Yield Co-Induced Highs
Yield cos are driving up asset valuations. Are they a fad or here to stay? Can yield cos maintain current growth rates? What happens if they cannot? Will developers without affiliated yield cos be at a competitive disadvantage when bidding for power contracts?
Chadbourne hosted a lively debate on the topic in June. The debaters are Stephen Herman, managing director of Energy Capital Partners, and Wyatt Wachtel, managing director of York Capital Management, for the view that yield cos will remain a permanent feature of the power industry landscape, and Paul Segal, CEO of LS Power, and Ed Feo, co-founder and president of Coronal Group, arguing that they are a temporary phenomenon.
An audience vote before the debate showed 52% of the audience viewing yield cos favorably and 48% not so favorably. The moderator is Kenneth Hansen with Chadbourne in Washington.
MR. HANSEN: The precise topic on which we have focused the debate is, “Resolved: Yield cos are not a fad, but are here to stay.” Steve Herman, you have up to five minutes to make an opening statement in favor of the resolution.
Large Growth Potential
MR. HERMAN: My job is to convince the naysayers to turn around and be in a position to make a lot of money. I would like you to think back to the 2007, 2008 and 2009 time period, when hydraulic fracturing, known as fracking, was getting off the ground.
How many of you in this audience saw the potential for that activity to change the entire energy industry? One. Well, you should not be here because you should have invested and have been off somewhere by now enjoying all your money.
Most of us did not see the potential. I submit that the formation of yield cos and this financial vehicle will transform energy finance in a major way, and for those who do not take advantage of yield cos, they will leave on the table a tremendous amount of value for others to collect.
I want briefly to describe what a yield co does and where the real value in the yield co is, and where it unlocks not phantom value, not investment banker-type value, but real value.
At the top you have a sponsor. The sponsor can be an independent power company. It can be a private equity fund. It can be a development company. It forms a yield co and sells some of the equity of the yield co to the public market. The other part of the equity continues to be held by the sponsor. The yield co will remain controlled by the sponsor even after the public offering.
The sponsor drops down assets to the yield co. Over time the yield co pays for those assets. The sponsor is paid the value of the assets.
What is the appeal to the public market?
It is a unique appeal that no other security, other than a master limited partnership, really fulfills, and that is the investors get a relatively stable distribution with a large potential for growth over time in the distribution and that growth is visible, unlike an ordinary equity, say, General Electric or IBM. I would not call the growth certain, but it is reasonably visible.
The reason is the sponsor has a large number of assets that over time it can drop down to the yield co and create more income distribution for the yield co, which the sponsor will do because the sponsor still owns a lot of that equity.
That is the real benefit. There is no other asset class that the public can buy that meets that criteria. That is very important in a time period in which yields are very low. At least in the western world, growth rates are projected to remain low.
So you see benefits to the sponsors. You see benefits to the public investors.
What happens if interest rates rise? Are yield cos going to crash?
The data shows otherwise. If you look at MLPs, which are the closest analogy to yield cos, and you look back at their long track record, MLPs have not fared badly in a period of rising interest rates on a relative basis compared to utility equities or REITs or anything else.
Why? Because they have that growth element to them. In fact, yield cos should not be called yield cos. They are really growth cos.
Another point: where is this growth going to come from? Will yield cos just compete for a limited number of assets and drive the asset prices up so that we have a bubble?
No. The potential class of yield co assets is tremendous. Even if you look at just what has been done to date. RBC Capital, which put out an excellent report at the end of April said that yield cos have only tapped 10% of the renewable energy market. But the growth is going to come not just from renewables. Traditional power assets are a potential asset class. Transmission assets are another.
TerraForm is now bringing in overseas assets. The RBC report projected that by 2030, $6.3 trillion in assets will qualify for yield cos.
MR. HANSEN: Thank you, Steve Herman. Speaking in opposition to the proposition, we have initially Paul Segal for five minutes.
Law of Large Numbers
MR. SEGAL: Steve Herman did a great job of laying out the proposition. These are companies that are supposed to buy or own high-quality, contracted cash flows and distribute those cash flows to their owners and investors, and they are supposed to grow that cash flow yield significantly over time.
