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Clean energy investment funds: moving beyond magic formulas to sound risk analysis
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Private Sector & Development #6 - Private equity and clean energy: how to boost investments in emerging markets?
It is imperative to develop a low-carbon economy in order to meet two major challenges that our societies will be facing over the next decade: how to guarantee an energy supply (under threat from the increasing scarcity of oil resources), and how to meet the climate challenge. It is likely that the combination of these two constraints will lead to a “new industrial revolution” where priority will be given to low-energy consumption and competitive solutions, thus paving the way for new growth strategies in numerous economic sectors. The fight against climate change does not constitute a brake to economic development. This has been fully grasped by many emerging countries, the first being China. A full-fledged sector of industrial activities has come into being in just a few years; Chinese and Indian companies have now become major global players in the wind power, photovoltaic solar energy and electric car sectors. In Africa – a continent facing a formidable challenge for energy growth – the most competitive solutions are often renewable energy solutions (hydropower, cogeneration, geothermal energy) which come with cost prices that are much lower than thermal solutions. Finally, the Keynesian recovery plans implemented by developed countries in 2009 are all characterized by the will to make long-term investments for future generations and the certainty that sustainable growth will only be possible if our economies curb their carbon consumption.
Developing countries' clean energies are attractive for investors, yet there are few specialized local funds. Analytical tools are undoubtedly inappropriate and underrate four specific areas of risk: fund size, management team skills, strategy balance and portfolio liquidity. If investors set out to analyze these risks and managers implement mechanisms to mitigate them, it is likely that the private sector would scale up its investments in developing countries' clean energies.
Over 270 private equity funds are operating in the clean technologies (clean tech) sector today, against seven in 2003 (Preqin, 2009). In 2009, USD 5.6 billion of private equity investments were made in this sector worldwide, against 8.5 in 2008 and 4.5 in 2006 (EMPEA, 2010). The sector may not have been spared by the financial crisis which began in 2008, but the fall in activity has been lower than in the rest of the private equity industry (Preqin, 2010), which demonstrates investors' growing interest in the sector. Emerging countries only host 19% of clean tech fund managers (against 45% in the United States) and attracted less than 15% of amounts invested in 2008 and 2009 (EMPEA, 2010). In addition, the amount of funds raised in these countries is falling: only USD 300 million in 2009 against 1.9 billion in 2007. However, some emblematic deals have been made in the clean technologies sector in emerging countries: in 2007, two of the five biggest investments were made in Brazil and China.1 Moreover, in 2009 Asia moved up to second place in the clean energy sector with USD 41.4 billion invested2 (Bloomberg, 2010a). Yet although emerging countries are generally attractive for clean energy investors, they are underrepresented in the landscape of private equity funds in this sector. It would appear that this paradox cannot be explained by a lower performance of private equity funds – all sectors taken together – in emerging countries. For example, over the past three years the performance index for private equity funds in emerging countries has constantly been higher than European and American indexes. It was the only one to be positive in 2008 and stands at 8.1 for the past three years, against 1.3 to 3.4 in Europe and the United States (Cambridge Associates, 2010). Moreover, as the perceived risk is higher in emerging countries, investors revise up their expected level of return in order to ensure the risk-return ratio remains attractive. This paradoxical situation could then be explained by the need to make adjustments to the risk analysis grid applicable to an equity investment into a clean energy private equity fund in emerging countries. Although external factors (regulatory framework, infrastructure quality, transaction costs)3 may contribute to the investment deficit, a greater understanding could be gained of certain specific risks: beyond traditional risks (country risks, recent nature of the sector, risk of sector concentration), the analysis must be adjusted in terms of the following elements: critical fund size, composition of its management team, balance of its investment strategy and liquidity of its portfolio. An approach tailored to these four criteria could allow investors to make a better analysis of investment proposals and managers to calibrate their projects better.
