...And a check in on clean energy’s “efficient frontier”
By: David Riester
Introduction
A couple things I enjoy: 1. putting things into broader context and 2. comparing the relative risk-adjusted return prospects of different investment opportunities. This short piece does both, first from the perch of a capital markets participant and then from that of a developer. The result is a sort of “menu” style landscape of different investments one can make into the clean energy sector writ large, organized and arranged according to an integrated developer’s organizational structure. I did it this way because I find many providers of energy infrastructure capital are a bit naïve with respect to i) what a “platform” is, ii) where the actual assets sit, and iii) the pros and cons of capitalizing development at different “levels” of a traditionally structured integrated developer/IPP.
Certain instincts, default behavior, and knowledge gaps in the capital markets also result in substantial inefficiencies across the proverbial “menu”. To stick with the metaphor a moment longer: it’s a menu where the prices bear little discernible relationship to what you’re getting. Some entrées are wildly overpriced; others are a steal – and the kitchen has no idea which is which. Many energy “entrees” (investments or investment products) are over-served and mispriced to the negative, and others underserved and mispriced to the positive. I’m unendingly fascinated by the stubbornness of the market inefficiencies in clean energy. We’re 20 years in and the market dislocation relentlessly persists! This is good news for opportunistic investors, but makes for a clunky, disjointed market. With that in mind, I thought it might be useful to offer some (very subjective) perspective on the relative risk-adjusted-returns – in today’s market – of different items on the menu. The “efficient frontier” serves as a great backdrop for this discussion, so I’ve updated this previously used framework to compare/contrast different investment types one finds in clean energy.
Finally, I’ll present a view of the same landscape through the eyes of a developer seeking capital. Segue spends a lot of time with power plant developers who are trying to figure out what, exactly, their options are for raising development capital. The market for development capital is thin, fluid, and inherently difficult to understand. 6+ years ago I attempted to set the scene in a white paper. The reader may have noticed that just a couple things have changed and evolved in the period since then. So, though the basic skeleton of development capital options remains superficially intact, the market for development capital remains as confounding as ever. When we are approached by a developer looking for development capital, most are understandably rather adrift and confused. Many believe they have options which they do not, in fact, have; and still others miss those options they do have. Options available for late-stage projects aren’t necessarily available in the early stages, and often the “tight frame” that comes with a narrow focus on loans/debt misses equity possibilities. It is legitimately complicated.
The Investor Menu
Not all developers are set up the same, but the structure diagram on the left shows a fairly typical organizational structure for a developer, specifically one with aspirations to “become an IPP” (or already do have an operating portfolio). The “Topco” – or “Platform,” if you insist1 – is where the employees, IP, and enterprise value (if applicable) sit. One level below is usually an entity where development stage projects (the “pipeline”) sit, shown here as “DevCo”. Underneath DevCo are the project SPVs which hold individual future power plant assets. If/where operating power plant ownership is retained, those same SPVs are usually moved into some sort of “OpCo”. So: there are four “levels” that we really care about in the context of capital investments (from top to bottom): 1. TopCo, 2. DevCo, 3. OpCo, and 4. Individual Projects.
Without turning this into a marketing piece, I’ll briefly note that Segue mostly operates at the DevCo level; or sometimes a subsidiary right underneath the pipeline entity that “ring-fences” a portion of the pipeline. This structure is a function of our team’s strengths/experience, our capital pool, and our market convictions.
There’s also an opportunistic, special situation component to our strategy, where we invest into bespoke nooks and crannies that require a nimble party who is comfortable underwriting weird situations or uncommon risks. This manifests itself in a bunch of different investment structures plugged into half a dozen different spots scattered about the company/pipeline/project landscape. Examples of these opportunistic one/two-offs are highlighted in the blue-outlined boxes (equity-during-construction, TE “pref” step up deals). If there is a common thread through this category of Segue deals, it’s usually that something “broke” (a deal, a Plan A) and the “fix” requires a nimble, rangy group that’s comfortable across geographies/technologies and can roll up their sleeves and close quickly. A byproduct of this special situations portfolio is that we “see” a wide swath of the investments on this proverbial “menu”.
