Energy: A world beyond funds

Buoyed by a combination of government policy, consistent regulation and readily available projects, Nippon Renewable Energy (NRE) is growing fast. The solar energy developer and operator was set up in early 2014 but already claims to be one of the largest players in its segment in Japan.

When Equis Funds Group and Partners Group seeded the platform - plus several co-investors - there were four projects totaling 47.5 megawatts ready for construction, with 300 MW in the pipeline for the next two years. About 12 months later, the initial investment of $250 million had become a commitment of $720 million.

Equis, which focuses exclusively on Asia energy and infrastructure, closed its second fund at $1 billion in early February. There was also a $300 million top-up for Fund I to cover the needs of existing portfolio companies over the coming year and a $400 million co-investment pool for two specific assets: the Japan Solar platform that feeds NRE and an India and Southeast Asia-focused wind energy platform called Energon.

Direct co-investment was the only way that the GP could deliver the capital required without exceeding the diversification limits to which the funds are subject, and holding the assets in free-standing platform facilitates the involvement of others. "They are growing at a very rapid rate," David Russell, CEO of Equis, told AVCJ at the time.

The GP is not alone in devising unorthodox ways to support assets that require substantial expansion capital. They include: Brait in South Africa, which turned itself into an investment holding company in order to raise capital from the public markets; Tarpon in Brazil, with its long-only fund, co-investment and hybrid-equity strategies; and India's ICICI Venture, which has formed a joint venture platform with Tata Power that is targeting struggling power assets.

These groups are a sample of a small but growing band of managers that are modifying the conventional fund model in favor of solutions that better meet the needs of their markets and their investors. It begs the question of how broadly the phenomenon will catch on in Asia.

Geography or sector?

When examining developments in this area, private equity fundraising data are not particularly helpful. Suffice to say, approaches vary hugely based on the target asset - from assets embedded into holding company structures to fairly standard co-investment vehicles. What unites them, according to Mounir Guen, CEO of placement agent MVision, is they are a product of necessity in emerging markets that are not necessarily suited to 10-year funds.

"If a GP comes back to market in five years or even three years, investors expect to see a deployment velocity similar to that of the US and Europe," he says. "But there aren't enough GPs and there is no real secondary business. The moment the investment leaves the ability to find an equivalent investment maybe very limited. You have to be really thoughtful about markets that are in the early stages of formation."

In this kind of environment, the argument continues, why would a GP relinquish an asset that is cash generative and has excellent growth potential? As such, holding an investment in a fund structure that requires the pursuit of an exit after approximately five years may not make long-term economic sense.

While Guen describes this phenomenon as particular to emerging markets as opposed to asset classes, it resonates most strongly in those that are capital intensive: energy and infrastructure. Indeed, the view shared by Roger Lloyd, managing director and CEO of Australia-based infrastructure investor Palisade Partners, sounds familiar. "If you are generating yield, why exit?" he asks. "In this world of low yields and very few places to find yield, if we can invest in an asset that provides capital protection and long-term sustainable cash, why get out?"

Palisade operates two open-ended funds that target assets ranging from ports to energy to social infrastructure. This approach was shaped by the nature of the industry in Australia. Lloyd contrasts it with the industry US and Europe, which was "born out of a private equity regime and that is generally closed-end."

Platforms come into Palisade's strategy as a means of accommodating investment mandates from large LPs that operate alongside the funds. Two years ago the GP acquired a majority stake in Waterloo Windfarm in South Australia, working in conjunction with a Canadian fund. Energy Australia, a leading electricity retailer and an off-take partner for Waterloo, held a minority interest in the business and Palisade recently bought it, using capital raised from existing investors.

Waterloo has a capacity of 111 MW and the private equity firm plans to increase this by 20%. Once again, existing backers are expected to meet the bulk of the additional funding needs, through the funds and the investment mandates. In these situations, if the fund maxes out its commitment, the co-investment portion becomes larger.

Partners Group has a similar strategy, whereby investments start out contained within a fund or a mandate but are spun out into stand-alone platforms once the capital needs reach a certain size. "The concept of a platform is you have a number of projects and one management team covers all of them," says Benjamin Haan, head of Asia Pacific private infrastructure. "By building up expertise in a sector of geography and assembling a high-class management team, you can deploy capital cost-efficiently."

