MLP Primer Part 1: Incentive Distribution Rights (IDRs)

MLP Primer Part 1: Incentive Distribution Rights (IDRs) July 16, 2014 Kevin Kaiser kkaiser@hedgeye.com @HedgeyeEnergy HEDGEYE ENERGY JULY 16, 2014 1

Introduction to this Primer The reach for yield has triumphed over common sense. MLP promoters and distributors have created new metrics and valuation methods that justify equity prices far in excess of what traditional analysis would deem reasonable. The historically-reliable standard of equity value earnings has been replaced with the highly-subjective distributable cash flow (DCF). MLP investors are placing abovemarket multiples on distributions that are often largely a return of capital and even that is spun as a tax advantage of MLPs, although corporate dividends that exceed earnings receive the same tax treatment. But the most egregious aspect of MLPs is the ownership and compensation structures that enable the General Partners (GPs) to strip enormous amounts of cash out of the partnerships while putting up a just sliver of the equity capital, often just one or two percent. In what is a zero-sum game, every incremental fee dollar paid to the GP is a dollar loss for the Limited Partners (LPs). For many MLPs, the allocation of risk and return is grossly in favor of the GPs at the expense of the LPs. How is this possible? It s likely that there is not a greater instance of information asymmetry in capital markets than there is in the MLP sector today. On one side is the retail investor buying the LP units, enticed by the above-market distribution yield with little mind to how that distribution is actually financed. Often, the LPs are just getting their own money back. And on the other side are the sophisticated individuals, private equity firms, and hedge funds invested in the GPs; and the investment banks, analysts, brokers, and lawyers that help make these parasitic relationships possible. The MLP sector is rife with misconceptions and logical fallacies that serve to justify both absurd LP unit prices and fees to the GPs. The aim of our MLP Primer which we ll publish in a series of notes is to set the record straight on a number of these issues. We start here with a discussion of the Incentive Distribution Right (IDR). HEDGEYE ENERGY JULY 16, 2014 2

Summary Bullets The IDR is a wealth transfer from the LPs to the GP. As good of a deal as the IDR is for the GP is as bad of a deal as it is for the LPs. It s in the interest of the GP to maximize the IDR fee; it s in the interest of the LPs to minimize the IDR fee. The IDR inherently conflicts the interests of the LPs and GP. The IDR cripples LP returns. LPs with IDR burdens should fear project backlogs. IDR fees are based off of LP distributions, not LP economic earnings. The LP distribution is at the discretion of the GP. The GP liquidates/loots the LPs when the LP distribution is greater than its economic earnings via an outsized IDR fee. A distribution payment is not, and never has been, a reliable standard of equity value, though MLPs are priced today as if it is. MLPs with IDR burdens are highly overvalued today. An Investment Proposition There exists the opportunity to invest in a business that s manager takes half of the business s income as a management fee. The manager owes limited fiduciary duties to you, and can act against your interests in the event of a conflict. You will receive an above-market distribution yield, but the business requires constant access to capital markets and high leverage to maintain or grow it. Much of the distribution will be a return of capital, in other words, you ll get your own money back. The industry is in the midst of a boom, but it s capital-intensive, competitive, and cyclical. And you can invest in this business at double the earnings multiple of the S&P 500. This is the investment proposition for many MLPs today. What is an IDR? Incentive Distribution Rights (IDRs) are claims on MLP distributions, typically owned by the GP. A form of management compensation unique to MLPs, the IDR entitles the GP to an increasing share of the MLP s total distributions, disproportionally greater than its economic interest, as the LP per unit distribution surpasses predetermined levels. Importantly, IDR payments are not based on the partnership s earnings, but on its declared distributions. It s not exactly intuitive, so we ll walk through how the IDR works using a real example the IDR fee that Williams Partners LP (WPZ) declared to its GP, owned by Williams Companies, Inc. (WMB), in 1Q14. WMB owns a 2% economic GP interest in WPZ and 100% of WPZ s IDRs. The WPZ/WMB ownership structure is fairly standard for the MLP industry. WPZ s IDR target distribution levels (often splits, tiers, or hurdles ) are determined by the GP (WMB) and laid out in its partnership agreement. When WPZ s quarterly distribution per unit is below $0.4025, the total cash distributions are allocated 98% to the LPs and 2% to the GP, which is consistent with their respective ownership stakes. Any quarterly LP distribution above $0.4025 triggers an IDR payment, such that the GP now takes a percentage of the total cash distributions that is greater than its 2% economic interest, and vice versa for the LPs. WMB takes 15% of the distributions when the LP quarterly distribution is between $0.4025 and $0.4375, and 25% of the distributions between $0.4375 and $0.5250. When WPZ s quarterly distribution HEDGEYE ENERGY JULY 16, 2014 3

