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The Importance of Incentive Distribution Rights for MLPs

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Overview of IDRs

Incentive distribution rights (or IDRs) determine the share of cash distribution paid to the general partner (or GP) for managing the operations of the MLPs. IDRs normally start with ~2% and may increase as the cash distribution increases.

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How IDRs work

Let’s look at a hypothetical situation that can help us to understand IDRs. Assume that the MLP declares a $4.00 distribution, so the LP receives $2.30 and the GP receives ($2.30 / 98%) * 2%, which comes to $0.046 per unit at Tier 1 of the distribution cycle.

From Tier 2, the incremental cash distribution will be split between LP and GP in a 85:15 ratio. At Tier 2, the LP receives $0.20 per unit and the GP receives $0.035 per unit of the incremental cash distribution. At this level LP receives $2.50 and the GP receives $0.081 per unit of the total cash distribution.

At Tier 3 the LP receives $0.50 per unit and the GP receives $0.099 per unit of the incremental cash distribution. At this level LP receives $3.00 and the GP receives $0.247 of the total cash distribution.

At Tier 4 the LP receives $1.00 per unit and the GP also receives $1.00 of the incremental cash distribution. At this level, LP receives $4.00 and the GP receives $1.247 per unit of the total cash distribution.

Total cash distribution is the sum of the LP share per unit, $4.00, and GP share per unit, $1.247, which comes to $5.247 per unit. LP unit holders receive 76.2% and GP unit holders receive 23.8% of the total cash distribution.

Assuming the share price of the MLP is $55.00, the distribution yield can be calculated as total distribution / share price (or $5.247 / $55.00), which comes to 9.5%. Distribution yield measures the total cash distribution as compared to the share price of the entity in percentage terms. From the above example, we can make out how GP share increases as the distribution increases and how it affects the whole MLP.

Energy Transfer Partners (ETP), Williams Partners (WPZ), Plains All American Pipeline (PAA), and Sunoco Logistics Partners (SXL) are among the MLPs that have a stable distribution yield. These MLPs have a combined weight of 23.71% in the Alerian MLP ETF (AMLP).

In the next part of the series we will discuss the pros and cons of IDRs.

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