Financial Advisory Insights: Renewable Power Deal-Making in an Unwelcoming Environment
By Chris Elrod, Principal
Energy Asset Advisors, LLC
May 4, 2010
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Given the gamut of varying investor risk profiles and the current capital market environment, how we, on the one hand, ensure protection of our potential new investments in renewable power while, on the other, not preclude ourselves from transacting is a path that is tricky to tread. Indeed, the detailed dance and choreography of structuring a transaction to meet both the buyer’s objectives of eliminating risk and measuring appropriate valuation and the seller’s goals of achieving favorable payout terms and maximizing value are seemingly mutually exclusive of the other.
This dilemma is particularly challenging when considering the current glut of early-stage renewable power development projects in the U.S. A multi-faceted explanation of cause and effect has led us to this point in the renewable power asset cycle; however, the dimness of visible transactions - where buyers and sellers cannot effectually meet the other’s demands - may become illuminated by focusing on three (3) key points: niche markets, valuation & profitability and transaction structuring.
Market Niches: Where to Look
Currently, you will have no trouble finding numerous opportunities to invest in low-yielding renewable power assets. A combination of the over-supply of early-mid stage development projects on the market and the fallout in the natural gas and power markets has had a crippling effect on PPA pricing throughout the U.S., making it difficult for even the most adept players to justify investing in the renewable power business (NextEra is cutting back on renewable generation investments). Perhaps even more importantly, the dysfunctional debt capital market environment (although said to be improving) has proven to be problematic from a project finance standpoint.
Amid the turmoil in the commodities and debt capital markets, there is a way for investors to find profitable and bankable renewable power deals. While utility-scale wind and solar have lost their luster (i.e. - profitability), fragments of fundable deals still exist within those industries. On the wind side, there exists a sliver of opportunity for projects that can demonstrate on-peak power production and can thus argue for a value premium in a PPA negotiation, particularly in states with an RPS with no specific solar carve-out (a REC is a REC, right?). Solar has suffered from similar setbacks, but viable solar models still exist. Distributed generation in PJM-East, parts of NYISO and NEISO, and California, coupled with a demand-side management program that allows the solar assets to ramp-down host load and sell on-peak power to the grid, makes projects more economically enticing. The rule of thumb with biomass is to steer clear of greenfield and target the CHP and/or brownfield repowering opportunities – this will minimize capex and maximize yield potential, notwithstanding any fuel supply concerns. Many more plausible paths and ideas exist, but the pertinent market point in renewable power investing is to target an asset that sits within a robust power market (and preferably a short REC/SREC market) and optimize the asset to take advantage of power market price premiums.
Valuation: Government Subsidies versus Profitability
On the whole, U.S. renewable generation has only been as economically viable as the government-funded subsidies that support it. Moreover, investment into most renewable power projects has proven to be diametrically opposed to how we characterize and view risk premiums among the varying asset classes in modern investment philosophy. That we should be content with achieving government-funded returns (most of which are in the form of tax subsidies), which, when risk-adjusted, are significantly less when compared to similar asset allocation options, is an enigma in and of itself.
The reality is that tax subsidization of renewable power has resulted in a paradigm shift from economically viable investment philosophies to complicated, nuanced investment structures geared toward squeezing the penultimate ounce of tax value out of a renewable power project in order to justify its viability. Rather than focusing on tax-driven incentives as part of an investment strategy (NOLs, Production Tax Credits, Investment Tax Credits or Grants-in-Lieu of the Investment Tax Credits), an investor should focus simply on profitability (project-level unlevered returns are a good place to start). With this view, a proper valuation is visible to the buyer of a renewable power project and appropriate risk considerations may be assigned thereto. More importantly, as more transactions are consummated with this view in mind, it should undoubtedly create more clarity around the valuation of renewable assets in the market.
Aligning Incentives in Transactions
When you figure out a niche market and assign an asset a proper valuation, then you must determine how to best structure your acquisition of the asset. Milestone-based payouts, or “earn-outs,” as they may be more commonly called, are generally applied to assets still within their development cycle, and can be useful when trying to off-load portions of the buyer’s risk onto the seller. Milestone-based payout structures also have their drawbacks as there are many transactions that have floundered due to the insistent nature of some buyers to structure entirely too many conditions precedent and negative covenant clauses within the milestones that sellers have no way of knowing for certain whether or not they will ultimately get paid. In other words, buyers cannot expect sellers to share in all of the future risks of an asset, and as more milestones and nuances to the acquisition structure are put in place the larger the disincentive becomes for a seller.
While some degree of payment milestones are important (particularly in development deals), it is also important to recognize the value that a specific seller might bring to the table post-transaction. For instance, a seller might want to stay onboard as an asset manager, or continue to work on behalf of the new business to develop, build and operate other assets. These elements should all be taken under consideration when structuring an acquisition and the buyer should indeed include them in its offer if desired. Lastly, as buyers consider how to properly pay and incent sellers, payouts in equity, carried interests and profit shares are usually helpful. These payment structures, when used appropriately, typically allow the seller to share in any upside the asset may achieve as a direct result of the seller’s efforts and participation in the process. By aligning incentives in a transaction, a buyer will be more effective in executing a given deal.
Although the deal-making environment for renewable generation may be currently unclear to most buyers and sellers, it will certainly evolve and grow into a more liquid and transparent market. It helps to focus on unique market plays, proper valuation techniques and savvy investment structures in order to yield a successful and timely investment in renewable generation. As the market develops, there will undoubtedly be new technologies and incentives that drive demand for acquiring renewable power assets; however, by viewing the market through these specific investment lenses, you should most likely continue to successfully invest in this more often than not unsuccessful investment environment.
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