Cash Flow and Master Limited Partnerships - dummies

Cash Flow and Master Limited Partnerships

By Amine Bouchentouf

The whole reason Master Limited Partnerships (MLPs) exist 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 GP

  • The difference between distributable and discretionary cash flow

The GP is responsible for distributing cash back to the 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. (But remember, this doesn’t mean that the investor with the greater number of units gets to keep all that cash — she still has to pay taxes on this income, based on her tax profile.)

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 85¢ and the GP gets 15¢ 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. The GP is thus encouraged to generate as much cash flow as possible because he gets a higher cut of the profits. This example shows the incentive behind this elegant and sophisticated tiered distribution system.

The distribution of cash flow is known as splits because the LPs split their share of cash flow with the GP. Tier 4, where the GP participates on equal footing with the LPs, is known as a high split.

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.

Before you invest in an MLP, ask your broker the following questions:

  • What’s the historical payout?

  • How much is cash flow?

  • What is the GP’s IDR?

  • What are the operational activities?

  • How much assets are under management?