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Dividend Investor
Safe Income and Dividend Growth

Analyzing Yieldcos

Today’s new addition to the high yield tier, Pattern Energy Group (PEGI) is a yieldco, a relatively new class of high yield investment.

Today’s new addition to the high yield tier, Pattern Energy Group (PEGI) is a yieldco, a relatively new class of high yield investment. Like REITs, MLPs and most other high-yield investments, yieldcos have some unusual ways of doing things, and it’s important to understand how they work before investing. Here are some of the terms and concepts you should understand before buying your first yieldco.

Drop Down Acquisitions and Right of First Offer (ROFO)

Yieldcos can grow their income in two ways. The first is through inflation escalators, which increase the price paid for energy through existing contracts. But these escalators are typically small, about 2% per year.

The primary way that yieldcos increase their cash flow is by growing their asset base, by buying completed projects from their parent company or another development company. When these assets come from the parent company, the acquisition is called a drop down acquisition. The yieldco still has to pay for the assets, but the terms are agreeable, and often the yieldco has a right of first offer to the assets.

The yieldco’s right of first offer (ROFO) means the developer must attempt to negotiate the sale of the asset with the yieldco before offering it to third parties. If the yieldco isn’t interested or can’t agree on the price of the asset with the developer, then the developer has the right to offer the asset to third parties.

Pattern Energy has a long “ROFO List” of Pattern Development projects on which they have the option to eventually make an offer.

Cash Available For Distribution (CAFD)

If you look at a yieldco’s EPS, you’ll notice some crazy numbers. Like REITs, yieldcos have high non-cash expenses, like depreciation, plus they frequently issue new equity. So yieldcos prefer to use a metric called cash available for distribution (CAFD) to measure and track earnings growth.

CAFD is equal to income minus cash expenses, which includes salaries, facility maintenance and interest and principal payments on debt. But it doesn’t include non-cash expenses, like depreciation. CAFD is designed to give investors a better idea of how much cash the yieldco actually has that it can then pass on to investors. In addition, most yieldcos aim to distribute a certain percentage of CAFD to investors. Pattern is currently targeting an 80% distribution rate, with the excess cash held back for investment or to smooth results in rough times.

CAFD is a non-GAAP measure, so it can vary from company to company. But looking at CAFD growth over time, the CAFD payout ratio, and how the company’s expectations line up to reality should give you a good idea of how well the company is doing financially.

Incentive Distribution Rights (IDRs)

Yieldco’s easy access to equity markets ultimately benefits their parent companies as well, creating a symbiotic relationship.

In addition, the parent companies of some yieldcos are compensated with “incentive distribution rights,” or IDRs. IDRs give the parent a right to a larger percentage of the yieldco’s distribution as it grows. They work similarly to marginal income taxes. For example, once TerraForm Power’s (TERP) distribution reaches $0.34 per share, a percentage of each additional cent paid starts going to its parent company, SunEdison. SunEdison receives 15% of each additional cent between $0.34 and $0.40, and 25% of each cent paid over $0.40. And if TerraForm’s distribution reaches $0.45, SunEdison receives 50% of every cent paid over $0.45.

While IDRs provide an incentive for parent companies to support the yieldco, they also limit the speed of dividend growth above a certain level. This month’s recommendation, Pattern, does not have IDRs.

Return of Capital (ROC)

Lastly, it’s important to understand that a yieldco’s distributions aren’t ordinary dividends, but instead are usually classified as return of capital (ROC).

Return of capital is not considered income; instead, it’s treated as if the yieldco is simply giving some of the money you’ve invested in it back to you. As such, you’re not taxed on this portion of the distribution. Instead, it reduces your cost basis in the investment.

For example, let’s say you buy PEGI today for $24, and receive an annual distribution in your first year of $1.60, which is classified entirely as return of capital. Your cost basis in PEGI will be reduced by that amount, to $22.40.

And your cost basis will continue to be reduced by the return of capital amount (sometimes called shielded income) each tax year. Eventually, the total amount of these distributions may exceed your original cost basis in the investment, making your adjusted cost basis zero. If this happens, you can no longer decrease your cost basis, and you can no longer treat any distributions from that yieldco as return of capital. Instead, you must pay taxes on the full amount of the distributions, at your regular income tax rate.

When you sell the yieldco, you will have to pay the income taxes you’ve deferred over the life of the investment. That means you have to pay taxes at your regular income tax rate on the difference between your original purchase price and your reduced cost basis. (You’ll also have to pay regular long-term capital gains taxes on your profit in the investment, if you made one.)

This might not seem attractive, but there are myriad reasons why deferring taxes, or paying them later, is preferable to paying them now, including deferring your taxes until your income tax rate is lower. And any investor can see the logic in hanging on to the cash so you can invest and grow it now, and then pay the tax bill with it later.