For most of the new millennium, U.S. oil and gas exploration has been booming. As the tides rose, so too did Master Limited Partnerships (MLPs) — especially within the robust midstream sector.
An advantageous tax structure, which allows MLPs to be qualified as a partnership, combined with historically low interest rates made the structure attractive to investors seeking yield. In turn, MLPs were given relatively easy access to new capital to reinvest in growth.
Recently, however, that momentum has begun to wane. In 2018 alone, 14 MLPs have converted to a c-corp or otherwise restructured — and more are likely on the way.
While tax reform and recent Federal Energy Regulatory Commission rulings have played a role, the main driver is structural. In a traditional MLP, the general partner/sponsor holds incentive distribution rights (IDRs). Provided that quarterly distributions to limited partners meet certain thresholds, the holder of the IDR is entitled to an increasingly large percentage of such distributions. To meet these thresholds, however, the MLP must constantly increase cash flow by acquiring new assets — which, in the highly competitive midstream space, has become increasingly challenging. What’s more, these disproportionate distribution rights — along with a perceived lack of transparency — have made it harder for many MLPs to raise new capital.
Existing MLPs should carefully evaluate their current situation. If they’re confident with forecasted cash flows and the ability to raise additional capital, an MLP sponsor may conclude that the traditional structure will continue to best meet its needs. If, however, the MLP sponsor concludes that a change of structure is appropriate, there are a range of options. For example, it could convert or merge into an affiliated c-corp, or maintain its tax efficiency but eliminate the disparate distribution by converting IDRs into limited partnership units.
As for new ventures, the future is less clear. MLPs remain tax efficient and, depending on overall industry conditions and interest rates, they may continue to be attractive to investors. What is clear is that moving forward, sponsors of a new MLP may want to consider potential adjustments to the traditional IDR structure.