Every master limited partnership (MLP) is a combination of two companies, a limited partner (LP) and a general partner (GP). When you purchase an MLP, you’re typically buying a stake in the LP, and as an LP unitholder, you’re entitled to a share of the cash flows generated by the MLP.

The GP is best thought of as part manager and part parent. The GP performs the day-to-day management of the assets and makes major business decisions such as acquisitions or the construction of new pipeline projects.

The best GPs also take steps to foster the growth of the MLP. In some cases this involves asset drop-downs, deals where the ultimate parent of the GP sells assets into the MLP. Typically drop-down transactions are priced so that they’re immediately accretive to cash flows and allow the LP to increase its distributions. GPs can also help with the financing of acquisitions, direct financial support during periods of market weakness or simply by providing management-level expertise.

As you might imagine, the GP doesn’t perform these functions out of the goodness of its heart. The exact relationship between GP and LP is governed by the partnership agreement–the basic document drawn up when the MLP is formed–which also sets out the fees the LP pays to the GP in exchange for its services.

The most typical structure for these fees is what’s known as incentive distribution rights (IDR) paid every quarter by the LP to the owners of the GP. Remember that IDRs are based on the size of the quarterly distribution made to LP unitholders. IDRs are tiered such that the GP gets a larger percentage cut of cash flows when the LP distribution increases; the GP only gets paid when the public unitholders benefit in the form of higher quarterly distributions.

As you might imagine, the GP/LP relationship is among the most important fundamental considerations when investing in an MLP. One of the most common questions we receive from subscribers is to explain exactly how much the GP is charging LP unitholders to manage the business. To answer this question, it’s important to understand how a tier-structured IDR system works.

The best way to explain is with an example. Let’s use Conservative Portfolio holding Sunoco Logistics Partners LP (NYSE: SXL), a refined-products pipeline MLP, as an example. The company has a four-tiered structure for calculating IDRs based on the distributions paid to LP holders:

• Tier 1: 98 percent to SXL holders and 2 percent to the GP up to a quarterly distribution of $0.50 per unit;
• Tier 2: 85 percent to SXL holders and 15 percent to the GP up to a quarterly distribution of $0.575;
• Tier 3: 63 percent to SXL holders and 37 percent to the GP up to a quarterly distribution of $1.5825; and
• Tier 4: 50 percent to SXL holders and 50 percent to the GP for all quarterly distributions above $1.5825

In mid-May, Sunoco Logistics paid a quarterly distribution of $1.115 to unitholders. Thus, Sunoco Logistics Partners is in the third tier of the distribution structure outlined above. Once the MLP exceeds a quarterly payout of $1.5825 it will be in the highest tier of IDRs–in industry parlance this is the high splits.

This structure causes significant confusion. Let’s alleviate these concerns.

Most important, just because Sunoco Logistics is in the third tier of its IDR structure does not mean that it’s paying out 37 percent of cash flows to the GP as an IDR fee. Second, the high splits concept is widely misunderstood. You cannot accurately gauge the GP’s fees by looking solely at the maximum high-splits percentage in the IDR tier structure. 

The only way to gauge the true IDR fees is to calculate what the GP received in the most recent quarter. Here’s how the calculation works for Sunoco Logistics:

• Tier 1: The first 50 cents paid to the LP unitholder represents 98 percent of the actual total distribution. That means that the total Tier 1 payout is 51.02 cents (50 divided by 0.98). This consists of 50 cents for ETP holders and a little over 1 cent for Sunoco Logistics GP.
• Tier 2: The next 7.5 cents (57.5 cents minus 50 cents) paid to the LP is 85 percent of the total distribution. That means the total payout is 8.82 cents (7.5 divided by 0.85). That’s 7.5 cents to the LP holders and about 1.32 cents to the GP.
• Tier 3: The next $1.0075 ($1.5825 minus 57.5 cents) paid to the LP is 63 percent of the total distribution. However, in the case of Sunoco Logistics, the distribution of $1.115 is below the maximum for this tier. Therefore, 54 cents ($1.115 minus 57.5 cents) is paid out. That means the total payout is 85.714 cents (54 divided by 0.63)–54 cents to the LP and 31.714 cents to the GP.
• Tier 4: The final tier only comes into play when Sunoco Logistic’s distribution is above $1.5825. So, in this case there is no payout under the high splits.

