On January 13th, TerraForm Power (TERP) received an unsolicited offer from Brookfield Renewable Partners (BEP). The proposed offer is 0.36 shares of BEP for each share of TERP. At the time, this represented a premium of 11% according to Brookfield but due to the strong performance of BEP, the value of the offer has increased and TERP trades 35% higher than the day prior to announcement. Year to date, TERP has gained almost 38%.
This may sound great, but it is not the point. What is truly special about this deal is that the market values TERP at a 4.1% premium to the offer. I think that any uncertainty around the offer works in the disadvantage of TERP and that if anything, TERP should be trading at a discount to the offer instead of at a premium. Entrepreneurial investors could profit from this situation by buying shares of BEP while simultaneously selling shares of TERP.
Background of companies and the offer
Brookfield Renewable Partners and TerraForm Power are both renewable energy YieldCos. They own and operate long-term contracted renewable energy assets and pay a high percentage of cash flow out as dividends to shareholders. The companies are viewed by the market as both a play on renewable energy and a stable yield also known as bond proxies. This combination has led the sector that was previously low beta, not very popular and quite cheap, to perform extremely well over the past 12 months.
Performance of YieldCo stocks. Source: Seeking Alpha.
It is also important to understand that YieldCos are just owners and operators of the assets they own. Traditionally, a YieldCo has a sponsor that develops assets and drops these down (sells assets) to the YieldCo. Part of this arrangement is usually that the sponsor holds the majority of (voting) shares in the YieldCo. It happens to be so that Brookfield Asset Management (BAM) is the sponsor of both TERP and BEP. The offer by BEP was for the 38% of outstanding TERP shares that were not owned by BAM already. Interestingly, BAM owns 60% of BEP and 62% of TERP which means that in economic terms, little changes for BAM after a merger. The main driver was to simplify the structure of the company, according to BEP.
We believe this transaction will create significant value for investors in both companies through a simplified corporate structure and continued sponsorship from Brookfield Asset Management”
Sachin Shah, CEO of Brookfield Renewable.
There are other reasons, such as that the transaction is accretive on multiples to BEP and that it will enable TERP to profit from the investment grade balance sheet of BEP. Personally, I see the advantages as minimal, and this was reflected in the minimal premium of 11% and the negative initial response by the stock market on BEP. That said, what we have is just a proposal, not an actual committed offer.
The offer was unsolicited and in a display of a good corporate governance practice, independent directors of TERP have formed a committee to evaluate it. Though it remains somewhat strange that the management of TERP says that the offer was unsolicited. TERP and BEP share the same corporate parent which must exert significant influence over the capital allocation decisions of both companies.
There are a few things that could happen from here. The first question is whether the committee accepts the offer. If it does, the deal is practically sealed and we can count our arbitrage profits. However, if it insists that the offer is too low, there are three possible alternative outcomes aside from still accepting the offer:
1) Brookfield offers more
This is not a likely outcome for several reasons. To start, the value of BEP’s offer has improved substantially over the past month. As the market value of BEP is 3.5 times that of TERP and BEP published well-received earnings two weeks ago, we should expect BEP to put most weight on the scale. In my view, TERP holders should be happy that they can profit from the offer by getting a large share of the pie and I think that the ultimate parent, BAM, will have the same view.
We must also consider that the initial response from BEP shareholders to the deal was negative, the stock was down remarkably on the announcement day while AY, NEP, CWEN and TERP were all up.
2) TerraForm finds a better offer
Very unlikely. At this point, all YieldCos have appreciated by a lot, but TERP is up most YTD with the exception of BEP. The run-up has made TERP very expensive on multiples. It has recently overtaken NEP with regards to CAFD yield; TERP now has the lowest CAFD yield. Another dynamic that rules out the outcome of a better offer from third party is that BAM owns the majority of TERP shares and it has not shown an interest in selling.
3) The deal falls through
Another unlikely outcome as it would probably entail both management and shareholders to reject the offer. It would be very puzzling if they did, considering the value of the offer. If the deal does fail to materialize, that would send shares of TERP lower. It would also be the best-case scenario for anyone acting on this merger arbitrage opportunity.
After combing through the SEC filings of TERP, I concluded that there is no information that refutes my thesis. I did find an interesting quote in these filings from BEP’s Feb. 6 earnings call:
Really, the TERP transaction should be thought of separate and really was about simplifying the structure between BEP and TERP. It is really just trading the TERP public shares for BEP public shares. … And that the strategy around the proposal for TERP was really around simplifying that structure and just moving those TERP shareholders up into the BEP structure.”
Wyatt Hartley, CFO of Brookfield Renewable Partners.
Clearly, the CFO of BEP doesn’t seem to care much about the merger and it almost seems like BAM pushed BEP to make the offer.
There is one more factor that can sow confusion which is that the shares to be issued to TERP shareholders will be BEPC, a new corporate share class. It is created to accommodate shareholders who want to own shares of a corporation instead of a partnership. The shares will have the same economic characteristics as BEP units and they will be convertible as well. I regard this as a minor detail to the thesis.
The spread between TERP and the fair value of the proposal is the most intriguing or worrisome part about this story. As you can see in the chart below, the spread (at close) has mostly moved between $0.50 and $1 or 3% and 6% and is currently close to 4%.
Spread between TERP and offer for TERP using daily closing prices. Source: author’s own calculations.
This implies that either my math is wrong or that there is a good chance of a better offer, but the latter is unlikely as discussed. Let us continue with the math.
The proposal from BEP is quite simple: 0.36 shares of BEPC for each TERP share. The calculation of BEP in the January 13 press release states that the offer is a premium of 11% over the last close. At the time, the last closing prices of BEP and TERP were $48.07 and $15.60, respectively. The math then is: $48.07 * 0.36 = $17.31 & 15.6 * 111% = $17.32, practically spot-on. So it is not the numbers that are off. Dividends are also not the reason for the stable spread, as yields on the stocks are quite similar to each other.
The discussion above leads me to believe that there is an opportunity here because the market mistakenly believes that TERP could fetch a higher price than the proposed offer.
As it looks, we have a deal where the majority owner offers an attractive premium to public owners of a subsidiary. That subsidiary is 3% to 5%% overvalued and that is an opportunity. If anything, TERP should be trading below the offer, not above it. TERP shareholders could exploit this situation by selling their shares and buying shares of BEP instead at a ratio of 25 TERP shares for 9 units of BEP. Investors who like to get into special situations could instead sell TERP short while buying BEP in the same 25/9 (1/0.36) ratio. Each ‘package’ of 25 TERP and 9 BEP shares traded like this has an expected pay-off (if merger happens at proposed terms) of $21.20, or 4.15% using Wednesday’s closing prices.
Last but not least, it is uncertain when -if ever- the arbitrage trade will be profitable but it still looks like a very favorable risk/reward deal to me.
Disclosure: I am/we are long BEP, CWEN.A. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am short NEP, TERP.