McCrone and Liebreich: Yieldcos – two big questions

By Angus McCrone, Chief Editor

and Michael Liebreich, Chairman of the Advisory Board

Bloomberg New Energy Finance

 

One of the big stories in clean energy in recent times has been the emergence of the “yieldco”. In the past 30 months, 15 quoted US and European renewable power ownership vehicles have raised a total of $12bn – one third of new public equity funding for all clean energy companies – and they have jumped to an aggregate market capitalisation of $27.6bn.

The fundamental logic behind the yieldco is strong. In an era of very low interest rates, infrastructure assets can offer stable returns above corporate bonds of a similar term, while bearing relatively low risk. Many asset managers find investing directly in individual projects impossible: they may not have the managerial skills or technical knowledge; they may not be able to hold a large enough portfolio to spread their risk; or they may be prohibited from holding unquoted investments, for instance by pension or insurance legislation.

Yieldcos therefore meet a real need: a quoted portfolio of assets, offering risk diversification and liquidity, with operational management of the constituent projects thrown in.

Clean energy yieldcos were just starting to be talked about before the financial crisis put capital market innovation on hold. Conditions have been friendly for the last few years, and a broad range of investors ‒ moms and pops in the US, wealth managers, pension funds, insurers and even a few hedge funds ‒ have warmed to the proposition they offer.

At the Bloomberg New Energy Finance Summit in New York in April, Jeff McDermott, managing partner of Greentech Capital Advisors, argued that yieldcos had the potential to grow in the same spectacular way that master limited partnerships have done. “I think this will be a $100bn market in the future,” he said.

Others, however, have raised important caveats. On the sidelines of the same Summit, Francesco Venturini, chief executive of Enel Green Power, a company that had been rumoured to be thinking of setting up a yieldco, said that he saw yieldcos as nothing more than “financial arbitrage”, with very little value creation. “Enel Green Power,” he said, “will not be setting up a yieldco”.

The truth is that yieldcos face two searching questions if they are to gain a permanent and sizeable place in the armoury of clean energy finance. First, the markets must reach a sensible consensus on how they should be valued. Second, their managers and promoters need to explain how they will work when the current low interest rate environment eventually comes to an end, as it inevitably will.

On the question of valuation, there has been a big difference on the two sides of the Atlantic. In North America yieldcos have been seen as growth stocks, rather than a simple aggregation of projects. Investors’ perception has been that, as they build their project portfolio through acquisitions, they pay an escalating stream of dividends per share.

On the European side of the Atlantic, by contrast, yieldcos (or quoted project funds as they are known in the UK) are seen as sedate vehicles for risk-averse investors. They pay a steady yield of 6% or so and their shares trade close to net asset value.

Over-hyped, overvalued and over there?

On the American side, the yieldco pioneer was NRG Yield, which was spun out of US generator NRG Energy in July 2013. It has raised a total of $1.7bn and saw its shares more than double to a peak early this year before slipping to stand 45% up, with a market capitalisation of $3.5bn. It has been joined in the ranks of quoted companies by TransAlta Renewables, Pattern Energy Group, Abengoa Yield, NextEra Energy Partners, TerraForm Power and, most recently, 8Point3 Energy Partners, an asset-owning creation of First Solar and SunPower.

In the European corner, the pioneer was Greencoat UK Wind, an independent fund floated in March 2013 with backing from the UK Department for Business. Greencoat has raised a total of GBP 520m, and is capitalised at $812m at the current sterling-dollar exchange rate. Greencoat shares have risen 13% since IPO. It has since been joined by fellow UK entities Bluefield Solar Income Fund, The Renewables Infrastructure Group, Foresight Solar Fund, John Laing Environmental Assets Group and NextEnergy Solar Fund.

There are also two continental entities with their own characteristics. Capital Stage is a German fund that listed in a very small way in 1998 and has raised substantial additional capital since 2013. Saeta Yield, the subject of a EUR 441m initial public offering in Madrid in February 2015, was born out of Spanish infrastructure company ACS.

The first thing to note is that the North Americans were all formed by spinning a bundle of assets out of large energy companies that develop their own projects. By contrast, the Europeans, with the exceptions of the John Laing fund and Saeta Yield, bought their assets from third parties in competition with other bidders, in some cases also from developers via bilateral agreements.

