An Interview with David K. Burton, Esq., Partner at Akin Gump Strauss Hauer & Feld LLP
Source: Stratton Report
David K. Burton advises clients on a wide range of U.S. tax matters, with a particular emphasis on project finance and energy transactions. In addition, he also advises clients on tax matters regarding the formation and structuring of domestic and offshore investment funds.
Stratton Report: Can you give us a brief description of a yieldco?
David Burton: Before I do that, I should note that the term, “yieldco,” isn’t a tax term; it’s not an accounting term; it’s a term that investment bankers thought up to market a new structure. Basically what it has come to mean is a publicly traded corporation that owns contracted energy producing assets that generate accelerated depreciation and possibly tax credits. The accelerated depreciation and any tax credits generally shelter the corporation’s tax liability for the first ten years or so. Therefore, most of the corporation’s net revenue is available for distribution to its shareholders, and the yieldco commits to making very large distributions to its investors—typically about 80% of their cash flow. The yieldco has fixed-price power sales contracts with utilities and other off takers for long periods of time, say up to 20 years. As a result, the yieldco can tell investors, “I have signed well-qualified buyers up with contracts to purchase my electricity. You can be pretty sure because of my contracts that I will have a steady supply of cash for the next 20 years. Because I can use tax credits and accelerated depreciation, I won’t have to use my cash to pay taxes, so I will have plenty left over to pay out to you as dividends.”
SR: I have heard it said that yieldcos are only able to pay out such high dividends because they aren’t replacing their assets with their retained earnings. Does that mean yieldcos are kind of a self-liquidating operation, at least over time?
DB: Less than you might think, because power plants have a useful life that is longer than the power sales contracts. At the end of a 15- or 20-year contract the owner will simply start selling electricity from the asset into the open market, or have to find some other buyer for the power. Although the power sales contract has a finite life span, that doesn’t mean the asset itself will be dust at the end of it. A lot of renewable generation seems to be looking at a 40-year useful life.
SR: is the cash flow that the yieldco retains sufficient to perform maintenance and replace damaged parts, etc.?
DB: Yes. There isn’t a huge amount of expense in maintenance for either wind or solar assets, and every yieldco that I know of is strongly committed to responsible operations and maintenance of their assets. They all have O&M vendors and contracts to keep their assets in good working order.
SR: So yieldcos are not, as some people have rather melodramatically claimed, Ponzi schemes?
DR: No. However, the accelerated depreciation that they take on their assets in order to avoid taxation does force them to grow aggressively. If they stop growing, they will start owing tax, which would reduce what they can distribute as dividends by the corporate tax rate, or 35%. And their balance sheet is going to shrink. The yieldco needs to buy new assets to get a new source of depreciation, to shield its earnings. Of course, the yieldco also may borrow to purchase the new assets, which can provides them with another tax deduction for the debt service. But without growth, the ability of the yieldco to pay very high dividends will be compromised.
SR: I have heard that yieldcos tend to pay top dollar for assets.
DB: Yieldcos have increased the market value of renewable assets. They have a lower cost of capital, which enables them to pay higher prices for assets. Your typical renewable project developer is backed by private equity. Private equity generally wants a double digit returns. Yieldcos are backed by retail investors, who have much lower return thresholds—in the mid-to-low single digits. If you’re a private developer with a, say, 10% cost of capital and you’re bidding to acquire an asset against a yieldco with a 3% or 4% cost of capital, you will lose. The yieldco will be able to outbid you. The combination of the lower cost of capital for yieldcos, and their treadmill need for growth, has been very good for sellers of assets. Smaller development companies that don’t have their own yieldco, and that try to go out to bid for assets against yieldcos are getting crushed. To the extent there is a secret sauce to yieldcos, it is primarily in replacing private equity investors with retail investors, which gives the yieldco a lower cost of funds.
SR: Do yieldcos buy new assets with cash or with stock?
DB: Yieldcos buy assets with cash or cash raised from debt. The people selling those assets want to get cash and redeploy it to develop new projects. The reason you see M&A transactions where a “C” corporation buys another “C” corporation with stock rather than cash is for tax reasons—that is, the deal can be structured as a tax-free reorganization for the company being purchased. That works great for someone who doesn’t want to roll the proceeds into a new venture, and is willing to hold on to that stock from the purchasing company and maybe pass it on to his kids. That doesn’t work well for renewable developers because they didn’t set themselves up as a “C” corporation to be publicly traded or with an eye to doing tax-free reorganizations. Moreover, many developers are deal junkies—holding on to any stock they would get in return for selling an asset is the last thing they want to do. They can’t wait to go out and develop another project with the cash from an asset sale. Yieldco stock is not really a currency in the renewable energy development world.
SR: Do yieldcos only purchase assets from their sponsoring companies?
