Incentive Distribution Rights (IDRs) is a concept from the MLP world, and is important to understand because it deals with how cash flows from MLPs are distributed to investors and managers. IDRs are a feature of the payout structure that dictate when manangers (GPs), are paid following payout to investors (LPs), and how much that payment will be. They are intended as a means of incentivizing managers and aligning GP and LP interests.
Q. So we know this is a MLP topic that’s important to investors. Why?
A. Because it governs how cash flows from the MLP are allocated to the LPs—the investors—and the GPs, the managers. They can make a big difference to the economics of investing in MLPs, especially over time; and they do vary MLP to MLP.
Q. OK, so it does sound important. What’s it mean?
A. IDRs are Incentive Distribution Rights. These are essentially bonus income that gets paid to the managers of the MLP once the distributions to the LPs from the MLP hit a certain level. So the dollars might go something like: first $2 to investors, then, of the next $1, 75 cents to the LPs and 25 cents to the GPs; then, of the next dollar, 50-50.
Q. OK, but doesn’t that just align the interests and the managers, so the greater the income the more they make?
A. That’s the traditional argument. (Funny how often when you hear “alignment” in executive comp it means more money to the managers). But, of course, there are other things you could do with that money even if you don’t distribute it all out to the investors. You could, for example use it to buy more income-producing properties. That might be more directly useful than “incenting” the management.
Q. Yep. So do the GPs sometimes just agree to do that, to cap their splits and leave more money in the MLP?
A. They do, and its something you should look at when investing. Note that often the worst deals for the MLP investors occur when the GPs are themselves traded entities: because then the GPs have their own, separate shareholders to worry about, and then it’s a competition between two sets of public investors. Another thing to check.
Q. Ok, interesting, anything else?
A. Yes. There’s actually now a new trend for some MLPs to not have any IDRs going to the GP at all. Obviously you don’t want to make an investment decision based on just one factor, but its very attractive to know that extra income will either go directly out to the investors, or used to expand the business.