The basic difference between MLPs and REITS is that these are taxable entities, but investors, at least at this point, are willing to ignore that distinction in large part due to the promise of very significant growth and the promise that the underlying assets supporting that significant growth will be of very high quality. They will generate cash flows under long-term contracts. That is the basic covenant between the investor and the yield co.
If investors stop providing the yield cos with a highly-priced currency so that they can do acquisitions and grow, that structure falls down, and if yield cos cannot provide the growth, or perhaps move up the risk curve, then the investors may run away.
It is important to step back and see how we got here and talk about whether or not that basic relationship is a durable one. It is less than two years since NRG basically did the first power yield co.
Since then, by the end of 2014, the big six power-related yield cos — NRG, NextEra, Pattern, TerraForm, TransAlta and Abengoa — have now over a $17 billion equity market cap.
From a financial metrics perspective, that translates into a roughly 5% 2015 cash-flow-available-for-distribution yield and a roughly 4% dividend yield. The markets are accepting these low yields, in one part because overall alternative investments are also yielding very low rates, but also because they expect 15% compound annual growth, at least that is what the market has been told to expect by the sell-side and management teams.
It is important to explore whether or not that is sustainable. The underlying assets that most of these companies own do not inherently grow cash flow. The assets have stable and in some cases declining cash flows, and so these companies need to rely on acquisitions.
If you look at that $17 billion equity market cap and the current financial metrics, these companies would need to buy roughly $6 billion worth of equity value in high quality contracted assets in 2015. When you move that forward into 2016, to achieve that 15% growth rate, that number becomes $15 billion and, by 2017, it becomes about $150 billion. These are astronomical numbers, and I think none of us believes such a staggering volume of acquisitions is likely without one thing: moving way down the risk curve.
When we look at single asset transactions, we are not seeing, outside of drop downs, many yield cos being the preferred or winning bidder on assets. Instead, what we see yield cos do is one of two things. They are buying large portfolios that usually have a development component, and they are participating in sponsor drop downs.
Why are they playing here as opposed to playing in the single asset, fairly transparent opportunities? It is primarily because in the large portfolio transactions, they are able to allocate value between the yield co and the sponsor, where the sponsor allocates any incremental value in excess of what it would take for the underlying transaction to be accretive for the yield co so that the yield co can hit its growth targets.
That ignores the fact that allocating that value will make it very difficult to re-contract those assets at an accretive price that will allow the assets to be dropped down to the yield co on an accretive basis.
The yield cos are also participating in drop downs. Those drop downs at this point are still benefitting from a much more robust contracting environment from a few years ago, and as those assets make their way through the drop-down pipeline and are transferred to the yield cos, they need to be replaced. The current contracting opportunities are much less lucrative.
So where do yield cos go from here? They will turn increasingly to emerging markets where they will take on more risk to get their yields.
They will move down the curve in terms of contract duration, perhaps moving to a place where contracts do not matter that much any more. And the question really becomes how long are investors willing to put up with that?
The growth is achievable, assuming that the investors are prepared to give up on a construct that was premised on long-term contracted cash flows. If the investors give up on that concept and accept that this growth can come from anywhere, then the yield cos can continue to buy assets accretively and grow. Otherwise, I believe that this structure will quickly disappoint.
MR. HANSEN: Thank you. With a follow-up statement in favor of the proposition, Wyatt Wachtel.
MR. WACHTEL: As a momentum investor, I do not need to convince the other side of anything. I just need to convince you in the audience to buy more.
Let me first give a disclaimer. We are an anchor investor behind Everstream in the new TerraForm Global Emerging Markets yield co, so as somebody who has to answer to his boss every day, I had better believe my story.
This debate is couched as a discussion about yield cos, but it really fundamentally is a question of whether you believe in renewables. If you look at the size and the opportunity of renewables, this product has to go somewhere.
It can sit within a large corporation or a large utility. However, when you look at the fundamentals of corporate finance and how to unlock value, the assets have to go somewhere outside of the developer. The natural home for them is in a yield co or an MLP.
