Master limited partnerships, or MLPs, are tax-advantaged entities that have been used by businesses like energy companies to raise capital since 1983. The most common type of MLP, a prototypical MLP or PTP, raises an average of $300 million at IPO, with some even exceeding the billion dollar mark. But though MLPs have been around for well over three decades, investors often find them confusing. In an effort to demystify these misunderstood vehicles, we break down a few key aspects of MLPs below.
- There are two different tax treatments for MLPs.
MLPs are commonly referred to as pass-through entities. Pass-through entities allocate their taxable income to investors, meaning they are not subject to entity-level taxes. But this is not true of all MLPs. While prototypical MLPs are pass-throughs, there are also taxable MLPs. As their name suggests, the latter are subject to federal incomes taxes. However, they retain the MLP designation because their capital structure and governance is similar to one type of pass-through MLP, and they are sold by brokers in a similar manner.
- Stability of returns may vary depending on the distribution policy of the MLP.
To some investors, especially dividend investors, one of the most attractive features of MLPs is their cash payouts. But the stability of MLP distributions varies, depending on the type of MLP. Prototypical MLPs can be broken down into two categories: traditional MLPs and variable distribution MLPs. The former intend to provide investors with stable quarterly distributions, while the distributions of the latter — as their name suggests — are expected to fluctuate. Taxable MLPs, which are similar in structure to traditional MLPs, also provide generally stable distributions.
- Some MLPs use “distribution waterfalls.”
All MLPs have two kinds of owners: general partners and limited partners. General partners are entities owned by a sponsor, such as a large energy company, and they’re essentially in charge of running the MLP. Limited partners are members of the general public and institutional investors. The MLP’s sponsor sometimes owns limited partner interests as well.
Variable distribution MLPs feature “common only capitalization,” meaning all owners, whether they’re GPs or LPs, receive the same distributions — based on their holdings — at the same time. But traditional MLPs and taxable MLPs use what’s known as “distribution waterfalls”: Members of the public — also known as common unitholders — receive minimum quarterly distributions (MQDs) first. If the MLP has additional money to distribute after providing MQDs to common unitholders, then general partners are entitled to the MQD on subordinated units, and thereafter the general partners may be entitled to IDRs as described below. After three years and the achievement of certain performance targets, the subordinated units convert to common units.
- MLP sponsors can be incentivized by IDRs.
What motivates a general partner to aim for outperformance? Incentive distribution rights, or IDRs, might do the job. In traditional MLPs and taxable MLPs, general partners can receive additional distributions when quarterly distributions exceed certain targets. The more that quarterly distributions exceed a specified target, the higher the “extra” distribution for general partners. IDRs can also be considered compensation to general partners and sponsors for holding subordinated units.
- Common unitholders rarely vote.
Though MLPs are publicly traded, their unitholders do not vote on issues with nearly the same frequency as shareholders of other publicly traded companies. An MLP’s sponsor determines the MLP’s governance structure, and appoints the directors to manage the general partner entity (which, in turn, runs the MLP). Unlike shareholders in a public corporation, common unitholders do not elect directors. Nor are MLPs required to hold annual meetings. There are only a few occasions in which common unitholders do get to vote, such as if the MLP is considering converting to a C-corporation, going private, or merging into another entity.
To learn more about MLPs, request a copy of V&E’s MLP Primer.