surpasses $0.5250, the LPs and GP split the distributions 50%/50%; this is commonly referred to as the high splits. Once the WPZ is in the high splits, WMB takes 50% of all incremental distributions, again, despite only owning 2% of the partnership. In 1Q14 WPZ declared a distribution of $0.9045 per LP unit, putting it well into the high splits. In 1Q14 WPZ declared distributions of $582MM to its LPs and GP, before $16MM of waived IDRs (more on IDR waivers later). Of that, $397MM (68% of the total) went to the LPs, $12MM (2%) went to WMB s 2% GP interest, and $174MM (30%) went to WMB in the form of IDR fees. Net of waived IDRs, WMB s IDR fee was $158MM and total distributions were $566MM. See TABLE 1. TABLE 1: IDR EXAMPLE: WPZ/WMB WPZ 1Q14 Common Units (MM) 439 WPZ 1Q14 LP Distribution ($/unit) $0.9045 Quarterly LP Distribution Marginal Percentage Interest in Distributions Target Amount LPs GP 2% GP IDR GP Total Total 1st Target Distribution up to $0.4025 98% 2% 0% 2% 100% 2nd Target Distribution above $0.4025 up to $0.4375 85% 2% 13% 15% 100% 3rd Target Distribution above $0.4375 up to $0.5250 75% 2% 23% 25% 100% Thereafter above $0.5250 50% 2% 48% 50% 100% Quarterly LP Distribution Distributions Paid ($MM) Target Amount LPs GP 2% GP IDR GP Total Total 1st Target Distribution up to $0.4025 $ 177 $ 4 $ - $ 4 $ 180 2nd Target Distribution above $0.4025 up to $0.4375 $ 15 $ 0 $ 2 $ 3 $ 18 3rd Target Distribution above $0.4375 up to $0.5250 $ 38 $ 1 $ 12 $ 13 $ 51 Thereafter above $0.5250 $ 166 $ 7 $ 160 $ 166 $ 333 Total Distributions before IDR "Waiver" $ 397 $ 12 $ 174 $ 186 $ 582 IDR "Waiver" $ - $ - $ (16) $ (16) $ (16) Total Distributions after IDR "Waiver" $ 397 $ 12 $ 158 $ 170 $ 566 Distribution per LP Unit $ 0.90 $ 0.03 $ 0.36 $ 0.39 $ 1.29 Share of Marginal Distributions 50% 2% 48% 50% 100% Share of Total Distributions before IDR "Waiver" 68% 2% 30% 32% 100% Share of Total Distributions after IDR "Waiver" 70% 2% 28% 30% 100% Sources: Hedgeye; WPZ Filings 2014 HEDGEYE IDRs: Iniquitous and Ubiquitous WPZ s reported net income to the LPs and GP was $352MM in 1Q14. Total distributions declared were 161% of net income, and the GP s IDR fee alone was 45% of net income. But we cite WPZ/WMB only for illustrative purposes. In fact, Kinder Morgan Energy Partners LP (KMP/KMR) pays its GP, owned by Kinder Morgan Inc. (KMI), the highest IDR fee of all MLPs $449MM after deducting $33MM of waived IDRs in 1Q14, which amounted to 60% of KMP s net income. This bears repeating: KMP pays out ~60% of its earnings to its manager, which owns merely 2% of the company. MLP trailblazers like Kinder Morgan and Williams have demonstrated (so far) that it s actually possible to pull off what must be of the most iniquitous ownership structure in corporate America today. As a result, IDRs are now ubiquitous, and growing increasingly popular. In TABLE 2 below we show 1Q14 IDR and net income data for 15 of the largest MLPs that are in the 50%/50% IDR split. Two MLPs on the list, Atlas Pipeline Partners LP (APL) and Crestwood Midstream Partners LP (CMLP), declared IDR fees that exceeded the partnerships net income in 1Q14. Before waived IDRs, KMP declared an IDR fee to KMI equal to two-thirds of its net income, and WPZ and Energy Transfer Partners LP (ETP) declared GP incentive fees equal to roughly half of their profits. In aggregate in 1Q14, HEDGEYE ENERGY JULY 16, 2014 4