Risk-Adjusted Returns & The “Efficient Frontier”
To begin, let’s start with the basics:
1. Expected return and risk should be inextricably linked.
2. The riskier an investment, the higher the expected return ought to be.
3. Risk is mostly subjective; one cannot quantitatively determine risk, and reasonable people can disagree.
4. The more “efficient” a market is, the more likely it is that people assess risk (or the appropriate return for that risk) similarly.
The institutional investment community uses something called “the efficient frontier” to illustrate these concepts. The renewable energy industry would be well served to familiarize itself with the concept. Here’s an example of an illustrative efficient frontier for major investment categories.
The Efficient Frontier – Traditional “Asset Classes"
The blue line represents the best you can do in an efficient market – anything below and to the right is achievable, anything above or to the left is not.
So what do hedge funds and commodities have to do with renewable energy? Well, for starters the chasm of differences between i) an investment in treasury bonds and ii) an investment in emerging markets equity, is no wider than the same gap between, say, i) long term project recourse debt, and ii) greenfield project development capital. The same framework can be useful to understand capital types and costs in the energy sector.
In the following image, I’ve color coded all the investment options by their relative attractiveness – to a potential capital provider/allocator - from a risk-adjusted-return perspective. It should go without saying this is extremely subjective.
For the avoidance of confusion, that is not the relative attractiveness to a capital-taker or asset seller, it is the view from the capital side.
Plot out all types of renewable energy investments on the same frontier, and it might look something like this:
The Efficient Frontier – Clean Energy Sector Investments
A Few Menu Items Worth Highlighting
The appendix walks through every box/dot, but three are worth pulling forward, because they come up in nearly every conversation we have with developers – and because the capital market gets them so consistently wrong.
Development Equity. This is most of what Segue does, so I’ll be brief and try not to turn it into a brochure. We inject capital into a Holdco that contains the specific projects we believe are worthy of support; there’s a distribution waterfall; the developer drives development while we give them room to cook and help where we can be useful. If the projects all die, we lose big. If the entire portfolio makes it and sells at good valuations, we get an awesome return and the developers can head to Tahiti. Pursuing any single portfolio is, arguably, irresponsible given the risk of complete capital loss – but capitalized in the context of a portfolio with many such uncorrelated risks, it’s entirely rational. In a sense, Segue does what an insurance company does: rendering an otherwise unpalatable risk palatable by bringing the Portfolio Effect into…um…effect.
Back-and-Build. Companies capitalized by infrastructure private equity, where one transaction funds the platform, funds development across the assets, builds what gets developed, and eventually sells whatever operating projects, pipeline, or enterprise value the market values after 4-7 years. One waterfall splits value between the fund and the management team, blind to the source of that value – simple, with very good alignment. The catch: it’s capex-heavy, so only proven groups secure commitments this large, and the investor’s looming need for liquidity can create execution pressure. I find it a relatively interesting avenue in the current market; confident, convicted firms can earn premium project returns by putting money behind their conviction, and the structure suits fast-evolving (or transitioning) markets well. It’s a good structure for this moment…for both investors and developers. A developer with a fairly-priced Back-and-build offer would, in most instances, be wise to take it.
Platform Buyout. About once every seven years there’s a 1-2 year stretch where “platforms” are deemed to have real value (2011-2013; late 2020 to early 2022). These are bad odds for an investor looking to time this perfectly. From a developer’s seat, it is pathologically insane to orient your business strategy around “catching” one of these brief windows and assuming you’ll have the good fortune to land a (usually misguided) buyout. Our brains latch onto the envy-laden image of another developer’s (or investor’s) big exit, and the positive data points are wildly overrepresented in the outlets where we get our news – nobody writes the boring article about the shingle-hanger who petered out when the business traction never came. Take Intersect, for example: I and most founders/CEOs I know are jealous as all hell. We crack jokes about how their business model drifted from one shiny object to the other until they practically stumbled into perfect market positioning, but that’s ego coping with envy. Had Intersect bungled it, people like me would have briefly banked a “told you so” and moved on with limited internalization of the “lesson” to be learned. So folks chase glory, usually at the expense of developing a few really good hard assets and turning a profit at a smaller (yet still life-changing) scale. My read (an amalgamation of accumulated anecdotal evidence) is that the industry-wide track record on platform buyouts is very, very bad once you isolate the premium paid for enterprise value against realized enterprise value. And the odds of a developer converting “platform value” into cash are extremely low.
