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% but may be as high as 20% or even 50%.
Understanding Incentive Distribution Rights (IDR)
A master limited partnership’s IDR schedule tends to be structured to encourage the general partner to drive distribution growth for limited partners. If the payouts for limited partners reach a predetermined level, the general partner receives an increasingly higher payment based on the limited partnership’s incremental cash flow. Incentive distribution rights are generally determined based on quarterly distribution figures.
Since 2016, IDRs have greatly gone out of fashion and are not as common as they once were. The primary reason is the increased cost of capital. IDRs work well at the start of an MLP’s operations, incentivizing general partners to grow the number of unitholders. This eventually becomes a problem for the MLP as the incentives for the general partner grow, increasing the cost of capital for the MLP.
The removal of IDRs greatly improves corporate governance, aligns the interests of both the general partner and the limited partner, and reduces the cost of capital for the MLP.
Complex Structure
IDRs are relatively uncommon and can be complex. They are often misunderstood by MLP investors. In addition, some general partners may abuse the IDR mechanism in order to generate outsized payments to themselves.
Each IDR within an MLP is structured differently, and prospective MLP limited partners need to carefully analyze that structure in any potential investment. Some structures may have the effect of promoting or inhibiting distribution growth for limited partners.
Reliable Cash Flow
The general partner incentive can be substantial. That generally means that the limited partner has also done well 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 a more steady, reliable cash flow. But cash flow and the risks 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.
Is MLP Income Passive?
Yes, the income from a master limited partnership (MLP) to investors is passive. MLPs are required to transfer a certain portion of their incomes to investors, which is a passive form of investment for the investors.
What Are Incentive Models?
Incentive models are forms of benefits, usually monetary, that are used to motivate employees. For example, incentive models can be used to encourage salespeople to hit certain sales targets whereupon they will receive a cash bonus or other benefit. Many CEOs are offered stock options, which directly tie their pay to the performance of the company, incentivizing them to make decisions that improve the company’s profitability, which ultimately would improve its stock value.
Is Income From an MLP Taxed?
Master limited partnerships (MLPs) provide many tax benefits due to their complicated tax structure. Investors can defer taxes until their cost basis is zero, not having to pay taxes on the distributed amount they receive.
The Bottom Line
Incentive distribution rights (IDRs) are used by master limited partnerships (MLPs) to encourage general partners to increase the number of unitholders for the MLP; they work as a sort of bonus. Though they work well at the start of an MLP, IDRs eventually become a cost burden. As a result, master limited partnerships have moved away from using incentive distribution rights (IDRs), which have improved the cost of capital and corporate governance for MLPs.