Generally, the US and Canadian yieldcos pay some 80-90% of cash flow out as dividends ‒ 80% for Pattern, 80-85% for TransAlta, 85% for TerraForm, 80-90% for NRG Yield. Some of the UK funds retain a bigger proportion of their cash flow ‒ Greencoat says it aims to pay out 60%, the John Laing fund says 70%, TRIG cites in its prospectus the equivalent of 77%. There is an exception, Bluefield, which styles itself a “full distribution fund”. In Spain, Saeta Yield says it aims to pay out 90% of cash flow.

There is also a difference in funds’ appetite for debt with, once again, the UK funds on the conservative side. Foresight Solar, for instance, has no asset-level borrowings, and fund-level leverage is capped at 30% of gross assets. In the US, NRG Yield has debt equivalent to 70% of total assets.

This combination of market perception and financing strategy has led to big differences in share price behaviour. The six North American yieldcos floated in 2013 or 2014 have been on a rollercoaster, with a powerful upswing last year giving way to a 30% average setback in the last few weeks. Despite that, they still remain 34% on average above their IPO prices. By contrast, the six UK funds have seen average gains of just 6%.

The US yieldcos have often traded at large (40% to 100%) premia to book value, while the Europeans have traded at premia of just a few percentage points. Can both valuation approaches be correct?

At heart, a yieldco is just a collection of projects

In thinking about how to value yieldcos, it is vital to understand that they are, at the end of the day, portfolios of projects. Any yieldco valuation has to start with a valuation of its underlying projects, and any premium over that value needs to be carefully justified.

Most wind and solar projects have a life of 20 to 25 years. Revenues over the first 15 or so years are often underpinned by feed-in tariffs, power purchase agreements or long-term green certificate sales arrangements. Revenue variations due to weather conditions are well understood (and can be insured against), and terminal values are generally understood to be negligible.

A yieldco that floats today with a static portfolio of operating-stage assets could pay out all of its cash flows as dividends, and there would be nothing left for investors in two decades’ time. Financially, therefore, this simplified yieldco would look similar to a serial bond, by which interest and principal are repaid simultaneously over time, or a fixed-term annuity, and should be valued as such.

What confuses the picture is that over time real-world yieldcos can add to their portfolios, enabling them to increase their dividends and giving the impression of growth. Most have a stated target return for assets they buy, and have been active in the market: a UK quoted project fund might say it pays 7-8% unlevered for a solar park, a US yieldco might say 9% “levered cash-on-cash return”.

Yieldcos can fund acquisitions by holding back some proportion of the cash flow from existing projects, or by raising new equity and debt. Either way, it is vital to note that this is not organic growth, it is acquired growth. It should only serve to increase the value of the yieldco if the projects are acquired below their market value, or if the yieldco can generate some sort of extra value in the portfolio.

Added value, but how much?

Yieldcos may provide some extra sources of added value, over and above the financial arbitrage described above, which could justify a premium over their underlying asset value:

  • They may have long-term options to buy projects from former parent companies, dubbed right of first offer (ROFO). These agreements, which are particularly common among US yieldcos, mean that the yieldco has access to an assured pipeline of projects.
  • Management may be able to add some value to the portfolio that was not present when projects were acquired, for instance by arranging lower-cost debt, bulk-buying operation and maintenance services, or improving the prices achieved for power or green certificate sales.
  • Revenues may offer an element of inflation protection, on top of the static yield on each asset. In some jurisdictions feed-in tariffs, PPAs or green certificate prices are adjusted for inflation over time.
  • There may be some terminal value to be realised, although this possibility has yet to be tested, as a result of repowering ‒ replacing the original equipment with more powerful or efficient models ‒ retrofitting improved components, or negotiating with landowners an extension to the project life or through land sales.

While each of these factors might justify some level of premium over the value of the underlying projects, the question is how much? Taken together, could they justify a 20% premium? A 40% premium?

A look at the list of holders of yieldco shares does provides some grounds for caution. Soaring valuations have attracted investment from hedge funds, which are likely to have return expectations higher than the yields available from the underlying clean energy projects held by the yieldco, even on a levered basis.

