The Nagging Issue With Some High Yield Midstream MLP's

Midstream MLP's – those that own transportation, processing and storage assets – are thought to be great investments because of their high and growing yields in a low-yield world. But some have this nasty thing called incentive distribution rights, which give the holder – which is often the MLP's general partner – the right to an increasing share of cash distributions if certain thresholds are met.

These IDR's, as they are called, can become a burden to MLP's as they grow because they add to their cost of capital and make projects and acquisitions less additive to cash flow. The problem becomes acute when these entities get into the "high splits," meaning the holder of the IDR receives 50% of every incremental dollar paid in a cash distribution to the limited partners.

Several MLP's have eliminated their IDR's over the past few years to the applause of investors, including Plains All American Pipeline, Andeavor Logistics, MPLX and Williams Partners. But some haven't yet, including Western Gas Partners, Antero Midstream Partners, Shell Midstream Partners and Phillips 66 Partners.

Earlier this month, Miller/Howard Investments wrote an open letter to MLP management teams urging them to eliminate their IDR's – "not when they become an impossible burden (they're a burden from the get-go), not when management's 'review' is completed, not when they start to seriously impact growth projects, but now," the letter said.

The letter didn't name names. But the firm estimates that among the 40 midstream MLP's it analyzed between 2015 and 2017, more than $12 billion was paid in IDR's, which represented almost 8% of the debt at the MLP's paying the IDR's. In addition, the IDR's paid represented 20% of the total distributable cash flow generated over the period.

"The $12 billion paid in IDR's could have been used to pay down debt, contribute to higher coverage ratios, fund organic growth projects and pay higher distributions to limited partners," the letter said. "Instead, the IDR's were used to enrich the general partners."

Portfolio manager John Cusick, who spent more than a decade as an energy analyst at Oppenheimer & Co., said that the firm has been talking awhile about the IDR issue and that some management teams repeatedly have given the same answers: That they continue to monitor their impact and that it takes time to eliminate them.

Cusick said some aren't moving fast enough, hence the open letter. "We believe they're not willing to address the issue in a timely manner," he said.

The open letter also cited two other issues that the firm thinks MLP's need to address: Improving disclosures about operations, including the percentage of contracts expiring each year; and shareholders' environmental concerns, including disclosing information on emissions, leak detection and repair systems and other environmental metrics.

"The days of financial engineering and over-leveraging these great and stable assets are over," the letter concluded. "It's time for MLP management teams to chart a new course."