Developer Perspective
Most of the discussion up to this point has focused on the perspective of capital providers. The view looks much different from the developer’s seat.
First, not all developers are the same. The biggest differentiators are i) size, and ii) level of vertical integration. There are a few different archetypes across those axes. There’s the Behemoth: a large, vertically integrated (EPC, O&M, Development, Finance, Operations, M&A) shop. There’s the large Developer/IPPs who outsource EPC and O&M. Moving down to medium-scale shops there’s the “Established Developer” (which is usually a current, or aspiring, IPP). There are the “Backed and Building”: those developers capitalized by the Back-and-build structure described in the appendix. On the smaller/newer/less-established end of the spectrum lies the fattest part of the bell curve – the lion’s share of the industry by count – “Emerging Developers” who are i) more likely to develop-and-flip, and ii) have a smaller asset base.
Retained Equity (a.k.a. “becoming an IPP”). Clearly one of the defining traits of a developer is whether it owns and operates power plants, so I want to highlight “Retained Equity” as called out in the previous two images. Any developer’s capital provider(s) needs clarity, intention, and discipline with respect to this defining choice. Owning operating assets (forfeiting sale opportunities) requires (forgoes) heaps of liquidity. The argument for retaining ownership of operating projects is usually that it ultimately results in i) a larger and more stable balance sheet and ii) recurring cashflows. As such, the matter is closely associated with platform value and the elusive platform sale. When the market pays for platform value it’s almost always a company with an operating-portfolio foundation that supports acquirer’s downside scenario underwriting – and acquisitions get done when investment committees have a downside to grab onto. Developers – and any equity capital partners they may have - know this pattern, and many respond by aggressively trying to “become an IPP”. With apologies to those who’ve heard me bloviate on this already: I think this path is over-pursued. Most companies oriented to this goal carry an effective corporate discount rate of 20-40%. The opportunity cost of retaining an asset you could sell at ~8-10% when your cost of capital is 32% is devastating. Sure, it occasionally works – the company raises corporate debt (never equity, naturally) that bridges it across the liquidity desert long enough to accrue an operating portfolio and unlock a juicy sale. (That all assumes, of course, that the developer proves capable of effectively operating the projects such that they generate distributable cash, which is not even a remotely safe assumption). But here too one needs to be aware of their biases: the became-an-IPP success stories are highly visible, while the cases where the same pursuit slowly tanks a business fall under the radar. Factor in the probabilities and trying to “become an IPP” reveals itself as one of the most unattractive investment (or capital allocation) decisions in the industry.
Focusing on Emerging Developers who are not actively trying to retain operating projects – the universe with which Segue usually partners – what development capital options are available? If we flip the “Investor Menu” graphic from earlier and make it into a “Developer Menu” for firms with a growing-but-unestablished balance sheet, it looks something like this:
The options are clearly fewer; and if, in practice, any Emerging Developer enjoys all four of these options for development capital, they should consider themselves extremely fortunate. “Topco” venture-like funding is awfully difficult to come by, and for good reasons (expanded upon in the Appendix). “Back and Build” deals are similarly tough to secure, requiring especially seasoned management teams find a private equity firm that is looking for the specific development/build/own variation on offer. An early project sale is no sure thing in this market…regardless of price/terms. And, finally, for every transaction Segue closes, there are 15-20 we pass on. It’s tough out there.
