What Are Incentive Distribution Rights?

Introduction

Incentive Distribution Rights (IDRs) are a type of financial instrument that is used to distribute cash flows between two classes of common equity in a master limited partnership (MLP). IDRs are typically issued to the general partner of the MLP and entitle them to a percentage of the cash flows generated by the MLP’s assets. In this article, we will discuss the concept of IDRs in detail and their importance in MLPs.

How Do IDRs Work?

In an MLP, there are two classes of common equity: the limited partner units and the general partner units. The limited partner units represent the ownership interest of the investors in the MLP while the general partner units are owned by the general partner, who manages the MLP. The general partner is responsible for making all the investment decisions and operating the MLP’s assets. IDRs entitle the general partner to a percentage of the cash flows generated by the MLP’s assets. This percentage typically starts at around 2% and can increase up to 50% or more depending on the terms of the agreement. The percentage of cash flows received by the general partner increases as the MLP’s cash flows increase. This creates a powerful incentive for the general partner to maximize the cash flows generated by the MLP’s assets.

Why Are IDRs Important?

IDRs are important because they align the interests of the general partner with those of the limited partners. Since the general partner receives a percentage of the cash flows generated by the MLP’s assets, they have a strong incentive to maximize those cash flows. This benefits the limited partners as well since they also receive a portion of the cash flows generated by the MLP. IDRs also provide a means for the general partner to receive a higher percentage of the cash flows without having to put up additional capital. This allows the general partner to have a larger stake in the MLP’s success without having to make a significant financial investment.

The Pros and Cons of IDRs

Like any financial instrument, IDRs have their pros and cons. Some of the pros of IDRs include: – Alignment of interests: IDRs align the interests of the general partner with those of the limited partners, which can help to increase the value of the MLP. – Increased cash flow: IDRs provide a means for the general partner to receive a higher percentage of the cash flows generated by the MLP’s assets, which can help to increase the general partner’s stake in the MLP’s success. – No additional capital required: IDRs allow the general partner to receive a higher percentage of the cash flows without having to put up additional capital. Some of the cons of IDRs include: – Increased complexity: IDRs can add an additional layer of complexity to the MLP’s capital structure, which can make it more difficult for investors to understand. – Potential for conflict of interest: IDRs can create a potential conflict of interest between the general partner and the limited partners if the general partner is primarily focused on maximizing their own cash flows. – Increased costs: IDRs can increase the costs of managing the MLP since they require additional accounting and administrative work.

Conclusion

Incentive Distribution Rights are an important financial instrument in MLPs. They align the interests of the general partner with those of the limited partners and provide a means for the general partner to receive a higher percentage of the cash flows generated by the MLP’s assets. However, IDRs also have their downsides, including increased complexity, potential for conflict of interest, and increased costs. Overall, IDRs are an important tool for maximizing the value of an MLP’s assets, but they should be carefully considered before being implemented.