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Avoid This Sneaky MLP Tax

When evaluating a master limited partnership (MLP), it is important to take note of the arrangement on incentive distribution rights (IDRs). Typically, an IDR agreement between an MLP and its sponsor (also known as the general partner, or GP) entitles the sponsor to a share of the distributions made by the partnership above a minimum threshold. This percentage typically increases once the distributions per unit reach agreed-upon levels, or tiers.

For example, PennTex Midstream Partners (NASDAQ: PTXP) went public just over a year ago. The minimum quarterly distribution was set at $0.2750 per unit. The IDR schedule is follows:

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What you will typically see following an IPO is that it doesn’t take too long for the distribution to reach a level that triggers incentive payments to the general partner.

Penntex came public during very difficult market conditions, and so far the quarterly distribution has only reached $0.2846/unit. So the sponsor is not receiving IDRs to this point. But once the distribution surpasses $0.3163/unit, the holders of the IDRs (which is split into two entities in PennTex’s case) will begin to extract 15% of its payouts above that level, going up to 25% and 50% above the higher tiers.

Of course this arrangement is hardly unusual in the MLP business. Over 80% of the publicly traded partnerships pay IDRs. The logic is that this tribute provides incentive for the GP to grow the affiliated partnership’s distribution as quickly as is practical.

I have to be honest, though. I loathe IDRs just like I loathe ATM fees. I understand the logic but have always been a little puzzled as to why the GP needs any extra incentive to expand a business that it already owns a stake in and, often, one it has promoted as a growth story to raise outside capital. I view IDRs as an escalating tax on limited partners.  

Eventually, the IDRs tend to increase the cost of capital and inhibit growth to an extent that the arrangement has to be reworked or abandoned entirely. In 2010, the largest MLP, Enterprise Products Partners LP (NYSE: EPD), eliminated them entirely in exchange for a big additional slug of LP units. Last year, EPD CEO Michael Creel highlighted the effect that the IDRs, if left in place, would have had on the partnership’s distributions:

“Enterprise would have paid more than $6 billion to its general partner under the IDR since the fourth quarter of 2010 and our distribution [coverage] this quarter would be 0.7 times instead of 1.3 times. And that assumes that we would have the same growth trajectory, the same cash distribution and the same credit ratings and that’s a big assumption.”

That’s pretty much the way I view IDRs. They siphon money from LP unitholders over time. All other things being equal, I prefer an MLP that doesn’t have to pay them. The problem is that, as noted above, most of them do. So we end up having to pay to play, or alternatively we can sometimes buy into the GP side of the business. There are now more than a dozen publicly traded GPs, and owning them allows an investor to profit disproportionately from growth of the affiliated partnership via the rising IDRs. There is always the risk that they could be eliminated or reduced, but this often happens on advantageous terms. The greater hazard is a stress-induced distribution cut by the affiliate.

My preference is to invest in those MLPs that have no IDRs, or at least limit that burden. A lot of the MLPs without IDRs tend to be the very aggressive and volatile upstream and downstream outfits. But there are a few exceptions.

In addition to EPD, large midstream MLPs without IDRs include Magellan Midstream Partners (NYSE: MMP), Buckeye Partners (NYSE: BPL), and Genesis Energy (NYSE: GEL). Somewhat less conservative than the midstreams but far less volatile than the upstream and downstream MLPs, Suburban Propane Partners (NYSE: SPH) is another option.      

Most of these MLPs are in fact in our portfolios at MLP Profits. The most recent addition to the portfolio among this group, Suburban Propane Partners, was added on Feb. 16 and has returned 52% since. Please consider subscribing for in-depth analysis of the entire MLP space.   

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

 


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