Penelope-like elements are a class of retroelement that have now been identified in >50 species belonging to at least 10 animal phyla. The Penelope element isolated from Drosophila virilis is the only transpositionally active representative of this class isolated so far. The single ORF of Penelope and its relatives contains regions homologous to a reverse transcriptase of atypical structure and to the GIY-YIG, or Uri, an endonuclease (EN) domain not previously found in retroelements. We have expressed the single ORF of Penelope in a baculovirus expression system and have shown that it encodes a polyprotein with reverse transcriptase activity that requires divalent cations (Mn2+ and Mg2+). We have also expressed and purified the EN domain in Escherichia coli and have demonstrated that it has EN activity in vitro. Mutations in the conserved residues of the EN catalytic module abolish its nicking activity, whereas the DNA-binding properties of the mutant proteins remain unaffected. Only one strand of the target sequence is cleaved, and there is a certain degree of cleavage specificity. We propose that the Penelope EN cleaves the target DNA during transposition, generating a primer for reverse transcription. Our results show that an active Uri EN has been adopted by a retrotransposon.