Summing all of these figures shows that Sunoco Logistics’ unitholders received $1.115 per unit in mid-May and the partnership’s GP received about $0.3405 per unit. Sunoco Logistics paid out a total of $1.4556, and the GP took a fee equal to around 23.4 percent of that total payout ($0.3405 divided by $1.4556). If you look at the maximum high split, it does not provide a meaningful measure of the GP’s take; you must look carefully inside the IDR structure.

The structure of IDRs is the key to determining distribution growth potential and sustainability. In the case of Sunoco Logistics, imagine a situation where the MLP is able to grow its distributable cash flow by $0.50 per unit, and the GP decides to pay out $0.40 as additional distributions and hold back $0.10 as a reserve cushion.

Given the structure of Sunoco Logistics’ IDRs, a $0.40 increase in total distributions does not mean a $0.40 increase in the payout to unitholders. Rather, the MLP could boost its payout to LP holders by about $0.25 from the current $1.115 per unit to $1.365. The remainder of roughly 15 cents would go to the GP as an additional IDR.

In other words, as an MLP moves through its tier structure it becomes more difficult for the partnership to generate growth in LP distributions. A larger percentage of each dollar of distributable cash flow would go to the GP.

Some GPs have taken steps to change their IDR structure to facilitate growth. Enterprise Products Partners LP (NYSE: EPD) was among the first to take that step when it cut its top “high splits” rate from 50 percent to 25 percent and then revised the parameters of its tier structure.

 On Jan. 26, 2010, Sunoco Logistics Partners also revised its tier structure; the calculations I detailed above are for the new, revised system. Sunoco Logistics increased the thresholds for the IDR tiers but changed the 25-percent IDR tier to a 37-percent tier. Despite that higher threshold, the impact of the changes was a drop in the GP’s take on IDRs. In fact, if Sunoco Logistics had maintained its older IDR structure, the GP would have taken more than 30 percent of the current total distribution rather than 23 percent. 

Other MLPs have taken these reforms to a different level by abolishing IDR tier structure outright. For example, Conservative Portfolio holding Magellan Midstream Partners LP (NYSE: MMP) recently purchased its GP by issuing additional units. Although the new unit issue was dilutive, it allowed the MLP to eliminate IDRs and boost the cash flow available for distribution. The net impact was positive.

In addition, investors should remember that GPs and managers can be compensated in other ways. In Magellan’s case, the former GP received shares of the LP when it was acquired; the former GP holders will benefit directly from rising LP distributions. In other cases, GP holders get subordinated units in the MLP that convert to actual units when certain distribution targets are achieved.

The structure of IDRs is important for LP unitholders. Generally speaking, the IDR structure provides an attractive incentive that aligns the incentives of the GP and LP.

By the Numbers

Without further ado, here’s a table showing the current percent IDR take for every MLP recommended in the three model Portfolios.

Source: Company Reports, Bloomberg, MLP Profits

In addition to the GP’s take the table illustrates the total distribution paid to the LP and the total amount paid out to both the LP and GP.

The final column shows the impact of a 10 percent jump in distributions to LP unitholders. For example, as we calculated earlier, the GP gets around 23 percent of the total distribution paid to GP and LP holders each quarter at the current distribution rate of $1.115. If we increase Sunoco Logistics’ distribution to LP holders by 10 percent to $1.2265, the GP’s take increases to just less than 25 percent.

