- I've covered BEP before and was quite bullish on the company.
- But recently I discovered just how much upside the fund gives up in fees to Brookfield.
- I take a deep dive into Brookfield fee structure, discuss management incentives and present my playbook for the company.
I've written quite extensively about my bullish outlook for renewable energy and consequently I've covered a number of interesting renewable energy plays here on SA. Some of my favorites include traditional utility giants with a significant and growing exposure to renewables, such as Enel (OTCPK:ENLAY) and others were simple green energy pure-plays such as NextEra Energy Partners (NEP) or Brookfield Renewable Partners (NYSE:BEP). Today I want to do an update on BEP, which has returned about 10% since my last article. Bear with me as I will get to the discussion of Q1 results and my updated outlook for BEP in the second half of the article. But first I want to describe my thinking, which caused me to sell my BEP shares and swap them for shares of the parent company. Spoiler alert, it has to do with management's incentives.
Let's talk about Brookfield's incentives
Recently it occurred to me, that not all Brookfield's funds are created equal. This might sound obvious, after all real estate is definitely not the same thing as a solar power plant or a port, but I'm not talking about the assets they hold here. What I want to focus on is the "seniority" of individual Brookfield funds (entities) within the Brookfield group. Understanding this, management's incentives and the various fees that are channeled from one entity to another is crucial to making an investment decision. Some of what follows are straight up facts and some are my opinions where I'm trying to connect the dots. I'm happy to hear your comments below on how you see it.
Let's first briefly describe the structure of the group. At the very top, we have Brookfield Corporation (BN) which is the parent company, a HoldCo. As a HoldCo it simply owns shares of other Brookfield's publicly traded entities plus other private investment (mainly real estate). What's important though is that this is the entity that the majority of senior management's wealth is tied to (mainly that of the CEO Bruce Flatt) so it's clear what they are incentivized to do here - increase the share price of BN.
They've already done a major step in trying to increase the share price of BN, which was of course the recent spin-off of 25% of their asset management business which is now publicly traded as Brookfield Asset Management (BAM). Management has been open about the fact that the primary reason for the spin-off was for the market to recognize the true value of this easy to understand and asset-light part of their business. Individual investors celebrated the fact that they can now invest into an asset-management pure-play, but let's not kid ourselves, Brookfield didn't do this to make people happy, but to increase the value of BN which still owns 75% of BAM. So far this hasn't entirely materialized. While the market has priced BAM at a pretty high FRE multiple of about 23x, BN's stock price has continued to fall, likely due to their have commercial real estate exposure. In either case, the spin-off confirms my thinking, which is that management will do everything to maximize the value at the HoldCo level.
Moving several levels down, we get to the YieldCo level, which is where you find BEP, as well as the rest of Brookfield's publicly traded funds. BN owns significant stakes in all of these funds which should theoretically give it some incentive, but looking at the big picture I'm going to make the argument that in reality the goal of these funds is to produce a return that is simply large enough (and ideally with a nice dividend, because who doesn't like that) so that investors in those funds are happy. If those funds, could continually deliver 20% returns, why give that to investors when you can introduce a complex set of fees to move some of this excess return to a place where it benefits the HoldCo more. BAM is the best place for that, because it's priced at the highest multiple, meaning that a dollar of earnings in BAM has significantly higher value that a dollar of earnings elsewhere (especially on the YieldCo level with lower multiples and only partial ownership). And indeed, this is happening as all YieldCos pay significant fees to the asset manager. The asset manager provides services in return, such as sourcing capital for the funds, but if I were in management I would surely be thinking of ways to increase the fees, run them through BAM and therefore increase the price of BN.
Is BEP still worth it?
None of this is meant to discourage you from investing to BEP, I was a shareholder myself before I switched to BN. It's simply to encourage you to think about the big picture and make the best decision for yourself. So without further due let's look at BEP. I covered the basics in my original article here, but to sum up the basic Brookfield Renewable is a green energy pure-play with 25,000 MW of installed capacity, mainly in hydro (53%), followed by wind (20%) and solar (15%). Their portfolio is primarily located in North America (62%), followed by South America (20%) and Europe (16%). The company targets a 10% FFO growth which should be fuelled by a vast pipeline of new projects. Notably half of the growth for the next five years is already locked in with 19,000 MW of capacity under construction or construction-ready.
In Q1 they certainly delivered, as their quarterly FFO increased by 13% YoY to $0.43 per share. The growth was driven by favorable hydro generation which increased by 26% YoY, increased prices (inflation driven) and a 23% increase in installed capacity (thanks to acquisitions and mainly 3,600 MW of newly commissioned projects over the last 12 months). Management has also stated that they remain committed to delivering 12-15% returns to shareholders over the long-term and growing their distributions by 5-9% annually.
Now let's have a look at the fees I've talked about to help you understand why further upside (beyond management's growth targets) is nearly impossible and why we might be better off investing in BAM which targets 20% shareholder returns and has a much better position within Brookfield corporate structure. The "incentive distribution" mechanism is explained in their materials as follows:
At first glance the fee may not seem that high. But the current distribution is nowhere near $0.20 per unit, in fact the recently declared distribution for Q2 2023 stands at $0.3375 per unit. That's well above the threshold which means that the fees are high and BAM (not BEP) captures 25% of all growth from here. I've put together a chart which shows the split between what BEP retains and what it has to pay out. The red line represents the current level of distributions. While it may not seem like BEP is taking a big haircut, the $27 Million paid in incentives distributions to Brookfield in Q1 2023 was more than 10% of total distributions paid to LP unit holders. Going forward, as distributions grow further beyond the $0.20 per share threshold, Brookfield as the GP will continue to capture 25% of all growth and the proportion of distributions that goes to Brookfield as an incentive distribution will increase from about 10% today to about 13% in 5 years. That's by no means insignificant.
The way I see it, this has a major impact on shareholders of BEP and while I recognize that Brookfield does bring value by sourcing capital, the fee heavily burdens the YieldCo to a point where returns beyond the 12-15% that management is guiding for are highly improbable. Combined with management's clear incentives to prioritize value creation "at the top" I've decided to exit my BEP position. That's not to say, it can't be a good investment for some. If you're ok with the above and for some reason don't want to invest in the asset manager or the corporation, then by all means go ahead and buy BEP as it is a solid business, but for me it is a HOLD at this time.
This article was written by
David Ksir is an ex-Private Equity investment professional with a strong European real estate background, now focused on active investing in US and EU equities. His goal is generating market beating returns with an emphasis on reliable (growing) dividends. He is primarily invested in REITs, Financials and Renewable Energy.David contributes to the Learn more.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.
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