By Isaac Arnsdorf and Alex Nussbaum
Most businesses focus on profits. The energy infrastructure companies known as master limited partnerships are all about cash.
That’s because MLPs pay investors almost all the money they bring in, and sometimes even more. And the more they pay out, the more company managers can charge in fees. Some of them take a cut of as much as 50 percent — hefty enough that investors complain the money is diverted from maintenance on the pipelines and storage tanks the partnerships own.
Pegging fees to investor payouts creates incentives for managers to boost dividends, usually called distributions, by issuing debt and selling more shares rather than spending to improve the company, a cycle that can be tough to sustain, according to critics including Stuart Miller, an analyst at Moody’s Investors Service Inc. Higher fees can mean thinner cushions of cash in case revenue falls, making the MLPs a riskier investment for retirees who are buying into the stocks more than ever as low interest rates make it difficult to find income.
“It’s management’s job to maximize the return and not to siphon money off the top,” said Elliot Miller, a 79-year-old retired tax attorney in Naples, Florida, who owns more than $9 million in MLP shares. “I just don’t like that they do it.”
Of 39 MLPs tracked by Morgan Stanley, those that paid more than 10 percent of their income to management took in $1.09 for every dollar they paid out last year, compared with $1.17 for the companies with lower fees, figures in a March 23 report show.
“It’s not good because there’s now an incentive to push money out instead of reinvesting in the business,” said Stuart Miller, the Moody’s analyst. “It’s definitely riskier because of the incentive to maximize distributions.”
MLPs pay no corporate income tax. The law requires them to draw at least 90 percent of their revenue from natural resources such as oil and gas.
Defenders including Dan Tutcher, the former president of Enbridge Energy Partners LP (EEP), a Houston-based pipeline MLP, say the fees are part of how the industry works, and they’ve paid off for investors.
“I always hear this argument from analysts and those who don’t like how the system has been set up,” said Tutcher, now the principal at Houston-based Center Coast Capital Advisors LP, which manages $3.25 billion, focusing on MLPs. “All you have to do is look at the growth in the last 15 years and you start to realize that’s just talk.”
The Standard & Poor’s MLP Index returned 27 percent annually the past five years, compared with 19 percent for the S&P 500 Index of U.S. stocks. The partnerships yielded 6.6 percent in the past 12 months, data compiled by Bloomberg show. Their number has almost doubled in the past four years and their combined market value topped $500 billion, data compiled by Bloomberg show.
Expanding the business gets more expensive as management companies increase their take, and the MLPs with the highest payments could find it hard to maintain their growth, said Gregory Reid, president and chief executive officer of Houston-based Salient Partners LP’s MLP business.
Reid, who helps oversee about $3 billion, said he usually avoids investing in the MLPs with high fees and instead puts his money in the fee-taking management companies instead.
The rising payments to managers commonly used now, known as incentive distribution rights or IDRs, were intended to tie fees to distribution increases, according to Kevin McCarthy, who helped develop the structure as an investment banker at PaineWebber Inc. in the 1980s.
“For 15 years I’ve been answering questions on IDRs and whether I thought they were good or not,” said McCarthy, now managing partner at Los Angeles-based Kayne Anderson Capital Advisors LP, which oversees about $26 billion. “They’ve spurred more growth than they’ve hindered.”
Still, investors will start demanding an end to management fees, said Brian Watson, director of MLP research at Oppenheimer SteelPath MLP Funds, which oversees about $10 billion.
“What worked for the last five years may not be the best place to be for the next five years,” said Reid of Salient Partners.
Management usually has discretion to decide how much to pay investors, according to the website of Latham & Watkins LLP, a law firm that specializes in MLPs. Unlike corporate shareholders, MLP investors typically lack voting rights.
Enterprise Products Partners LP (EPD), the largest MLP by market value, quit paying fees when it bought out its management company in 2010. The Houston-based pipeline operator is now more transparent than MLPs with separate management companies and affiliates, Chief Executive Officer Michael Creel said on a March 18 conference call for analysts and investors.
“We’re invested alongside with the public,” he said. “We’re invested in exactly the same thing.” The company has “50,000 miles of natural gas, NGL crude oil, refined products and petrochemical pipelines,” according to its website.
Enterprise Products made $1.48 for every dollar it paid to investors last year, according to the March 23 estimate by Morgan Stanley.
On the other end of the spectrum is Kinder Morgan Energy Partners LP (KMP), the second-largest MLP. Kinder Morgan Inc., a separate publicly traded company, controls the MLP, owns 12 percent and takes 50 percent of distributions over 23 cents per share. The MLP took in $1.01 for every dollar it distributed in 2013, according to Larry Pierce, a company spokesman.
