SDCL Energy Efficiency Income Trust — Answering five key investor questions

We have based this note on the questions raised by some investors during our investor outreach and via email. This is a subset of a longer list and we have prioritised the most commonly recurring queries. The answers provided in this note are our own and based on our opinion, rather than management guidance, and we welcome any direct feedback.

For a full detailed overview of SEEIT, including a description of its asset portfolio, please see our initiation note.

It is possible that SEEIT’s assets could be worth more in the private market, further supporting the significant undervaluation in the current stock price. This is a major issue across both the listed investment trust and private equity market. Listed investment trusts have raised their discount rates in response to the rise in interest rates globally. SEEIT now stands at an 8.7% weighted average unlevered discount rate (March 2023: 7.7%) and 9.4% levered (March 2023: 8.5%) at 30 September 2023. The weighted average discount rate was 7.5% three years ago.

The implied discount rate the market is applying to the assets is in the order of 10–12%. This seems excessively high for assets with long-dated and relatively secure income streams. If SEEIT can recycle capital through the sale of more mature, derisked assets with valuations closer to their NAV carrying value, or even at a premium (which has been seen in relation to solar assets recently) to the discount to NAV assumed by the market, this highlights a strong signal of mispricing. SEEIT can then use this capital generated to further reduce short-term debt, explore accretive expansions on existing assets or more strongly build out its dividend cover, which are all positive signs in our view.

Like any public company, the potential for assets sales is opaque but, in its interim results (to 30 September 2023), SEEIT stated that it is ‘actively pursuing options to realise liquidity for the company through selective asset disposals’ and ‘progressing selective disposals to bolster the balance sheet’. CEO Jonathan Maxwell indicated he has received ‘a number of credible proposals in relation to multiple assets that are within its range of pricing expectations and thereby support the most recently published NAV’.

Since its interim results, SEEIT has added further traction to the argument that its assets are worth more in the private market than the public market with the announcement on 7 May 2024 of the sale of its 69MW UK on-site solar portfolio, UU Solar (9% of SEEIT’s NAV as at 30 September 2023), to UK Power Networks Service Holdings Limited for a total consideration of £90.8m. The sale represented a 4.5% premium to SEEIT’s carrying valuation of UU Solar as at 30 September 2023. The proceeds from the sale will be used to reduce its short-term borrowings via the company’s revolving credit facility (RCF), which was £155m drawn at March 2024. The sale of UU Solar is therefore a primary example of how SEEIT can create further liquidity and capital allocation options, allowing it to strengthen its balance sheet and recycle capital into its proprietary/organic pipeline and existing investments to generate higher returns. The announcement also stated that strengthening the balance sheet remains a key focus for SEEIT, and good progress is being made with further asset disposals and co-investment partnership opportunities, as referenced in its interim update statement on 19 March 2024.

Other emerging signs of the disconnect between private and market valuations came to light throughout 2023 and at the beginning of 2024. For example, in November 2023, Foresight Solar Fund sold 50% of its 99MW Lorca portfolio in Spain for €26.9m, which was at a 21% premium to its Q3 holding value. Additionally, in August 2023, The Renewable Infrastructure Group (TRIG) exchanged contracts to sell three wind farms in the Republic of Ireland for a combined consideration of c €25m to Statkraft. This was at a 26% premium to TRIG’s valuation at 31 December 2022.

In our view, maintaining the dividend seems very likely. Dividend security can never be guaranteed for any public equity, but based on current data, we do not believe there is any particular reason why SEEIT would be looking to cut its dividend, especially as its income and asset stream is relatively diverse and its refinancing risk appears low. At H123 (ended 30 September 2023), the dividend cover was 1.1x (ie 1.1x covered by cash generated by the portfolio) and management stated it expects this to grow by the end of 2024 and over the medium term. In its interim update statement (published 19 March 2024) management highlighted that SEEIT is on target to deliver a fully covered aggregate dividend of 6.24p for FY24 (ended 31 March 2024). Although never certain, we emphasise the following factors in favour of relative dividend security: 

There are two parts to answering why the discount to NAV is so large. Firstly, why do discounts to NAVs exist across the renewable energy infrastructure sector? Secondly, why is SEEIT’s so large? 

We have addressed the reasons why discounts to NAVs exist in the renewable energy investment trust sector in our note on Premier Miton Global Renewables Trust as it is a common query. In summary, in our view, the market has treated much of the sector as bond proxies, derating the stocks as interest rates have risen. Where the market was content to hold these stocks at 4–5% dividend yields and where these are achievable through risk-free gilt or money market funds, the sector has needed to shift to 8–10% fields to attract marginal investors. It is possible to argue (and we have) that many investment trusts are able to organically growth their NAVs and, therefore, should be considered more highly rated than bonds. However, this is not widely considered by investors, in our view, and the inherent risks in some underlying businesses remain a key concern. We have also argued that the sector has been somewhat a victim of fund flows and a stabilisation of rates (rather than a full reversal) might be sufficient to drive some investor interest back more broadly into the sector. 

The second part of our question is whether SEEIT’s discount to NAV is relatively large compared to its peers. With the discount to NAV of 26%, compared with the sector weighted average of 23% (as at 6 June 2024), the data suggest that it is. However, this is unusual as SEEIT’s discount is large despite its relative size, and the other funds closer to SEEIT’s discount are either smaller in size or more focused. This relative discount is therefore unjustified in our view. The market seems to be treating SEEIT as subscale (which it clearly is not) or potentially as a trust with a relatively risky underlying asset base, which seems unjustified (see points 1 and 2 in the question above). 

Like other management teams in the investment trust sector, we believe SEEIT’s management team is deeply concerned about the discount. The sale of UU Solar further emphasises that SEEIT is undervalued and that there is a clear disconnect between public and private market valuations, as SEEIT is still trading well below NAV despite as UU Solar being sold at a 4.5% premium to SEEIT’s carrying valuation at 30 September 2023. There are several steps, both major and minor, SEEIT is undertaking to help close this gap, including:

SEEIT’s largest single asset is the Red Rocester (RED) district energy system, which is the exclusive provider of 16 on-site energy efficient services to customers within the Eastman Business park in the US, at which it has contractual and regulated utility-status franchise rights (see our initiation note for full details). Red Rocester accounts for 16% of SEEIT’s portfolio and its carrying value was written down from £254m at FY22 to £180m at H123. The issues at Red Rochester appear to be due principally to a lack of capacity utilisation and this was being conservatively reflected in its valuation. The main concerns are:

In our view, this looks like a comprehensive review of valuation assumptions, with some conservatism built into each. On 19 March 2024, SEEIT stated that the building of the CHP co-generation plant at Red Rochester was progressing as expected and that it will add to margins and cash flow in 2025.

SEEIT stands out compared to the other listed renewable energy infrastructure investment trusts in its AIC peer group because: