Finding Development Capital
It has never been easy for smaller developers to raise the large sums of capital needed to develop a project. For many, the game is to push the project as close to construction as possible before selling. Projects build value as they pass certain milestones along the development path. The slope of the value curve steepens, indicating that value is building more quickly the closer the project gets to the start of construction.
The following is an edited transcript of a discussion among three investors who are potential sources of development capital. The conversation took place by phone as part of an Infocast webinar in the fall. The panelists are Scott Gardner, managing director with US Renewables Group, a private equity firm that manages funds focused on renewable energy, biofuels and other types of clean energy infrastructure, Patrick Eilers, managing director of Madison Dearborn, a fund manager that manages numerous funds, including one that has invested about $2 billion to date in the energy sector, and Ricardo Diaz, executive director with Grupo Santander, the investment banking arm of Banco Santander in Madrid, which has made a decision recently to start investing development capital in projects in the United States. The moderator is Keith Martin with Chadbourne in Washington.
MR. MARTIN: Scott Gardner, does US Renewables Group provide capital to developers and, if so, do you do it on a project basis or are you only interested in acquiring interests in companies with portfolios of projects?
MR. GARDNER: We do both. There have been instances where we will invest in a one-off project or in platform companies that focus in a particular sector, such as solar thermal or geothermal.
MR. MARTIN: Pat Eilers, does Madison Dearborn do both?
MR. EILERS: Yes, although our strong preference is to invest at the holding company or corporate level and then try to build out projects and, as the projects are built out, finance them at the project level, typically investing the appropriate amount of equity in the project itself.
MR. MARTIN: Ricardo Diaz, I believe Grupo Santander is more focused on projects, or is it like Madison Dearborn, you want a company?
MR. DIAZ: We are interested mainly in solar and wind and we invest on a project-by-project basis. We do not usually invest in companies. What we do is to create portfolios out of individual projects.
MR. MARTIN: Scott Gardner, how do you structure your participation if you are investing in a single project? Is it a loan, is it equity, is it warrants plus a loan? How does it work?
MR. GARDNER: There is more than one answer to that. While we don’t often do one-off projects, we will do them if they have sufficient scale or there is a sufficient risk-reward profile. If we get involved in the development stage, we usually make a loan that is convertible, at closing of the construction financing, into equity in the project company that is developing the project. The idea is that if the project has issues or misses milestones, there would be triggers in the loan that would allow us to take control or, if the project has failed, to cause the company to liquidate and get what it can for the development assets.
MR. MARTIN: Conversion occurs when you start construction. How large an equity interest do you take at that point? How do you calculate your ownership interest?
MR. GARDNER: On a one-off project, we usually seek a controlling investment. We agree to provide 100% of the equity the project company requires, comprised of our development capital plus new capital. However, there is usually some uncertainty about how the negotiation will play out with lenders, so we make a commitment for a not-to-exceed number based on what should be a reasonable amount of debt on the project. For example, if the project costs $100 million and we think, with conservative coverage ratios, the project can achieve 70% leverage, then we would make an equity commitment not to exceed $30 million. The reality is that our actual equity investment is a negotiation with the banks and also depends on how firm a price is being quoted by the construction contractor.
MR. MARTIN: So you will supply all of the equity up to a cap. What is the developer left with? Does it have a carried interest? What percentage of the project does it retain?
MR. GARDNER: The developer’s compensation has three components. These are reimbursement of development expenditures, a development fee at construction closing and a carried interest. The first two amounts are built into the capital budget. The proposed development fee may end up being further negotiated with the lenders. The carried interest is a right to a portion of equity distributions, back-ended after the equity investor earns back its capital, plus a preferred return.
MR. MARTIN: So the back-ended carried interest would be what percentage? What is typical: 20%, 30%, 5%?
MR. GARDNER: In a typical project, 100% of distributable cash flow would go to the equity investors until they have been returned all of their capital plus a pre-tax 12% to 15% return, at which point the distributions shift to something like 90% to the equity investors and 10% to the developer. After another return threshold is reached, say 25%, then anywhere from 20% to 50% of the cash flow might go to the developer, depending on the value of the project. The initial return threshold is usually projected to be reached in something like seven years after the project is completed, but it varies.
MR. MARTIN: Last question — and let me bring Ricardo Diaz into this — what is a typical developer fee as a percentage of total project cost?
MR. DIAZ: It depends on the technology. However, typical numbers we have seen in the market are between 10% and 15%.
MR. MARTIN: Scott Gardner, let me get your answer as well.
