minimum amount of cash flow out to unitholders. The cash that MLPs distribute is generally slightly below their “distributable cash flow,” which is (in very broad terms), cash generated from normal operations, less interest, less maintenance capex (or money spent to maintain assets and keep them operating at a normal level). However, as MLPs distribute this cash out to unitholders, that leaves little cash to fund growth projects. So master limited partnerships often must raise cash through the capital markets—that is, issuing debt or equity to investors.
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As rates rise, this affects the cost of funding for MLPs. Let’s use an example of a company that has a project that costs $100 million and is expected to generate $10 million of cash every year. The company may wish to borrow $100 million to fund the project. Assuming it costs the company 5% every year in a “low-rate” environment, its yearly interest expense is $5 million. After the cost of funding the new project, the cash flow to the company is only $10 million – $5 million, or $5 million yearly. If interest rates were to rise to 8%, the interest expense would be $8 million yearly. Then the ultimate cash flow to the company would be $10 million – $8 million, or $2 million yearly. If rates rose past 10%, it might not even make sense for the company to pursue the project at that moment, at least if funded with all debt.
Because MLPs pay out most of their excess cash flow to unitholders through distributions, they rely more on external financing rather than internally generated cash flow to fund projects. In this way, they can be more sensitive to volatility in the capital markets than other companies.
Kinder Morgan Energy Partners (KMP) states in its 10-K:
“Adverse changes to the availability, terms and cost of capital, interest rates or our credit ratings could cause our cost of doing business to increase by limiting our access to capital, limiting our ability to pursue acquisition opportunities and reducing our cash flows. Our credit ratings may be impacted by our leverage, liquidity, credit profile and potential transactions. Also, disruptions and volatility in the global financial markets may lead to an increase in interest rates or a contraction in credit availability impacting our ability to finance our operations on favorable terms. A significant reduction in the availability of credit could materially and adversely affect our business, financial condition and results of operations… Consistent with the terms of our partnership agreement, we have distributed most of the cash generated by our operations. As a result, we have relied on external financing sources, including commercial borrowings and issuances of debt and equity securities, to fund our acquisition and growth capital expenditures. However, to the extent we are unable to continue to finance growth externally, our cash distribution policy will significantly impair our ability to grow. We may need new capital to finance these activities. Limitations on our access to capital, whether due to tightened capital markets, more expensive capital or otherwise, will impair our ability to execute this strategy.”