DB: Not exclusively. We’ve recently seen TerraForm, which is SunEdison’s yieldco, going on an acquisition tear. They are not just buying from SunEdison. They are buying from third parties.
SR: When yieldcos buy project-financed assets, do they have to refinance the debt? What are the concerns of the project lenders when the project changes hands?
DB: Generally there is no need for refinancing. It’s frequently described as a defining characteristic of project finance debt that it is non-recourse to the original sponsor and owner of the project. The lenders in making the loan aren’t looking to the credit-worthiness of the sponsor, so when one sponsor replaces another they really aren’t too concerned. The lenders are focused on the credit-worthiness of the off-take contractor and that’s not changing in the sale of an asset. There are a couple of procedural hurdles lenders make the parties jump over before they let a sale occur. First, the lender wants to be sure that the transfer of the asset to a new owner won’t cause a tax problem. Second, the lender doesn’t want to let an asset to be sold to a bad actor (e.g. the Mafia), or to a new owner who is not competent to operate the asset.
SR: I read about the proposed Sol-Wind yieldco that tried to combine MLP and yieldco structures. Do you think that will be done in the future?
DB: With Sol-Wind, the MLP owned a “C” Corporation, which was supposed to generate dividends and interest for the MLP. Dividends and interest qualify under the MLP qualifying standards. But this doesn’t really accomplish anything. The “C” Corporation would still owe corporate tax. So that particular way of combining the two entities doesn’t seem to be fruitful, at least in generating a tax advantage for investors. Sempra has discussed combining their oil and gas investments with renewable investments in a way that still qualifies for MLP treatment, but as far as I know they are the only organization looking at that sort of hybrid approach. Also, there is a question of who would invest in such a hybrid vehicle. To wildly overgeneralize, yieldco investors are from the coasts who tend to be kind of “green”, while MLP investors tend to be from the heartland and drive pickup trucks. There aren’t many investors who want wind and solar and oil and gas in the same investment.
SR: Some yieldco portfolios have considerable multinational diversification, others far less so. Is it clear which will be the dominant approach in the future?
DB: I think there are two schools of thought on diversification in yieldcos: some like the spreading of risk with geographical diversification, while others tout their specific expertise with respect to a single geography. Many yieldcos either have, or plan to have, some assets outside the U.S. Canada, the U.K., and Mexico are probably the leading jurisdictions at this point. Geographic diversification seems more likely as the trend at the moment.
SR: I have seen predictions that yield of yieldco stocks will rise, somewhat dramatically, over the next there years. Do you know why that might be?
DB: Yieldcos have to compete with other yield products. If interest rates rise, and other yield products start paying out higher returns, yieldcos will have to compete and raise their dividends.
SR: I have heard that the price of yieldcos partly reflects how confident the market is that the yieldcos will be able to grow vigorously. The more likely there will be vigorous growth, the lower yield investors will accept. Is it possible that these predictions of rising yield reflect some doubt that yieldcos will be able to grow as vigorously three years in the future compared to their relatively rosy prospects today?
DB: The quality and future prospects of the sponsoring company definitely affect the market perception of yieldcos. A sponsor of higher perceived quality will be able to command a higher stock price than one with a less impressive track record in developing successful projects.
SR: Is this causing any hesitation about launching new yieldcos?
DB: The growth of new yieldcos is not slowing! I’ve heard reports that 15 companies are planning to launch yieldcos. Of course, not all of them may come to fruition, but today everybody and their dog is talking about launching a yieldco.
SR: Do you think all of these will do well?
DB: My concerns about yieldcos mostly concerns the investors. If yieldcos are held widely by retail investors, I suppose that there is some risk that one day a particular yieldco will do something foolish, and it will be on CNBC, and all of a sudden everybody will dump their shares in all yieldcos. On the other hand, if the bulk of yieldco stock is actually held by hedge funds, then I could imagine that they will all hold on to their yieldco shares until the day the think they’ve hit the top, and then everybody will suddenly decide it’s time to exit. This sort of problem is always a risk with a new vehicle like yieldcos.
SR: Do yieldcos have a lot of room to grow? Will they come to dominate the ownership of renewable assets in the future?
DB: I don’t see why not. They have probably the lowest cost of capital of any vehicle currently owning renewable assets. We’ve already seen announcements that residential solar is going into yieldcos. I think that utility-scale or residential storage or distributed generation assets could all go into yieldcos. Anything whereby you can have a long term fixed price contract related to energy is a good candidate. I don’t think they are running out of room to grow anytime soon.
SR: I’ve heard it said that the real competitor for yieldcos may turn out to be investor-owned utilities suffering from low internal growth opportunities.
DB: That is definitely possible. I’ve certainly seen utilities competing for assets with yieldcos.
SR: Is it clear between the two who has the lower cost of capital?
DB: I’m not a utility finance expert but I’d guess a well-respected yieldco like NRG Yield would have a lower cost of capital than a utility—at least today.