High-Yield Limited Partnerships, the Next Home for Renewable Energy Investments

By Markets Fool.com

One of the big clean-energy trends in the last couple of years has been the creation of so-called yieldcos. These publicly traded companies own and operate renewable and other power facilities that have long-term contracts. They are similar to limited partnerships, or LPs, in some ways, but lack the tax advantages. Sol-Wind Renewable Power LP's IPO plans could be a sign that this is about to change.

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What's a yieldco?
When SunEdison looks to raise cash for future investment, it can use the typical methods of selling shares, issuing debt, or taking a loan from a bank. The other option is to sell assets, but then SunEdison would lose control of whatever asset it sold. Unless what's sold is noncore, that might not be most desirable way to raise cash.

So, the company chose, instead, to create a yieldco called TerraForm Power. Essentially, SunEdison controls TerraForm. But because TerraForm is its own corporate entity, it can tap the public markets to raise capital. And then use that capital to buy assets from SunEdison. In this way, SunEdison gets to retain control of key assets, getting paid to operate them, while still raising cash from their sale.

Source: Schwnj, via Wikimedia Commons.

The allure for investors is that yieldcos, as the name suggests, are designed to pay shareholders dividends. That's why they tend to own energy projects with long-term contracts. This is, in the end, a bit of fancy footwork that creates something roughly similar to a limited partnership. In a limited partnership, there is a general partner that manages the LP that is often owned by a company with assets it wants to control, but monetize.

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The LP thing...
For example, in mid-2013, Phillips 66 spun off Phillips 66 Partners LP . Phillips 66 owns midstream, chemicals, refining and marketing, and it specialties businesses in the energy patch. It's got a global footprint and is looking to grow. Raising cash helps on the growth front. Phillips 66 Partners was created to "own, develop and acquire primarily fee-based transportation and midstream assets." That's basically one piece of what parent Phillips 66 does.

Phillips 66 owns a large stake in the partnership and acts as the general partner, essentially running the business. The LP lets Phillips 66 sell assets to raise cash and still control them. In early 2014, just such a transaction took place (called a drop down), when Phillips 66 Partners bought the Gold Line products system from its parent. According to Phillips 66, "The partnership will continue to pursue acquisitions from Phillips 66 and third parties."

One of the biggest benefits for investors in partnerships like Phillips 66 Partners is that they provide income. But not just any income, it's tax-advantaged income. This is because of tax code benefits unique to the energy industry that allows certain energy assets to create "qualifying income." Basically, LPs are allowed to pass depreciation and depletion charges through to shareholders, shielding the income they receive from current taxation.

It's a pretty complex topic, but that's enough to understand the differences here. Note, however, that there are some headaches to go along with the tax advantages. For example, investors receive a K-1 form at tax time that can be pretty complex to understand -- enough that you should consult a tax advisor. And taxes aren't permanently avoided; they are put off until the LP units are sold. But, in the end, a relatively high yield that benefits from tax deferral is a pretty compelling deal.

Clean energy assets like solar and wind power don't generate "qualifying income." So, yieldcos can offer dividends, but not the tax benefits of an LP.

Source: U.S. Government, via Wikimedia Commons.

The Sol-Winds of change
That hasn't stopped Sol-Wind Renewable Power LP from trying to go public. To make the LP shift, Sol-Wind has a corporate entity that pays taxes shoved into the mix under the LP. It believes it will be able to shelter much of its income from taxes with its unique structure. Thus, it expects investors to benefit from the LP structure even if it can't shelter income the same was as a traditional LP can.

But it's more likely that Sol-Wind is getting ready for tax law changes that could be coming down the line. The proposed Master Limited Partnerships Parity Act, which has bipartisan support, would essentially put renewable power on par with oil and gas assets like pipelines by letting renewables create "qualifying income." Instantly, Sol-Wind would be able to pass along tax advantaged income to shareholders because it's structured as an LP. (It also gets to send them K-1s at tax time... yeah!)

Yieldcos, meanwhile, would likely have to go through the effort of changing their corporate structures before they could do the same thing. So, assuming Sol-Wind goes public, it could be the first step of yieldcos shifting from regular corporations to limited partnerships. This one-off event, could quickly turn into a stampede before you know it -- if you aren't paying attention.

So, if you invest for income and like renewable power, this is a space and an IPO you'll want to watch. It could lead to a major shift in the way utilities and renewable power companies operate. But the linchpin here is "qualifying income" and the Master Limited Partnership Parity Act.

The article High-Yield Limited Partnerships, the Next Home for Renewable Energy Investments originally appeared on Fool.com.

Reuben Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.