Why isn’t portfolio or corporate debt on here? Well, I’m talking about developers whose pipelines are either too thin or too unseasoned to secure one of those loan options. I expand on this in the Appendix.
The takeaway: be realistic about what kind of capital you can raise given who you are and what you have. For example, we talk to a lot of groups who want to raise $50-100m of flexible capital available for development, SG&A, and maybe even retained project ownership. That’s a mighty big Back-and-build ask coming out of the gate; we rarely fault anyone for having the self-belief and vision necessary to go to market with an ask like this; however, if the market “speaks” – you aren’t getting any takers – listen to it and adjust accordingly. Some emerging developers need to jog before they run, and the capital markets express that opinion by extending smaller initial commitments with more investor control. You might disagree with this feedback, but at some point you do need to listen to it, or risk stubbornly drifting around the market while your development thesis gets stale and capital providers tire of the bid/ask spread. A great way to prove them wrong is to take the best option available, focus on execution, crush it, and then go pursue the bigger capitalization you initially sought. Most investors will be quite pleased to participate in that success, acknowledge a “you told me so”, and get in line for the next pitch. Achieving that toehold of early development success usually opens up the other, less expensive pools of capital discussed above.
Closing Thoughts
As the energy transition battles through perhaps its fiercest headwinds ever, the market is bigger, more complex, and more inefficient than ever. The evolving regulatory landscape, increased development timelines & costs, larger projects, shifting community solar markets, and changing technology all leave investors with a lot to sort through on the quest to allocate capital wisely. Meanwhile, developers – as always – must take on the unenviable task of capitalizing the development process responsibly; which, despite years of market maturation, is barely easier today than it was 20 years ago. Hopefully, seeing different investment types in the context of a developer’s corporate structure offers a useful way to think about the “menu” of investment options. And, as always, putting capital costs (returns) and risks in context with each other provides a snapshot of where market opportunity lies and/or reasonably priced capital is available.
Appendix
(Reminder that the comments here are calibrated to the capital provider’s perspective)
Corporate Loan – Essentially senior secured loans that benefit from all assets in the ecosystem, and any enterprise value that might emerge. I have this coded orange (“uncompelling”) because in the current re-stabilizing market, there is high risk of developer failure, and usually the interest rates on these loans do not fairly compensate the investor given the non-trivial possibility of bankruptcy. Much of this capital usually goes toward SG&A and the pursuit of growth, which should be funded with equity capital. However, renewable energy developers are obsessed with keeping their equity and extremely reticent to raise dilutive equity capital (more on this below).
Corporate Preferred Equity – This is not as common as senior secured debt, but many larger developers have done “pref equity” deals over the last decade. Investors get higher returns here but usually sit behind a senior lender.
Venture Style Raise – Back in the 2000’s, venture capital firms became very confused and misunderstood solar developers to be technology companies with exponential growth potential, which resulted in a couple dozen platform investments in plain old developers. This was a strange phase, and it produced very poor returns for the VC investors2. Understandably, a long capital dry spell for VC-style developer equity investments followed. “Back and Build” (see below) structures largely backfilled over the last 10-15 years, which is a rational market response. It’s worth noting that the market for relatively plain vanilla, common equity investments in development platforms has come back a little bit. Most of the capital demand comes from impact-oriented family offices, or savvier climatetech VCs that actually understand the risk-return profile of a developer and therefore come at these opportunities clear-eyed. None of this surprises me. What does surprise me, however, is that the developer community (broadly speaking; I’m generalizing) doesn’t seem very interested in pursuing this path. My intuition is that this arises from developers’ overestimation of their “platform value” potential, and a systemic obsession with avoiding dilution. Why would you give away some of your equity when you can fund your business with debt and keep all your upside? Well, I don’t consider that a rhetorical question – I consider it one with very good answers. 1. Increasingly, you can’t, in fact, fund your business with debt when you have virtually no asset base, or an asset base that’s particularly difficult to value with the approaching post-ITC epoch. And 2. Because debt is the wrong instrument when the risk of default is material - which it is for many developers. The risks a small/medium sized developer is asking a capital provider to take are often equity risks, not debt risks. It’s generally a bad idea to try and jam debt products into such a situation with equity risks.
