Is Your Project Yieldco-Ready?
The rise of yieldcos in the renewable power market has brought an increase in project merger and acquisition (M&A) activity along with it. In some respects, a yieldco has a peculiar view of the world, but it’s primarily focused on acquiring well-structured projects with predictable cashflows.
Before we discuss what makes an attractive project, let’s set the stage. A yieldco is not really anything special, and it is not a new concept. It is a corporation that owns operating assets and promises a dividend and growth to its shareholders.
For a developer, forming a separate yieldco allows the developer to divorce the development risk associated with development-stage projects from operating assets – therefore, increasing the value of the operating assets. A corporation is not an ideal ownership vehicle in most cases because it is subject to two layers of tax. There is a tax on corporate-level earnings and a second tax on dividends paid to shareholders.
However, a corporation can start to look attractive when coupled with renewable power projects. These projects throw off a large amount of tax benefits, as wind farms generally qualify for tax credits and accelerated depreciation.
The tax benefits can wipe out the entity-level tax for five to nine years. In addition, because the tax burden is so low at the entity level in these years, there may not be any tax earnings even though there is cash. That means the corporation can distribute cash tax-free for a time. Simply put, eliminating the tax burden frees cash for distribution. Although a corporate vehicle may seem less efficient in theory, the tax benefits associated with renewable power projects can actually make this ownership vehicle function in an attractive manner.
Why are projects now attractive acquisition targets? A couple of factors are converging at once. Private-equity investments in wind enabled a fair amount of consolidation over the past few years. Some of the private-equity investments are reaching their investment horizons, with the investors seeking to cash out. This has created a kernel around which the M&As in the power market could develop.
Also, because the yieldco phenomenon is new to renewable power, the existing yieldcos feel some pressure to perform. That means they need to show some growth in the short term and make sure that the promised dividend materializes. Acquiring a large number of projects helps prime the pot. The need to acquire projects has eclipsed the ability of most yieldcos to self-develop.
So, the yieldcos are on an acquisition tear, but what does a yieldco expect to see in an acquisition target?
A project will not make an attractive acquisition target if the financials do not bear out. Every buyer has its own metrics, but it is important to keep in mind that pricing will vary depending on where the project is in the development cycle. Because yieldcos are focused on yield, a project that has been operating for several years will receive the most attention and, therefore, the most attractive pricing. These projects are “de-risked” in that they likely have either worked through or identified the normal blips associated with a new project. Yieldcos generally will not take development risk and are reluctant to take construction risk, but some construction risk may be tolerable if the pathway to an attractive yield is unobstructed.
It is important to note that the majority of yieldcos place the most value on the first 10 or so years the yieldco will own the project. Locking down cashflows in that period is paramount. This means that a pre-packaged transaction with construction/term financing in place will not be attractive if it siphons off cashflows to lenders. It also means that packaging the deal with a tax-equity investor that is willing to take all or a majority of its cash return after year 10 will be an attractive option.
A strong residual value is a great add-on, but a project just is not attractive to a yieldco if it doesn’t have strong early-year distributions.
Nevertheless, part of analyzing potential growth takes residual value into account. A project with lease and permit terms that allow operations after 10 years – and at least after the term of the off-take agreement – will be valuable, provided there is a liquid market for the project’s output beyond the current off-take agreement, the useful life of the equipment, and the potential operations and maintenance costs needed to support continued operations.
A Clear Path to Distributions
Assessing the pathway to strong early-year distributions includes determining what factors might cause a block to distributions.
The yieldco will want to control the day-to-day activities associated with the project. If the project will be owned by a joint venture (JV), including a tax-equity vehicle, then the yieldco should be the managing member. Other partners should be limited to voting on important issues, such as selling the project.
There should be limited or no cash sweeps in favor of either project-level lenders or other partners in a JV. Tax-equity investors often negotiate for cash sweeps in cases where the developer owes an indemnity. If at all possible, these sweeps should be limited to actual bad acts of the developer, rather than mere risk allocation measures. Related to this, negotiated indemnities should be limited. If at all possible, indemnity risks should be shifted to the developer or contractor.
For example, if the project has received a cash grant from the U.S. Department of the Treasury, care should be taken to ensure the yieldco is not at risk for the repayment of any portion of the grant. Any additional capital funding required by the yieldco should be modeled clearly. This includes any remaining construction expenditures, deferred maintenance, commitments to expand or dismantle the project, and obligations to pay off existing lenders or the original developer.
The better able the seller is to backstop these risks, the better pricing the project can support. Assess whether the seller can financially back its representations and warranties alone. If it cannot, then it may make sense to partner early in the development process with a strategic investor that can provide backstop capabilities – particularly if the seller is looking to cash out entirely when it sells to the yieldco.
Location, Location, Location
Projects with the highest net capacity factor will get the most attention. In the case of wind, for example, this generally means the Midwest. The data behind the net capacity factor determination is key. For operating projects, how has actual performance compared to forecasts to date? For other projects, how many years of data do you have, and does that data correlate with publicly available datasets?
The old adage “beware of a site near a Starbucks” generally holds true. Assess community support and continue assessing. A development or construction stage project may be derailed by permitting hurdles (including those related to environmental issues or community support), but an operational project can also become a headache if the community has turned against it. Make realistic assumptions related to timing and cost of permitting.
Going back to the potential for additional capital requirements, you should assess whether the permits have any unusual conditions that will make the project difficult to operate long term or will increase the cost of operation or shutdown (e.g., if the land needs to be restored to its original state).
An interconnection agreement should be in place or the process should be in the works such that you have a clear view to when the project will be able to export power, to the cost of any network upgrades/interties and to the risk of curtailment.
Assuming you can get the power to market, a yieldco will be concerned with who will purchase the power, at least for the first 10 years. Ideally, the project would sell power under a long-term (at least 10 years) power purchase agreement (PPA) to a creditworthy off-taker. Is there a hair trigger for the off-taker to terminate the arrangement? Is the PPA a service contract for tax purposes?
A yieldco will want to know the remaining term of the off-take/hedge agreement and what the likelihood of a replacement is – both if the contract is terminated early and at the end of the term. Therefore, it is important to know whether there is a renewable portfolio standard in the area, who the possible power purchasers are (and how many will be competing for their attention) and whether there is a liquid market if the PPA is lost.
Transitioning Existing Capital Stack
Many projects are developed or constructed with a combination of debt and equity. Project owners may also have certain development fees that are payable at construction completion. A project seller should clearly identify any future payments or liabilities of the project company and try to structure the liabilities to remain with the seller, as opposed to being transferred with the project.
Identify early which project documents require consent from the counterparty in order to accomplish a sale to a yieldco. Also identify potential third-party consents required, such as consent from the local utility commission or zoning/permitting board. If possible, negotiate to eliminate such consents from the start.
The sale of an operating project may require the retirement of existing debt or a tax-equity buyout. Canvas the counterparties about their willingness to cooperate with a sale process. Tax-equity deals involving existing operational projects may require some renegotiation to make them more yieldco-friendly. If the project has been operating for a number of years, it is likely that the transaction was not negotiated with a yieldco in mind.