Targeting critical size
The critical size of a fund depends first and foremost on the type of target: the fund's equity requirements will be greater when the target companies are well established and/or the chosen sectors are highly capital-intensive. The question of critical size is even more acute in the clean energy sector. A fund investing in renewable energy projects – with similar characteristics as infrastructure projects – must have the capacity to commit tickets of a high minimum size due to the highly capital-intensive nature of the projects that are financed. In addition, the fund must be able to anticipate financing for successive project extensions, since raising capacity is one of the levers for optimizing the return on investment once the project is in the operating phase. Finally, a certain size is required when the strategy aims to build – within the same holding company – a diversified portfolio of renewable energy assets. All this explains why in emerging countries, particularly Southeast Asia, many specialized funds' strategies focus on sizes ranging between USD 100 and 300 million. For some managers, an interesting differentiation strategy could involve setting up a smaller fund – between USD 50 and 150 million – focused on targets where competition is limited: small subcontractor businesses and suppliers of major renewable energy producers, for example, or small-scale generation projects, such as mini hydropower plants and small wind farms. Funds that are under USD 50 million will sometimes face difficulties when they seek to diversify their portfolio and build synergies between their investments.
Articulating skills within teams
There are real operational risks relating to the way investment teams operate. As with other funds, they should seek to align stakeholders' interests and develop mechanisms that help ensure the stability of teams. The analysis of a team's expertise could go beyond classical assessment criteria (capacity to identify and structure deals, value-add to portfolio companies, etc.) in order to focus the appraisal on the complementarity that exists between the profiles of the investment team. Investors will expect teams to have sound technical knowledge of the energy sector and technological issues – part of the team could specialize in specific technologies. Indeed, the team will need to have a capacity to build a quality technical dialogue with a project developer, supervise the technical and regulatory engineering of the project (particularly during the decisive construction phase), develop the investment as much as possible, by benefiting, if possible, from experience in project financing for the financial and legal aspects. Yet even in developed countries it is hard to come by individuals with such versatility, particularly due to the fledgling nature of both the sector and the teams that have been set up.4 In clean energy, the “first teams” are often sector experts that have no experience as equity investors, while experienced teams enjoy expertise in private equity investment, but lack sectoral skills. It is consequently advisable to count on the complementary nature of profiles, while ensuring that there is cohesion among teams. Advisors could also support the team. If they are formally put together as a committee, this will be seen favorably by investors, especially if the fund receives support from academic and/or political personalities with sound knowledge of the sector, institutional contacts and a capacity to anticipate strategic and regulatory changes.
Balancing the investment strategy
As with any fund, it is recommended to implement diversification ratios imposing limits by country, sector, etc. The balance of a specialized clean energy fund's investment strategy is particularly important as its sectoral targeting heightens the risk of concentration. A fund that is exclusively dedicated to renewable energy generation projects will be exposed to the same types of risk on its entire portfolio. These risks will be much greater in emerging countries (risks relating to construction, duration, raw material price increases, credit risk on the off taker, etc). However, a fund specialized in clean energy can adopt a diversified strategy based on both power generation projects – which, moreover, can be acquired at different development stages in order to provide vintage diversification– and by acquiring companies that provide products and services to the renewable energies sector. Funds can also diversify by investing in both renewable energy projects and acquiring companies in the energy efficiency sector. The return periods will consequently differ within the same vehicle (Figure 1).