Last year Partners Group acquired a majority interest in Fermaca, a Mexican gas distributor, through a management buyout. At the time, Fermaca had two assets, a pipeline that has been in operation for 10 years and another about to enter operation, but the investment coincided with energy deregulation, which prompted a wave of new tenders. The company has since announced two additions to its existing pipeline network: one that extends into Texas and another that stretches further into central Mexico.

The driving force behind these developments is the desire to transport more gas from Texas, where it is very cheap, to central Mexico, where it is relatively expensive. Existing Partners Group programs have reached the maximum desired exposure to the Mexican gas sector so the expansion funding required to capitalize on this opportunity was raised through a dedicated fund and co-investment from a number of large institutional players.

A band apart

The pension funds and sovereign wealth funds that account for the bulk of co-investment coming into projects backed by Partners Group and Palisade are a logical source of capital, but not the only one.

Tim Baldwin, the partner responsible for oil and gas coverage at Hong Kong-based GEMS, favors taking deals to larger global natural resources PE firms. Despite the potential of Asia Pacific-based assets as they move from exploration into appraisal and development, these primarily North American GPs are relatively inactive in the region. Baldwin puts this down to the lack of $100-500 million deals - a function of the $20 million deals not getting done, largely due to concerns about where the next $100-500 million is coming from.

This chicken-and-egg situation can only really be resolved once global players are confident that Asia can deliver scalable projects. It is not just a question of asset quality, but also finding strong teams. GEMS frequently finds situations in which projects fail to deliver on their potential because they are marshaled by groups that do not offer the full range of skill sets required in the oil and gas space. While there is the possibility of matching teams and assets - indeed, some resources-focused PE firms identify teams, build platforms around them and provide capital to acquire assets - it is a time-consuming process.

"Getting that Holy Grail of team and asset is quite tough. It can take 3-4 years to find assets that make sense," Baldwin says. "You might have a team that comes out of Shell - a couple of technical guys, a commercial guy, a strategy guy - and they do a start-up. That conceptually sounds fine but they only know the Shell way. How do they bring in operating experience in a smaller company environment? How do they bring in additional skill sets to scale up and create something more material?"

While the idea of setting up independent structures for long-term, capital intensive projects is compelling, it is also challenging. Investors must be convinced that they are placing their capital in the hands of teams that can execute on its strategy. Equis won initial backing on the basis of its pipeline and the track records of its principals. The firm now employs more than 315 professionals across its various platforms, including 117 construction and operational engineers and 55 investment and business development professionals.

"We bottom-up benchmark and target our sectors," Russell told AVCJ. "That process, and forming management teams that attack those strategies, can take 6-24 months. Once we get to that point of the first investment we have already identified the strengths and weaknesses of the sector, why we need to be there, and the management team. It is then a quick process of deploying capital into multiple asset strategies."

What Equis also has is control. The firm is taking on construction risk but at the same time it is not a minority partner reliant on local developers. For many investors in renewable energy projects, success hinges not only on putting together the best team and the best asset, but also on picking a strong developer and a jurisdiction with a transparent regulatory system. It hasn't always worked.

"There are fewer managers globally that are developing assets in power generation - that has been the trend of the last couple of years," says Nupur Garg, regional lead for South Asia and climate change funds at the International Finance Corporation (IFC). "Funds investing in asset-based projects have not delivered expected returns. With services and technology-based investments it is easier to get liquidity and you have a faster turnaround."

No Europe redux

Europe was the problem market. Spain, for example, unveiled feed-in tariffs in 2008 but failed to include a mechanism that would reduce rates if capacity targets were exceeded. The government was expecting a slow roll-out, but instead there was a torrent of investment and capacity soared to several times the projected figure. The utility companies, unable to pass on the full cost to the end user, could not make good on their commitments to pay a fixed rate for electricity from all new solar projects. Retroactive policy changes then virtually wiped out the industry.

Regulation is a risk beyond the control of any manager, but Eric Marchand, investment director with Unigestion, believes that governments in Asia may have learned from the experiences of Europe. At the same time, the region's demand dynamic suggests that renewables have a clear long-term future.