A Morgan Stanley analysis of 39 MLPs found that the Kinder Morgan MLP took in 97 cents for every dollar it paid out in 2013 — a figure Kinder Morgan disputes, Pierce said — and the management company took 46 percent of the distribution.
Because the financial measures MLPs use aren’t standard, companies and analysts can define them differently, according to Julie Hilt Hannink, head of energy research at New York-based CFRA, an accounting adviser. Kinder Morgan adds items to its available cash that might not match analysts’ calculations, she said in a phone interview.
“It’s complete management discretion,” she said.
Kinder Morgan announces quarterly earnings today.
When MLPs pay out more than they take in, they make up the difference with debt or by issuing more shares, also called units, which dilutes existing investors’ stakes. That might be fine if they’re funding expansion projects that will return more cash in the future, said Quinn Kiley, senior portfolio manager at Advisory Research Inc. in St. Louis, who helps oversee $4.5 billion in MLP investments.
Or it might be a sign of a company that can’t afford its distributions to investors, said Reid, the Salient fund manager.
The 114 MLPs owe a combined $219 billion, up from $193.8 billion in 2012, according to data compiled by Bloomberg. Eighteen have investment-grade ratings from Standard & Poor’s, compared with 41 rated non-investment grade. (The rest aren’t rated.) In the past year, the companies issued shares 77 times totaling $24.9 billion, a 4 percent increase from the $23.9 billion in the preceding 12-month period, data compiled by Bloomberg show.
MLPs that pay out close to or more than the cash they make have less margin for error to cover their distributions to investors if something goes wrong, said William Ferara, an analyst at S&P in New York. Management fees play a role because they encourage more aggressive capital spending, which has to be financed with debt or equity, he said.
In a class-action lawsuit filed Feb. 5 in Delaware Chancery Court, investors allege that Kinder Morgan inflated its payout by miscategorizing maintenance spending. There’s a conflict of interest because Kinder Morgan Inc., the MLP’s management company, makes almost eight times more from fees than it does from its stake in the partnership, according to the complaint.
Kinder Morgan said the lawsuit lacked merit and moved to have it dismissed on March 3. The Houston-based company said it often pays for maintenance out of operating expenses, so how it categorizes capital spending doesn’t affect the bottom line.
Kinder Morgan’s stock price has suffered as investors focus on how management fees make it more expensive for the company to grow, John Edwards, a Houston-based analyst at Credit Suisse Group AG, said in an April 2 report. Shares have fallen 12 percent to $77.86 in the past year. While investors would benefit, Edwards said changing the management-MLP structure could disadvantage Richard Kinder, the company’s billionaire founder, who’s slated to get $1.9 billion in dividends over the next four years. Kinder takes $1 a year in salary.
Kinder Morgan said in an e-mailed statement that both the MLP and its management company are attractive investments that have “produced substantial cash flow in virtually all types of market conditions.”
“If we get to a point where we cannot deliver attractive returns to our investors, we would consider other options,” the company said in the statement.
Among the MLPs that have the highest management fees are Dallas-based Energy Transfer Partners LP (ETP), which paid its management company 32 percent in 2013; Tulsa, Oklahoma-based ONEOK Partners LP (OKS), whose management took 30 percent; and Williams Partners LP, which paid managers 24 percent, according to Morgan Stanley.
Vicki Granado, an Energy Transfer Partners spokeswoman, declined to comment. Brad Borror, a spokesman for ONEOK Partners, didn’t return calls seeking comment about the fees.
Williams Partners may have to slow its distribution growth as it pays out more money than it takes in for a third year, according to Christopher Sighinolfi, an analyst at Jefferies LLC in New York who downgraded the company to “hold” from “buy” on March 20. Sighinolfi also cited thinning profit margins from natural gas and oil products Williams Partners (WPZ) sells.
Amid the cash squeeze, the Tulsa-based company has been reducing spending on pipeline maintenance, Sighinolfi said in a March 20 report. That raises the question of whether Williams takes money from maintenance to smooth over its payouts, Sighinolfi said in a phone interview.
“There’s a coincidental movement there,” he said.
Williams Partners, in an e-mailed statement, said it has invested $1.4 billion in maintenance capital projects over the last four years, more than comparable energy partnerships. Its management company has waived fees in the past to support its MLP. It also owns 66 percent of the MLP’s stock, serving to “tightly align” the interests of the two, the company said.
Miller, the retired Florida investor, said he’s happy with the high returns he’s gotten from MLPs. He favors partnerships such as Enterprise Products and Denver-based MarkWest Energy Partners LP and avoids the ones with high fees.
“As a semi-religious belief, I prefer MLPs with no fees,” he said. “It’s money that should go to unitholders.”