The master limited partnership (MLP) continues to be the hottest funding trend in the energy space, as evidenced by a marketplace that has grown fivefold in the last several years to $200 billion in total capital.

The benefits of an active MLP market can be observed in the strong U.S. energy infrastructure. However, with significant additional investment still needed during the next several years to address changes in the flow of natural gas, crude oil and refined products, a continued strong MLP market may now be more important than ever.

The MLP market has seen an influx of more than $10 billion in new equity issuance to this sector through late August. Much of this growth has been fueled by institutional demand. Historically, institutional capital comprised less than 10% of the marketplace, but that level has now expanded to roughly a third, as a result of institutional interest in both the consistently strong returns in the MLP marketplace and the broader acceptance of the MLP structure.

For example, the Alerian MLP Index posted an annualized total return of 21% since the beginning of 2006, even taking into account the 14% downturn during this past July and August.

A recent indication of broader acceptance of the MLP structure is the Federal Energy Regulatory Commission's proposal to allow MLP-structured pipelines to be included in proxy groups for cost-of-equity determinations. Furthermore, the MLP structure has been expanding again into more asset classes, such as shipping, E&P and oilfield services.

Finally, the myriad new variations that have evolved recently on the traditional MLP structure-limited liability corporations, public general partners, institutional shares-illustrate a vibrant, evolving marketplace. Ultimately, the wisdom of these new asset classes and structures will be borne out in time, as capital becomes scarce and gravitates toward the more successful strategies.



High splits

One of the oldest and most cherished aspects of the MLP structure is incentive distribution rights (IDRs) or "high splits." Given their complexity and potentially profound influence on sponsor behavior, IDRs warrant greater examination by investors.

IDRs define the allocation of cash distributions between the holder of the IDRs (who is typically also the sponsor and general partner or GP) and the limited partners (LP), with the proportion being based on the amount of cash distributed per LP unit.

These tiers are established at the time of the IPO, and defined in the partnership agreement. In a typical breakdown of tiers, the sponsor initially receives only its pro rata 2% of distributions, but potentially receives up to 50% of incremental distributions when the MLP reaches the highest tier.

There is a growing share of aggregate distributions paid to the GP/IDRs as the distribution per LP unit grows, asymptotically approaching 50% of aggregate distributions in time.

Early in the growth of an MLP, IDRs provide significant incentives to the sponsor to grow the MLP, to the benefit of all partners. However, as the distribution per unit grows, these incentives may create diverging interests between the sponsor and the limited partners, may encourage behavior that is not in the long-term interest of the partnership, or could possibly discourage mergers or divestitures that would otherwise make economic sense to the company as a whole.

The tiered method of IDRs can be rationalized as a compromise, whereby the sponsor takes disproportionate downside risk by subordinating its LP equity to the public's, but is likewise rewarded with disproportionate upside through the IDRs.

However, subordination evolved into the MLP structure before IDRs came on the scene, and the market is currently seeing IDRs surviving while subordination is being shortened, diluted or eliminated altogether. There are a few recent exceptions to this trend, where companies have been structured without any IDRs, but so far they are only the exception.

Today, the potential rewards of IDRs have attracted much greater capital and entrepreneurial risk-takers into the MLP market. Financial sponsors, in particular, are increasingly recognizing the benefits of IDRs and have made a marked move into these vehicles. Financial sponsors such as Riverstone, Natural Gas Partners, ArcLight, GE Financial Services, Morgan Stanley and Goldman Sachs have been active in acquiring existing GPs or IPOing new MLPs.

More recently, as these financial sponsors have sought to maximize the value of their retained GP interest in their MLPs, they have chosen to IPO the GPs as new public vehicles. Since 2005, when this trend began in earnest, there have been 10 GP IPOs, including companies such as Enterprise Products Partners, Energy Transfer and Buckeye.

Some of these are pure plays on the IDR economics. Others, in an effort to improve the realized valuation to the sponsor, dilute the IDRs by also including LP units in the GP IPO. This strategy isn't necessarily a detriment to public investors, since they are unlikely to fully value the growth potential of the IDRs anyway, but investors should be certain they understand what they are buying.

When comparing the trading yield for MLPs and GPs to their projected growth rate, the market tends not to reward higher-growth MLPs or GPs with lower yields (and therefore higher valuations).

Consequently, the public GPs tend to trade in a relatively tight range of yields, even though their expected growth rates can vary widely. Said another way, IDRs, which are generally an option on the growth and acquisition strategy of the underlying MLP, are not efficiently valued in a yield-oriented marketplace.

Given that the economics of the IDRs are not easily determined, their contribution (and cost) is often overlooked. This is shown by comparing the trading yield for LP units of various MLPs to their breakeven yield. Breakeven yield is defined as the trading yield grossed up by the amount required to be paid to the IDRs to make that LP distribution.

For example, if an MLP is at the distribution level that results in the IDRs receiving 30% of total distributions (assuming 1.0 times coverage, where the MLP pays out all distributable cash flow, rather than retaining a portion), then a 7% LP yield equates to a 10% breakeven yield.

