Yield Cos Compared
Use of the phrase “yield co” to describe three recent share flotations by NRG Yield, TransAlta Renewables and Pattern Energy Group, Inc. masks very different business arrangements. What is interesting is the different decisions each company made in structuring a yield co that would appeal to the market.
The three companies are among five project developers that set up or attempted to set up yield cos since the summer.
Two companies – Silver Ridge Power and Threshold Power – attempted listings in Canada but withdrew the offerings. A sixth company, Hannon Armstrong Sustainable Infrastructure, converted itself into a real estate investment trust in April 2013, a structure that has features in common with a yield co.
The idea behind yield cos is to put a portfolio of projects that are already operating in a new corporate subsidiary and sell part of the shares to the general public while keeping projects that are still under development in a separate entity. The yield co can raise equity at closer to debt rates because it owns derisked assets that throw off predictable cash flow. Investors pay a premium not only for the predictable earnings, but also for the ability to trade their ownership positions in a liquid market. The subsidiaries are called “yield cos” because they distribute most of their earnings to shareholders through quarterly dividend payments. The appeal is to investors seeking higher yields than are available in the bond market.
The NRG Yield share offering was more than 10 times oversubscribed when the company listed on the New York Stock Exchange in July. The company listed at $22 a share and a projected dividend yield of 5.45% based on the initial share price. The shares were up 64% by early December, and the dividend yield had fallen to 3.33%.
TransAlta Renewables listed on the Toronto Stock Exchange in August at an initial price of C$10 a share and a projected dividend yield of 7.5%. The stock was trading up 7% by early December. The dividend yield had fallen to 7%. Pattern Energy listed simultaneously on the NASDAQ Global Exchange and the Toronto Stock Exchange in late September at an initial share price of $22 and a projected dividend yield of 6.25%. The share price has since increased 13.2%, causing the dividend yield to fall to 5%.
In general, a developer should have at least $500 million in operating project value that can be put in a yield co and then plan to sell a large enough share to raise at least $100 to $200 million in the initial public offering.
Timing may be key. It takes months to put a filing together. Demand for yield co shares could soften as interest rates rise.
NRG raised $471 million net after underwriting discounts and commissions by selling a 34.5% interest in 1,324 megawatts of conventional and solar power projects, plus the equivalent of another 1,098 megawatts of thermal facilities that produce steam or chilled water and another 123 megawatts of small cogeneration facilities. NRG retained control over the subsidiary with a 65.5% voting interest.
The assets are in nine states. Most went into service from 2009 to 2013. They include two portfolios of rooftop solar installations on schools in California and Arizona.
The power projects (not counting the cogeneration units) are 68.7% conventional power plants. Ninety-three percent of the output is contracted under long-term power contracts. The power purchase agreements have a 16-year weighted average life. This month, NRG Yield agreed to purchase the assets of Energy Systems Co., a Nebraska-based district energy company that provides steam to buildings in Omaha.
TransAlta raised C$202.1 million against a portfolio of 28 projects with a capacity of 1,112 megawatts. The company sold a 19.3% interest. It retains control through the ability to name a majority of the six-person board of directors for as long as it retains at least 35% of the shares.
The projects are all in Canada, but the company signed an agreement recently to acquire a wind farm in Wyoming. Wind projects account for 90.7% of the portfolio by capacity. The remaining 9.4% are hydro projects. Except for one wind farm that went into service in March 2013, the TransAlta assets have been in service for between one and 22 years, with 5.8 years in weighted average years of operation. All of the output has been contracted, but some of the projects are really merchant plants with TransAlta as the offtaker. The affiliate power contracts run 20 years or, if shorter, the remaining useful life of the project, with fixed prices of C$30 a MWh for wind and C$45 a MWh for hydro adjusted annually by the consumer price index. (The company will have to be careful before entering into affiliate power contracts on any US projects as it could lose the ability to claim net losses from depreciation.) The average remaining life of the output contracts on all the projects is 17 years.
