A Peek into YieldCo’s Relative Cost of Capital: An Analysis of a Recent Transaction
By Lang Reynolds
YieldCos represent a surging trend in renewable energy finance and a valuable innovation to access relatively low-cost capital for the right players. Along with securitization and other financial innovations, YieldCos represent a critical pathway to support renewable energy project deployment and market growth past incentive expirations.
The general purpose of a YieldCo is to lower the cost of finance through a specialized investment. By 1) transferring the project off balance sheet, and 2) refinancing the project at a lower cost of capital, sponsors can free up more capital with which to deploy more projects, and sell the energy for a competitive price. Importantly, YieldCos are generally affiliated with a parent company (i.e., a developer or asset investor), but represent a separate investment mechanism.
However, exactly how (or even if) currently operating YieldCos are achieving this low cost of capital relative to their parent companies has not been entirely transparent. Luckily, NRG Yield's (NYLD) purchase of the Alta Wind facility last summer offers just enough transparency to suggest that, at least in this particular transaction, the YieldCo does appear to enjoy a lower cost of capital than its parent company, NRG. This article will walk through some back-of-the envelope calculations pertinent to the transaction to illustrate how this works.
On June 4th, 2014, NYLD announced the purchase of Alta Wind from Terra-Gen Power LLC. With a capacity of 947 MW, this wind facility in Tehachapi, California is the largest in North America . NYLD has a right of first offer (ROFO) to procure "drop-down transactions" from NRG's development portfolio. And although other assets were procured thru the ROFO prior to the Alta Wind deal, this was the first renewable energy asset in the YieldCo marketplace with publicly-disclosed terms. The table below describes key terms of the Alta Wind transaction.
|Alta Wind — Transaction Overview|
|Developer/Operator||Terra-Gen Power LLC|
|Purchaser||NRG Yield, Inc|
|Nameplate Capacity||947 MW|
|Power Purchase Agreement Counterparty||Southern California Edison|
|Weighted Average Contract Life||22 Years|
|Purchase Price||$870MM + $1,600MM Assumption of Debt|
|Source: , |
Completed on August 12, 2014, the Alta acquisition was funded through a 50/50 split of equity and debt. For the equity, NYLD closed a common stock offering for net proceeds of $630 million, $442 million of which were slated for the Alta purchase. For the debt, NYLD issued $500 million in senior unsecured notes due in 2024 with a coupon rate of 5.375%. Note: This debt issuance was increased by $100 million and underwriters of the equity offering exercised their option to purchase an additional 1.58 million shares, reflecting strong demand for both capital offerings ,.
Cost of Capital Analysis
Now let's look at exactly how the Alta Wind transaction illustrates the difference between NYLD's cost of capital and that of its parent company, NRG.
We'll start with the equity. Hypothetically, if two companies are making the same acquisition at the same purchase price, the one with a higher equity valuation (i.e. the stock price) would enjoy a lower cost of equity. That is, a higher equity valuation allows a company to issue fewer shares, thereby reducing any dilution of distributions per share. In the case of the Alta Wind transaction, NYLD's equity value rose over 100% from its IPO up to the purchase announcement, resulting in a significantly higher valuation relative to its parent, NRG. At the time of the transaction, investors valued NYLD equity at almost twice the EBITDA (earnings before interest, taxes, depreciation, and amortization) of NRG over the six months prior to the equity offering. This suggests that NYLD enjoyed, at the time, cost of equity advantage over its parent.
Next, let's take a look at the debt. The NYLD bond issue executed to fund the transaction was priced with a 5.375% coupon. As shown in the table below, this is a full 87.5 basis points lower than both of NRG's debt offerings in 2014. While the benchmark 10-Year Treasury yield fell ~24 basis points from the time of NRG's two debt issuances to NYLD's, this difference accounts for less than one third of the total spread between the offerings.
Therefore NYLD appears to also enjoy a significant cost of debt advantage compared to NRG.
|Type||Senior Unsecured||Senior Unsecured||Senior Unsecured|
Based on this transaction, NYLD appears to possess advantages in both the debt and equity components of cost of capital over its parent company, providing tangible support to the cost of capital argument for forming a YieldCo. However, it remains to be seen how much of this advantage can be maintained over time and to what degree it persists across other YieldCos. For example, it could be difficult to improve upon the cost of capital of a diversified utility such as NextEra; however for a pure-play developer with a relatively higher cost of capital, the spread could likely be more favorable. Furthermore, market conditions, especially interest rates, are expected to significantly affect the YieldCo business model. That is, distribution yields would need to keep pace with any significant increase in interest rates to maintain investor interest.
Given the nascent state of the YieldCo marketplace, many questions are yet to be answered and outcomes are yet to be determined. Future acquisitions by other YieldCos, provided they make use of the public markets as the Alta Wind transaction did will shed more light into the relative financing costs of YieldCos and their parent companies. Over time, YieldCos, securitizations, and other financial innovations could provide significant capital-raising capabilities for developers and owners of renewable energy projects, thus reducing financial barriers to scaled deployment and competitive cost of energy.
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4. "NRG Yield closes common stock offering SNL nyld equity offering." SNL Energy. Accessed August 28, 2014: http://www.snl.com/InteractiveX/article.aspx?ID=28758879&KPLT=2.
5. "NRG Yield Operating upsizes, prices senior note offering." SNL Energy. Accessed August 28, 2014: http://www.snl.com/InteractiveX/article.aspx?ID=28795824&KPLT=2.