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Published:
October 14, 2009
Longtime readers of my Dividend Opportunities
newsletter know I'm a big fan of master limited partnerships (MLPs).
There's not much to dislike.
The partnerships don't have to pay corporate income taxes as
long as they earn 90% of income from operations relating to
natural resources or commodities -- and they must pass on the
bulk of that income along to investors.
The result is high yields, usually approaching double-digits.
Moreover, most MLPs operate in energy infrastructure like
pipelines and processing facilities. These partnerships usually
earn a fee for processing or delivering products like oil,
ammonia, or natural gas. They are essentially toll collectors on
the energy highway, a consistent business model that leads to
steady and generous distributions.
MLPs are also famous increasing their distributions to partners.
For example, well-known MLP Kinder Morgan (NYSE: KMP) paid
quarterly distributions of $0.475 per unit in 2001. That amount
has since climbed all the way to $1.05 per unit today.
But I'm seeing a monumental shift in the MLP space, and I think
it could lead to even sweeter payments for income investors.
A High-Yield Shift in Corporate Structure
You see, behind every good master limited partnership is a
general partner (GP). General partners manage the day-to-day
business of master limited partnerships. The MLPs are like
silent partners. They receive cash flow from the pipeline
assets, but aren't involved in running the business.
That's the job of the general partner (which usually also trades
on a major exchange). The general partner, for instance,
identifies potential acquisitions, arranges financing, oversees
operations, and even sets dividend policy.
In return, GPs are amply rewarded
for their efforts. They typically
own a 2% equity stake in the MLP,
but that's not all. They receive a
special management fee in the form
of incentive distribution rights (IDR).
These additional distributions are
paid out according to a pre-set
formula that's given in the
prospectus when the MLP is formed.
Typically, the GP receives an
initial 2% of the MLP's
distributable cash flow to reflect
its 2% equity interest, while MLP
unitholders get the remaining 98%.
As the limited partner's
distributions increase, however, the
percentage take of the GP also
increases, often to a maximum of
50%.
You can take a look at my table to
see how it works: Say the latest
quarterly distribution for an MLP
totaled $1.00 per unit. Of that, GP
investors in my example receive 2%
of the first $0.29, 15% of the next
$0.04, 25% of the next $0.06, and
50% of everything above $0.39.
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In other words, as the distribution grows for the MLP, the
general partner receives a larger piece of the distribution pie.
Many GPs have grown to claim an enormous stake on payments,
sometimes a third or more of a limited partner's total
distributions paid.
But quietly, a few MLPs are making a ground-breaking move.
They've opted to merge the general partner and the limited
partner.
For example, MarkWest Energy Partners (NYSE: MWE) and its
general partner merged operations last year, which eliminates
the need for incentive distribution rights. Eliminating this
drag on distributions has created a new form of MLP that should
pay larger distributions in the long run.
In fact, MarkWest's distributions increased +16% in the year
following the merger, despite the the partnership issuing new
units to acquire the outstanding shares of the general partner
(as is usually the case).
Eliminating the distribution rights and simplifying the
partnership structure also reduces the cost of capital needed
for expansion. Since MLPs must pay the lion's share of their
income to partners, they're reliant on the capital markets to
grow the business.
Lowered costs allow MLPs to be more competitive in future
acquisitions and expansion projects. The result should be an
increased growth rate for the partnership, paving the way for
further distribution hikes.
If investor sentiment toward merging partnerships is any
indicator -- in one recent merger, 97% of votes were in favor --
I expect the trend pick up steam. And I think that's good news
for income investors and a sign that MLP could continue being
one of the most attractive income investments on the market.
-- Carla Pasternak
Editor
High-Yield Investing,
High-Yield International |