these 15 MLPs declared $1.2B of IDR distributions to their GPs, which was ~40% of their adjusted earnings. TABLE 2: MLP IDR Fees as a % of Net Income before XO Items 1Q 2014, in $MM MLP Current IDR Split Gross IDR Fee as a % of Net Income Net IDR Fee as a % of Net Income Net Income to LPs and GP before XO Items* Gross IDR Fee Declared IDR Fee Waived Net IDR Fee Declared 1 APL Atlas Pipeline Partners LP 50% / 50% -74% -74% ($7) $5 $0 $5 2 CMLP Crestwood Midstream Partners LP 50% / 50% 188% 188% $4 $8 $0 $8 3 KMP Kinder Morgan Energy Partners LP 50% / 50% 65% 60% $746 $482 ($33) $449 4 WPZ Williams Partners LP 50% / 50% 49% 45% $352 $174 ($16) $158 5 ETP Energy Transfer Partners LP 50% / 50% 49% 32% $345 $168 ($57) $111 6 SXL Sunoco Logistics Partners LP 50% / 50% 36% 36% $107 $38 $0 $38 7 EEP Enbridge Energy Partners LP 50% / 50% 34% 34% $97 $33 $0 $33 8 EPB El Paso Pipeline Partners LP 50% / 50% 30% 30% $173 $52 $0 $52 9 ACMP Access Midstream Partners LP 50% / 50% 29% 29% $61 $18 $0 $18 10 PAA Plains All-American Partners LP 50% / 50% 29% 29% $384 $110 $0 $110 11 OKS Oneok Partners LP 50% / 50% 27% 27% $265 $72 $0 $72 12 WES Western Gas Partners LP 50% / 50% 26% 26% $87 $23 $0 $23 13 DPM DCP Midstream Partners LP 50% / 50% 26% 26% $92 $24 $0 $24 14 NGLS Targa Resources Partners LP 50% / 50% 26% 26% $122 $32 $0 $32 15 SEP Spectra Energy Partners LP 50% / 50% 15% 15% $242 $37 $0 $37 TOTAL 42% 38% $3,071 $1,275 ($106) $1,169 *Note: XO Items include unrealized derivative gains/losses, gains/losses on sale, and imputed preferred dividend effect. Sources: Hedgeye; Company Filings 2014 HEDGEYE The Perfect Mouse Trap? A few important truths about IDRs: 1. This is a zero-sum game. An incremental $1 of IDRs paid to the GP is a $1 taken out of LPs pockets. 2. It s in the interest of the GP to maximize the IDR fee. 3. It s in the interest of the LPs to minimize the IDR fee. 4. The GP has disclaimed the fiduciary duty of loyalty to its LPs and is thus allowed to act in its own interests, counter to the interests of the LPs, in a conflict. 5. The IDR is a function of the LP per unit distribution, which is at the GP s discretion. 6. A distribution (or dividend) is not, and never has been, a reliable standard of equity value. A distribution payment may or may not reflect the partnership s economic earnings. There is a perverted truth to the IDR it certainly gives the GP the incentive to grow the LP per unit distribution. But is that in the LPs interest? The popularly held belief is that the IDR aligns the GP and LPs because both benefit from a higher LP per unit distribution. That sounds right, but it s not. Economically, the optimal distribution for the LPs would be the one that pays the GP no IDR fee at all. For instance, KMI s IDR kicks in when KMP s quarterly distribution is above $0.15125/unit. Thus, economically, the best case scenario for the KMP unitholder would be to keep the distribution at or below this level, paying KMI no more than it deserves, 2% of the total distributions. HEDGEYE ENERGY JULY 16, 2014 5

