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by Bruce Huber, CEO, Alexa Capital
UK's YieldCos are in a tight spot. Once a darling of dividend-seeking renewable energy investors, they are now struggling as interest rates have soared to current highs. This rise in debt costs is making it tough for YieldCos to finance new projects, leading investors to eye other assets with better growth expectations. Moreover, the risk of debt refinancing looms over YieldCo financial structures.
The upshot is that the share index for London-listed YieldCos is practically a mirror image of 10-year gilt yields, falling in almost the same way as gilts have risen over the past year. In November 2023, YieldCo shares were trading at ranges from a 15-40% discounts to net asset value (NAV). This is in marked contrast to traditional YieldCo valuations, which have historically traded around or even at a small premiums to NAV.
Today, practically risk-free bonds with yields of 4-5% are crowding out investments in renewable YieldCos. Yet, this harsh share value correction seems excessive when considering the lower yield volatility of the broader investment trust category compared to 10-year bond yields over the past 20 years.
YieldCos appear discounted – with enterprise value to EBITDA multiples trading at an average of 8x, they are well below the c.12-13x multiples we are seeing for independent power producer (IPP) peers. Why such a difference?
Much of the valuation disconnect comes down to perceptions of risk-return and growth, with investors being more attracted to the more comprehensive set of services provided and growth offered by the IPP model. IPPs reinvest most of their profits and dividend little back to shareholders, focusing more on capital growth. YieldCos, meanwhile, are more tightly focused on operational asset management, maximising cashflow and dividends – at the expense of higher growth. These differing aims also mean YieldCos have a narrower toolset for growth than IPPs.
An analysis by Pexapark shows IPPs have a broader service capability to manage risks and returns – supporting the full lifecycle of development, construction, operation and trading of energy. YieldCo’s narrower focus on ownership of operating assets with largely contracted (vs merchant) revenues and corresponding commitments to low corporate cash retention / high dividend payouts raises questions on whether these vehicles can sustain growth. This model has stoked investor fears that these listed entities might be eating into their capital to pay high dividends. Unsurprisingly, investors are now more likely to prefer the currently available higher yields from bonds where there is secure downside protection.
At discounted NAVs, YieldCos cannot raise new equity without diluting existing shareholders. And contractual commitments to higher dividend yields and maintenance of appropriate dividend cover means there is little scope for increased debt to trade through this cycle. So many listed renewable investment trusts run the risk of becoming ‘zombie companies’, restricted from growth due to capital structure constraints.
Faltering investor interest has left YieldCos scrambling for ways to avoid haemorrhaging value, with several resorting to share buybacks, albeit that these have had limited impact on valuations. For many UK YieldCos managers, the most likely outcome is to diversify into private funding sources (rather than rely on their zombie listed vehicles to fund development pipelines), and consider shifting their listed funds into private ownership.
Relegation to ‘zombie status’ is not the case with all the YieldCos. At Alexa Capital, our analysis has identified a select number of YieldCos with the scale, quality of contracted cashflows, breadth of holdings (by geography and/or generation type), efficiency of operation, balance sheet resiliency and cashflow generation potential that supports continued growth – albeit at a slightly slower pace relative to IPPs. Groups such as Greencoat (Renewables and UK Wind) and Bluefield Solar have the potential to transition from the YieldCo taint to evolve into high-yield IPPs, making them more attractive to long-term institutional investors.
YieldCos are still trading with 30-40% discounts of relative EBITDA multiples as compared to listed IPPs, with the benefits to investors of higher cash dividend yields (+/-6%), so a differentiated opportunity for energy transition capital allocation. Also, implied discount rates for the YieldCo’s taking into account the trading discounts to NAV show these trading at 250-300bp higher than the weighted average costs of capital for the IPP group – which is another indication of the value gap.
Further to the perspective of relative value, an investment in YieldCos can be see as ‘interest rate trade’ due to the high correlation displayed in the chart above: expecting an interest rate mean reversion from 30-year highs, the category looks compelling on a standalone basis, especially for the funds that are well-positioned to weather the storm of rising all-in debt costs (including swaps etc). Not only will reductions in interest rates support value recovery, but there is materially increased policy pressure momentum to support investment – notable being pressure from the recent COP28 UAE conference, Article 6 of the 2023 IPCC Fifth Assessment Report and the UK government’s relief from the Electricity Generation Levy (EGL) for new infrastructure investments. Policymakers need to drive faster decarbonisation of the power generation sector to have any hope of meeting net zero targets.
The YieldCo-IPP valuation gap has also arguably been exacerbated by the limited availability of quality data and reporting on the YieldCo category, due in part to reporting differences between listed corporates and investment trusts. Enhanced YieldCo reporting and disclosures will encourage investors who are not accustomed to this niche and improve comparability, helping close the valuation gap.
In my view there is a material valuation gap – for an asset class which has limited downside and asymmetric risk-return to the upside.