Green Plays That Offer Growth and Income

You probably already know that real estate investment trusts (REITs) and master limited partnerships (MLPs) are a way for Average Joes to invest in, respectively, real estate and energy infrastructure. Literally and figuratively, these businesses collect rent and distribute a big chunk of the cash flow they generate back to unitholders.

Arising in the early 1960s, REITs invest in a portfolio of real-estate assets and must distribute at least 90% of their taxable income to shareholders. As a result, REITs remain popular income investments to this day.

Formed around a similar concept, MLPs followed in the early 1980s. They allow investors to invest in primarily upstream and midstream oil and gas assets.

A relatively new class of investment has emerged in the last decade that similarly offers individual investors a way to invest in renewable energy infrastructure (such as solar and wind farms) and collect cash distribution.

These entities are called yieldcos.

Making Green, from Green

A yieldco is a company formed specially to own operating renewable energy assets that produce a highly visible cash flow. The assets are typically on long-term contracts with customers (utilities, municipalities, commercial customers, etc.) and thus generate recurring and predictable revenue and cash flow. As a result of the steady cash flow, yieldcos are known for paying generous dividends.

Developing renewable-energy projects (wind, solar, hydroelectric, etc.) are large and risky endeavors. As a result, raising capital is difficult and expensive. However, once the projects are completed, they become very stable revenue generators with low maintenance costs. In order to separate the low-risk operational assets from the riskier assets under development, renewable-energy companies formed yieldcos.

A yieldco typically works as follows: A parent company, usually a renewable-energy developer, forms a public subsidiary (the yieldco). The parent company then sells, or “drops down,” operational assets, often already with existing long-term power agreements with customers, to the yieldco. The parent company gets a sum of cash to fund other growth projects while the yieldco will collect a steady revenue stream, guaranteed by the long-term contracts.

The Advantages of YieldCos

Over time, a yieldco will grow through the acquisition of more renewable-energy assets from the parent company as well as from third parties. Yieldcos also enjoy the benefit of large (non-cash) depreciation expenses, which reduce or eliminate taxes.

Because of their more stable, non-cyclical business models, yieldcos are usually able to acquire capital at a lower cost than their parent companies, so yieldcos became a cheaper source of capital for the parent companies, through asset transactions and dividend payment. The parent companies often retained significant ownership of the yieldcos.

Also, some yieldcos are structured as a partnership and pay incentive distribution rights (IDR) to the general partner (the parent company), who manages and operates the assets. IDR is payment to the general partner for achieving certain distribution goals. In other words, as the yieldco partnership’s distributions increase, the general partner will take a larger cut of the distribution.

On the one hand, this incentivizes the general partner to increase the cash distribution, benefiting other unitholders, but on the other hand, the other unitholders get a smaller share of the larger pie. Still, we think the tradeoff is well worth it.

Growth and Income

We believe yieldcos offer strong choices for income investors who want to invest in companies that generate predictable revenue and cash flow and offer a good chance for dividend growth over time. Additionally, even though income generation is their primary focus, yieldcos also offer potential for capital appreciation.

There’s no doubt the renewable-energy industry will grow over time as the world shifts toward cleaner energy. Provided yieldcos can acquire additional assets at terms that generate positive return on investment, we believe their share prices can also rise significantly over time, providing both capital appreciation and high income for investors.

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