Once the LP distribution is above the first IDR hurdle, every distribution increase harms the LPs, as it increases the IDR payment. This is lost upon the majority of MLP investors and analysts that clamor for higher distributions. As an example, suppose we asked all of KMP s unitholders to vote on, Should KMP cut the distribution to zero? We bet that the LPs would overwhelmingly vote No, even though it would be immensely beneficial to them to do exactly that; they would save close to $2B in IDR payments each year! To the delight of the GPs, MLP investors have come to believe that the distribution is indicative of the value of the business paying it. Maybe it is, but maybe it s not. Regardless, MLPs are yield-supported securities. And because the GP controls the LP distribution, it also controls the market prices of their MLPs and the IDR fees that they collect from them. Seemingly, the GPs have built the perfect mouse trap. Bleeding the LPs If an MLP s distributions are actually representative of its economic earnings, the only problem with the IDR is the mere fact that it exists, giving the GP a share of the partnership s earnings and distributions in excess of its ownership stake, and depressing the LPs returns. But if the distribution declared is greater than the MLP s economic earnings, the GP systematically bleeds the LPs, because the distributions are financed with new LP capital. At least in the short run, the GP is incentivized to have the LP distribute more than it really earns, as the LP investors are suckers for the higher distribution and the GP collects a higher IDR fee. And when the MLP has to issue more LP units to finance outsized distributions, all the better for the GP, as that, too, increases the IDR fee. This self-reinforcing process can work well for some time, but not indefinitely. In the long-term, it is sure to end badly for both the LPs and the GP (unless the GP exits with a sale to its LPs first). MLP investors tend to be wary of MLPs with coverage below 1.0x that is when distributable cash flow (DCF) is less than distributions declared as it could be a precursor to a distribution cut. But it s worse than that for MLPs with IDR obligations. For now we ll assume that DCF is indicative of economic earnings (though, in our experience, it rarely is). If total DCF is less than the LP and GP distributions declared, the MLP is part Ponzi scheme because it finances distributions with new capital. Not only is the LP distribution too high, but so is the IDR fee paid to the GP. NuStar Energy LP (NS) and Enbridge Energy Partners LP (EEP) are two MLPs that have had coverage on their reported metrics below 1.0x in recent years, but did not cut their distributions. The GPs, owned by NuStar GP Holdings, LLC (NSH) and Enbridge Inc. (ENB), respectively, have undoubtedly collected IDR fees in excess of their MLPs ability to fund them organically. What s more, EEP recently restructured, canceling its existing IDR obligation to ENB in exchange for $2B of new LP units and a new IDR schedule. So after overcompensating ENB for years, EEP paid ~15x that outsized IDR fee to get rid of it Incredible! While this is a subject to be explored further in another chapter of this primer, another way that the GP can liquidate the LPs is to justify distributions (and its IDR fee) with a DCF figure that does not reflect the partnership s economic earnings. When this is the case, reported DCF coverage is meaningless. The MLP is a Ponzi, it s just less apparent. In our view, this issue is endemic in the MLP sector today. As evidence, in 2013, the Alerian MLP Infrastructure Index (AMZI) paid out dividends equal to 179% of its earnings. The most common DCF adjustment is the substitution of maintenance capital expenditures (CapEx) for DD&A. Conveniently for the GPs, non-gaap, non-audited maintenance CapEx is typically a small fraction GAAP, audited DD&A. In 2013, the midstream MLPs, on average, reported maintenance CapEx equal to just 28% of DD&A. This is a problem for all MLPs, though it s particularly egregious for an MLP with IDRs. HEDGEYE ENERGY JULY 16, 2014 6

