Fund managers line up for high-yielding energy company subsidiaries

The hunt for dividend yield is pushing U.S. fund managers into an unproven new offshoot of the alternative energy industry.

Yield companies - commonly called "yieldcos" - are spinoffs of alternative energy companies that own assets such as wind or solar farms and pay investors dividends out of the cash flow generated by long-term contracts to sell power to utility companies. Though many investors have never heard the term, yieldcos are popping up in the portfolios of some of the most widely-held mutual funds in the United States.

After a broad push into the sector, more than 900 actively managed and passive funds now own at least one yieldco, according to Lipper data. Notable buyers include the $29.3 billion BlackRock Equity Dividend Fund and the $9.2 billion T. Rowe Price Small-Cap Stock fund.

"We see these as a way to get a decent yield now and high likelihood into the yield growing substantially in the future," said Scott Moore, the lead portfolio manager of the $33.4 million Buffalo Dividend Focus Fund, the top-performing dividend fund so far this year, according to Morningstar data. He said he expects to add several yieldcos over the next year.

Just a year ago, yieldcos were practically non-existent in U.S. portfolios. Since then, solar and other alternative energy companies have spun off almost a dozen of the companies as a way to raise cash and to create a buyer for their completed projects, effectively separating the manufacturing part of their businesses from the revenue generated from past projects. Yieldcos, for their part, often have a right of first refusal to purchase projects such as a solar farm from their parent company, and may also acquire completed assets from independent companies.

NRG Yield, a spinoff from parent company NRG Energy, is widely seen as the first North American yieldco. Since it began trading on July 2013, approximately a dozen yieldcos have begun trading on U.S. exchanges, including Nextera Energy Partners, TerraForm Power and Abengoa Yield, with each offering dividend yields of approximately 4 percent or more. In most cases, the parent company retains an ownership stake of 70 percent or more in the spinoff.

A dividend yield is a ratio that shows how much a company pays out in dividends relative to its share price, so that a company with a share price of $20 and a dividend of $1 has a dividend yield of 5 percent.

Investors in yieldcos say that they are attracted by the prospect of growing dividend payments, while at the same time tapping into the expanding alternative energy sector without the risk of turbulent commodity prices. Yet over the last month, yieldcos have proven to be no less volatile than the stocks of their parent companies.

The prospect of rising interest rates in the U.S. have sent the shares of several yieldcos reeling over the last month, not long after many of these same companies jumped twenty percent or more at their initial public offerings. TerraForm Power, a subsidiary of SunEdison that owns solar farms in the US, Canada, and Chile, has fallen 15 percent over the last month along with the shares of its parent company. Abengoa Yield, a spinoff of Spanish energy construction company Abengoa, has dropped 14 percent, compared with its parent company's 23 percent drop.

INVESTOR ATTRACTION

Angie Storozynski, an analyst at Macquarie Research, said that recent price declines have more clients asking about the sector.

"We've seen a lot of interest in yieldco stocks as of late given the sharp pullback in the names, which seems driven by their limited liquidity and some global growth worries," she said.

Abengoa Yield, whose portfolio of assets includes a solar farm in the Mojave desert, wind farms in Uruguay and electric lines in Peru, now makes up his second-largest position, just behind Apple Inc. Based on conversations with Abengoa Yield, he expects the company to raise its annual dividend payout to $1.68 per share from its current $1.04 per share by 2016, which would increase its dividend yield to nearly 6 percent from its current 3.2 percent, based on its current share price.

With Abengoa, "you have a very stable asset base and contracts with an average life of 26 years, plus inflation escalators," Moore said. "As long as Abengoa keeps completing projects that they can sell to the yieldco, which they have done for 70 years, we have no doubt that its asset base will grow."

GROWTH QUESTIONS

Acquiring additional assets in order to raise their dividend payouts is a chief aim of yieldcos.

Storozynski, the Macquarie Research analyst, initiated coverage of the sector on September 17, giving those yieldcos with a strong parent company and a proven development pipeline such as NextraEnergy Partners and NRG Yield an outperform rating. She gave Pattern Energy and other independent yieldcos a 'hold' rating, largely as a result of the fact that they may not have a right of first refusal to buy completed projects from a parent company such as SunEdison.

"The role of a sponsor as a growth driver grows in importance as public yieldcos multiply, inflating the value of contracted renewable power projects. The yieldcos relying predominantly on third party acquisitions for growth should therefore rush to secure growth projects, even if they feel that current project valuations look bloated," she wrote in a Sept 17 note to clients.

The competition among yieldcos to buy assets, thereby boosting prices, is giving some investors in the alternative energy sector pause.

"For me the big worry about these assets is that they will have to reinvest incredibly well over time to justify their prices," said Edward Guinness, who runs the Guinness Atkinson Alternative Energy Fund and invests in several solar companies. "I am skeptical as to whether in 20 years time these companies will be persevering and returning capital at the forecast rates."