From the investor’s point of view, assuming a pre-money valuation is appropriately humble: where a developer has i) first rate management team, ii) right-sized SG&A, iii) right-sized growth ambitions, iv) a critical mass of quality projects, and v) a willingness to raise equity, I think the risk-adjusted-return prospects are potentially interesting. However, listing those 5 things is very different from underwriting/confirming those 5 things, so I give the overall menu item an average/moderate mark.
Platform Buyout – Covered above.
Retained Equity – Covered above.
Back-and-build – Covered above.
Portfolio Development Loan – These are the pipeline level, cross collateralized loans. This is usually only an option where there is a critical mass of anchor late-stage projects that can be underwritten as downside protectors. My personal opinion is that, in the current market, most of these loans are mispriced on the low side, and do not represent very compelling risk-adjusted returns. Let’s face it: the risk of project attrition and/or compressed margins is currently elevated. Project margins are harder to predict in general. Timelines too. Most of these loans have real risk of some capital loss, with best case returns in the 10-15% IRR range. I don’t find that risk-adjusted-return proposition very compelling, and the turnover of capital providers in this market segment suggests it may not be sustainable. The other side of this opinion: if a developer can get a high-priced loan for development capital/risk, they’d usually be wise to take it. When we’re thinking about capitalizing a development portfolio and our would-be partner says they have a non-recourse 12% loan offer, I usually encourage the party to focus on that option. They usually call us back ~4 weeks later.
Development Equity – Covered above.
Backleverage Portfolio Loan – Debt at the portfolio level that primarily underwrites diversified cashflow as opposed to hard asset collateral. These notes are usually subordinated behind tax equity investors. I consider this capital appropriately priced at present.
Portfolio M&A/Project M&A – The trials and tribulations of the last year have left countless “platforms” in dire straits. Many of those companies are for sale full “platform” offerings. I think this is rather aspirational, even naïve. The energy transition will carry on, and many companies will find success, but how/when/who is as hard to predict right now as it ever has been. That makes it extraordinarily uncomfortable for an acquirer to buy a company. Having said that, there are some fantastic “getable” portfolios/pipelines in the market right now. By taking a moderate amount of risk, a buyer can get a very nice mix of late/mid/early-stage projects (with diversified PIS dates) at a very good price. A lot of these potential deals aren’t closing because the would-be buyers are getting paralyzed by the breadth of opportunities and are letting many wonderful opportunities pass them by for fear of missing the perfect opportunity (or getting the absolute bottom dollar valuation). Buyers seem to think any acquisition should be a “free option” deal in the current market (a deal where almost no money changes hands up front, the “buyer” takes the project deposits over, and if the project reaches NTP a discounted price will be paid to the seller). That’s a bit of a misread on the depth of market distress. No doubt, valuations should be a bit lower than 5 years ago, and perhaps payment terms ought to be a bit more backloaded. But there’s an overcorrection happening right now, and that’s got the market a little stuck in a wide bid-ask spread. As a buyer, Segue is finding spots to take advantage of that, purchasing quality mid/late stage assets at deflated prices and buyer-friendly terms…. but not pennies on the dollar or “free option” cram-down deals. Perfection gets in the way of progress. Too many opportunities die of FOMPWGWDJF: Fear Of Missing Perfect When Great Will Do Just Fine.