For an MLP in the 50%/50% IDR split, every $1 of capital expenditures (or replacement reserve) that should be maintenance CapEx and isn t, is a $0.50 loss for the LPs and a $0.50 gain for the GP a direct wealth transfer. The GP and LPs split the incremental $1 of DCF $0.50/$0.50, but the LPs finance that extra $1 of growth CapEx. When reported maintenance CapEx is not enough to keep cash flows flat, both the LP distribution and GP s IDR fee are overstated relative to the MLP s economic earnings, and the LPs finance distributions. IDR Impact on LP Returns It s hard to believe that a business can earn its cost of capital in a competitive industry when it forfeits at least 50% of its profits from new investments to its manager. Consider an MLP that is 98% owned by the LPs and 2% by the GP, and in the 50%/50% IDR split. The GP decides that the MLP will make a $100 equity investment in a new pipeline with a 10% return on equity. In this scenario, the LPs put up $98 and receive $5 of incremental distributions, for a 5.1% ROE; the GP invests $2 and also receives $5, for a 250% ROE. The GP s return is ~50x greater than the LPs. We present project ROEs for the LPs and GP under various IDR scenarios in TABLE 3. TABLE 3: Impact of IDRs on LP and GP Returns Assumptions GP Ownership Stake in MLP 2% LP Ownership Stake in MLP 98% Payout Ratio (Distribution / Earnings) 100% Project / Acquisition Return on Equity 5.0% 7.5% 10.0% 12.5% 15.0% LP Return on Equity No IDR 5.0% 7.5% 10.0% 12.5% 15.0% In 85%/15% Split 4.3% 6.5% 8.7% 10.8% 13.0% In 75%/25% Split 3.8% 5.7% 7.7% 9.6% 11.5% In 50%/50% Split 2.6% 3.8% 5.1% 6.4% 7.7% GP Return on Equity No IDR 5.0% 7.5% 10.0% 12.5% 15.0% In 85%/15% Split 37.5% 56.3% 75.0% 93.8% 112.5% In 75%/25% Split 62.5% 93.8% 125.0% 156.3% 187.5% In 50%/50% Split 125.0% 187.5% 250.0% 312.5% 375.0% Sources: Hedgeye 2014 HEDGEYE As you can see from TABLE 3 above, LP project economics are crippled by the IDR. If the LPs required rate of return (cost of equity) is 10% absent the IDR, then it is 20% when burdened by the 50%/50% IDR split. Once in the high splits, the LPs are highly unlikely to earn their cost of equity on a new project or acquisition, particularly as the MLP sector grows more competitive. This is important to consider in the context of project backlogs and serial acquisition/ drop down strategies. The MLP industry is obsessed with expansion, which is not surprising given the incentive the GP has to put as much LP capital to work as possible. The Kinder Morgan management team said the word backlog more than 60 times during its January 2014 annual analyst presentation. No doubt, KMI investors want to hear all about the backlog. But the LPs should really fear the backlog, as every project added to it is another project that the LPs will likely lose money on (or at least wear all of the risk for just a fraction of the reward). HEDGEYE ENERGY JULY 16, 2014 7

Contrary to popular opinion, a giant backlog is a giant liability for LPs burdened by an IDR. Being an LP with a 50%/50% IDR burden is worse than being an LP in a hedge fund with a 50% performance fee; at least the hedge fund s performance is marked to market, and the fee is objectively calculated. MLP GPs name their performance fees, regardless of the performance! Are IDRs Priced Right? Are IDRs fair? Of course not. The GP owns 2% of the MLP but takes a significantly larger percentage of its income. These GP/LP arrangements are not fair and they never were intended to be; the GPs sign the partnership agreements with disclaimed fiduciary duties on the behalves of all the LPs. There is no competitive bargaining between the two parties, it s an anti-capitalistic arrangement. KMP compensates KMI ~$2B per year (above and beyond G&A) for what, exactly? What value does the GP add? What does the GP do that justifies this fee? We ask the same of all GPs. Many are of the view that such questions are irrelevant because the GP/LP arrangement is fully disclosed in the partnership agreement, and the LPs are free to choose to own LP units or not. Caveat emptor. Better yet, the popular quip goes, If you don t like it, just own the GP. At least in the near-term, we do agree with these sentiments. But in a competitive industry, how long can a business survive when only a fraction of its profits reach its owners? In our view, the IDR mechanism is destined to fail, and we don t want to own either the GP or LP when the day of reckoning arrives. While the IDR makes for a great philosophical debate, the question that really concerns us is whether or not the IDR is priced appropriately at the LP level. The AMZI is currently trading at ~37x TTM earnings versus the S&P 500 at 18x. This is difficult to justify given that some of the largest AMZI components (KMP, WPZ, ETP, OKS, PAA, etc.) are in the high IDR splits. One would expect an MLP with an IDR burden to trade at a significant discount to the market. Further, on average, MLPs are significantly less profitable with higher leverage (risk) than the broad market. According to Bloomberg data, over the TTM, the AMZI earned a 6.1% ROE with 42% debt-to-capital and 4.5x net debt-to-ebitda versus the S&P 500 s 15.1% ROE with 24% debt-to-capital and 1.7x net debt-to-ebitda. The only statistic where the AMZI has an edge over the S&P 500 is, not surprisingly, in dividend yield: the S&P500 yields 1.9% versus the AMZI at 4.9% (TTM). However, the S&P 500 has a 6.5% free cash flow yield, while the AMZI is free cash flow negative. See TABLE 4. TABLE 4: Key Metrics, MLPs Vs. S&P 500 TTM Metrics (as of 7/16/2014) S&P 500 AMZI P/E Ratio 18.1x 37.1x Free Cash Flow Yield 6.5% -3.4% Dividend Yield 1.9% 4.9% Return on Equity 15.1% 6.1% Debt-to-Capital 24.4% 41.5% Net Debt-to-EBITDA 1.7x 4.5x Sources: Hedgeye; Bloomberg Data 2014 HEDGEYE HEDGEYE ENERGY JULY 16, 2014 8