Generally speaking, the higher the figure in the “Percent GP Take” column, the higher the fees paid to the GP, and the tougher it is for the MLP to generate distribution growth. It’s also useful to compare the final two columns.  If there’s a major jump in the GP’s take due to a 10 percent increase in LP distributions, this is a huge incentive for the GP. Under such a scenario, one would expect the GP to be firmly focused on distribution growth, so that it can move through the tiers.

This table also provides a useful framework for evaluating changes to the IDR structure. If a company reshuffles its IDRs, a drop in the GP’s take should be considered an investor-friendly move.

That being said, it’s always dangerous to rely too heavily on any single number–there’s no golden quantitative standard for evaluating an MLP. It’s important to consider both qualitative factors and quantitative factor when evaluating the group.

Here’s a brief list of other factors to consider when reading this table.

The risk level of the underlying MLP. The MLPs that have the lowest IDR takes tend to be relatively newly listed partnerships. When MLPs are first listed, the partnership agreement is typically structured so that the IDR fees to the GP are low, allowing the MLP to generate solid distribution growth and attract investors’ attention.

But sometimes these newly minted MLPs are in businesses that bear commodity price risk–for example, gathering and processing. In that case, a low IDR take may attract investors to an MLP in a shakier sector. Alternatively, an MLP with a relatively large IDR take may be a large well-capitalized partnership in a defensive sub-sector. Such a partnership can still attract investors with a higher GP fee.

Quality of management. A valid analogy is that the IDRs are a way for investors to pay managers. If you want better, proven managers, you have to pay higher salaries and offer te potential for better compensation.

Classic examples are Portfolio recommendations Enterprise Products Partners LP (NYSE: EPD) and Kinder Morgan energy Partners (NYSE: KMP). The former was run by one of my personal heroes, Dan Duncan, until he passed away earlier this year.

Since then his hand-picked management team has followed in his footsteps. The GP has a 15 percent IDR take, but the partnership’s experienced management team is worth it and then some. The company’s extraordinary asset base, easy access to capital and history of consistent defensive distribution growth warrants that fee.

Kinder has the highest IDR take of any MLP on the list, and one could argue that the company might benefit from a shift in the IDR structure. But the man in charge of the GP and LP is Richard Kinder, one of the most experienced midstream operators in the business.

When funding was tight in late 2008, Kinder stepped up and said that the GP (a private company) could provide funding to help the LP grow if that were needed and credit markets remained closed. That statement shored up the stock, which outperformed in the toughest market in a generation. That sort of support when it counts most warrants a higher pay. 

The nature of the GP. Some GPs are publicly traded companies like Energy Transfer Equity (NYSE: ETE), the GP of Energy Transfer Partners (NYSE: ETP). We highlighted publicly traded GP firms in the Nov. 20, 2009, issue, Faster Growing Income.

Other GPs are private firms controlled by private equity interests. And some are controlled by publicly traded energy companies like ConocoPhillips (NYSE: COP), Williams (NYSE: WMB) or Chesapeake Energy Corp (NYSE: CHK).

Refining giant Sunoco (NYSE: SUN) controls the GP of Sunoco Logistics (NYSE: SXL). This has helped SXL’s growth because the parent has assets it can drop down into the MLP to facilitate growth. This warrants a higher IDR than a private-equity GP that might try to sell out of the deal for a quick profit when market conditions warrant.

And remember that the IDR structure offers a useful incentive. LP unitholders want high yields and growing distributions–those are the two major factors that drive MLP performance.

Under an IDR structure, GPs want exactly the same thing as LP holders; they get paid more when LP holders receive higher distributions. And since their percentage take of each incremental dollar rises with the distribution, this heavily incentivizes the GP to boost the distribution.

Generally, the IDR structure aligns the interests of the GP and LP but, investors need to examine this relationship closely. The GP might try to grow the distribution too quickly in an effort to run up higher fees. This is why Roger and I always evaluate the underlying business with an eye toward the sustainable cash flows and distribution payments