Yieldcos are publicly traded entities with a funny name and a focus on renewable energy that have delivered not-so-funny results for investors during the sector’s stunning downturn since midyear 2015.
These entities are holding companies created by power-generation enterprises to operate renewable energy assets such as solar and wind power (although some operate conventional energy projects). Typically, the parent company owns a majority stake in the yieldco and spins off the rest in an initial public offering. There are about 20 yieldcos that trade in North America and Europe, with roughly half being U.S.-listed. Most yieldcos have gone public since 2013.
For the parent company, or sponsor, spinning out a holding company to buy and operate energy assets provides capital to develop future projects at a cheaper cost than the company could with tax equity finance. Yieldcos, short for “yield companies,” buy power projects from their parent company through “drop-down” transactions. These projects have long-term agreements to deliver electric power to customers, and they generate steady cash flows.
Because yieldcos can take advantage of tax benefits such as MACRS (modified accelerated cost recovery system) depreciation, as well as investment tax and production tax credits, they can offset gains and not generate taxable income for many years. In general, anywhere from 70% to 90% of the cash accrued by yieldcos is paid out to shareholders at—in most cases—significantly higher levels than yields offered by dividend stocks or bonds.
On paper, it sounds like a winning formula that addresses two powerful themes in today’s investment zeitgeist: the yearning for income in a low interest rate environment and the rising demand for “green” investing in areas such as clean energy. Initially, investors ate up the platter of yieldco IPOs dished out in recent years. Of late, they’ve been spitting them out.
Among U.S.-listed yieldcos, as of mid-March all but two were down at least 30% from their 52-week highs registered last spring (the two best performers had low double-digit losses). TerraForm Power Inc. and TerraForm Global Inc. both were off more than 75%.
In the case of the two TerraForms, they and their parent company, SunEdison Inc., have been clobbered by the latter’s financial problems and questions about its relationship with its two subsidiaries, which have cast doubt on the sustainability of its yieldco structure.
The Bullish Case
These missteps fuel the fire of critics who contend the yieldco structure is flawed. For others who believe in yieldcos, the early stumbles of a nascent industry create a buying opportunity.
“Absolutely this is a good time [to buy yieldcos],” says Tom Konrad, a certified financial analyst who manages portfolios for individuals and institutions focused on renewable energy and energy efficiency themes. “I don’t think we’ll see as good an opportunity again to buy yieldcos just because it’s such a young space, and you don’t get mispricings like this very often.”
Konrad stresses that not all yieldcos are alike. While TerraForm Power and TerraForm Global, along with Abengoa Yield Plc, have been negatively impacted by the financial problems of their parent companies, he notes that NextEra Partners has a strong sponsor, while other yieldcos such as Brookfield Renewable Energy Partners and Hannon Armstrong Sustainable Infrastructure develop projects internally. Another yieldco, Pattern Energy Group, has a private sponsor with protections in place to avoid conflicts of interest with it.
For income stocks such as these, Konrad uses the dividend discount model to estimate future dividends and chooses a required rate of return, or discount rate, which he says should be higher for riskier yieldcos. Based on his calculations, he says most yieldcos are trading below their inherent net worth.
For investors who don’t feel comfortable analyzing the merits or demerits of individual yieldcos but who still want to participate in the sector, the Global X YieldCo Index ETF is the lone fund focused on this space. This exchange-traded fund tracks the Indxx Global YieldCo Index consisting of 20 companies, and its recent SEC 30-day yield was 6.63%.
The product debuted last May, or just when the yieldco space in general was starting the head south. The fund has mirrored that trend, and as of mid-March was down about 30% since inception.
But Global X research director Jay Jacobs remains bullish on yieldcos for several reasons. For starters, he says there’s lots of expected growth in wind and solar power over the next five to 15 years, and Congress’s recent renewal of tax credits for solar and wind companies should encourage more investments in those areas. In addition, there’s a growing global commitment to renewable energy and climate change. And continuing falling costs in both wind and solar should continue for the next decade or so.
Regarding the downdraft in yieldco share prices, Jacobs offers that investor expectations aren’t aligned with the realities of the business model. “In 2014 and 2015, the growth expectations and how people were valuing them were much higher than they are now,” he says. “People were discussing 15% distribution growth rates. The market is now pricing them at a much lower distribution growth rate, which we think is undervaluing the growth over the long term.”
The Bearish Case
Yieldcos are somewhat related to master limited partnerships and real estate investment trusts in that they’re all publicly traded, yield-oriented vehicles that own project assets. That said, yieldcos don’t share the same entity tax status as the other two.
The comparison between yieldcos and MLPs is more apropos because they both deal with energy, albeit with MLPs being focused on fossil fuels and yieldcos primarily linked to clean energy. They have different operating structures—MLPs are partnerships requiring the dreaded K-1 tax form for investors, while most yieldcos are corporations requiring the more user-friendly 1099 tax form.
But critics have their beef with the yieldco structure. Some people knock renewable energy’s reliance on subsidies and tax credits. Others call yieldcos a product of financial engineering dreamed up by Wall Street firms looking for additional investment banking revenue. Still others contend that the drop-down acquisition model used by sponsors to sell assets to yieldcos is sort of a shell game that simply moves assets from here to there within related entities.
Ideally, yieldcos are meant to thrive in a virtuous cycle where the attractive dividend or dividend growth potential attracts investors and allows the yieldco entity to trade at a price that offers a cost-of-capital advantage to the sponsor. This enables the sponsor to develop energy projects at a faster pace than it could on its own, and if it drops down the projects into a yieldco vehicle, it gets relief for its balance sheet and can recapitalize a new project, which provides new revenue sources for the yieldco so it can keep generating income and support its distributions. As the yieldco’s dividend valuation increases, it can theoretically raise fresh capital from the public markets that lets the sponsor do more projects.
Some investors aren’t buying it. “The reason we’ve stayed away from yieldcos is it’s a vicious cycle where you’re caught in raising the valuation of the yieldco based on the dividend, which is kind of flawed,” says Alexander Oxenham, a partner at Hilton Capital Management and co-manager of the Direxion Hilton Tactical Income Fund.
“They should be valued based on their projected ability to earn cash flow above depreciation and capex expense,” he adds. “And that income stream should be valued as if it were a regular company, and not on the basis of a dividend. We worry the asset class was started and funded based on, ‘Hey, look how great these yields are, and this is where you should go for clients looking for growth and income.’”
Oxenham notes that during the past year cracks in that valuation model have curtailed the access to capital for yieldcos as investors have fled the space. “And this strategy is all about access to capital and less expensive capital for the sponsor,” he says. “And if that doesn’t work, the entire model is flawed.”
The Wait-N-See Case
Philip Blancato, CEO and president of Ladenburg Thalmann Asset Management, says he runs multiple dividend strategies and is interested in yieldcos but hasn’t yet pulled the trigger on them. “We’re watching them because for us it’s a matter of making sure the cash flow will be there,” he says. “For now, we think the renewable energy space is still too reliant on government subsidies. If the cash flow is there, I’ll be a buyer.”
For investors who believe in the green energy story and possess long-term horizons, yieldcos at their current levels might be worth taking a flyer on. But as shown during their brief existence, the dividend income churned out by yieldcos will likely come with stomach-churning volatility.