More master limited partnerships (MLPs) are on the horizon, but selective investors should focus on vehicles offering incentive distribution rights (IDRs), which represent “one of the best wealth creation mechanisms,” according to Robert W. Baird & Co. senior research analyst Ethan Bellamy, who spoke recently in Denver at an Energy Finance Discussion Group meeting.

Bellamy cited IDRs as contributing to much of the wealth of such well-known midstream figures as Kinder Morgan Chief Executive Rich Kinder and the late Enterprise Products Chairman Dan Duncan.

IDRs are the “the most compelling incentive structure that I am aware of,” said Bellamy. “Think of IDRs as a permanent, non-resetting carried interest of up to 50% of a partnership’s cash flows.”

Compared to hedge fund economics, which may often involve a 2% management fee and a 20% performance fee, based on the net profits of the partnership, the IDR fee structure is set at 2% initial split to the general partner (and 98% to the limited partners), rising to a 50:50 split between the general and limited partners as prescribed thresholds are met, he said.

“Understanding the embedded rewards of IDRs is the single most important variable in understanding how MLPs work and the general partner’s incentives,” according to Bellamy.

How they grow

IDR cash flows can grow in two ways, he noted. First, as the partnership grows its distributions, it triggers increasing IDR payments under a tiering mechanism. Secondly, IDR payments go up as the partnership’s unit count accelerates— that is, when the MLP sells more equity.

Bellamy described the latter element of IDRs as “perverse” and perhaps not widely understood.

“With most stocks, if you sell more equity, it’s dilutive. Just the opposite takes place for IDR holders. As you sell more limited partner equity, the cash flow payout to the IDR holders goes up. There’s so much incentive to sell more stock, to get bigger, so that the IDR incentive payments come up,” he added.

Elsewhere, Bellamy said the MLP sector is on track to have an enterprise value of about $1 trillion by about 2015 at the current rate of growth, although this growth rate is “probably unsustainable” longer term. Driving the growth is “the confluence of extraordinarily cheap capital meeting this extraordinary resource opportunity in the U.S.,” which is “completely unprecedented.”

Bellamy forecast the MLP sector “could easily see another 40 initial public offerings (IPOs) in the next 18 months.” New MLPs are no longer originating from just the pipeline and midstream sector, but also from such varied areas as retail gasoline stations, frac sand suppliers, refiners and chemical companies. Through early December 2013, MLPs had raised $27.6 billion in equity through 86 transactions, comprising 67 secondary offerings and 19 IPOs.

Capital discipline

Bellamy noted the valuation uplift that can be achieved in selling assets into an MLP—“there’s a big arbitrage”—reflecting investors’ thirst for yield and the tax efficiency of MLPs. “There’s also the capital discipline of having to pay your entire capital base on a quarterly or monthly basis,” he added.

On the commodity front, Bellamy characterized himself as “neutral to bearish” on natural gas, calling prices above $5 per thousand cubic feet “a gift—you should be happy, you should hedge it. Producers are just way too good at what they do.”

Ethane was described as “a huge train wreck,” and Bellamy suggested that anyone succeeding in finding a way to hedge long-dated natural gas liquids exposure, such as ethane, “deserves a Nobel prize.”

In terms of tax-change risks, Bellamy considered it “low, but not zero.” Tax leakage from MLPs in the energy sector is estimated at $1.3 billion annually, “a rounding error” in the federal budget, and investment in midstream could fall on the order of 25% to 60% without MLPs. In addition, it would be “a massive job killer” in a sector that currently employs more than 325,000 workers.

How would MLPs react to a spike in interest rates?

In response to a question hypothetically outlining a 300 basis-point rise in U.S. Treasury yields approaching 6%, yields on MLPs could rise from 5.5% to 6% to around 9%, and MLPs possibly trade down by around 15% to 25%. In that unlikely scenario, “that would shock a lot of people,” said Bellamy. People would be reminded, “Hey, these are actually equities. They have a 65% correlation to the equity market.”

Comments