If you follow the clean energy investment space, you’ve probably heard the term “YieldCo” thrown around quite a bit in recent months. 

YieldCos have burst onto the investment scene and quickly become the company structure du jour for publicly traded power producers looking to capitalize on their renewable energy assets. 

In the past year, we’ve seen a flurry of activity in this space as companies such as NRG, TransAlta, NextEra, and Abengoa have spun off the renewable portions of their power portfolios into separately held YieldCos.  

Following their lead, SunEdison plans to spin off 524 megawatts ofsolarfarms across the U.S., Canada, the U.K. and Chile into a YieldCo called TerraForm Power later this month. 

The YieldCo structure has become so popular that analysts at Deutsche Bank expect as many as six more entities to become publicly traded in the coming twelve to eighteen months. And even private equity behemoth KKR is getting into the act by acquiring a 33 percent stake in Acciona with the goal of cashing in on a future YieldCo spin-off. 

So what exactly is a YieldCo, why are companies suddenly attracted to this corporate structure, and most importantly, should you consider investing in one?

Let’s start with the basics. YieldCo is shorthand for "yield company." In the investment world, yield is synonymous with income. So, essentially, a YieldCo is a corporate structure where the income component (generated by the underlying assets) is emphasized.  

YieldCos are similar in concept to an MLP (master limited partnership) in the oil and gas sector or a REIT (real estate investment trust) in the real estate sector. All three investments are designed to provide a dependable stream of cash flow to investors.

Whereas MLPs use oil or gas pipeline income and REITs use commercial real estate lease income, YieldCos use completed renewable energy projects with long-term power purchase agreements in place to deliver dividends to investors. 

So why are so many companies embracing this new structure? The primary reason is to unlock shareholder value. By spinning off their renewable power assets into a separate, high-yielding entity, power producers are attracting interest from two types of investors who may not have been interested otherwise: socially responsible investors and income investors. 

The SRI investor

Prior to creating a YieldCo, most power producers commingled renewable energy assets with their other businesses. For example, in addition to wind and solar, NextEra has exposure to natural gas, nuclear and oil-fired power plants. A purist socially responsible investor may have avoided buying NextEra stock specifically because of this exposure (even though NextEra has long been a leader in the renewable energy space). 

By creating a YieldCo, they were able to segregate their renewable power assets from fossil fuel and nuclear power plants while still retaining ownership in both. The same purist SRI investor who may have balked at owning shares in NextEra’s entire power portfolio (via the parent company) can now invest in a pure-play renewable company via NextEra’s YieldCo. 

The income investor

In addition to being renewable, YieldCos by design are created to house completed power projects with long-term PPAs in place. This means the more capital-intensive, less cash-flow-positive business units like R&D and construction can be retained by the parent company. Without these capital-intensive units under the YieldCo’s umbrella, a higher portion of the profits can be paid out to shareholders via dividends rather than reinvested back into the company. 

Given the current historically low interest rate environment, many income investors (who are traditionally more risk-averse compared to growth investors) have been pushed out of their bonds-and-blue-chip-stocks comfort zone and forced to find yield elsewhere. Enter the YieldCo, which, like MLPs and REITs, emphasizes cash flow over growth and owns a portfolio of lower-risk assets.

Now that we’ve established what a YieldCo is and why companies are creating them, the question remains: are they worth investing in? Like any other investment, a YieldCo has pros and cons that an investor should carefully consider before putting any money to work.   

Pros

  • YieldCos provide SRI investors with a pure-play clean energy investment vehicle (while a few may contain fossil-fuel exposure, most are 100 percent renewable).
  • Since they are consist of completed projects with long-term PPAs in place, YieldCos are less speculative and carry lower risk relative to other clean energy stocks (such as biofuels, solar panel manufacturers, etc).
  • Unlike other clean energy stocks (which are growth-oriented), YieldCos are designed for predictable income via dividends.
  • A YieldCo will provide a geographically diverse portfolio of several power projects.
  • Unlike energy MLPs, cash flows from YieldCos aren’t dependent on fossil fuel prices, so they don’t carry a commodity price variable.

Cons

  • YieldCos will likely be vulnerable to rising interest rates. Low rates have allowed power producers to borrow money on the cheap to build and acquire new assets. Higher rates will mean that these activities will become costlier. Also, while historically low rates have drawn income investors into alternative asset classes, higher rates will mean they can return to the safety of bonds.
  • For growth, YieldCos will be dependent on having a pipeline of new projects to add to their portfolios. This means risk exposure to future legislative and tax policies (which are currently favorable toward renewables), which could adversely impact the costs associated with construction and acquisition.
  • YieldCos are equity investments, so they will tend to trade with the movements of the stock market, which means they are susceptible to stock-market volatility.
  • Utility-scale solar and wind power are still relatively new sources of energy, so it’s a bit of an unknown what the life cycle of these assets will be. It’s difficult to project what maintenance costs will be twenty to 30 years from now. Will energy production (from solar in particular) degrade over time, and if so, how will this impact cash flows?

On balance, for an investor comfortable with stock market volatility and looking for a pure-play renewable investment that provides income and is less speculative than many other cleantech investments, YieldCos will likely make a nice portfolio addition.

That said, valuations for several YieldCos seem quite rich at the moment. Yes, it may be an exciting space to be in, but just like any other stock investment, you need to pick your entry point carefully. As always, the fundamentals of investing still apply.

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Louis Berger is co-founder/partner of Washington Square Capital Management, a New York-based independent investment advisory firm. Louis specializes in managing socially responsible investment portfolios for both individual and institutional clients.

Disclosure:  Washington Square Capital Management is a registered investment advisor in the states of NY, CT, TX and CA. We hold shares of TransAlta, NextEra and SunEdison in client accounts.