What are Incentive Distribution Rights?
Incentive distribution rights (IDR) give a general partner an increasing share of a limited partnership's incremental distributable cash flow. Used in master limited partnerships (MLP), IDRs outline per-unit distribution increases to the limited partners. The general partner's share of incremental distributable cash flow usually starts at 2% and climbs to higher levels such as 20% or 50%. IDRs are used to align the interests of all parties in a partnership.
Incentive Distribution Rights Explained
A master limited partnership's IDR schedule tends to be structured so as to encourage the general partner to drive distribution growth for limited partners. If the payouts for limited partners reaches a predetermined level, then the general partner receives an increasingly higher payment based on the limited partnership's increment cash flow. Incentive distribution rights are generally determined based on quarterly distribution figures.
IDRs are often misunderstood by MLP investors because they can be complex and are relatively uncommon. Some general partners abuse the IDR mechanism, leading to outsized payments to them. Each IDR within an MLP is structured differently, and therefore prospective MLP limited partners are well-served by analyzing this structure in any potential investment. Some structures may have the effect of promoting or inhibiting distribution growth for limited partners.
Incentive Distribution Rights: What to Watch
Some incentive distribution rights are structured in a way that unfairly benefits the general partner (GP). Bob Coble, a portfolio manager and analyst writing for Oppenheimer Funds, provides a few examples of IDR mechanics within an MLP:
"Kinder Morgan Energy Partners (NYSE: KMP), on an adjusted basis, distributed $0.63 per unit to its LPs in 1995 and $2.1 million to its GP through IDRs. In 2013, prior to the roll-up of KMP by its GP, Kinder Morgan Inc. (NYSE: KMI), KMP was paying $5.33 per unit to its LPs and $1.6 billion annually to KMI through IDRs. For little incremental investment, KMI experienced a 75,000% increase in IDR cash flow, which accounted for 52% of the total cash flow being distributed by KMP."
"Plains All American Pipeline LP (NYSE: PAA). In 1999, PAA, on an adjusted basis, distributed $0.92 per unit to its LPs and $230,000 to its GP through IDRs. For the most recent quarter, prior to its IDR restructuring, PAA was distributing $2.80 per unit to its LPs and $615 million annualized to its GP through IDRs. For little incremental investment, PAA’s general partner experienced a 250,000% increase in IDR cash flow and which accounted for 34% of the total cash flows being distributed by PAA."
As Coble noted, the general partner incentive can be enormous. That generally means that the limited partner has done well, too, over a long period of time. And if the MLP's performance should falter, the limited partner should see their cash flow hit less drastically than the general partner because of the IDR's structure. The bargain for limited partners is that they trade some (or a lot) of the upside for more steady, reliable cash flow. But cash flow and risk aspects of IDRs frequently lead to contentious relations between limited partners and the general partner. Some GPs abuse the IDR mechanism, creating terms that drastically favor them over the limited partners.