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Master limited partnerships (MLP) comprise two entities: an operating limited partnership (LP) and a general partner (GP) that usually owns a 2 percent stake in the LP and receives compensation for managing the operating partnership’s assets.

Not only does the general partner receive a regular distribution from any common units that it holds, but in many cases the GP also holds incentive distribution rights (IDR) that entitle it to a higher proportion of the LP’s quarterly distribution.

Readers often ask how the fees associated with IDRs are calculated, the extent of these obligations for particular names, and how these fee structures affect an MLP’s ability to grow its distribution over time.

To illustrate how IDRs work, we’ll examine the case of Energy Transfer Partners LP (NYSE: ETP), a midstream MLP that went 1996.

The fee schedule associated with a general partner’s IDR is established before the operational limited partnership goes public, though the general partner and LP may agree to revise this structure. In recent years, several larger MLPs have reduced the IDR obligations in an effort to stimulate distribution growth and attract investors.

Energy Transfer Partners’ IDR payments to its general partner, Energy Transfer Equity LP (NYSE: ETE), are determined by four distribution tiers.

• Tier 1: When the LP’s quarterly payout is $0.275 per unit or less, holders of the common units receive 100 percent of the payout. IDR holders receive no remuneration on this portion.
• Tier 2: When the LP’s quarterly payout is between $0.275 per unit and $0.3175 per unit, holders of the common units receive 87 percent of the total distribution within this interval. IDR holders collect 13 percent.
• Tier 3: When the LP’s quarterly payout is between $0.3175 per unit and $0.4125 per unit, holders of the common units receive 77 percent of the total distribution within this interval. IDR holders collect 23 percent.
• Tier 4: When the LP’s quarterly payout exceeds $0.4125 per unit, holders of the common units receive 52 percent of the total distribution above this threshold. IDR holders collect 48 percent.

Energy Transfer Partners has distributed $0.89375 per unit in every quarter since August 2008; the MLP reached the top tier of its IDR structure–called the high splits–years ago.

Investors should note that Energy Transfer Equity doesn’t receive 48 percent of the MLP’s cash flow as part of the fee associated with its IDRs; these payments are separate from the quarterly disbursement to unitholders. When Energy Transfer Partners declares its quarterly distribution of $0.89375 per unit, investors will receive the stated amount.

Here’s how the IDRs would be calculated for Energy Transfer Partners’ current quarterly payout of $0.8975 per unit.

Source: Energy Transfer Partners LP, Energy & Income Advisor

Tier 1: For the first $0.275 per unit, the LP unitholders receive 100 percent of the distribution. No IDRs are paid to the GP.

Tier 2: For the next $0.0425 per unit of the quarterly distribution ($0.3175 per unit minus $0.275 per unit), investors in the LP receive 87 percent of the total distribution and the GP collects the remaining 13 percent. The total distribution is $0.04885 per unit, or the LP distribution divided by 87 percent.  In other words, Energy Transfer Partners disburses $0.0425 per unit to investors and about $0.00064 per unit (the total distribution minus the payment to LP unitholders) to its GP, Energy Transfer Equity.

Tier 3: Investors in Energy Transfer Partners receive 77 percent of the $0.095 per unit to be distributed. This translates to a total distribution of $0.12338 per unit ($0.095 per unit divided by 77 percent), of which the GP receives $0.0284 per unit.

Tier 4: Investors in Energy Transfer Partners receive $0.48125 per unit, which equates to a total distribution of $0.92548 per unit ($0.48125 per unit divided by 52 percent). At the current payout rate, the GP collects $0.4442 per unit.

If we sum these tiered IDR payments, Energy Transfer Partners pays a quarterly distribution of $1.3727 per unit, with investors receiving $0.89375 per unit and the GP raking in $0.479 per unit, or 35 percent of the total payout.

The IDR structure aligns the general partner’s interests with those of the operating limited partnership; the fees collected by the GP only increase when the LP hikes its quarterly distribution, incentivizing the GP to pursue a strategy that will grow the cash flow generated by the LP’s assets.

Investors must weigh these considerations when analyzing forthcoming initial public offerings or MLPs that have only traded for a few months. The majority of publicly traded partnerships set a minimum quarterly distribution that the GP receives little to no IDR fee for meeting.

To incentivize growth, the GP’s cut of the total distribution increases sharply as the LP’s quarterly payout increases. Examining a fledgling MLP’s IR structure provides insight into the payout’s near-term growth potential–an important consideration because a rising distribution drives overall returns. (See Investing in MLPs: Yield vs. Distribution Growth.)

However, burdensome IDRs can impede an MLP’s distribution growth once it hits the high splits. For Energy Transfer Partners to boost its quarterly payout to unitholders by 10 percent, the MLP’s total distribution would increase by much more because the GP receives 48 percent of any disbursement that exceeds $0.4125 per unit. Check out the table below.

Source: Energy Transfer Partners, Energy & Income Advisor

A 10 percent increase in the distribution paid to LP unitholders would translate into a 12.5 percent uptick in Energy Transfer Partners’ aggregate quarterly payout. To support this total distribution of $1.5443 per unit, the operational limited partner would require its cash flow to grow by more than 10 percent.

Also note that when Energy Transfer Partners increases its distribution to unitholders by 10 percent, the payout to the Energy Transfer Equity jumps 17.2 percent, to $0.56134 per unit. Although units of Energy Transfer Equity offer a lower yield than Energy Transfer Partners, the GP’s distribution will grow at a faster rate once the LP starts to grow its payout.