Yield Cos: Where to Next?
By Eli Katz
Several veterans of the independent power market talked about the pros and cons of yield cos — when it makes sense for a company to form one, how they affect the cost of capital, whether they are good investments for shareholders and what the future holds for them — at a meeting organized by Bloomberg and Chadbourne in New York in late October. The following is an edited transcript. The panelists are Christopher Radtke, a director in the investment banking division at Credit Suisse, Jerry Peters, managing partner of Energy Power Partners, Gerhard Hinse, a managing director of SunPower Corporation, and Ted Brandt, CEO of Marathon Capital. The moderator is Eli Katz with Chadbourne in New York.
MR. KATZ: Chris Radtke, let’s set the table by describing the basic structure of a yield co and what it is designed to do. Let’s pick NRG Yield as an example because it was the first and possibly the simplest to understand.
MR. RADTKE: NRG had a large number of both renewable and fossil assets with contracted cash flows. The average life of the cash flows was more than 15 years, and NRG believed it was not getting full credit for the asset value in its stock price. So it set up a yield co. It dropped operating assets with contracted cash flows into a limited liability company that is a partnership for tax purposes. The partnership is owned by the yield co. The yield co is owned by NRG and the public. Cash earned by the projects moves from project companies to the partnership and from the partnership to the yield co, and almost all of the cash gets distributed by the yield co. This type of vehicle trades on the amount of distributions and the yield on those distributions.
MR. KATZ: Ted Brandt, people have been talking about yield cos for three or four years, but the product began to take off only recently. What made all the stars finally align, and what is making yield cos so attractive now that almost everyone is talking about them?
MR. BRANDT: There are two factors. The first has been the continuing policy of the United States to run a near-zero interest rate leaving few places that anybody can invest for yield. There is little yield in corporate or municipal bonds. The second factor is the section 1603 cash grant program. That program meant that there are a lot of contracted cash flows that are not tied up in tax equity deals. The cash is free to move into a yield co. Those have been the driving factors behind virtually each one of the six yield cos that has come to market.
MR. KATZ: If low interest rates and the cash grant program were the impetus, what does that say about the prospects for more yield cos in the future?
MR. PETERS: History has shown that whenever debt rates increase, the return on equity must also increase. Yield cos are equity investments. As interest rates rise, there will have to be a corresponding increase in returns that yield cos must pay to attract capital, and when we get to the point where they will be competing with other sources of capital, such as my private equity capital, I think you will see a decline in this product generally.
MR. KATZ: What about Ted Brandt’s point that yield cos really only work with renewable energy projects that were paid Treasury cash grants? That program has now expired. What does that say for future deal flow to support yield cos?
MR. HINSE: I think what is driving yield cos is low interest rates. It is not a novel concept to separate operating assets from a development pipeline and spin off the operating asset company. What is different about this wave is that the current yield cos are able to self-shelter income from taxes by using the tax benefits associated with the renewable energy assets. This makes them essentially into entities whose earnings are subject to only one level of taxes. Viewed this way, the opportunity should remain for solar assets that qualify for 30% investment tax credits through 2016. Even wind projects will still have depreciation deductions, and wind projects that were under construction by December 2013 also qualify for tax credits.
The real issue is the inefficiency of trying to monetize tax benefits and at the same time put the assets under a yield co to raise cheap equity. That is a problem the market is still trying to solve.
MR. KATZ: To Ted Brandt’s point, the story for the yield co investor is much simpler if he just sees cash coming up from the projects. If a tax equity investor is introduced into the mix, then it is a more complex story. Maybe the yields go up. Is that the point?
MR. HINSE: Yes. And remember that the recapture period on many of these assets is five years after the project is placed in service. For a project that has a 20- or 30-year life, that is only a small part of the asset’s life. Investors can still invest solely on the basis of cash flows more than five years out. That might be enough.
MR. BRANDT: One way to look at yield cos is as a way to pull some cash out of projects while still retaining control over the projects. They are an alternative to selling the projects.
Assume you have a project that throws off $100 million of free cash. If you sell the project into a market where buyers use an 8% discount rate to bid, then you should be able to get $1.25 billion. At a 7 % discount rate, the number goes to $1.42 billion. At 5%, it is $2 billion. At 3%, to use the current yield at which NRG Yield is trading, it is $3.3 billion.
So make no mistake about it, a lot of what is driving the yield co boom is this simple math. Of course, the 3% yield assumes some rate of growth, and the math behind growth and yield accretion is much more complex.
MR. KATZ: Let me pull on that thread a bit. Yield co investors are now getting somewhere in the 3% to 5% range in current yield. That is too low for an equity return, so anyone buying is counting on some amount of growth. How much growth does one need to justify investing at a 3% to 5% dividend yield?
