The big news in the midstream sector the past week was Williams’ (NYSE: WMB) announcement that it would buy out its MLP affiliate Williams Partners (NYSE: WPZ) in an all-stock deal at an 18% premium to WPZ’s closing price immediately prior.

This is a clone of the merger deal in which Kinder Morgan (NYSE: KMI) absorbed its two MLPs last year. Like Kinder, Williams will get to exchange partnership units that had been yielding more than 7% for shares yielding in the 4% range.

Also as with Kinder, the Williams bid provides it with a stepped up tax basis, minimizing taxes for years to come at the expense of the bought out MLP’s limited partners, who will incur a tax liability on their entire realized gain once the deal closes.

Both deals were driven by the rising cost of capital for the MLP affiliate, saddled with stubbornly high yields as growth slowed. That might have been in part because investors knew that a large chunk of the MLP’s incremental cash flow would be siphoned off by the sponsor’s incentive distribution rights.

Payments to Williams accounted for 44% of the total distributable cash flow at Williams Partners during the most recent quarter. Payments to Kinder Morgan consumed 46% of the cash flow at Kinder Morgan Partners just before that merger.

As the industry considers who else could use a merger to jettison incentive distribution rights that have grown onerous, the most obvious candidate is the Energy Transfer complex, where following Energy Transfer Partners’ (NYSE: ETP) merger with Regency Energy Partners the merged MLP just paid 39% of its quarterly cash flow to Energy Transfer Equity (NYSE: ETE) for ETE’s 2% general partner interest and incentive distribution rights.


Source: Energy Transfer Equity presentation, 2/24/15

The difference between Kinder Morgan and Williams on the one hand and Energy Transfer on the other is that the Energy Transfer family on the whole is still growing plenty fast enough to sustain the lopsided incentives. Despite their toll, ETP still managed to increase its quarterly distribution nearly 9% year-over-year recently. And with ETE’s own payout surging 37% annually even before the partnership deploys a $2 billion buyback, founder, CEO and leading unitholder Kelcy Warren is making way too much money to call this ballgame.

Instead, ETE keeps offering ETP short-term relief in exchange for much more lucrative longer-term concessions. Recently, the subsidiary partnership won some breathing room by selling to its parent the bulk of its own incentive distribution rights from Sunoco Logistics (NYSE: SXL). It may soon repeat that trick with IDRs backed by Sunoco’s (NYSE: SUN) filling stations.

But mergers and acquisitions by affiliates are ETE’s real bread and butter, because these cause the affiliates to issue more equity, often increasing their total IDR burden in the process as was the case in the ETP/Regency merger.

“It is not a good thing for an MLP to be our size with their family and pretty much all of the family members without the correct combination of M&A and organic growth,” Warren said on a recent conference call. And all I could think of was Warren force feeding “family members” so as to make foie gras from their livers.

If that’s a disturbing image, so is the concept of incentive distribution rights, used to quietly funnel an ever growing proportion of an MLP’s cash flow to its sponsor. The sponsor, aka the general partner, makes the decisions on investments and acquisitions that risk limited partners’ capital while guaranteeing itself a distributions boost. And the executives making the decisions are inevitably heavily invested in the sponsor’s equity.

It’s an ethically dubious scheme notwithstanding all the small-print disclosures, with terrible optics and great abuse potential.

In its first-quarter results, Energy Transfer Partners reported net income attributable to partners of $281 million. But common unitholders’ interest in that came to a loss of $48 million, because all of net income and then some was promptly passed on to ETE. That means ETP’s limited partners were paid their distribution entirely from amortization, which while a noncash cost is still a real one, because amortized assets will eventually need to be replaced.

It’s tough to work up too much indignation over an MLP with a 7% yield and a payout growing almost 9% annually, even if there’s financial engineering involved. On the whole, the Energy Transfer family offers an unmatched combination of scale and growth, no matter how skewed in ETE’s favor. And as we’ve seen with Kinder Morgan and now with Williams, when the IDRs do finally turn into too much of a drag, the resolution needn’t be a painful one.

What’s a little painful already is watching a brilliant strategist like Warren play what amounts to a shell game with the H units, the I units and all the other gimmicks that conceal the severe long-term tilt of the arrangements in favor of ETE at the expense of ETP.   

He’ll eventually tire of this. But maybe not until he gets much richer.