The use of 'YieldCos' has been a topic of significant interest in renewable energy finance circles ever since December 2012 when NRG Energy Inc. incorporated NRG Yield Inc., which then subsequently undertook an IPO in July 2013 to raise the capital required to acquire a portion of NRG Yield LLC from NRG Energy Inc. Since the NRG transactions, TransAlta Corporation completed an IPO of its YieldCo subsidiary, TransAlta Renewables Inc., and Pattern Energy Group LP completed an IPO of its YieldCo subsidiary, Pattern Energy Group Inc.
The term “YieldCo” is buzz a word in the world of energy finance recently brought back to life by the transfer of operating renewable energy assets into segregated operating companies. Operating renewable energy projects, it turns out, are ideal yield-producing assets.
Large energy development companies (“DevCos”) have recently begun using a corporate financing structure that allows them to effectively lower their cost of capital by raising (or 'recycling') equity to finance ongoing operations and new project developments.
In its most basic form, a renewable energy DevCo will incorporate a new subsidiary (the “YieldCo”), roll its developed/operating/de-risked portfolio assets into the YieldCo and then sell a minority interest in the YieldCo to the public via an IPO. With the proceeds from the IPO, YieldCo can purchase additional operational assets — solar farms, wind farms, hydro stations or some combination of assets — from the sponsoring DevCo thereby allowing DevCo to free up capital investments to acquire new assets, retire debt and issue dividends.
Since the acquired assets are operational, they typically generate highly predictable cash flows which are available to be distributed as dividends to the shareholders of YieldCo.
Along with being predictable, dividend yields offered by YieldCos are typically quite high and the dividend payout can represent up to 85% of cash available for distribution, making YieldCos an attractive investment for income investors who would typically avoid the volatile renewable energy project development stage market segment.
While the corporate structure of a company executing a YieldCo strategy can be complex, as discussed below, a YieldCo is essentially just an equity carve-out — a classic form of corporate divestiture. An equity carve-out is a partial divestiture of a company’s subsidiary business unit. The parent company will usually retain a majority stake in the subsidiary, while that balance of the subsidiary’s equity is sold to the public. This strategy is usually used to separate a non-core segment from core segments of business operations.
One of the main reasons for implementing an equity carve-out is to ‘unlock a conglomerate discount’. For several reasons, public markets often misprice companies that compete in multiple industries or business lines.1
Viewing a ‘pure-play’ company in the market resulting from an equity carve-out, analysts are able to perform a better intrinsic valuation of the subsidiary company. As a result, the ‘conglomerate discount’ is unlocked as the subsidiary is freely traded by the market. Where a conglomerate discount truly existed, the sum of the parent and subsidiary market valuations after the equity carve-out will be greater that the valuation of the entire company before the divestiture. Additionally, with the parent company still owning a majority stake of the subsidiary and maintaining effective control, the parent’s market valuation will also benefit from the subsidiary’s higher valuation.
What differentiates YieldCos from other forms of equity carve-outs is their predominant use in the renewable energy industry to operate functioning energy generating assets and their model of returning cash regularly to their shareholders at high dividend yields.
YieldCos generally acquire energy generation businesses that have entered into Power Purchase Agreements with creditworthy counterparties such as government agencies. As a result, a YieldCo’s revenue stream is generally highly predictable and stable. This fact, in conjunction with the reality that renewable energy assets, like solar panels, have a long useful life and incur minimal variable maintenance costs, means that there is a low risk of variability to the cash flow available for distribution to shareholders.
Similarly, the YieldCo may own a number of subsidiaries which each operate the renewable energy assets. In this way, the YieldCo effectively mitigates its cash flow volatility by diversifying away from its idiosyncratic or firm-specific risks such as the disruption of operations at a specific solar farm. As a result, the risk of significant deviation from predicted cash flow levels is minimal.
As the name implies, a YieldCo has a defined strategy of attracting a clientele of investors that values ongoing cash flow. From an investor’s perspective, the most important decision making criteria to evaluate a YieldCo would be the dividend yield of the investment. Since a YieldCo has long-term predicable cash flow, its common shares are comparable to corporate bonds. A bond’s price fluctuates based on current interest rates in comparison to the interest rate on the bond. In recent years, low interest rates and investor frustration with insufficient returns on low risk debt instruments have contributed to the popularity of YieldCos. As a result of a YieldCo’s cash flow predictability, the prevailing influence on the YieldCo’s stock price will be its dividend yield’s competitiveness with interest rates on securities with comparable risk profiles. Factoring out bond market/interest rate factors, we see YieldCos as a reasonably good barometer of the market opinion on the renewable energy sector more broadly.
As thousands of newly built solar, wind and bio-material energy projects continue to come on line around the world, and as financial and operational norms for this class of financial asset are set, we see YieldCos as a potentially significant new source of capital for the renewable energy industry able to provide stable long-term capital competitively priced with that available from the LifeCos, pension funds and bond market. If this trend continues, diversified YieldCo portfolios — segregated along project jurisdiction, remaining PPA contract life, asset life, asset location, concession grant risk, tax incentive availability, fuel source, equipment characteristics and numerous other lines — could even emerge providing increasingly sophisticated products serving the needs of interested renewable energy investors seeking a position in very narrow risk categories.
1 When analyzing a non pure-play company, equity analysts have difficulty finding comparable companies to perform a relative valuation. In addition, when equity analysts perform an intrinsic or cash flow based valuation, they often use a Weighted Average Cost of Capital (“WACC”) that reflects the analyst’s best estimate of the riskiness of the whole company’s future cash flows. Companies with multiple business units will have different risk profiles based on their respective business fundamentals and key success factors.