What it means
A master limited partnership, or MLP, is a business structure that is traded on a stock exchange and passes most of its income to investors. It has two types of owner: limited partners, who are the investors who buy units, and a general partner, who manages the business.
IDRs are a way of paying the manager. The arrangement works through a ladder of tiers.
Up to a first level of distribution per unit, the general partner receives only a small share, often around 2%. Once the payout passes defined thresholds, the general partner's share on the additional cash steps up, to 15%, then 25%, and in some cases as high as 50%.
The aim is to align interests. The general partner earns more only if the partnership raises the cash paid out to unit holders, so it has an incentive to grow the business through acquisitions or expansion.
In theory, both sides benefit from higher distributions. The drawback is that IDRs become costly as the payout grows.
The general partner takes a larger and larger share of each additional dollar, which raises the partnership's cost of capital because new projects must earn enough to cover that heavy share. This is one reason some partnerships have bought out or eliminated IDRs, often exchanging them for units or a lump sum.
For investors and analysts, the key task is to look at cash available for the limited partners after the general partner's take. A headline distribution figure per unit may hide the fact that a rising slice of total cash flow is going to the general partner.
Reading the partnership agreement and the tier table is essential for this. The nuance is that the thresholds and percentages are negotiated and differ from one partnership to another.
The example below is a simplified illustration and not a description of any real partnership.
In practice
Real-world examples.
Example
A pipeline partnership raises its payout every quarter. The general partner's share of each extra dollar rises with each tier crossed, so by the third year it receives a quarter of every additional dollar distributed.
Example
An analyst comparing two partnerships notices that one has a headline yield of 8% but pays a high share to the general partner. After adjusting for the IDR burden, its yield to ordinary unit holders is lower than the other partnership's yield of 7%.
Example
A partnership buys out its IDRs by issuing new units to the general partner. The management team explains that this lowers the cost of capital, because the partnership no longer gives up a large slice of each extra dollar.
Formula
Calculation
General partner IDR payment = sum of (cash in each tier x general partner percentage for that tier)
Suppose an MLP has 10,000,000 units and distributes $0.70 per unit, a total of $7,000,000. Tier 1 covers the first $0.50 per unit with a 2% general partner share, tier 2 covers the next $0.10 with 15%, and tier 3 covers anything above $0.60 with 25%. Tier 1 cash is 0.50 x 10,000,000 = $5,000,000, giving the general partner 5,000,000 x 0.02 = $100,000. Tier 2 cash is 0.10 x 10,000,000 = $1,000,000, giving 1,000,000 x 0.15 = $150,000. Tier 3 cash is $1,000,000, giving 1,000,000 x 0.25 = $250,000. The general partner receives 100,000 + 150,000 + 250,000 = $500,000, or 7.14% of the total, and the limited partners receive 7,000,000 - 500,000 = $6,500,000.Case study
Seen in the real world.
Greywater Energy Partners is an illustrative, fictional MLP that owned storage terminals. As its distribution grew, the general partner's IDR share rose to 25%, and finance staff noticed that a new $100,000,000 project had to earn a much higher return to be worthwhile for the unit holders.
The CFO modelled two options. She showed that after the IDR payments, a project with a 9% return gave unit holders an effective return of only about 7%, which was less than the cost of the equity needed to fund it.
The board agreed to negotiate a buy-in of the IDRs in exchange for new units. The illustrative lesson is that IDRs can reward growth early on but later act as a tax on growth, so the structure may need to change as the partnership matures.
Watch out
Common mistakes.
- Reading the headline distribution per unit without checking how much of the total payout goes to the general partner.
- Assuming IDR percentages apply to total cash, when they apply to the cash in each tier.
- Thinking IDRs are the same as ordinary ownership, when they are a separate contractual right to a share of the distributions.
Questions
People also ask.
Who holds incentive distribution rights?
They are held by the general partner of the MLP, though they can be sold or exchanged under the partnership agreement.
Why do some partnerships eliminate IDRs?
Because the rising share of cash going to the general partner raises the cost of capital and makes new investments harder to justify.
How are IDRs different from a management fee?
A management fee is usually a fixed or percentage charge, whereas IDRs scale up as the distribution grows.
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