It’s all about risk

Recent events have suggested the market is taking a closer look at the risk of investing in yieldcos. Existing yieldcos have succeeded in raising new money (TerraForm raising $688m in June being just the largest issue), and 8Point3 Energy completed a $420m IPO, also last month. There are also some new IPOs being marketed – including a second TerraForm yieldco, this time concentrating on assets in emerging markets, and a second NextEnergy vehicle, aimed at solar in Spain and Italy.

However, two other attempts to float continental European asset-owning vehicles have hit turbulence, with Solairedirect of France postponing its $242m IPO in April because of insufficient interest and Chorus Clean Energy of Germany putting its $142m IPO on ice this month, blaming “the sharpened economic situation in Greece and the impact on global financial markets”.

Investors have also received a reminder that these entities can be exposed to regulatory risk. On July 8, UK Chancellor George Osborne surprised the renewable energy sector in his country by removing the exemption of renewable electricity from the country’s Climate Change Levy. Our BNEF colleagues estimate that this move will reduce revenues for existing wind and solar projects by about 2% over the next 20 years. The move was unexpected and led to next-day falls of 3% or more in the share prices of UK quoted funds such as Greencoat, TRIG and Foresight Solar.

Shifts in regulation and policy support are, of course, not the only hazard that yieldcos face. Electricity price risk is an important one, whether it relates to the period after the expiry of a power purchase agreement or that part of revenues not covered by a green certificate or feed-in tariff.

In all, US yieldco TerraForm Power lists no fewer than 27 pages of “risk factors” in its 2014 annual report, ranging from the mundane “wind plants located in Maine have experienced curtailment issues which may adversely affect revenues” to the zoological “harming of protected species can result in curtailment of wind project operations”.

Biggest risk of all

However, perhaps the biggest risk of all inhabits just a single paragraph on page 48 of the TerraForm report. It states: “Market interest rates may have an effect on the value of our class A common stock”.

Investors’ enthusiasm for yieldcos has been driven partly by their increasing confidence in wind and solar projects as an asset class to compare to traditional infrastructure such as roads and hospitals. But it has also reflected the hunger of pension funds, insurance companies and wealth managers for dividend income at a time of record-low interest rates.

A yieldco paying 6%, or even 5%, with the chance of that rising over time, has a relatively low bar to overcome in investors’ minds when US 10-year government bond yields are at 2.4%, those in Germany at 0.9% and in the UK, 2%. That bar, however, would look much more daunting if US 10-year rates return to 5.25% as they were in 2007, or even to 4% as they were in early 2010.

If that happens, the market would expect yieldcos also to offer higher yields than they do now. That does not mean the model ceases to function, as the underlying sources of value it provides would still be there. As Mike Garland, chief executive of Pattern Energy, said at the BNEF Summit in April, if interest rates go up, his yieldco would look for higher internal rates of return on the projects it bought. In other words, it would pay less.

However, higher interest rates would mean lower share prices for yieldcos, and this would make it a lot more difficult for them to raise new equity. A the same time, higher interest rates would make the floating-rate proportion of yieldco and project debts more expensive to service, reducing the cash available from operations to fund acquisitions. All this could result a vicious cycle: the end of acquisition-driven growth might trigger a reduction in market-to-book premiums, in turn triggering a rush to the exit by shareholders who had been attracted in by the hope of capital appreciation.

Having a ROFO arrangement with a former parent might offer protection, but only up to a point: the yieldco may hope to source projects from that quarter at lower prices, but its ability to do so would come down to what was in the interests of the former parent’s shareholders. Yes, they still own some equity in the yieldco, so they would want the yieldco to do well. But they also need to extract the best price for the assets they sell, and the yieldco might no longer be the highest bidder. They may also hold onto operating-stage projects rather than selling them, in the hope of getting better prices later.

All of this is, of course, speculation. We do not know if interest rates are going to rise this year or next, nor by how much. And it is always dangerous to predict the reactions of the market’s animal spirits.

Reassuringly, the underlying clean energy projects will continue generating power and throwing off cash, regardless of what happens to the yieldco market. Investors that keep your eye on the underlying cash generation should fare better than those looking for the infinite creation of market-to-book premiums for liquid assets. The yieldco itself, however, meets a real need and is here to stay.

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