YieldCo – Simply large publicly or privately held dividend yielding portfolios of operating power plants. The difference between a YieldCo and an IPP is that a YieldCo is more of a “pure-play” asset ownership strategy. Technically, they purchase operating power plants, but spiritually they buy cashflow streams. Some may recall that YieldCos had quite a moment circa 2013-2017, and then the air came out of the bubble. I don’t have a strong opinion about the current valuations of public YieldCo’s. Their implied annual yield (around 10-12% last I checked) appears attractive on the surface, but this is a bit of a mirage. With time, all YieldCo’s seem to experience NAV decay and ever-compressing dividend yields due to the fundamental constraints of the business model, which call for ongoing investment in new projects (to shore up degrading/depreciating asset base) which, in turn, cannibalizes cashflow. Tack on the overhead required to keep this machine humming, and it simply does not remain a 10%-yielding asset for long. That said, in the market phase to come, I think the notion of forming new YieldCos deserves open-mindedness. The opportunities available to YieldCos increase substantially in a post ITC world (cashflows fatten without preferred tax equity distributions and the barriers to entry associated with tax equity structure complexity fall away). If power prices continue their upward slope, the NAV/CAFD erosion problem might also soften. Though a bit of an afterthought these days, perhaps we’ll see a swing back toward YieldCos in the years to come.
Construction Loans – I’ve labeled this as leaning uncompelling, mostly because the ratio of [bandwidth + risk]:[margin + fees] is uninteresting to me. They are short term loans, a heavy DD/document lift, and of course “you can’t eat IRR”. I can think of lower risk ways to get 6-7% IRRs and 1.08 MOICs. But I’m surely grateful for the large universe of banks, insurance, and private credit funds who roll up their sleeves and get these loans done. And the business model would appear to work given that the construction lender community has been comparably stable.
TEBL – Some of the same comments apply here, as the time horizon, DD/documentation lift, and return profile are very similar to construction loans. That said, I like this investment marginally better, simply because the liquidity of the transferable tax credit market is quite strong right now, which makes the underwriting a little more straightforward, and the security agreement simpler.
Pref “Step Up” – A lot of capital was raised around this product, which has compressed pricing/terms to very competitive levels. That said, the risk profile for the step-up party is quite low, and there is some dislocation and inconsistency in this market (juicier returns can be found). Segue has done a couple of these where the project(s)/circumstances are quirky, or the check too small for many, offering an opportunity for returns that are sufficiently compelling.
Construction Equity – Usually the construction equity for a project is provided by either i) the developer, or ii) the party planning to own/operate the project after COD (which is sometimes the same party). Occasionally, a developer wants to sell the project post COD and is interested in raising 2nd-lien capital to get there. Or, a more exotic set of circumstances: a developer could retain ownership of a project without needing to leave much equity in the COD capital stack, but the construction/TEBL lender has a minimum equity during construction requirement that exceeds the equity needed in the “permanent” capital stack. If the developer can get to that COD capital stack, they would likely enjoy outrageously good levered IRRs going forward. But how to get there? Well, we’ve also done a couple of these at Segue, where we sit second in the construction capital stack, underwrite EPC/PF execution, and get taken out at COD (from some combination of perm loan or tax credit purchase proceeds). They are usually small checks, short-term investments, a quirky underwrite, and rather rare. By now you might be able to guess that Segue likes this niche.
Permanent Senior Debt (Operating Projects) – There were a few years where the combination of low interest rates and absurdly tight spreads rendered this a deeply uninteresting risk-adjusted return, but both rates and spreads have lifted to a point where I think most of these operating phase loans are just about properly priced. An overcorrection has occurred in the storage sector, where a tough run for ERCOT batteries has caused the lending community to become very, very skittish about merchant storage, even when the ERCOT experience bears no resemblance to the project in question. One can forgive credit committees for a “no nonsense” reaction to the ERCOT NPLs. Yet…I think this debt market would be safe in reverting a little towards rational, math-based landing spots.
Tax Equity – Tax equity always has – and always will be – the best risk-adjusted return in the entire market. If you are a C-Corp that has i) tax appetite, ii) cash, and iii) an active tax management strategy, this is the best item on the menu. The risk is extremely low. Tax attorneys’ livelihoods depend on convincing you otherwise, but the data tells a different story: capital loss on tax investments is very nearly unheard of. The IRRs are phenomenal, the MOICs not-so-much. But with the relatively liquid and increasingly efficient tax credit purchase/sale market, capital can be recycled with enough efficiency to make up for the humble multiples.