MR. RADTKE: The investor is looking for a total return. The yield is only one component of that return. Another component is going to be growth of the distributions, which will then carry on into growth in the stock price.
We have seen this over the 18-plus months since NRG Yield has been public. There has been a substantial growth in the stock price. The shareholders have been expanding from niche investors into more mainstream portfolio managers who are starting to see the potential in these stocks. In terms of the total return needed, most yield cos went public hoping for growth in the 10% to 15% range. Add the dividend yield to that and you get a total expected return in the mid-teens.
Both NextEra and NRG have pushed those boundaries and said, “We think we can do even better.” NextEra announced recently that it expects to grow its distributions substantially. If you graph the distribution yield against the growth expectations, there is a high correlation, both in MLPs and yield cos, in that the higher growth expected, the lower the current yield.
Good for Investors?
MR. PETERS: As an investor, I would worry about both yield and growth.
I would worry about yield because we do not know what the tax situation will be in the near to mid-term. Production tax credits for wind, geothermal and biomass projects have already expired, and the investment tax Yield Cos credit for solar is scheduled to drop from 30% to 10% after 2016. It is also possible that we will see changes in the tax depreciation schedules. Without these tax benefits, a yield co will have to pay dividends in after-tax dollars. And if your after-tax dollars are reduced because the yield co is now paying taxes, it will not be able to maintain the current yield. That will push yields down.
Growth is also a concern because you have the old NextEra or NRG still developing projects. Each one of these yield cos seems to have a different arrangement with respect to competition from the parent company that contributed the assets. Some do not have any limits on competition; at best, the yield co has a right of first offer on the assets of the development company. A right of first offer is really nothing more than setting the target price that you try to beat. I would be very concerned about the assumption that there will be an unlimited pipeline of projects available to the yield co from the parent company that contributed the original assets if other cheaper sources of capital begin to compete for the same assets.
MR. KATZ: Does anyone know if each of the existing yield cos has a right of first offer on all of the assets of its parent company?
MR. RADTKE: They do not. The right applies only to specific assets, but there is an expectation that the parent company will sell its assets into the yield co. The broader point is that the company takes operating assets, which have a larger buyer base than projects that are merely under development, and matches the assets with capital providers. The existing yield cos have produced benefits both for the yield co investors and for the parent company investors.
MR. KATZ: Gerhard Hinse, it is no secret that SunPower is thinking about a yield co. What are some of the factors that weigh in favor or against creating such a vehicle?
MR. HINSE: We announced that we are exploring one. We are still working through the issues. We have the same concerns as anyone thinking of investing in a yield co. We want to make sure that the long-term strategy fits with what we are trying to accomplish. We are not particularly worried about the asset growth in the vehicle. The solar market is going through a period of rapid growth that will outpace the 10% to 12% growth needed for a yield co. One concern is what happens when interest rates change significantly. Will yield cos still be the cheapest source of capital? The yield vehicle will have a right of first offer, but if there are cheaper forms of capital, it may not be the highest bidder for the assets. What is the long-term yield necessary to support these vehicles?
MR. BRANDT: Let’s go back to the math I used in my example. I can take my $100 million in cash flow and, at current yields of 4% to 5%, I will have a market capitalization of $2 billion. Let’s say that is $20 a share for 100 million shares, and I have committed to annual distributions of $1 a share.
How do I grow this pool of assets? The existing assets are running down, and they basically have a series of flat cash flows with escalating costs. Thus, my cash flows are probably declining over time.
The yield co needs to buy new assets. The only place for it to get the cash to do so is to issue new shares to the public. The formidable challenge is how to issue those new shares to purchase assets in a competitive market and still show the required growth rate to the existing shareholders. That is why I think most of the growth and value accretion will come from drop downs from the developer pipeline. The open question is whether the developer is willing to support the yield co stock price, given that it owns a large share of the stock, by dropping assets in and retaining control, or will it sell to other buyers with cheaper capital? That is the open question.
MR. KATZ: Yield cos have become the high bidder in asset auctions. Do you agree?
MR. BRANDT: We don’t think so. They have won a couple large auctions, but we think there are other buyers that out compete the yield cos.
MR. KATZ: Who would that be?
MR. RADTKE: At the end of the day, the best bidder is a corporate with a long-term strategy and tax appetite because it will pay a premium to market, and it will not have to pay high yields to attract a tax equity investor. We have seen some utilities play this role very successfully. But the yield cos can be fiercely competitive as well because they can achieve tax deferral for a substantial period of time and pay tax-free distributions to shareholders. In terms of growth, the potential is there for yield cos to expand beyond renewables. There is no limit to the types of assets with contracted long-term cash flows that can eventually fit in this asset box.
MR. KATZ: So looking at yield cos as an acquisition vehicle, what is your best estimate of their cost of capital for renewable energy assets?