If such an MLP were to issue $100 million in equity ($98 million from LPs and $2 million from the GP) to acquire an asset generating a 10% return, then the LP units will just break even, without any accretion or increase in LP unit distribution.

By contrast, the GP will have invested its $2 million up front, but will receive $3 million a year in incremental IDR distributions.

This is one example of the diverging interests that can develop as an MLP grows its distribution per unit, and illustrates how public GPs can have such high growth rates. IDRs can incentivize sponsors of seasoned MLPs to issue lots of equity for marginally accretive assets.

This is potentially mitigated in a few ways. Sponsors that also own significant LP equity will be less likely to favor the IDR economics. Also, any sponsor that favors the IDR economics too consistently risks seeing its LP units trade to a higher yield that makes subsequent transactions less attractive to both the GP and LPs.

MLPs are generally in the practice of relying on the independent directors of the GP to review these potential conflicts of interests. As such conflicts increase, or public investors become more critical, these directors may find themselves in a more difficult position, and may be more likely to seek outside advice or fairness opinions to help them in their role.

This example also illustrates a hidden cost of the IDRs. One might think an MLP need only generate a return on newly issued LP units equal to its yield to break even. But, as discussed above, that breakeven point may actually be several hundred basis points higher.

Moreover, to actually get to the true cost of MLP equity, one should also take into account the coverage ratio and distribution-growth rate. To help manage the growing burden of IDRs, beginning with DCP Midstream in 2005, MLPs began incorporating a reset feature, in which once an MLP believes its IDRs have become a burden, it could convert the existing IDR cash flow into LP units and reset the IDRs to higher levels, above the existing distribution.

This collapses the breakeven yield back to the trading yield. However, since it is only an option exercisable by the sponsor, it requires a sponsor that favors future growth prospects over its existing lucrative IDR position.



Dropdown strategy

Another trend in the MLP marketplace is for sponsors to engage in IPO-structure arbitrage via what is described as a dropdown strategy. This strategy can benefit both sponsors and investors, although not necessarily in all the ways they may expect. Sponsors of new MLPs these days are more likely to only contribute a portion of their MLP-qualifying assets at the time of IPO, holding back the rest to potentially contribute at a later date.

The argument for this strategy is twofold. First, since both subordination and IDRs are defined by the size of the initial MLP, the sponsor is able to minimize the size of subordination and grow more quickly through the IDRs by starting small and subsequently dropping down significant additional assets on accretive terms.

Second, with a warehouse of potential acquisitions from the sponsor, the MLP is likely to generate higher growth rates than other MLPs and, therefore, should (and generally does) trade at a lower yield.

However, both sponsors and investors should tread carefully. Sponsors of such MLPs certainly are motivated to drop assets down, but investors should keep in mind that they are not obligated to do so, and the terms of such dropdowns may not be as accretive as hoped.

For sponsors, the benefit of trading at a lower yield and achieving higher IDR tiers must be weighed against the costs.

Those costs include the lower sales price realized on the dropped-down assets, the increased governance and other burdens of managing a business in a more complicated legal structure, and the transaction costs from executing the dropdowns without any synergies or strategic benefit.

The benefit of a dropdown strategy depends on a large set of factors, including the IPO yield, aftermarket trading yield and valuation of subsequent dropdowns. Nevertheless, it can be shown that there may be little benefit to the sponsor in pursuing a dropdown strategy, as measured by the NPV to the sponsor. Even if one were to assume that an MLP with no dropdown prospects suffers a higher yield at both the IPO and in the aftermarket, the costs of the dropdown strategy (primarily the lower valuation of the dropped-down assets) can oftentimes largely offset the benefits.

It is assumed that an MLP with no dropdown prospects suffers a higher yield at both the IPO and in the aftermarket than a dropdown MLP. Nonetheless, the costs of the dropdown strategy largely offset the benefits.

It is always dangerous to generalize, as there are a wide range of factors to consider in determining the best MLP strategy for a sponsor. Having some dropdown candidates for an MLP, as a hedge against an overheated M&A market, can be a prudent strategy for protecting the MLP's trading yield.

On the other hand, forming an MLP where dropdowns are the only source of growth, rather than third-party acquisitions or organic growth, is unlikely to generate more value for the sponsor than a more simple MLP structure.

MLPs continue to be a huge success for sponsors, investors and the energy industry as a whole. Although their complexities may confuse investors and sponsors alike, they are a critical tool to further promote investment in U.S. energy infrastructure. While significant time may be spent in an attempt to understand or optimize the structure, it is ultimately the management team and the underlying business that determine the success or failure of any particular MLP.



Ed Guay is a partner in Tudor, Pickering & Co., heading the Houston-based energy investment-banking and research firm's MLP and midstream practices. Previously he was with Goldman Sachs' natural resources group, Salomon, Smith Barney's global energy and power group and an energy analyst for Wertheim Schroder & Co.

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