"In Europe the subsidies were there to replace existing fossil fuels and change the product mix. In Asia it is changing the product mix but it is also part of the puzzle - governments need renewable energy. Some statistics suggest that oil-based electricity production will increase faster to 2025 than renewable energy," he says. "You also have the option here that the off-taker might be a private entity, not the government. For instance, you can build a project that provides energy to an entire industrial area."

There is also evidence that more greenfield renewables platforms are successfully entering operation. Industry participants say a handful of other dedicated India wind and solar businesses have also got traction and are gradually turning their big ambitions into meaningful scale.

Goldman Sachs controls ReNew Energy, which has wind projects capable of generating 545 MW, while Morgan Stanley Infrastructure Partners-owned Continuum Wind Energy has 145 MW in operation. Both platforms have received additional debt and equity funding to support expansion. Greenko, which has received capital from the likes of GIC Private, TPG Capital and EIG Global Energy Partners, is even farther ahead with operating capacity of 715 MW across wind and hydro power as of December 2014.

Greenko's growth has been fueled by a combination of private and public money; it listed on London's AIM board in 2007. In the past year there has been $550 million bond issue and a $125 million convertible debt package provided by EIG. The others are still under private ownership and scale is a crucial consideration as investors consider their path to liquidity.

"The problem with renewable energy is if you don't get to a certain scale and size your exit options can become limited," says Unigestion's Marchand. "If you get to a utility size platform you have lots of options; if you don't then the value of what you are selling might be negatively impacted because you may attract a less diverse group of buyers."

This flexibility on exit is also a key component of Partners Group's platform strategy. The firm generally avoids investing in the large cap core infrastructure space because valuations are high when compared to historic averages. However, it is happy to sell assets into this space and creating platforms is one way of achieving the requisite scale. "By aggregating a number of small projects into a platform we can build up a portfolio that is attractive to a different kind of buyer that might have a lower cost of capital than we do," Haan explains.

Fermaca in Mexico, for example, is now seen as a potential candidate for a trade sale to a strategic buyer or an IPO. Equis takes a similar view of its assets, with Russell noting that local capital - pension funds, sovereign wealth funds and strategic players - is generally hungry for assets in Japan and willing to price them very aggressively.

Looking for yield

The prospect of a public market exit has become all the more alluring in the last two years with the emergence of yield companies, or yieldcos, in the renewable energy space. These function much like real estate investment trusts (REITs) in that they bundle up long-term, cashflow-positive operating assets into listed vehicles. By separating low-risk operating assets from higher-risk greenfield projects, investors get access to high-quality yield-generating assets while the developers can raise capital at lower cost for use elsewhere in their business.

NRG Energy was the first group to launch a yieldco in the US in July 2013 based on a combination of conventional and renewable energy assets and it currently has a market capitalization of $2.7 billion. Wholly renewable yieldcos since launched by SunEdison and TransAlta Renewables are worth $4.9 billion and $2.4 billion, respectively.

Unigestion's Marchand sees the potential but also notes that yieldcos are popular because investors are chasing yield. "You have yieldco stocks on the market in which you get 5-6% yields, sometimes more," he says. "That is very attractive in a low interest rate environment, but how competitive are they going to be if the US raises interest rates to, say, 2%? These yieldcos' returns are somewhat fixed and will become less attractive as interest rates rise."

It remains to be seen if the yieldco craze also takes root in Asia's emerging markets. The general expectation is that these platforms will list and this reinforces the viability of the model. At the same time, there is no shortage of demand from private markets investors for exposure to Asia, provided the manager and the thesis are strong. More capital will gravitate towards platforms because there is nowhere else for it to go.

"Picture a wall that is 30 feet high. Through the private equity structures that are currently in the marketplace, only about 5-6 feet of that 30-foot wall can be deployed. There is 25 feet of capital that can't find assets, which is why you see significant investor groups opening large offices and launching big initiatives out of Asia," says MVision's Guen. "There is no way funds can absorb all that capital that is looking for investments."

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• Topics
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• North Asia
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• Partners Group
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