Finding Value in MLP IDRs

02/17/17 | Maria Halmo

Incentive distribution rights (IDRs) are one of those often-confusing, MLP-specific quirks that few traditional investors understand, even in their simplest form. Alerian has explained the structure in the past, but given recent transactions in the MLP space, it’s time to look further in depth and explore their nuance.

Designed specifically to align the interests of the MLP and its general partner (GP), IDRs still have their flaws. While a greater portion of incremental cash flow goes to the GP as the LP raises its distribution, that incentive only works when MLPs are growing distributions. What happens when MLPs are now keeping distributions flat (or very low growth) to raise coverage ratios and invest capital back into their business? Or, once IDRs have hit the highest tier, the MLPs cost of capital can rise so high that it becomes more prohibitive to find growth projects that have a high enough return to justify the risk. An MLP management team thus hobbled does little to benefit the GP.

In the recent past, Plains All American Pipeline (PAA) solved the cost-of-capital conundrum by buying the IDRs from Plains GP Holdings (PAGP). It also cut the distribution as part of this simplification and now PAGP functions as a C corporation tracking stock for PAA. A few months later, Williams Partners (WPZ) and Williams Companies (WMB) also eliminated the IDRs (for 289 million WPZ units) and cut the distribution, also creating a tracking stock. Without these decisive, prophylactic reorganizations, each family of companies would have suffered. Now, they have reset their distributions, satisfied some investors demands for MLP-like investments without a Schedule K-1, and no longer need to play investment banker. In short, while the IDRs elimination came at a cost, both firms may now totally focus on operating and growing midstream companies.

On the other hand, DCP Midstream LP (DCP) chose to maintain the IDR structure with its GP (DCP Midstream LLC, a privately-held company), while simplifying their structure.

Over the past few years, ONEOK Partners (OKS) and its GP, ONEOK (OKE), have been very vocal about trying to pursue M&A on a large scale. As a clever analyst quipped, they found it in their own MLP, as OKE will be buying OKS. Buying the MLP entire is not as unusual as it sounds. Kinder may have been the best known, but Enbridge Inc (ENB) followed a similar playbook announcing it would buy Midcoast Energy Partners (MEP) just a few weeks ago. While many worry this is a condemnation of the MLP structure itself, one might instead say this is a sign of management frustration in the attempt to use the MLP as a primarily financing vehicle. Enbridge describes MEP as “EEP’s primary vehicle for owning and growing its natural gas and natural gas liquids (NGL) midstream business.” In these cases, a consolidated entity was more valuable than having a separate MLP and benefiting from not only simplification, but IDR elimination, even if the MLP had to be purchased at a premium.

However, most interestingly, a few weeks ago, NextEra Energy Partners (NEP) took an entirely different tack. Its GP, NextEra Energy (NEE) eliminated 75% of the IDRs indefinitely and for free. It’s a radical move we haven’t seen in over a decade and one which requires the kind of lateral thinking so valued by consulting firms. The last time we saw this method was Enterprise Products Partners (EPD) when the private GP gave back IDRs in 2002. While the businesses NEP and EPD run are as different as apples and watermelons, EPD has been a runaway success over the past 15 years. In both cases, management has chosen to invest primarily in LP units, just like every other investor.

What the NEP deal highlights, more than anything, is that IDRs may not be worth as much as everyone thought they were. GPs used to be taken public (or C corps would form MLPs) on the strength of IDRs providing leveraged exposure to the MLP. Which isn’t to say I am now claiming all GPs are about to disappear or are overvalued. Like learning about IDRs themselves, the situation is nuanced and specific to each family of companies.

Throughout 2017, additional consolidation and simplifications transactions can be expected, and the value of the IDRs will be dependent on the future growth prospects of the MLP, the financial stability of the GP, and where in the splits the company is. While it is not as dire as “IDRs are worthless because NEE gave them back for free”, the potential risk of their elimination could make investors pause and reconsider (or reduce) the valuation of any outstanding GP owning IDRs.