In the second part of this exclusive interview, Mona Dajani, a partner in the banking and finance practice at Baker & McKenzie’s Chicago and New York offices, talks to PFR about the sustainability of the yieldco business model and the consequences of high levels of liquidity in a credit market pepped up by new entrants.
PFR: Going off the themes of M&A and consolidation, what’s your take on yieldcos?
DAJANI: That’s been keeping me very busy. It’s really hot right now. There is a lot of pent up demand for yieldcos. Every yieldco has been different to date, and they’re changing. Each yieldco transaction is different. In 2015, there will probably be a dozen that will come to market.
There are many other new energy and infrastructure projects being built worldwide, and while we think that the yieldco valuations may fall—and this is debatable—we think it’s a sustainable business model. If the valuation multiples come down, and the sustained dividend growth becomes harder, then it will become harder for them to cut dividends. But we’ve seen master limited partnerships do that. MLPs will cut dividends and then start growing again from the low level. And the availability of U.S. tax credits for U.S. renewable projects seems to make these yieldcos able to make generous distributions through its shareholders.
There are today at least six private equity firms that are building portfolios in advance of a planned initial public offering and some of them are Asian developers, because their cost of capital is lower than the returns on equity that private equity firms expect. It’s a great monetization tool for private equity.
Sol-Wind Renewable Power, backed by 40 North Management, postponed their IPO in February because the pricing came in lower. However, what they had done was interesting. Unlike their predecessors, they bought all of their assets from another developer and they were going to use that as the new structure. While most existing yieldcos are C-corps that own a partnership, Sol-Wind was structured as an MLP, which is interesting. The solar and wind assets do not generate qualifying income for the partnership, but are held indirectly by the MLP through a blocker corporation.
We’re also seeing independent power producers, like Lightbeam Electric, which has also has taken steps to launch an IPO for a yieldco. There are some existing yieldcos, such as TerraForm Power, which is SunEdison’s listed yieldco, that have already added distributed generation to their portfolios, and I know SunEdison is planning to launch yieldcos focusing exclusively on emerging markets like Asia and Africa.
PFR: Are there other qualities or factors in this next generation of yieldcos that separate them from their predecessors in any way?
DAJANI: The market has become a little too frothy. Market values have become a little too inflated. You’re going to see yieldcos from companies that maintain strong development pipelines, and then augment that with acquisitions from third parties. Also, these yieldcos will look at other places for assets—other geographies, and residential solar. I think you’ll see a broader mix of assets that will be put into the yieldco. It’s a natural evolution. This whole thing with yieldcos is the search for lower costs of capital than can be applied to the ownership of assets that would then result in a lower cost of electricity pricing.
PFR: What is your take on investment appetite for more yieldcos? Do you think that existing investors still have an appetite for more of this type of paper, or will these companies need to tap new pools of investors?
DAJANI: The yieldcos are highly motivated to continuously grow. They are subject to corporate income tax and their shareholders also pay tax on dividends, and the only way to avoid this is that their assets benefit from accelerated depreciations, and they can quickly write down the value of the assets. Some of the renewable incentives, the tax credits, investment tax credit and the production tax credit, can help minimize this. But they have to grow.
The low interest rates have allowed the yieldcos to retain the attention of the equity market, but the interest rates will eventually rise and when they do, yieldcos and other equity vehicles that offer only low stable dividends will become less attractive. Investors are taking low yields right now because debt markets are not giving anything. But when interest rates go up, those yields won’t be good enough. The increase in the interest rate will definitely impact it, but right now investor-owned utility performance is highly correlated with interest rates, too, and yieldcos offer substantially higher growth.
People are comparing yieldcos to MLPs. People were very skeptical of MLPs 20 years ago and now they’re doing really well. There is a lot of room for yieldcos to grow. At the end of the day, a yieldco is basically an opportunity to invest in an asset class like real estate and it has a lot of similar characteristics to real estate investment trusts today. If you look at the REIT market, REITs have been around for 25 years and they have a current market cap of more than $400 billion. If you compare REIT assets with yieldco assets, yieldcos are a much better asset class. There is a lot of pent up demand for yieldcos in 2015 because yieldcos are very similar to what was done in the REITs base.
PFR: Can you describe some of your more recent transactions and/or clients?
DAJANI: I recently led a team representing United Airlines in its equity investment in U.S.-based alternative fuels developer Fulcrum BioEnergy, a pioneer in the development and commercialization of converting municipal solid waste into low-cost sustainable aviation biofuel. It is also the single largest investment by a U.S. airline in alternative fuels and sets United apart in the aviation industry in the advancement of aviation biofuels and carbon emissions reductions. In addition to the equity investment, United and Fulcrum have entered into an agreement that contemplates the joint development of up to five projects located near United's hubs, which are expected to have the potential to produce up to 180 million gallons of fuel per year.
I’m working on some deals in conventional power and in renewables—in wind, biomass, solar and geothermal—here in North America and abroad. I’m also working on water infrastructure and water privatization deals, and petrochemical and LNG deals.
PFR: Given the breadth of what you’re working on in power and energy, what types of deals are you seeing on the project finance side? Is there anything that stands out to you in the recent past?
DAJANI: It’s been robust in the U.S., but globally it’s been down with the exception of the Middle East and Africa. The level of activity has been facilitated by significant liquidity in the credit markets.
We’re seeing financing available from a wide range of sources, such as development banks and new entrants, such as infrastructure debt funds and investment banks. There has also been a continued participation of Japanese, Canadian and regional U.S. banks that have entered into the market in the wake of a lot of European banks leaving the U.S. market. The Japanese banks were mandated arrangers in many of the largest transactions that closed in 2014, including the Cameron LNG and the Astoria power plant financings. We’ve seen Canadian banks involved in all the sectors, in deals for Atlantic Power and Midstates Petroleum.
PFR: With these new investors and players, what are they looking for in transactions? What’s attracting them to this sector now as opposed to several years, or even several months ago?
DAJANI: They all have different strategies. Some infrastructure funds want to be a direct investor, and that works out if you have a lot of public and private pension funds and other institutional investors that want to achieve double-digit returns. We’re seeing a lot of infrastructure portfolio growth, even though the asset class of infrastructure is relatively new. What they’re looking for is to grow their portfolios and diversify, both by sector and by geography.
From a sector perspective, energy usually comprises a majority, or almost a majority, of some infrastructure portfolios. As part of their diversification strategy, these infrastructure companies are open to more economic types of infrastructure like transportation and toll roads, toll bridges, etc., which in the U.S. is a massive opportunity. But they’re all different. Infrastructure debt funds are emerging almost as mezzanine lenders, offering another level of debt, more risky but a little more expensive.
We’re seeing a lot of European infrastructure debt funds come to the U.S. because they believe that the macroeconomic picture is quite robust compared with Europe. In energy in North America, there has been a significant change with non-conventional oil and gas, really shifting the U.S. from a net importer to becoming self-sufficient and soon to be an exporter. It’s creating a lot of interesting opportunities in midstream. They all have different strategies. Some infrastructure funds won’t invest in economic infrastructure. Some want to do only power, some only conventional power, some only renewables, some only midstream.