This article is provided by Scott McMurtry, a professional consultant with Mercatus Inc
It’s a brave new world for yieldco’s and their parent companies as a volatile stock market has dampened valuations and elevated dividend yields. While all of this is a common theme irrespective of the industry, yieldco’s are nearing a particularly painful inflection point given that they are, by definition, voracious users of capital and must feed the hungry beast that are Dividend Per Share (“DPS”) growth expectations.
Compared to other defensive stocks and yield vehicles like MLPs and regulated utilities, Yieldco’s have recently pivoted to offer both yield AND growth, contrary to the “yieldco” nomenclature. Over the past two years, as companies realized that they could juice overall shareholder returns by adding growth to the yield equation, stock prices of YieldCos soared upwards. Consequently, DPS growth targets are considerably higher than they were at the time of respective IPO. NRG Yield, for example, has guided upwards from 12.5% to 16.5% annual growth, while TerraForm has doubled its guidance, from 15% to 30%.
Given their inherent cost of capital advantage, yieldco’s have been at the forefront of M&A activity for contracted assets and also have been able to replenish development pipelines to meet investor expectations. But what happens when the world as we know it changes overnight?
Recent wanes in valuations may indicate a broader change in investor sentiment toward yieldco’s that could portend additional obstacles. Immediately following TerraForm’s announcement of the Vivint acquisition, its stock price was negatively impacted. During an investor update, TerraForm articulated that it had expected to issue a certain amount of equity to finance the acquisition, in-line with a common “balanced” structure widely expected by banks, investors and rating agencies; however, the company soon revised this structure to be 100% debt financed, citing a “very undervalued share price at which it is not economical to raise new equity capital.” Given that multiples are likely to compress over the near-term, it would not be the least bit surprising to see this become a pervasive theme sector-wide.
Lacking an ability to issue equity at reasonable multiples, yieldco’s must raise incremental debt to finance growth. Given credit profiles premised upon stable, predictable cash flow generation, these entities have robust debt capacities and credit ratings typically in the BB range – significantly higher than the preponderance of their respective parent companies. Thus, incremental leverage shouldn’t be a big deal.
However, consider that banks now are uniformly bound to the leveraged lending standards as prescribed by the U.S. Office of the Comptroller of the Currency. As such, any borrower levered over 4x on a pro forma basis is considered a “leveraged borrower” and such transactions attract significant internal scrutiny during the credit approval process. Today, most yieldco’s look at forward cash available for distribution (“CAFD”) using outsized pipelines to help improve views of future performance, thereby lowering leverage. When leverage is viewed on a run-rate holdco debt to run-rate CAFD basis, the ratios for many yieldco’s come close to or exceed 4x – thereby rendering incremental debt raises as increasingly difficult.
On the other side of the balance sheet, as equity multiples erode and dividend yields rise, the overall cost of equity advantage that the yieldco’s have enjoyed will also dissipate. From a weighted average cost of capital (“WACC”) perspective, times they are a changin’. What happens when a yieldco cost of capital approaches that of ones’ parent company – does the incumbent yieldco affiliate remain a natural buyer of any set of right of first offer (“ROFO”) assets from the parent development arm? Or does a third party become a more attractive buyer?
Clearly this creates issues. With high DPS growth rates, a constant need for inorganic growth via M&A to supplement ROFO assets has driven yieldco’s to pay outsized M&A premiums for assets in the markets in order to continue to meet/beat promised CAFD and DPS growth rates. But as cost of capital advantages erode, so too will growth prospects for the sector.
From a parent company perspective, the issues are complex. Most yieldco parents rely significantly upon these stable dividend streams to support standalone holdco credit profiles. Given the symbiotic relationship between parent companies and yieldco subsidiaries throughout the development, construction, asset seasoning and operating cycle, such parent development companies require continued access to capital in order to complete the circle. Likewise, incentive distribution rights (“IDR’s”) further turbo charge this relationship – hence their pervasiveness.,.
The virtuous cycle between parent development arms and the captive yieldco buyers works well when rates are low and stable and equity premiums continue to improve. When the opposite is true? The virtuous cycle becomes more vicious. Should the yieldco’s find their ability to raise capital constrained, then ROFO assets may be sold to third parties at less robust multiples and large development pipelines may wither away. Ongoing dividend streams from the yieldco’s to their parents will continue in perpetuity, but the overall machine falls apart. Lack of growth leads to lower equity multiples. Lower equity multiples require more debt financing for growth capital. Incremental debt financing depresses credit profiles. Depressed credit profiles lower debt capacity. Lowered debt capacity decreases the ability for yieldco’s to finance new assets. The end result: parent companies that are over-levered and lack the ability to fund development pipelines alongside yieldco’s that are back to being just that – high yielding vehicles, just without outsized growth prospects.
Scott McMurtry, a professional consultant for Mercatus Inc, has 12 years in finance experience buying and selling, focusing on the power and alternative energy sectors. He has banked the preponderance of the solar developers and their yieldco’s, from a strategic and a financing perspective, along with their utility counterparts.