Yieldcos: How an Alternative Investment Vehicle became the Darling of Renewable Energy Finance
By Russell B. Cohen, Esq.
Renewable energy financing has long been an obstacle for project developers. In the past, project development largely relied on complex tax equity investments or costly bank debt to fund solar and wind projects. However, an increasing demand for renewable energy investment, fueled by environmentally conscious investors and favorable yield potential, has led to the rise of the yieldco – a listed fund that invests in contracted renewable energy assets and then distributes a share of cash flows to investor shareholders as dividends. While yieldcos can be structurally complex, they essentially work like this: new projects, like wind or solar, are developed by a parent company, which creates the yieldco as a subsidiary spin-off retaining the majority stake and most of the underlying asset risk. The yieldco, which generates cash flows on its underlying asset power purchase agreements (PPAs), then trades like a stock.
While relatively new, the explosive growth in yieldcos is undeniable – $5.9 billion raised in public equity markets since the first yieldco hit the market in 2013. By 2014, six listed yieldcos gobbled up $2.9 billion in funding, up from just $145 million in 2013. Given their popularity, Morgan Stanley projects that yieldcos could unlock as much as $150 billion in renewable energy investments in the next few years. And according to Bloomberg New Energy Finance, investments in solar alone is expected to hit $3.7 trillion between now and 2040, with much of the money coming from these public offerings.
The benefits of the yieldco are myriad: they generate stable cash flows by selling electricity under PPAs with utilities, which make them low-risk. Moreover, yieldcos are liquid assets, since they trade on the open market like other equities. For project developers, the capital raised can be used to pay down more costly bank debt or can be used to finance new projects at lower rates than those traditionally available through more complex tax equity finance structures. In exchange, yieldco investors typically earn three to five percent annual returns and long-term dividend growth targets of up to 15 percent. While yieldcos have only been offered since 2013, some are now trading at between 30 to 40 percent above their initial public offering price.
Unlike the familiar master limited partnerships (MLPs), which under federal law may only invest in depleting resources such as oil, natural gas, coal extraction or pipeline projects, yieldcos offer the benefits of MLPs, but with access to the growing renewable energy sector. In fact, yieldcos are often referred to as “synthetic MLPs” because they are structured to achieve similar benefits, which are primarily tax advantages and liquidity. MLPs are designed to avoid double taxation of earnings at both the corporate and investor level. While tax regulations preclude yieldcos from exploiting this “pass-through” treatment, they nevertheless mimic MLPs by using tax depreciation offsets on their underlying portfolio assets that equal or exceed the yieldco’s taxable income, thus creating the desired investor returns. Many shareholders also prefer yieldcos over MLPs for their tax reporting ease, since receiving a 1099-DIV, rather than the unpopular Schedule K-1 associated with MLPs, makes tax filing less complex.
Yieldcos have also gained popularity thanks to favorable government policy. “Near-zero interest rates leave few places that anybody can invest for yield,” says Ted Brandt, CEO of Marathon Capital. Another factor is the Treasury Department’s Section 1603 program which, through 2016, provides renewable energy project developers direct federal grants in lieu of investment tax credits. “Those have been the driving factors behind virtually each one of the yieldcos that has come to market,” says Brandt.
As of 2014, the U.S. market offered six renewable energy yieldcos: NRG Yield Inc. (symbol NYLD), Pattern Energy Group, Inc. (PEGI), TransAlta Renewables, Inc. (RNW), Abengoa Yield Plc (ABY), Next Era Energy Partners, LP (NEP), and SunEdison’s TerraForm Power, Inc. (TERP). In 2015, rivals SunPower and First Solar formed an unlikely alliance, launching their joint yieldco, 8point3 Energy Partners (CAFD), which today has a market cap of $1.28 billion. And SunEdison recently announced plans to add a second yieldco to its portfolio with TerraForm Global Inc., which seeks to raise nearly $700 million on emerging market assets in Brazil, China and India.
Despite strong investment data, yieldcos are not without risk. A yieldco should have the “right of first offer”, which provides the first opportunity to bid on new projects developed by the parent company. But according to Gerhard Hinse, Managing Director of SunPower, even if a yieldco has a right of first offer, if there are cheaper forms of capital, it still may not be the highest bidder for the assets, and may lose dividend-paying cash flow. A greater risk is the imminent Federal Reserve hike on interest rates, with corresponding higher bond yields that may put a dent in both the appeal and profitability of yieldcos. “You do start to question whether or not the investor interest is going to be there,” says Joe Salvatore, a Bloomberg New Energy Finance analyst.
Another concern is that renewable projects may start slowing down once federal tax subsidies begin expiring next year, which could lead to fewer underlying yieldco assets and lower dividends. “Make sure they have a strong pipeline of projects to continue distributions to shareholders,” says Andrew Bischof, equity analyst at Morningstar. This sentiment is echoed by Salvatore who notes that beyond 2017, these companies may need to increase their geographic and asset-type scope just to sustain growth. Yieldco cheerleaders, however, remain bullish, noting that companies will always need low-cost capital and investors will continue seeking the low-risk, dividend-paying benefits yieldcos offer. “Five years ago these yieldcos probably wouldn’t have been viable, and now there’s scale,” says Louis Berger, Co-Founder of Washington Square Capital Management, an energy portfolio manager. “It’s grown considerably and yet is still in its infancy.”
Want to learn more about Yieldcos? Come to EUCI’s Rise of the Yieldco course July 29-30, 2015 in Anaheim.
Russell Cohen is a contributing author to Energize Weekly. He is currently an associate attorney with Lear & Lear, LLP in Salt Lake City, concentrating his practice in energy and natural resources law. He can be contacted at [email protected]
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