The yield co structure is incredibly efficient. There will be mistakes made. Paul Segal made the point earlier about yields becoming very tight. I absolutely agree, particularly in the United States. They are tight and will continue to tighten, and mistakes will be made given new technology.
If you look back at the history of new financial technology, things like CDOs, CLOs, MLPs, they have all gone through periods of dislocation. However, as a product, yield cos make sense because this product specifically, unlike MLPs, has the ability to retain earnings, which gives it the ultimate amount of flexibility.
The one thing that will need eventually to shift is the holders of most of the yield cos are momentum investors, hedge funds such as myself. Because the yields are low and they view this as a growth story, these investors are not buying the yield. Eventually this will have to shift. A key metric for success for yield cos will be when you start to see more traditional, long-only investors come into this product.
Part of that will be driven by a longer-term track record and transparency, which is absolutely critical for a lot of these long-only investors, and the flexibility. When the long-only investors look at it from a portfolio-managed perspective, the ability to put multiple asset classes in yield cos will allow much more consistency in earnings and visibility on earnings.
So my view as an investor in this space is I view yield cos as a very efficient, tax-efficient means of investing. I view them as a basic corporate finance vehicle that is very efficient in terms of unlocking value. I view them as something that, so long as there is transparency, will start to attract more traditional investors which will support the values of the yield cos and, in turn, unlock value in more proj-ects for the developers allowing them more quickly to recycle cash.
MR. HANSEN: Thank you very much. With that, I would like to turn to Ed Feo for an opening statement in opposition.
Investment Banker’s Dream
MR. FEO: Yield cos are yet another piece in a long and honorable tradition of Wall Street dreaming up schemes for companies to move assets from point A to point B to generate investment banking fees. That is what this is about.
Before yield cos, the assets we are talking about arranged their equity through long-term investors — insurance companies, pension funds, funds that had funds from those folks — and they would hire people who would look at these assets and carefully evaluate the risks and think about the tenor of the investment. They would match the investment with the life of the asset and price it accordingly.
What yield cos do is say, “Let’s jump the hedge. Let’s go to the yield-starved public investor, those twitchy folks out there in the boondocks on Scottrade, and let’s sell them these assets on the following proposition: We will pay you a really crummy cash payment, on the one hand, but on the other hand, we are going to give you really monster growth.”
We have all heard about how the growth story is going to work. Is there anybody here who thinks that that guy on Scottrade in Lompoc knows more about these assets than, say, Grant Davis?
My co-debater, Paul Segal, has highlighted the squeeze that will occur with yield cos. To be fair, we have to differentiate between the two types of yield cos.
The first group includes the guys with megawatts in a cupboard. We know who they are. They are going to do the drop downs. They have seasoned assets. Drop them down. Create managed growth.
And then you have the other group, which is the got-to-grow group. They have no assets, but they have to buy them or develop them. The got-to-grow group is already out in the market and it is already in trouble because it has already bid up asset values, so each deal it does is less accretive than the last, and almost as importantly, this group has effectively told the market where the bottom is.
Where has this led? Developers are out doing power contracts with assumed capital costs of something like 6%. So the next deal the yield cos do will even be less accretive. And, of course, we can think of exogenous events, such as interest rates going up. Add to that the law of big numbers that Paul mentioned, and the return squeeze will occur.
Every deal will be less attractive and will have a harder and harder time to make the numbers work. So the yield cos will do what Paul described, which is they will go back to the S-1 and say: “Wait a minute. Yes, we did say we are going to do long-term contracts with investment-grade entities, but it says we can do other stuff. So we are now doing merchant deals in Rwanda.”
Or the yield co will say, “The offering prospectus says we can do energy-related transactions, so we talked to our friends at Chadbourne and they said, ‘That can be interpreted broadly.’ Solar energy through photosynthesis creates wood. Wood, with the energy of saws and hammers, creates furniture. Well, we bought a furniture factory servicing the Burundi market. That’s our new market. High yield.”
We have all seen this before. Somebody will blow up. Somebody will push it too far and when one of these guys blows up, the whole sector will be tainted, the public investors will run for the exits, and the spiral will start.
