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Longtime readers of Dividend Opportunities 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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Example
Distribution Rights |
| Quarterly Distribution |
MLP |
GP |
|
Up to $0.29 |
98% |
2% |
| From $0.29 to
$0.33 |
85% |
15% |
|
From $0.33 to $0.39 |
75% |
25% |
| Above $0.39 |
50% |
50% |
|
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.
Good Investing!
Carla Pasternak's Dividend Opportunities
P.S.
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