Exit strategies
Finally, the question is raised of how to optimally manage the sale of the portfolio of clean energy funds in emerging countries where there is less liquidity than elsewhere. Some initial public offerings have been successfully conducted, such as, for example, the one made by China Longyuan Power in 2009 in Hong-Kong. This wind power producer raised USD 2.2 billion on the Hong-Kong Stock Exchange. It is also possible to group power generation projects together and list them on the stock exchange.5 However, the possibility of listing the entire fund would today seem quite unrealistic, despite a slight recovery on markets. Few funds are listed, with the exception of a few major funds specialized in infrastructure. Exit routes for most clean energy funds will consequently consist in trade sales. The renewed increase observed6 in the volume and number of acquisitions is a promising sign in this direction. The international financial environment continues to be uncertain and managers will consequently need to ensure they structure their deals in the best possible manner – particularly through put options if the financial surface gives a certain value to this option – and build and maintain contacts with strategic investors, especially production and distribution companies working in conventional energy. The latter have a financial capacity to purchase assets in the renewable energy sector, thus contributing to gradually “decarbonating” their activity. Private capital provision already plays (and will increasingly play) a major role in implementing efficient and low carbon energy structures in emerging and developing countries. Investors seeking to develop their exposure in the clean energy sector in areas experiencing strong growth could overhaul their analytical tools by paying specific attention to four risk areas: critical fund size, team expertise and investment and exit strategies. If, at the same time, managers implement human, legal and financial mechanisms capable of mitigating these risks, then developing and emerging countries should fully enjoy a favorable context for projects and investments to be scaled up in clean energies.
1 That year, Brazilian Renewable Energy (ethanol production and distribution) raised USD 200 million and Yingli Green Energy (photovoltaic panel manufacturing and distribution) mobilized USD 118 million.
2 These amounts include amounts invested in equity, stock markets, asset financing, mergers-acquisitions and carbon markets.
3 On these points, read the articles by Éric J.F. Francoz, Duncan Ritchie and the article by Philippine de T'Serclaes and Cédric Philibert in this issue of Private Sector and Development.
4 In 2007 and 2008, 27% of infrastructure funds were raised by “first teams” and 42% by managers that had not previously invested in infrastructure (EMPEA, 2010). One can reasonably estimate that this trend applies to emerging countries and clean energy funds.
5 The example of the initial public offering made by the company Greenko, presented in the article by Jean-Pascal Tranié and Vivek Tandon in this issue of Private Sector and Development illustrates this strategy well. 6 In India, Green Infra, an electricity producer held by the IDFC fund, acquired three wind farms with a total capacity of 100 megawatts (MW) from BP Energy India in September 2009 for almost USD 75 million. Moreover, in October 2009, the BTG Pactual fund invested some USD 170 million in ERSA, a Brazilian hydropower producer, whose total project portfolio capacity tops the 500 MW mark.
The term clean energy or “low carbon” covers power generation (electricity, heat…) using renewable sources, as well as energy efficiency.
Renewable energy is produced using wind, solar, hydro, tidal, geothermal or biomass energies. Renewable energy projects account for 80% of global investments in the clean energy sector (Bloomberg, 2010b). Energy efficiency refers to the relationship between energy generated by a system for a specific purpose and the energy consumed. Measures that increase energy efficiency include reducing line losses on electricity grids, thermal insulation in buildings and optimizing energy consumption in industrial processes. The term clean technologies (clean tech) covers all technologies that make it possible to replace or improve materials, products or processes while reducing the environmental impact, particularly in terms of greenhouse gas emissions. Although the main input is from clean energy, it does cover other sectors, such as environmental services.
References
Bloomberg, 2010a. Bloomberg New Energy Finance Summit – Results Book 2010, Bloomberg, Londres / Bloomberg, 2010b. Bloomberg New Energy Finance Summit – Fact Book 2010, Bloomberg, London / Bloomberg, 2010c. Bloomberg New Energy Finance Summit – Clean Energy League Tables, Bloomberg, London / Cambridge Associates, 2010. PE Returns in the Emerging Markets reality vs wishful thinking, IFC/EMPEA 12 Global PE Conference, document de travail /Carmody, J., Ricthie, D., 2007. Investing in Clean Energy and Low Carbon Alternatives in Asia, BAD, report. /EMPEA, 2010. Cleantech, EMPEA Insight, april. Preqin, 2009. The 2009 Preqin Private Equity Cleantech Review, report /Preqin, 2010. Preqin Special Report: Private Equity Cleantech, april.