We have these two classes of yield cos and I want to differentiate between them, because I do not want you to think that I am biased or that I have not thought about this.
The got-to-grow group will do what drowning people always do. They will glom onto each other. In Wall Street speak, they will do “strategic combinations.” And to their aid will come opportunity folks who will explore the opportunity of separating those funds from their assets at a steep discount, and they will consolidate that side of the market.
The other side of the market, the fellows with a lot of seasoned megawatts in the cupboard, will say, “We are immune.” But they will not be. The cost to keep the game going will have to be a higher cash payment and a better overall return. The sponsor will then look at every drop down and say, “Hmm, this does not look so good.”
While they are in that quandary, the investment bankers who sold them the deal in the first place will come back and say, “Wait a minute. Do a stock buyback. Don’t keep this thing alive. You sold it for a dollar, buy it back for 50¢. It’s a slight premium over the public market. Those investors will be ecstatic. They have already gotten hammered. The market is going to pay them 46¢, you pay them 50¢. They are gone.”
And so, ladies and gentlemen, those two circles will combine and all these assets will go back to the private hands where they started. It is all one big circle.
MR. HANSEN: Nicely done. At this point we are going to turn to some Q&A within the panel. Steve Herman, might you have a question for Ed Feo?
Real or Sham Growth?
MR. HERMAN: I do. I heard a couple things that I could not quite put together. On one hand, you said that the investors in yield cos were very sophisticated hedge funds and, at other times, you referred to them as Scottrade traders.
But, whatever kind of investor, can you think of another asset class where the growth, at least in the intermediate term, is absolutely locked in?
The sponsor has the assets. The assets have a predictable cash flow. The yield co has a right of first offer on the assets. The sponsor has an incentive to sell them to the yield co because the sponsor owns part of the equity and may even have something called incentive distribution rights.
So can you think of another asset class, if you were a public investor, where you can see almost certain visible growth in cash distributions?
MR. FEO: The distinction I was making was between sophisticated investors such as pension funds and insurance companies and the very skilled people they hire, some of whom are here today with us, who really know how to evaluate these assets and properly price an equity investment in those versus the yield co which is essentially providing liquidity to a public investor.
Liquidity is the one thing that it provides in exchange for what is essentially a negligible return, but somewhat more than the negligible return you might get from treasuries.
The growth story is a bit of a sham, frankly. The drop down mechanism is not growth. That is just moving assets from point A to point B, still controlled by the same people, and just taking some money off the table from the public investor.
Is there another asset class? I would rather invest in a REIT because I can look at a market that has matured with real growth and not manufactured growth.
MR. HANSEN: Paul Segal, will you have a question for Wyatt Wachtel?
MR. SEGAL: You mentioned the tax efficiency of this structure. One of the things that I scratch my head about is that seems to work fine as long as growth is continuing at a very rapid pace.
If growth were to stop or pause or the markets were to become diverted, what happens in that case? The yield co is a C corp. It has accelerated MACRS depreciation. It has tax credits. What happens when the tax attributes run off, and how do investors think about that?
MR. WACHTEL: From an investor standpoint, I look beyond the tax credits because expiration is coming up on us quickly. If you believe in renewables and the size of the market, then yield cos are a sensible investment. I am not saying that yield cos will not hit periods of bumps because they are a newer technology. What will ultimately happen in the event that growth slows is you will see different investors rotating into this stock. You will see a different type of investor. It is no different than any other stock.
Sometimes stocks go from growth into different points in the lifecycle, and you will see shifts in the investor base. It happened for Microsoft. Microsoft moved from a growth stock into a large cap dividend-type of stock. You will eventually see that in yield cos.
You will see a re-pricing and a shift. But, in my view, that is very far off in the distance. Given what is happening in the energy space, I do not think you need to go to Rwanda or Burundi to grow your portfolio.
You can go to developed markets. You can go to the likes of Japan. You can go to the likes of other parts in Asia. You can go to China, India, and other markets like that may not be fully developed. If you have been to China and have seen the amount that is going on, you have a clear view to growth for the next five, 10, 15 years.
