The master limited partnership (MLP) structure often comprises two entities: a limited partnership that owns the underlying assets and a general partner (GP) that’s responsible for managing the operating entity.
In addition to a minority stake in the limited partnership, the general partner holds incentive distribution rights (IDR) that entitle it to an incrementally higher percentage of the LP’s distributable cash flow as the payout reaches certain predetermined thresholds.
This arrangement effectively motivates the GP to pursue initiatives that will enable the operating MLP to grow its cash flow and quarterly disbursements to unitholders; a rising payout at the LP level translates into disproportionate increases to the GP’s incentive distribution. Many GPs also own a significant percentage of the LP’s common units.
As the MLP achieves certain distribution targets laid out in the partnership agreement, the IDR schedule allocates a growing proportion of the LP’s cash flow to the GP.
The first interval of these sharing arrangements usually starts with the GP receiving 2 percent of cash flow designated for disbursement and the LP unitholders receiving 98 percent. Meanwhile, the top tier of the IDR schedule–the “high splits” in industry parlance–often entitles the GP to about 50 percent of incremental cash flow.
That is, in order to raise the LP distribution by $0.01 per unit, the MLP would need to pay a corresponding $0.01 to the GP for each outstanding LP unit. (Elliott discusses the ins and outs of the IDR schedule and its implications in The Lowdown on MLP IDRs: Incentive or Impediment.)
The distributable cash flow allocated to the GP also increases when the LP issues equity; the general partner is entitled to receive additional payments for each additional LP unit.
Although shares of pure-play GPs tend to offer inferior yields relative to the associated LP units, investors shouldn’t overlook the importance of a growing quarterly payout to a stock’s performance: Not only do rising distributions increase the current return, but they also tend to capture investors’ attention and drive stock prices higher.
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Elliott and Roger on Apr. 26, 2018
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