Written by John Richardson, our Vice President of Business Development
Article originally appeared in Infrastructure Investor on November 20, 2018
US renewable energy deal watchers have witnessed a tremendous uptick in the supply of attractively priced capital. For long time participants, this sellers’ market has been either a blessing or a curse. The conversation has recently shifted toward speculation around whether the sector is overheating or not? Are we at the peak of the market? To answer those questions, we must first examine the global, national and industry factors at play to understand the current state of affairs and the implications for the future.
Asset Allocation and Fundraising in Infrastructure
The infrastructure asset class provides a great example of non-market correlated performance in the context of a well-diversified portfolio. Recognizing a 10-year bull run in public equity markets, it is understandable that portfolio managers are increasing allocations to non-market correlated infrastructure assets to preserve their years of gains through the next downturn. According to Preqin, the number of institutional investors allocating to the sector rose steeply from 2,844 in 2016 to 3,216 in 2017.
Supply / Demand Imbalance for Infrastructure Assets in the US – An Increased Focus on Renewables
While covering our global investor network, we have handled a surge of interest for US renewables from foreign pensions, infrastructure funds and energy strategics. These players are entering the US market from Canada, Europe and Asia for various local reasons, but all are seeking to fill their OECD infrastructure mandates or pursue a share of the expanding US market.
According to Infrastructure Investor, global infrastructure funds raised $68.16Bn in 2017 and $68.82Bn in 2018 with two months left in the year. Many investors have broad infrastructure mandates, but their focus on renewables is due in part to a shortage of core-infrastructure US P3 projects and a smaller than expected Trump infrastructure plan. For various reasons, the prospect of privately owned and financed infrastructure projects have yet to catch on, with US municipalities preferring to tap the proven municipal debt market.
Renewables are expected to garner nearly $300Bn of investment by 2030 and $810Bn by 2050 according to Bloomberg New Energy Finance’s NEO 2018 report. This is a great outlook for investors seeking to deploy significant amounts of capital, but it also plays well with ESG mandates and LP sustainability objectives. Due to falling costs and strong market fundaments, renewables could reach an estimated 55% of the US power generation mix in 2050. The result would practically eliminate coal fired generation and bring power sector emissions 58% below 2017 levels (while GDP rises 91% over the same period).
Implications for US Renewables
The influx of capital focused on US renewable energy assets and companies comes at the perfect time. The US renewable energy industry has matured into a firmly middle market sector. The industry has a historical entrepreneurial streak, with several early contenders developing into strong private and public companies. Today’s top teams are experienced and adept at managing the full life cycle of developing, financing, owning and operating assets. This maturation also comes at a time when we are unlikely to observe IPOs, mainly due to the ample supply of competitive capital from the private market.
The current market has been rewarding for the long terms players in the field. This year, CohnReznick Capital has seen exceptional interest in platform investments. Strategics and institutional investors have a need to acquire pipelines of assets to increase their exposure to renewables and avoid highly competitive auctions. Several strategics and the largest global infrastructure funds have found this to be the right time to acquire US platforms necessary to achieve scale. It was not long ago that investors attributed little value to a developer, instead focusing valuation on the underlying assets. While assets remain the primary value driver, investors are assigning more value to proven teams. As a practical effect, the reduction in cost of capital for these firms will likely result in further consolidation in the field.
Investors are feeling the squeeze in a seller’s market. We’ve observed an increase in direct vs. indirect participation by pensions. Pension fund direct investment teams have found the industry’s maturation and increase in $250-500MM+ investment opportunities appealing. There are several highly successful infrastructure funds that have remained relevant in the upper range, however directs are quickly rising to meet the supply with many infrastructure funds seeking less efficient pockets of the market.
Old guard investors in the space are evolving to meet their new reality. The industry’s traditional investors, some still locked into higher cost of capital vehicles, have moved earlier into the development cycle or tapped into lower cost of capital LP’s. Pension funds and insurance companies have become a great partner for many leading infrastructure funds. These Infrastructure Fund GP’s sell down a significant percentage of their operating assets to achieve a lower blended cost of capital and prove their ability to exit investments. A growing and related trend is the adoption of this sell down strategy with energy strategics and IPP’s that have amassed similar opportunities at scale.
Many of these experienced investors have an edge in navigating riskier development stage assets compared to new entrants. Though what may be surprising to some is valuations for projects reaching Notice to Proceed (financing/construction ready) nearly match valuations for operating assets. Today, NTP projects command 50-100bps of premium, reflecting the elimination of binary risks and proven project construction and delivery track records.
Debt and tax equity investors have not been immune to the recent shift. Tax equity has been a historically constrained source of capital for new projects, as it requires sector expertise and US tax liabilities to make investments. Due to the attractiveness of the investments profile and stability of returns, the traditional 10 investors have expanded to a group of 50+ with more entrants expected to join. With an expanded universe, tax equity returns thresholds have compressed. Debt providers, focused on back-levering sponsor positions historically had a much larger spread to tax equity hurdle rates. In recent years, the debt market has converged toward lower rates as the asset class matures and competition increases.
Key Takeaways for Participants in the Sector
Asset Valuations are high, but are they too high? The short answer is no. Equity and debt underwriting remains robust with risk premiums stabilizing at an appropriate level compared to risk in asset performance (e.g. lower DSCRs, that better match historical performance). US renewable energy represents a maturing asset class with stabilized return hurdles. Infrastructure investors are attracted to renewable energy for the investment grade offtakes, long duration and established operational performance. The class’s track record is bolstered by independent engineers supporting positive shifts in valuation assumptions (e.g. longer asset life, production & degradation profile improvements, O&M optimizations, etc.).
We are not observing private investors funding irrational growth stories that would indicate a bubble, instead they’re sticking to their proven underwriting criteria. It is true that the supply of available projects is far exceeded by the demand in the market, however we have not observed behavior that would constitute excessive risk-taking by investors seeking to deploy capital.
This year’s results are reflective of a maturing market that has all the signals of momentum and long-term growth. The transition to low-cost, long term capital is simply a recognition of the proven track record of a maturing asset class. For existing investors finding it difficult to compete, there is good news. New subsectors, such as distributed generation and a growing interest in energy storage are potential high growth markets commanding premium returns. Investors with dry powder would be wise to monitor these new avenues to deploy capital at the industry’s frontiers.