And then when you add on what in my view will happen to a number of utilities and how they will ultimately have to hive off different parts of their businesses to unlock value, to maintain their dividends, moving transmission into other types of structures that are more efficient, I just see a longer-term growth pattern.
MR. HANSEN: Wyatt Wachtel, might you have a question for Paul Segal?
Corporate Finance 101
MR. WACHTEL: Points were made earlier that private investors ultimately should be the most appropriate owners. How does that reconcile with corporate finance 101, which suggests that a public currency is always cheaper than a private currency? How can a private currency ultimately compete for these assets with a lower-cost public currency?
MR. SEGAL: Many of the tax attributes for renewable businesses, particularly here in the United States, are best used by C corps or individuals who can use them efficiently. If they are stuck in a publicly-traded yield co and used over the course of nine years instead of an average life of two, there should be a very different cost assigned to that capital.
Many of the investors in yield cos are ignoring the fact that depreciation is great on the front end. It sucks five or 10 years out in the future when you have to pay that money back, assuming that you get into a world where you actually have to pay your creditors back, which many of the yield cos are using as a convenient tool to optimize front-end cash flow available for distribution.
We are not seeing a lot of amortizing debt in these structures. We are seeing bullets. Bullets are great because you do not have to pay back the principal. The yield cos are optimized to maximize that very near-term metric. That very near-term metric becomes very difficult to sustain absent growth.
MR. HANSEN: Thank you. Ed Feo, do you have any questions for Steve Herman?
MR. FEO: I do. Steve, you are in the business of investing in energy assets and you have investors and you undoubtedly have a target rate of return. The interesting thing about the yield cos is the high returns being projected on contracted assets. What, in your view, is the appropriate level of return associated with this asset class, even in a public vehicle?
MR. HERMAN: You are looking at yield cos, if I have it right, that are currently trading at about six times EBITDA. You see public sponsors maybe targeting 13 times EBITDA, so you are trying to get that arbitrage. We do not have a yield co yet.
MR. FEO: Where is your S-1 by the way? [Laughter.]
MR. HERMAN: We have an MLP, which is similar, but I would like to submit that yield cos are better because MLPs can only invest in certain limited types of assets. Yield cos can invest across the board in anything, but a lot of MLPs have done extremely well and the public investors of the yield cos have done very well. They are more than satisfied.
MR. HANSEN: Wyatt Wachtel, I would like to invite you to ask a question of Ed Feo.
MR. WACHTEL: I am struggling with the concept of how this is different than an MLP. I understand there are tax attributes that are specific to this asset class, but the MLPs out have withstood the test of time.
This vehicle has the ability effectively to retain earnings because it is a C corp. What is the difference between the MLPs and this, given the track record and the history of MLPs, albeit there have been some blowups at various points in time in the MLP space, but by and large, MLPs have been proven to work.
MR. FEO: MLPs have a long track record. They have worked their way through whatever issues they had from their early days.
There is a lot more variability in the MLP market, in terms of the kinds of investments that are available, whether it is a growth vehicle or a low-growth vehicle, and the kinds of assets they invest in. The fact that it is a deeper market and broader product mix helps avoid the kind of catastrophic event I described because you can, you know, put things in different places and you are selling to different markets.
While MLPs are limited in what they can invest in, they are dealing with an asset class that is gargantuan.
Renewables are a good asset class. I don’t have any doubts about that, but is the asset class as large as what the MLP market can get its hands on?
We’re having fun here. The reality is yield cos make sense, but there will be teething issues. They are relatively new and the risk is that people will push the envelope and, if somebody blows up, it will set back the whole sector. MLPs have been around for 20 years.
MR. HANSEN: Ed Feo, would you like to respond with a question to Wyatt Wachtel?
MR. FEO: I know a little bit about hedge funds. My question for you is: which of the yield co stocks are you shorting? [Laughter.]
MR. HANSEN: Wyatt, you have up to three minutes. [Laughter.]
