Investors like buying master limited partnerships (MLPs) because they want to earn yield. MLPs historically offered energy pipeline investors a powerful combination of low risk, high growth, and high dividend yields. But in recent years, various MLP structures have proven to be more of a pipe dream, leading to meaningful reductions in payouts to investors.

The MLP structure has always been complex. In exchange for that complexity, it offered tax advantages that often led to a lower cost of capital than traditional corporate structures could. At the risk of oversimplifying, today’s MLPs are running up against several structural walls that make their promises to investors unsustainable. A key challenge has been the Incentive Distribution Rights, or IDRs, that MLPs traditionally granted to their parent companies. IDRs essentially require an MLP to pay out an escalating percentage of cash over time, which eventually creates an unsustainable cost of capital—at some point, the MLP is unable to find new projects that offer high enough returns to justify investment.

As a result, many MLPs have either collapsed their MLP structures and returned to a more standard operating company model, or retained the MLP model but eliminated the IDRs. Companies often refer to these as “simplification transactions,” but in reality, these are effectively dividend cuts that address an unsustainably high payout. Kinder Morgan—historically the bellwether for the asset class—collapsed its MLP in late 2014, and a variety of others have followed suit.

MLPs That Have Been Collapsed or “Simplified” In Recent Years

MLPs That Have Been Collapsed or “Simplified” In Recent Years

Source: Bloomberg

This year, regulatory pressures are mounting for MLPs. Specifically, the MLP universe was surprised in March when the Federal Energy Regulation Commission (FERC) disallowed a rate-setting practice that was highly favorable to the MLP structure. Pipeline operators set their rates according to a FERC-regulated “cost-plus” formula. For many years, this formula included projected tax expenses—even within an MLP structure that did not actually pay those taxes. The FERC ruling removed this favorable treatment, eliminating a powerful structural advantage for MLPs.

On the heels of this FERC ruling, Enbridge and Williams Companies—two notable players in the shrinking MLP universe—recently announced plans to “simplify” their MLP structures. Enbridge announced it would acquire its four MLP vehicles (including Spectra Energy Partners, one of the largest MLPs in the U.S.), in a transaction financed by issuance of new equity from the parent company that is expected to reduce distributions by roughly $700 million per year. Williams announced similar plans to acquire its MLP vehicle, Williams Partners. The pending transaction offers some tax benefits for the company’s regulated pipelines, but Williams effectively cut the dividend payout last year when it eliminated the IDRs associated with Williams Partners. The key takeaway: Both Williams and Enbridge are meaningfully reducing the dividend payouts to investors from these energy assets.

MLPs face big structural and regulatory challenges, and these recent transactions are further evidence of those challenges. But MLPs are just one way to invest in oil and gas—there are still plenty of attractive opportunities in the energy sector. Equity investors can find an attractive and sustainable mix of growth and yield in the energy sector, and savvy credit investors can invest in corporate bonds of midstream companies offering attractive yields. 




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