Editor’s note: This conversation with David March, managing partner, Entropy Investment Management LLC was conducted on behalf of Sullivan & Worcester LLP’s Elias Hinckley. Furthermore, the analysis here should be of interest to those who have or are interested in financing or investing in wind farms.
In 2013 yieldcos began their exponential climb as a financing vehicle for energy projects. Yieldcos were touted as a transformational vehicle for unlocking value in electric generation assets and reducing capital costs. In 2015 the yieldco market crashed down to earth, dropping 43% in average value. The tailspin has continued into 2016.
While some investment managers are questioning the yieldco model, yieldco managers are largely reaffirming their value in the market. In a recent investor call, Michael Garland, CEO of Pattern Energy, a large independent power company, said, “We believe [the recent volatility] is very healthy for Pattern and the sector, as it allows us to highlight the strength of our corporate strategy, the robustness of our cash flows and soundness of our growth strategy.” Other yieldcos, including NRG Yield, 8point3 Energy Partners, and Abengoa Yield, also have reaffirmed their commitment to the model and expectations of renewed growth in 2016.
How can yieldcos regain investor confidence? Yieldcos are intended to provide investors with an attractive dividend plus growth, while providing an accessible and attractive source of capital to the energy developer to improve earnings and operations. Do Yieldcos really achieve their goals?
Sullivan & Worcester’s Elias Hinckley caught up with Dave March of Entropy Investment Management to discuss the yieldco markets and the challenges that exist from a developer’s perspective.
HINCKLEY: Entropy sells a lot of operational generation assets into the market, so clearly you are paying attention to the changing landscape for yieldcos and have some thoughts on that part of the market. What would be really interesting is your perspective on what went wrong, or that the market is getting wrong about yieldcos.
MARCH: I have thought about this model and what parts work and what parts don’t work. I wanted to better understand the value and equity pricing of a yieldco and so put pencil to paper to attempt to derive the mathematics underlying these businesses. My motivation was to identify strategic aspects a yieldco might be able to exploit in order to help differentiate themselves in the market and provide a more robust and compelling value creation story.
HINCKLEY: So rather than a purely theoretical exercise, you decided to test and prove a value story for yieldcos?
MARCH: Right, I wanted to actually codify the mathematics which define a yieldco’s value. I laid out a clear set of generators:
- Dividend Value. The base asset group, over the productive life of the asset pool, assuming a declining energy production rate, due to panel degradation (solar), wear, and induction loss (wind). To simplify, I created a composite average asset rather than integrating across all assets.
- New Asset Purchases. This is the value of new assets acquired from the excess cash from the IPO over the amount needed for working capital.
- Reinvestment. Reinvestment of non-distributed cash flow into new assets. It assumes reinvestment into assets that closely mimic the composite asset described above.
- Operational Efficiency Gains. This is improvement in cash flow based on better performance and lower operating costs generated by the consolidation (economies of scale) and focused management.
- Developer Cost Improvement. The amount that the developer is able to reduce development and construction cost by their partnership with the yieldco and how much the developer will share with the yieldco from that improved cost basis.
- And I made a couple of other assumptions for simplicity:
- I ignored currency risk on the assumption that currency exposure can be effectively hedged as part of the operating management.
- I also ignored differential counterparty risk. I assumed that the asset portfolio is sufficiently large to mitigate, and the simple fact that I don’t think the market will support the IPO if counterparty risk management is poor.
- I ignored interest rate effects, because these will have a uniform impact on all yieldcos and so won’t be a good basis for differentiation across the yieldco sector.
The calculation looks like this: Click here for the calculation.
HINCKLEY: So that’s a lot more rigor than we’ve seen in trying to show the best value proposition for a yieldco. What did you find?
MARCH: First, a yieldco should focus on improving operating cost structure and cash flow returns. Second, a yieldco should focus on driving down development and construction cost. The relationship between the yieldco and the project or pipeline development must create further synergy as compared to efficient external markets, or the yieldco will have no differential financial value. The more integrated the development process and the better and more effective control of costs, the higher the potential growth derived value of the firm. If independent developers are used the yieldco must “share” these savings in a significant way so that the developer is committed to selling the assets to the yieldco (this may require some form of development and or construction financing supplied by the yieldco). Finally the yieldco must find ways to enhance the productive life of the assets; as long as an asset makes a positive marginal cash contribution the activity should be continued.
HINCKLEY: That certainly brings a much more quantitative approach for yieldcos to consider. Hopefully some of the managers will pick up on this approach. Thanks Dave.
SunEdison’s Bankruptcy Filing
On April 21, SunEdison – which created two yieldcos – TerraForm Power and TerraForm Global – filed for Chapter 11 bankruptcy protection. Facilitated by an energy market awash in plentiful and relatively cheap money, SunEdison accumulated debt to unsupportable levels as the result of an overly aggressive acquisition strategy. While there was plenty of appetite for growth within SunEd, the staggering pace of buying was done largely to build a pipeline of assets that could be sold into its affiliated yieldcos.
As of this writing, both TerraForm Power and TerraForm Global remain outside of the bankruptcy proceeding. Both have asserted they have adequate liquidity to continue operations and that the yieldcos’ assets will not be available to satisfy SunEd’s creditors in bankruptcy. The yieldcos have the benefit of owning both hard assets and long-term streams of revenue, though whether they can remain free of SunEd’s bankruptcy (and TerraForm Power’s obligation to buy assets as part of SunEd’s acquisition strategy will no doubt receive scrutiny from SunEd creditors) remains to be seen.