MR. BRANDT: That is the most important question we have discussed today. The funny thing is that every solar developer thinks it is the dividend yield. It is not. It is the price on a leveraged piece of equity that will allow the yield co to give a raise to its current shareholders and sell enough shares to raise the needed capital. I think it might be in the 10% to 13% after-tax range.
MR. PETERS: I was talking to a friend in the space, and he concurs with that range. When I heard those numbers, they were music to my ears because we private equity funds can probably compete with that cost of capital.
MR. RADTKE: NRG Yield disclosed a useful data point from its recent acquisition of the Alta wind farms from Terra-Gen, and that was an 8% leveraged cost of equity in the first year. It took into account the existing financing that was already in place. That probably made NRG Yield the high bidder.
MR. HINSE: That was an interesting deal because the lease equity was already in place, so NRG Yield was just buying cash flows. That may not be a representative transaction.
MR. RADTKE: Correct. It is hard to give a one-size-fits-all answer because each opportunity will have a different underlying capital structure.
MR. KATZ: Maybe then the answer is that yield cos win when the deal already has financing and tax equity, and the corporates with tax appetite have the inside track on greenfield deals, at least until the yield cos put the pieces of that puzzle together. Turning to asset mix, a recent Bloomberg chart showed that yield cos predominantly hold renewables, although NRG Yield has plenty of thermal assets as well. Bloomberg predicts that small-scale PV is where the growth will be. Gerhard Hinse, do you agree?
MR. HINSE: Yes.
MR. RADTKE: Distributed solar in Yield Cos the commercial and industrial space is still a big problem. There is no great financing solution for this sector yet.
MR. HINSE: The distributed solar markets are becoming far more efficient. SolarCity proved with its securitizations that there is a stable revenue stream from these assets. That is really the big news of the last three to five years. Historically, when people began aggregating solar rooftop systems, the question was whether you could achieve pools of assets with an investment grade. That question has now been answered. We have very long contracted cash flows with investment-grade quality. There should be significant growth in this sector.
MR. KATZ: Where do you think the yield cos will get the distributed solar systems? Will they rely on the parent company or buy them from other developers?
MR. HINSE: The third party ownership model for rooftop solar is only about seven years old in the US. The sector is still evolving. It will eventually standardize its financial arrangements, and yield cos will probably be a key part of the financing chain.
MR. KATZ: Bloomberg put up a slide earlier that shows where yield cos are focused geographically. So far they have been heavily weighted in the US and certainly in the Americas. To grow these vehicles, do you think they will have to venture outside these areas? How do you think they will fare in other parts of the world?
MR. BRANDT: I think they will grow wherever the assets are located. The Pattern yield co has been investing in Chile and Canada.
MR. HINSE: It will be interesting to see where this goes. We are seeing a lot of activity today in Latin America and Mexico, but we are not sure how much appetite there will be from yield co investors for non-dollar-denominated deals. That being said, if there is good credit behind foreign deals, then there could be significant growth in those regions.
MR. RADTKE: I agree. Any OECD-type country should fit within the box. We have already seen the six existing yield cos own assets in the United States, Canada, Spain and other countries. When TerraForm went public, it disclosed that it is thinking about forming a separate yield co to acquire assets in non-OECD countries. As long as there are contracted cash flows with low risk and the sovereign risk is kept within certain bounds, the assets should fit in these types of vehicles, and so why not expand internationally?
How Many More?
MR. KATZ: We have six yield cos so far. Chris Radtke, I imagine one of your mandates is to bring more to market. How many more do you think we will see in the near term, and can you give us a sense of what the profile is for a good yield co candidate?
MR. RADTKE: I think we will see at most another 10 yield cos in the next couple years. The types of companies who might do it are companies like SunPower, equipment manufacturers who have usually sold their projects. They could benefit by forming a public-sector vehicle as an outlet for their projects. Another good candidate is utilities that have grown a substantial amount of renewable assets. Lastly, you have independent developers who are looking at aggregating projects and then taking them public. I think you will see new yield cos by all three of these types of actors.
MR. BRANDT: There are several private equity groups in the market that are very aggressively trying to get the critical mass to have enough distributable cash flow to float sometime in 2015 or 2016. This is where some of the most aggressive capital is in the market right now.
MR. KATZ: So those guys will have no pipeline when they go public? They are effectively just a closed-end acquisition vehicle?
MR. BRANDT: That’s right. I think everybody knows there are two kinds of vehicles: the drop-down vehicles which is everyone except Pattern and then something like a closed-end fund. We may well see growth in the closed-end funds.
MR. BRANDT: Is it a rule of thumb that you need at least $300 million in assets to go public?
MR. RADTKE: The rule of thumb was always based on amounts of distributed cash flows. Once upon a time, it was in the $100-million range. Then it dropped to the $50-million range, and I think that we are now inside that in the current market.