MR. WACHTEL: If you knew York very well, you would understand. We are long and strong just about everything. We are not very good at shorting stocks and so we are not short any yield cos.
With that said, I am able to traverse between publics and privates, and I view our private side effectively as a positive carry short on a number of utilities. That is about as close as we get to a short. We are only really short when we have positive carry. Otherwise, the market could whipsaw us too hard, and we have learned our lesson over the past 23 years, that sometimes that whipsaw can be vicious.
MR. HANSEN: Steve Herman, do you have a question for Paul Segal?
MR. HERMAN: Paul, forgive me as I am going to get very personal with you. I view LS Power as one of the best, if not the very best, developers in the United States. One of the great things that you have done is you were forging ahead in transmission development and, in my opinion, you have one of the very best developers, Sharon Segner, leading that effort.
Given your track record, you are going one day to make some money on this and develop lots of transmission assets. Why wouldn’t you consider putting those assets in a yield co? Wouldn’t that give you much more value? Why are you going to ignore that as a potential way to reap the rewards of your hard work?
MR. SEGAL: Steve, thank you for the very nice comments about the organization. I want to hit on a couple things quickly, and then I will answer your question directly.
A big difference between MLPs and yield cos is what has been sold to the investors. The concept is that we are not going to do anything under a 10-year contracted life and that we are going to be buying high-quality cash flows.
Once you abandon that concept, the whole universe opens up very broadly and there is no reason why Calpine or Dynegy or NRG parent are not yield cos or could not become yield cos overnight.
So if that is the concept, yes, the whole universe opens up and assuming that investors do not care about the shift in focus, you may well be right.
I submit that investors will care. When you look at the refining MLPs, those trade very differently. Drilling MLPs trade very differently than the less risky pipeline MLPs.
Back to transmission and maybe some of our own personal motivations: we are a flow-through entity and in the environment that we have been living in with MACRS and bonus depreciation, there is nobody who will be better situated to use those tax benefits than us. Once we develop a project and take those tax benefits, we sure are not going to trigger recapture by selling them to a yield co.
REITS are different. There are a lot of really interesting structures that you can undertake with a REIT to defer the tax consequences of transferring those types of assets. So the underlying yield co structure is less advantageous than REITS and the way that it has been advertised to investors is very different than MLPs.
MR. HANSEN: For the final question of our structured round, Paul Segal, do you have a question for Steve Herman?
MR. SEGAL: Why do you think the universe will be so big and investors will be willing to tolerate the shift in concept in terms of target acquisition opportunities?
MR. HERMAN: You can start with renewables. If you think the renewables sector is going to grow, it will remain a great source of projects for yield cos.
There are plenty of traditional power assets with long-term contracts. That is another an area of potential growth.
I have a lot of confidence in the creativity of the hedge market to open up merchant assets, just like the creativity on the fracking side. It was creativity and it continues to be creativity that drives this sector.
One day, you will either have your own yield co or sell your so-called merchant hedge projects to yield cos. I look at other asset classes: transmission, for example. I don’t want to take time, but I can make an argument that transmission belongs more appropriately in a yield co than it does in a REIT and it certainly has a defined revenue stream.
Going to other parts of the world, there is political risk there, sure, but there is also such risk in the United States. We have all been bitten by California political risk, New York political risk, New England political risk, manipulating capacity markets.
I could argue in other parts of the world there is no more political risk than there is in the United States, so that is another big area of growth.
MR. HANSEN: Okay, thank you. A whole new debate topic. We are going to move now a little more informally to questions from the audience.
Deer in the Headlights
MR. FONG: Christian Fong with Renewable Energy Trust. Sponsors were trading at a dollar or two. With the advent of yield cos, they are up 10 or 20 times. Liquidity was a huge concern, and yield cos are a great vehicle to add liquidity.
Fast forward. There is no lack of liquidity. What happens to the sponsor’s share price if the yield co cannot keep up the growth or it is going to be taken private or those sorts of events? Just walk through how the dominoes will fall leading to that sort of event and how it affects the developers.
MR. FEO: Here is the scenario. Market conditions change, the Fed increases interest rates, people are reevaluating risk and repricin