At SteelPath, we launched a suite of funds, including the first ever open-end mutual funds, to focus on midstream investment because we recognized that the asset class offered a unique level of return potential for the level of fundamental risk present. We still believe in this investment thesis. In fact, as the recent cyclical commodity price break appears to be at or near the point of recovery, we believe the asset class is positioned particularly well. But, recent general partner actions have provided a reminder that investors still need to be cautious when considering one relic of the MLP model, the Incentive Distribution Right or IDR.
While most investors know IDRs exist and know the general partner (GP) holds them, few know much more. This opaque understanding is a natural consequence of the complicated and unusual nature of the mechanism. At Initial Public Offering, (IPO), the GP sponsor typically only receives 2% of the cash distributions paid by the MLP, a share equal to its nominal ownership interest, but the IDR structure allows the GP to receive an increasing share of the cash flows disbursed by the MLP as the distribution rate is increased. Essentially, once an MLP’s quarterly distribution rate eclipses certain amounts, the holder of the IDR receives an increasing share of total cash distributed by the partnership.
To put this mechanism into perspective, consider some examples. Kinder Morgan Energy Partners (NYSE: KMP), on an adjusted basis, distributed $0.63 per unit to its LPs in 1995 and $2.1 million to its GP through IDRs. In 2013, prior to the roll-up of KMP by its GP, Kinder Morgan Inc. (NYSE: KMI), KMP was paying $5.33 per unit to its LPs and $1.6 billion annually to KMI through IDRs. For little incremental investment, KMI experienced a 75,000% increase in IDR cash flow, which accounted for 52% of the total cash flow being distributed by KMP.
A more timely example is Plains All American Pipeline LP (NYSE: PAA). In 1999, PAA, on an adjusted basis, distributed $0.92 per unit to its LPs and $230,000 to its GP through IDRs. For the most recent quarter, prior to its IDR restructuring, PAA was distributing $2.80 per unit to its LPs and $615 million annualized to its GP through IDRs. For little incremental investment, PAA’s general partner experienced a 250,000% increase in IDR cash flow and which accounted for 34% of the total cash flows being distributed by PAA.
These examples suggest the term “incentive” may understate things a bit. But, the argument went, the IDR cash flows only go up this dramatically when the LP does really well for a very long time. Further, if things take a turn for the worse, the LP should experience a less dramatic decrease in cash flows than the GP because the IDR mechanism is designed so that a decrease in distributions per LP unit results in a much more dramatic decrease in IDR cash flow.
Therefore, the implicit bargain offered to LP investors has been that the LPs get to enjoy a lower risk stream of cash flow in exchange for giving up some upside (or a lot of upside), while the GP, through the IDR, takes greater risk in exchange for potentially eye-popping returns. This bargain seems nearly fair. However, while GPs seem to dutifully comply with the accepting-of-tremendous-upside part of the bargain, some don’t like the accepting-of-greater-risk part.
For example, PAA recently announced that it would acquire the GP and IDR interests of its GP and, secondly, that in the upcoming quarter PAA unit holders would experience a 21% cut to their distribution payments while PAGP unit holders, the holders of the IDRs, would experience only an 11% reduction to their distribution. If this outcome seems counter to the bargain discussed above, that is because it is.
Bad times came to PAA and management felt it necessary to lower PAA’s payout by 21%, which should have resulted in a 39% reduction to the cash being paid to the GP through the IDR mechanism. However, it appears to us that PAA’s GP didn’t care for that part of the bargain so instead had PAA’s LPs buy its GP and IDR interests for $7.2 billion.
For context, on a post-cut basis, PAA’s general partner had PAA’s LPs buy the IDR and GP cash flows for an approximate 18x multiple. While several GP buyout transactions have been executed at similarly high multiples, these MLPs were not facing headwinds so severe that a distribution cut was executed simultaneously or was generally considered imminent.
Though this transaction clearly reflects a failure of the IDR mechanism, Plains has received little criticism from sell side or buy side commentators. However, we do not believe this seeming acceptance represents a defense of the IDR mechanism but rather simply suggests market participants have begun to expect GP’s to break their end of the bargain.
To be fair, not all GPs have abused the IDR mechanism. For example, in 2002 Enterprise Products Partners’ (NYSE: EPD) GP eliminated the most aggressive tier of its IDRs for zero cost to its LPs in order to ensure EPD could continue to benefit from a competitive cost of equity for the foreseeable future. More recently, both Energy Transfer Equity (NYSE: ETE) and The Williams Companies (NYSE: WMB) took action to support the cash distributions of their respective MLPs. WMB elected to essentially reinvest the distributions it receives from its LPs into new LP units; notably, WMB cut its dividend payout by 69% to finance this support. Even more helpfully, ETE is essentially foregoing a portion of its IDRs for a period of time to support Energy Transfer Partners (NYSE: ETP) until new projects come on stream and while market fundamentals heal.
Therefore, while some GP sponsors seem to respect the bargain implicit in the IDR mechanism, many have not. Unfortunately, PAA’s actions may provide a precedent for other GPs to mimic which could further erode confidence in MLPs with GP sponsors. Hopefully, too, investors will begin to push back a little harder on management teams and investment banks that structure this mechanism into future MLP IPOs. While some form of GP incentive may be found that represents a fair bargain, clearly the traditional IDR mechanism does not.
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Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Each Fund’s investments are concentrated in the energy infrastructure industry with an emphasis on securities issued by MLPs, which may increase volatility. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling. Additional management fees and other expenses are associated with investing in MLP funds. Diversification does not guarantee profit or protect against loss.
The Oppenheimer SteelPath MLP Funds are subject to certain MLP tax risks. An investment in an Oppenheimer SteelPath MLP Fund does not offer the same tax benefits of a direct investment in an MLP. The Funds are organized as Subchapter “C” Corporations and are subject to U.S. federal income tax on taxable income at the corporate tax rate (currently as high as 35%) as well as state and local income taxes. The potential tax benefit of investing in MLPs depends on them being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation, its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution which could result in a reduction of the fund’s value. MLP funds accrue deferred income taxes for future tax liabilities associated with the portion of MLP distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments. This deferred tax liability is reflected in the daily NAV and as a result a MLP fund’s after-tax performance could differ significantly from the underlying assets even if the pre-tax performance is closely tracked.
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These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the open of business on August 24, 2016, and are subject to change based on subsequent developments.