• Keeping It Simple: MLPs Continue to Eliminate IDRs

    12/03/19 | Bryce Bingham

    Summary //

    • The vast majority of AMZ and AMZI constituents have eliminated their incentive distribution rights since 2016.
    • IDR buyouts have been numerous so far in 4Q19 and have mostly been attractive to unitholders.
    • Most of the remaining IDR holdouts in the AMZ Index are expected to eliminate their IDRs in time as the general partner’s take becomes more of a burden.

    Incentive distribution rights (IDRs) were once a staple of the MLP space. In recent years, however, midstream MLPs have widely moved to eliminate their IDRs, simplifying their structures and greatly improving corporate governance in the process. Today, we will discuss some of the more recent IDR buyouts, who still has them, and our expectations for the future. For a general explanation of IDRs and how they work, see our 2015 piece on IDR basics here.

    Most MLPs have eliminated their IDRs in recent years.
    Although they were arguably beneficial to unitholders in the early days for an MLP, IDRs have fallen out of favor with investors over the last several years. The structure was intended to better align the interests of the general partner (GP) and limited partners (LP) by incentivizing the GP to grow distributions to unitholders. However, IDRs become unsustainable in the long run as distributions to the GP grow and become a significant burden on the MLP’s cost of capital. As a result, the vast majority of MLPs in the Alerian MLP Index (AMZ) have moved to buy out their IDRs from their GPs. In December 2016, only seven of the forty-three constituents of the AMZ (42.2% of the index by weighting) did not have IDRs. Today, 84.6% of constituents by weightinghave eliminated their IDRs. The chart below compares the percentage weighting of MLPs without IDRs in both the AMZ and the Alerian MLP Infrastructure Index (AMZI). In addition to lowering the MLP’s cost of capital, the removal of IDRs puts the GP and LP on equal footing in regard to distributions, helping to improve corporate governance by better aligning the interests of the two groups (for more on midstream corporate governance, see our ESG white paper). The removal of IDRs also helps to simplify the MLP story and makes the space more investable.

    In addition to existing MLPs shedding IDRs, new MLPs are foregoing GP payments from the start. Rattler Midstream (RTLR), a subsidiary of Permian pure-play producer Diamondback Energy (FANG), went public earlier this year without IDRs. (RTLR is also unique as an MLP because it elected to be taxed as a corporation.) We would expect future MLPs to follow in RTLR’s footsteps and avoid IDRs altogether.

    Multiple simplification transactions have been announced this quarter.
    IDR buyouts have been frequent in 2019, with the GPs of EQM Midstream (EQM), Phillips 66 Partners (PSXP), and Summit Midstream Partners (SMLP), among others, eliminating their MLPs’ IDRs earlier this year. This trend has continued in 4Q19 as several IDR transactions have been announced within the last few months. Hess Midstream Partners (HESM) was the first to announce an IDR simplification this quarter, which comes alongside a proposed acquisition of Hess Infrastructure Partners and subsequent conversion into an Up-C structure. HESM’s transaction is set to close by the end of the year. DCP Midstream (DCP) and Noble Midstream Partners (NBLX) both followed with IDR eliminations in November. DCP’s management had been hinting at an IDR elimination for some time, with CEO Wouter van Kempen telling investors as early as its 2Q18 earnings call that “it’s not a matter of if we will do an IDR conversion, it’s more of a conversation around when will [we] do it.” NBLX’s transaction marked the end of the ongoing strategic review of the MLP by its parent company, Noble Energy (NBL), which eased concerns about a potential sale or consolidation of the partnership (read more).

    Alongside the benefits of a lower cost of capital for the MLP and improved corporate governance, the IDR transactions themselves have also been mostly attractive to unitholders. In the case of NBLX, the acquisition of NBL’s midstream assets and IDRs is expected to be ~5% accretive to distributable cash flow (DCF) per unit in 2020, reduces pro-forma leverage, and removes the need for equity financing. Combining the expected IDR payments and 2020 EBITDA from the acquired assets implies a combined transaction multiple of 8x. Along with DCP’s IDR elimination, which represented a multiple of 9x to current IDR payments per management, these recent transactions have been attractive relative to multiples upwards of 15x seen in the past.

    Who’s next?
    With the majority of IDR eliminations behind us, what can MLP investors expect going forward? There are currently twelve AMZ constituents who still have IDRs, but we would expect most of them to remove incentive payments to the GP in time. Those names in the high splits, including CNX Midstream Partners (CNXM), Delek Logistics Partners (DKL), and Shell Midstream Partners (SHLX), are likely more inclined to address IDRs in the near term.  SHLX has previously received parent support for its IDRs in the form of waivers, which reduced the partnership’s IDR payments by $50 million for the first three quarters of 2019. Now that those waivers have expired, investors are likely looking for a permanent IDR solution, and management noted that IDR discussions with its sponsor were “ongoing” during its 3Q19 earnings call. CNXM and DKL gave similar commentary on 3Q19 earnings calls, noting that IDRs were undesirable and under evaluation.

    The table below shows the twelve AMZ constituents who maintain IDRs in their structure.  The fifth column represents the point at which each MLP will reach the high splits. Typically, the highest tier of marginal GP interest in distributions is 48% or 50%. TC PipeLines (TCP) is the exception to this rule; the partnership’s highest incentive distribution tier is 25%. BP Midstream Partners (BPMP), Cheniere Energy Partners (CQP), Oasis Midstream Partners (OMP), and USD Partners (USDP) are the closest to breaking into the high splits, while Enable Midstream Partners (ENBL) has yet to reach its first distribution target of $0.330625 per unit. From 2008 to 2016, Martin Midstream Partners’ (MMLP) GP had a 50% marginal interest in MMLP’s distribution, but after distribution cuts in October 2016 and April 2019, MMLP is now in its first distribution tier.

    Bottom Line
    Alongside strengthening balance sheets, the shift to self-funding equity capital expenditures, and improving distribution profiles, IDR eliminations have been one of the most notable positive steps that midstream MLPs have made in the last few years. Given the benefits that an IDR simplification can bring to corporate governance and cost of capital, investors can expect that, in time, many of the remaining IDR holdouts will join the majority in removing their IDRs.