Master limited partnerships (MLPs) have been the hottest sector within the U.S. energy revolution theme over the past several years. 

#-ad_banner-#Units of these companies give investors exposure to the infrastructure that is driving U.S. energy independence while benefiting from volume-based contracts and stable income.

Shares of the ALPS Alerian MLP Fund (NYSE: AMLP) are up nearly 5% over the past year on top of the 5.8% yield. Units of individual partnerships are soaring as the hunt for assets drives mergers and acquisitions. Units of Williams Cos. (NYSE: WMB) are up more than 75% over the past year on higher distribution and a merger with Access Midstream Partners (NYSE: ACMP).

The United States has surpassed Saudi Arabia as the world’s largest oil producer, and the growing demand for energy transportation and storage should continue to drive distribution growth in the sector. 

That is great news for unitholders — but one hidden condition in the business model for these partnerships could soon create a conflict… and take money from your pocket.

As my colleague Chuck Marvin wrote recently, MLPs own pipeline and storage assets but many have no employees. A general partner (GP) manages the day-to-day operations and is entitled to a 2% equity position in the limited partnership. As the volume of energy products moving through the partnership’s assets increase, the general partner increases the distribution of income to unitholders. 

In addition to the equity position, the general partner often is entitled to incentive distribution rights (IDR), which increases when the distribution increases. 

And that is where the problem starts. 

As an example, consider the IDR schedule for Tallgrass Energy Partners (NYSE: TEP):

As the distribution is increased, the GP is entitled to a larger share of the total payout. The IDR incentivizes the GP to increase the distribution, which puts more cash in unitholders’ pockets — but it may also create a conflict of interest. 

The GP may increase the distribution to unsustainable levels to reach the next tier in the IDR schedule. In fact, many investors have started to question capital spending in the space. 

A GP may be able to artificially boost distributions by cutting investment in maintenance or new assets. Unitholders would see a short-term bump in income, but the partnership would have to cut distributions over the long term on maturing assets and lack of growth.

Tallgrass Energy Partners has more than doubled its distribution in less than a year. The most commonly used metric, the ratio of distribution to the distributable cash flow (DCF), shows that the partnership covers its distribution by more than 1.5 times. This is around the industry average and would not raise any liquidity alarms for investors since cash flow more than covers the amount paid out to unitholders.

As the distribution increases from here, however, TEP investors may be in for a rude awakening.

In its first quarter, the partnership reported $20.1 million in distributable cash flow, or $0.49 per unit. Investors looking at the quarterly distribution may think that DCF coverage was 1.51 times but it was actually 1.46 times after accounting for the $400 million paid to the GP. The difference is marginal now, but it will likely increase significantly as the distribution increases because of the IDRs.

Looking at the most recent quarterly filing, the general partner’s share of the distribution has increased from its 2% equity position to nearly 3% just in the past six months. In fact, if the distribution were to increase by just 25%, the general partner’s share would more than double to 6.7% of the payout. 

Tallgrass Energy is a relatively new partnership and the IDRs have not yet become an issue for unitholders. I am not recommending you sell out of you position if you hold the partnership but only using it as an example of a growing problem in the industry. 

Investors have three choices: Keep an eye on the IDR schedule in their partnership investments, invest in shares of the general partner, or watch for partnerships eliminating or re-evaluating their IDR schedules. 

While an investment in the general partner is tempting, especially given the higher income from the IDR structure, I prefer MLP investments for the ability to defer taxes on much of the distributed income. With limited time to track the IDR schedule for every MLP in my portfolio, I prefer partnerships that are proactively addressing the potential conflict.

TC Pipelines (NYSE: TCP) recently capped its top IDR level to 25% of the distribution. The $3.2 billion partnership owns six interstate natural gas pipelines throughout the western and midwestern U.S., transporting nearly 9 billion cubic feet of gas per day. Units pay an annual distribution of $3.24, a yield of 6.6%, and have increased at an annualized rate of 2.6% over the past three years. While the 25% IDR cap still shifts money to the general partner, it removes the incentive to raise the distribution in an unsustainable manner.

Magellan Midstream Partners (NYSE: MMP), Buckeye Partners (NYSE: BPL) and Enterprise Products Partners (NYSE: EPD) have all bought back their general partners. This means that management of the assets is handled directly by the partnership and eliminates the IDR structure of compensation. 

I own units in Magellan Midstream and Enterprise Products Partners, which have increased their distributions by an annualized pace of 16.6% and 5.8% over the last three years. Magellan Midstream, an $18.5 billion pipeline and storage partnership, pays a $2.45 annual distribution for a 3% yield. Enterprise Products, a $72.5 billion partnership, pays a $2.84 annual distribution for a 3.8% yield.

Risks to Consider: As the revolution in U.S. energy production develops, MLPs should see ever-higher cash flows, which will likely lead to greater distributions. Investors need to be aware of conflicts of interest in partnership agreements and should not rely on traditional coverage metrics.

Action to Take –> Incentive rights in an MLP partnership agreement do not necessarily make it a poor investment, but I prefer those that have already confronted the matter (such as the four stocks just named) by capping the top incentive level or eliminating the IDRs completely.

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