We provide additional detail on MLP returns in TABLE 5, where we show the adjusted ROEs for midstream and coal MLPs in 2013. Our numerator is earnings to the LPs excluding extraordinary items and our denominator is average LP equity. In 2013, the median ROE was 7.8% and the average ROE was 8.7%. TABLE 5: MLP ROEs in 2013 Sources: Hedgeye; Company Filings 2014 HEDGEYE These are low ROEs for a sector that trades at 2X the P/E multiple of the market, but it is not surprising. Because as good of a deal as the IDR is for the GP is as bad of a deal as it is for the LPs and that s not well understood by most MLP investors, as evidenced by current MLP valuations. Consider the valuation of the IDR bellwether, KMP. KMP has guided its 2014 partnership net income to $3.0B and GP distributions to $1.9B. The LPs are left with earnings net of GP distributions of $1.1B, or ~$2.50 per LP unit. At the current unit price of $81, KMP is trading at 32x 2014e earnings, double the multiple of S&P 500. But KMP earns a mid-single digit ROE, is highly leveraged, and gives +50% of its incremental income to its GP. In our view, KMP is substantially overvalued; we cannot justify it trading at any premium to the market. Only on the arbitrary metric of distribution yield can one say that KMP is reasonably priced, and that is the MLP hook. HEDGEYE ENERGY JULY 16, 2014 9

In Closing, On IDR Waivers Occasionally the GP will waive (forgive, forego, give-back) IDR fees. In 1Q14, the GPs of KMP, WPZ, and ETP waived some IDR distributions. MLP supporters often couch IDR give-backs as the GP supporting the LPs. That s nonsense. What it really signifies is that the GP/LP model is broken (the LP cannot support the distributions), but the GP prefers to give up a little to keep the game going (and the LP stock price up), rather than cut the LP distribution. In our view, giving back a small percentage of the fees that the GP has no legitimate right to in the first place is not it being supportive, it s doing what it can to keep the golden goose alive. HEDGEYE ENERGY JULY 16, 2014 10

Disclaimer Hedgeye Risk Management is a registered investment advisor, registered with the State of Connecticut. Hedgeye Risk Management is not a broker dealer and does not make investment recommendations. This research does not constitute an offer to sell, or a solicitation of an offer to buy any security. This research is presented without regard to individual investment preferences or risk parameters; it is general information and does not constitute specific investment advice. This presentation is based on information from sources believed to be reliable. Hedgeye Risk Management is not responsible for errors, inaccuracies or omissions of information. The opinions and conclusions contained in this report are those of Hedgeye Risk Management, and are intended solely for the use of Hedgeye Risk Management s subscribers. In reaching these opinions and conclusions, Hedgeye Risk Management and its employees have relied upon research conducted by Hedgeye Risk Management s employees, which is based upon sources considered credible and reliable within the industry. Hedgeye Risk Management is not responsible for the validity or authenticity of the information upon which it has relied. Terms of Use This report is intended solely for the use of its recipient. Re-distribution or republication of this report and its contents are prohibited. For more detail please refer to the appropriate sections of the Hedgeye Services Agreement and the Terms of Use at www.hedgeye.com. HEDGEYE ENERGY JULY 16, 2014 11