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Commodity Investment Vehicles: Distributable and Discretionary Cash Flow

The whole reason master-limited partnerships (MLPs) exist in commodities markets is to distribute all available cash back to the MLP unit holders, which has to be done on a quarterly basis. These factors determine how much cash is distributed to each investor:

  • How many units the investors hold

  • The incentive distribution rights (IDRs) created for the general partner (GP)

  • The difference between distributable and discretionary cash flow

The GP is responsible for distributing cash back to the limited partners (LPs) proportionally to their holdings. In other words, an investor who owns 1,000 units gets twice as much cash as an investor who owns 500 units in the same MLP.

To promote the GP’s efforts to increase cash flow for shareholders, many MLPs include incentives for the GP. Generally, the more cash flow the GP generates back to shareholders, the more cash he gets to keep. Although IDRs are different for each MLP, they’re always based on a tier system. A typical IDR incentive structure for GPs increases the distribution rate to unit holders, as the following table illustrates.

Distribution Tier Dollar Distribution LP Payout GP Participation
Tier 1 $0.50 98% 2%
Tier 2 $1.00 85% 15%
Tier 3 $1.50 75% 25%
Tier 4 $2.00 50% 50%

Using this tier distribution system, if the GP generates $1 of cash flow per unit (Tier 2), the LP gets 85cents and the GP gets 15cents of that dollar.

However, if the GP is able to generate $2 of cash flow per unit (Tier 4), he gets to keep 50 percent of that amount, or $1; the LP gets a smaller percentage amount (50 percent, down from 85 percent) but gets a higher cash payout ($1) than other tiers.

Therefore, it’s in the best interest of the GP to maximize the cash flow to the investor. This point is important because the GP has a lot of discretion over how much of the available cash is actually redistributed to shareholders and how much will be used for operations related to the MLP — the difference between distributable cash flow and discretionary cash flow.

Distributable cash flow

Distributable cash flow describes the amount of cash that’s available to redistribute to shareholders. Generally, most MLPs calculate distributable cash flow by using the following formula:

MLP distributable cash flow = Income + (Depreciation and amortization) – Capital expenditures

This amount is the cash available to all members of the MLP, including both the GP and the LP. To calculate how much cash is distributed back to the LPs only, use the following formula:

LP distributable cash flow = Income + (Depreciation and amortization) – Capital expenditures – GP distribution

This formula takes into account the cash flow participation of the GP and is a more accurate indicator of how much cash will flow back to the regular investors — the LPs.

Discretionary cash flow

The GP has a lot of discretion over how much cash flow is distributed to shareholders. Although he could theoretically distribute all available cash flow back to shareholders, he’s unlikely to do so because the GP has to have cash to operate the MLP. This cash is known as discretionary cash flow, and, as the name implies, the GP can use it at his discretion.

Whereas distributable cash flow is a measure of how much cash could theoretically be distributed back, actual cash flow is calculated by factoring in discretionary cash flow. This simple equation gives you a more accurate way to calculate how much money you’ll end up with:

Actual cash flow = Distributable cash flow – Discretionary cash flow

This amount is the difference between how much can be paid and how much is actually paid.

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