Pattern Energy raised $318.6 million in net proceeds on the sale of a 36.8% interest in eight wind farms in the US (including Puerto Rico), Canada and Chile, with a total owned capacity of 1,041 megawatts. It retained 63.2% of the voting rights.
Six of the projects have been operating between two and four years. The remaining two were still under construction at the time of the offering and are expected to be completed by the second quarter of 2014. Ninety-five percent of the output is committed under long-term power purchase agreements with an average remaining contract life of approximately 19 years.
The three yield cos plan to distribute between 80% and 83% of cash after debt service. All three expect to grow by acquiring additional projects, but they are not typical growth companies retaining earnings to fund expansion. For NRG Yield, only 31% of projected adjusted EBITDA in 2014 is expected to be cash available for distribution and 37% in 2015, suggesting a large amount of senior debt ahead of the NRG Yield shareholders in the capital structure. The 2014 figure for Pattern is 25.4%. It appears to be closer to 62% for TransAlta.
Different Business Strategies
Pattern starts as a classic yield co with a portfolio of operating or near-operating projects, but the yield co will morph into a full-fledged development company once its market capitalization reaches $2.5 billion.
The Pattern workforce will be split between the yield co and old Pattern until this market capitalization is reached, after which all the employees will move to the yield co. Until then, the project development, legal, finance and administrative staff will stay in old Pattern with the operations and maintenance personnel in the yield co and the top executives splitting their time between the two companies.
NRG Yield and TransAlta Renewables are classic yield cos in that they will own solely operating assets.
NRG Yield has a right of first offer or ROFO for the next five years to make bids on six projects from NRG that are expected to go into service during the period March 2013 through early 2014.
TransAlta Renewables agreed in a governance and cooperation agreement with the TransAlta parent company that it will rely “exclusively” on the parent to identify investment opportunities.
The Pattern yield co has a right of first offer for the next five years to make bids on any projects in the 3,000-megawatt development pipeline that old Pattern informs the yield co it plans to sell. The option is extended automatically for additional five-year periods unless terminated by old Pattern or the yield co. It will terminate early if the yield co fails to make offers on at least three projects that old Pattern is able thereafter to sell. The yield co also has an option to buy old Pattern if the current owners of old Pattern, including private equity fund Riverstone, decide to sell a material portion of the equity or substantially all of the assets.
Unlike the other yield cos, old Pattern has promised not to compete with its yield co for acquisitions of generation and transmission projects for as long as the yield co retains a ROFO over old Pattern projects.
Each of the developers will earn fees for managing its yield co.
NRG will earn $4 million a year, plus be reimbursed for its costs (but not employee salaries or overhead). The fee is adjusted annually for inflation and will also increase by 0.05% of the enterprise value of each future project acquired.
TransAlta will earn C$10 million a year, adjusted for inflation, plus be reimbursed for costs including employee wages and benefits “not captured by the fee.” The fee will increase or decrease by 5% of the projected change in the yield co’s EBITDA as a consequence of buying or shedding assets. It will also be reset no less frequently than every five years to take into account changing economic circumstances, regulatory requirements and general workload to manage the company.
Unlike the other two yield cos, the Pattern yield co will have its own employees and pay them directly, but will also compensate old Pattern for any use of legal, finance and administrative staff until the entire work force is reassembled under the yield co.
The NRG and Pattern yield cos have complicated ownership structures.
There are A and B shares in the NRG yield co. The NRG parent company, NRG Energy, Inc., which is also a publicly-traded company, owns all the B shares, giving it a 65.5% voting interest in the yield co but no economic interest. The public shareholders own all the A shares. They have all the economics, but only 34.5% of the vote.
Immediately below the yield co is a partnership. The NRG parent company owns a 65.5% economic interest in the partnership. The yield co owns the balance and is the managing member, but since the yield co is controlled by NRG, NRG also controls the partnership. All the projects are at least two tiers down from the partnership.
