MLP Structural Simplifications: Part 2 – IDR Eliminations

Last week we discussed reorganizations in the MLP space, and today, we look at the other prevalent simplification transaction in MLP land – incentive distribution right (IDR) eliminations. Several sponsors and MLPs have taken steps to eliminate IDRs and convert their general partner (GP) interest into a non-economic interest. Recall, IDRs entitle the GP to receive increasing percentages (typically up to 50%) of incremental cash distributions when the distribution to LP unitholders reaches certain levels. Over time, IDRs can become a burden to the MLP’s cost of capital. As we’ll discuss, lowering the cost of capital isn’t the only benefit of IDR eliminations.

IDR eliminations benefit the MLP by lowering the cost of capital.

In recent years, we’ve seen MLPs move to eliminate IDRs, as several management teams have acknowledged that IDR structures are not sustainable. IDRs are a great tool to incentivize the parent to grow the distribution following an IPO (and will likely continue to be included in MLP IPOs). However, IDRs become a burden as the MLP gets into the high splits. Prior to the elimination of its IDRs, Holly Energy Partners (HEP) was paying just over 30% of its total quarterly cash distribution to its GP HollyFrontier (HFC) as of 2Q17. Similarly, MPLX (MPLX) was paying roughly 30% of its total quarterly cash distribution to its GP Marathon Petroleum (MPC) as of 3Q17, even with a portion of distributions waived. The parent company, which received LP units in exchange for its GP interest and IDRs, will continue to receive significant cash flows from LP distributions, but the MLP will not have the burden of IDRs as distributions grow.

The transaction to eliminate IDRs can be dilutive to unitholders for a time but is expected to be accretive as distributable cash flow (DCF) grows. The MLP typically issues millions of LP units to its parent to buyout the IDRs, which can result in the distribution payout exceeding DCF (dilution). As growth projects come online and DCF exceeds the distribution payout, the transaction becomes accretive. Andeavor Logistics (ANDX) issued 78.0 million ANDX units to Andeavor (ANDV) to cancel its IDRs, and ANDV agreed to waive an additional $60 million in distributions. The transaction is expected to be accretive to ANDX’s DCF by 2H19 and reduces the need to issue equity. MPLX’s IDR elimination is expected to be accretive to DCF in 3Q18. Spectra Energy Partners’ (SEP) IDR elimination transaction is expected to be breakeven to DCF per unit by 2H19 and accretive thereafter.

Eliminating IDRs permanently reduces the cost of equity capital for MLPs, as MLPs are free from the requirement of paying an increasing percentage of distributions to the GP. Without IDRs, the cost of equity capital is just the distributions paid on LP units, or effectively, an MLP’s yield. As such, it is less expensive to issue equity because there isn’t the increase in IDR payments that comes with an increase in units outstanding. For example, let’s assume an MLP has a yield of 7%. Without IDRs, its cost of equity is just 7%, but with IDRs, the cost of equity when factoring in the GP take (let’s assume 30%) is closer to 10%, which is calculated as 0.07 / (1.00-0.30). As the 30% continues to increase over time, so will the cost of equity, all else being equal. A lower cost of capital reduces the hurdle rate for project returns and broadens the opportunity set for MLP growth projects. In sum, eliminating IDRs improves the long-term sustainability of the partnership.

IDR eliminations can benefit the parent companies.

Parent companies also stand to benefit from IDR eliminations to the extent that transactions provide increased clarity around the value of ownership in the LP. Recall, parent companies typically own IDRs as well as a certain amount of LP units. The LP units have a clear value, as determined by the market. However, placing a value on the IDRs can tend to be somewhat opaque when held within a broader C-corporation like an independent refiner (e.g. HFC, MPC, ANDV) or exploration and production company [e.g. Hess Corporation (HES)]. In a simplification transaction, often the LP will issue common units to the GP in exchange for the elimination of IDRs and conversion of the GP interest into a non-economic interest. The result is that the parent will own a greater proportion of the LP’s interest following the elimination and will continue to receive significant LP distributions (though some GPs have waived a portion of their LP distributions to support the MLP). The chart below shows examples of how parent ownership of the MLP increased following IDR elimination transactions.