Income investors no doubt know about real estate investment trusts (REITs) and master limited partnerships (MLPs).

REITs were set up to give average Joes a chance to invest in real estate properties without needing hundreds of thousands of dollars by owning units in these trusts. By law, to qualify as a REIT for tax purposes, a company must distribute at least 90% of taxable income to unitholders each year.

On the other hand, MLPs give investors a chance to own a piece of America’s energy infrastructure. Unlike REITs, MLPs don’t have a tax-related requirement to distribute at least 90% of taxable income to unitholders, but MLPs nevertheless pay out most of their free cash flow to unitholders.

Thus, both REITs and MLPs are known for their relatively high yields and generous dividend policy.

In the last 10 years, as the renewable energy industry has rapidly grown, a new class of high income paying investment vehicle has emerged as well in that industry.

They are called yieldcos.

Why a YieldCo?

Developing renewable-energy projects (wind, solar, hydroelectric, etc.) are large and risky endeavors. As a result, raising capital is difficult and expensive. However, once the projects are completed, they become very stable revenue generators with low maintenance costs.

To separate the low-risk operational assets from the riskier assets under development, renewable-energy companies formed yieldcos.

A yieldco typically works as follows: A parent company, usually a renewable-energy developer, forms a public subsidiary (the yieldco). The parent company then sells (or “drops down”) operational assets, often already with existing long-term power agreements with customers, to the yieldco.

The customers are usually entities that deliver power to end users, such as utility companies or government agencies. The parent company gets sales proceeds to invest into other growth projects while the yieldco will collect a steady revenue stream from customers, guaranteed by the long-term contracts.

Over time, a yieldco can further grow through acquisition of more renewable-energy assets from the parent company as well as from third parties. Yieldcos also enjoy the benefit of large (non-cash) depreciation expenses, which reduce taxes and thus increases cash flow, leaving more cash to distribute to unitholders.

Because of their more stable, non-cyclical business models, yieldcos typically can acquire capital at a lower cost than their parent companies, so yieldcos became a cheaper source of capital for the parent companies, through asset transactions and cash distribution.

The parent companies often retain significant ownership of the yieldcos and operate as the general partner. Accordingly, they receive incentive distribution rights (IDRs), a special form of cash distribution, from the yieldcos.

The more cash flow generated by a yieldco, the greater the IDR to the parent company, and the greater the distribution to common unitholders. In this way, the interests of the general partner and those of the common unitholders are aligned.

Long Growth Runway Ahead

The transition away from fossil fuels to renewable energies is a global effort that will take decades. Concerns about climate change and oil prices, in addition to falling costs of renewable energy (in particular solar power), have sparked wide regulatory support throughout the world.

Most major economies have set clean-energy goals. Clearly, renewable energy is an area that should have many years of growth ahead.

Even before the Russian invasion of Ukraine, oil prices were rising. The war has tacked on more upward pressure since Russia is a major producer of oil and gas. This highlights the need for the world to keep its foot on the accelerator when it comes to building renewable energy infrastructure.

After all, oil and gas need to be produced from the earth, and some of the world’s biggest producers aren’t exactly the most reliable countries. By contrast, wind and sunshine are natural occurrences that don’t depend on the whim of the producing country.

For investors who want to invest in the renewable energy arena but prefer companies that generate predictable revenue and cash flow, yieldcos are definitely worth consideration.

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