NRG can exchange units in the partnership for A shares in the yield co. When these exchanges occur, the yield co will redeem and cancel a corresponding number of B shares that NRG holds in the yield co. Over time as the yield co raises more equity to make acquisitions, the share of the partnership held by the yield co will increase, either because the yield co will make capital contributions for more partnership units or pay the money to NRG to buy part of its partnership units.
The Pattern yield co will also have A and B shares. Old Pattern will hold all the B shares. The public will own the A shares. No dividends are paid on the B shares, but the shares have identical voting rights. According to Pattern, the A and B share structure is being used to mitigate risk to the public shareholders on one of the two projects that is still under construction: the South Kent wind farm in Ontario, Canada. The B shares will convert automatically into A shares at the end of 2014 or, if later, when construction of the South Kent project has been completed.
Benefits and Drawbacks
The TransAlta and Pattern yield cos own largely wind farms, which have variable output. Both intend to pay quarterly dividends in equal amounts during the year.
Combining renewable energy facilities with fossil fuel-fired power plants, as NRG has done, creates a tax base within the yield co to use tax benefits from the renewable energy projects.
NRG Yield does not expect to owe significant federal income taxes for approximately 10 years, perhaps longer if it grows by acquiring additional renewable energy projects. This means that not only will there be no taxes taken out at the company level, but also distributions to shareholders should be treated as returns of capital until the shareholders get their investments back. Distributions after that would be reported by shareholders as capital gains.
The market sometimes refers to a yield co in this position as a “synthetic MLP.” Master limited partnerships, which require a statutory change before they can be adopted widely in the power industry, do not pay taxes at the entity level on earnings. Any tax is solely at the owner level. The fact that their earnings are subject to only one level of tax allows them to raise capital more cheaply.
In addition to providing access to cheaper capital, yield cos offer other benefits.
They provide a developer with a captive outlet into which to sell operating projects for cash, with the project valuation determined at a low discount rate. However, the sale is of only a fraction of each project.
Because of its low capital cost, the yield co is a good vehicle for bidding on projects put up for sale by others. The winning bidder is usually the one with the lowest cost of capital. A yield co also gives a developer a currency in the form of publicly-traded shares that might be used to make acquisitions. Private equity funds holding projects directly or through private equity-backed developers may be reaching the end of their desired hold periods for projects that went into service before 2009.
There are also potential drawbacks.
Moody’s flagged a potential drawback in a posting in November. The rating agency warned that moving a portion of a developer’s most reliable cash-flow producing assets to another entity cannot help the parent company’s credit profile.
A sale of more than 20% of a subsidiary corporation will prevent a US parent from filing a consolidated federal income tax return with a US yield co, with the result that there will be some double taxation of earnings once the yield co moves out of a tax loss position.
Canadian investors buying shares in US yield cos listed on the Toronto exchange will be subject to a 15% withholding tax at the US border on any cash distributions that are considered dividends for US tax purposes. (There is no withholding tax on cash distributions considered returns of capital.) Dividends paid to non-Canadians will not be subject to any withholding or other taxes in Canada.
The newest yield cos have many antecedents even within the power industry. At least seven other companies fit the pattern to varying degrees, including Algonquin Power & Utilities Corp., Atlantic Power Corporation, Brookfield Renewable Energy Partners, Capital Power Corporation, Capstone Infrastructure, Innergex and Northland Power. Greenbacker Renewable Energy Company said in a filing with the US Securities and Exchange Commission that it plans to form a “yield co” to raise a minimum of $2 million and as much as $1.5 billion to make investments initially in pipelines of solar projects in an effort to connect smaller- to medium-sized developers to public markets. The company suggested in the SEC filing that it plans operate as a partnership, despite US tax rules that normally treat partnerships whose units are publicly traded as corporations. The investors would be investing into a blind pool.