MR. GARDNER: It is a really hard question to answer. I agree that it depends on the sector. We have seen formulaic approaches that are more like two times or three times the invested development capital. For example, if the developer put $2 million during the development stage into the project, then his fee might be $4 to $6 million, in addition to the reimbursement of the $2 million at closing. Also, sometimes a portion of the development fee is made contingent on reaching further milestones — for example, commercial operation of the project.
MR. MARTIN: Ricardo Diaz, Banco Santander prefers to invest in individual projects. Is that investment a loan, an equity investment or some combination?
MR. DIAZ: We are flexible. We can buy 100% of the development rights. If the developer is only interested in selling the project when it is ready to start construction, we can provide capital with an option to buy then. If the investor wants to keep the project, we can invest between 50% and 100% of the equity.
MR. MARTIN: So you are willing to leave the developer in and just take a percentage interest?
MR. DIAZ: If the developer has the financial strength to invest equity, we do not need to be the only investor in the project. We can share that, as long as we have the control over the investment. So we can invest anywhere between 50% and 100% of the equity, but we need a controlling interest.
How Early Stage?
MR. MARTIN: Scott Gardner, going back to you, how far along must the project be in the development cycle before you have an interest in it?
MR. GARDNER: It depends. When we invest in portfolio companies, they usually have a series of projects, some fairly early stage, so we have to have patience as to when we might have the opportunity to invest project equity. In one-off projects, we like to wait until most of the off-take and resource arrangements have been worked out. We are looking to invest equity at the start of construction, but there have been cases when we invest earlier because there is competition for a good project, or a particularly attractive risk-reward profile.
MR. MARTIN: Is it fair to say that you will not usually invest in a power project until the developer has signed a power contract?
MR. GARDNER: I actually think it’s a little different in today’s market. It used to be that signing a power contract was the Holy Grail of having achieved a meaningful milestone, but today I think it is all about the resource in the renewable sector. It is about getting the wind site or the scarce turbine slots or, in geothermal, it is about having proven the resource through drilling or, in waste to energy, it is about locking in a supply of waste fuel. The feedstock or resource is the key asset. We tend to believe that once that piece is in place, there is so much demand for renewable power expressed through renewable portfolio standards, that a well-structured project with the right resource can be expected to get an offtake agreement.
MR. MARTIN: How large a project must it be in terms of capital cost to be of interest?
MR. GARDNER: It will change as our fund raises more money, but at the moment, we would look at a project that requires as little as $10 million in equity. That might mean a project as small as $30 million in total capital cost, on the assumption that two-thirds of the project cost will be financed by borrowing. As we grow the firm, our minimum deal size will increase, probably more in the $25 to $50 million range for the equity component.
MR. MARTIN: Ricardo Diaz, if you invest in a single project, how far along must it be in the development process? Must it have a power contract, for example?
MR. DIAZ: We look for a project in an advanced stage of development, meaning the project must have secured land, have a power purchase agreement with a creditworthy offtaker and have secured acceptable interconnection arrangements so that the project can move its electricity to the grid. Those are the main three things we look at. Other stuff like environmental licenses or construction permits do not need to be in place for us to start investing.
MR. MARTIN: That’s very interesting. You are focused on the offtake arrangements and the ability to get the product to market, while Scott Gardner is focused on whether there is a strong enough resource. Ricardo Diaz, how large must the project be before you will look at it?
MR. DIAZ: The minimum equity required must be between $5 and $10 million, which translates into a total project cost of $20 to $50 million.
MR. MARTIN: So you are assuming greater leverage of four to five times equity.
MR. DIAZ: We are used to leverage of 80% or 85% in European wind projects. Solar power is a little less than that, perhaps 75%. In the US, there is a form of intermediate capital called tax equity that one might also treat as leverage.
MR. MARTIN: Scott Gardner, will you do a one-off project with a developer who has only one project, or must you see a pipeline of other deals?
MR. GARDNER: That’s an important question. We usually focus on developers who have an anchor project, and that becomes our initial focus, but who also have a pipeline in the works. That’s important because one of the top things that we have to evaluate when we make an investment is the management team, and often what we see is too top-heavy a company structure with too few resources devoted toward development. Good management teams are few and far between. Once you find one, particularly one with the skill set in a particular renewable sector, you don’t want to do just one project. You want to keep the relationship going with that team and do multiple projects. Our goal is usually to build that team into more of a development company and work on a series of projects.
MR. MARTIN: Scott, you and I have both been in this business a long time. I am guessing the one thing that scares you away — correct me if I’m wrong — is a team that has ambitious plans, can reel off a long list of projects that it is developing, but lacks the focus to get the first deal across the finish line. Is that the number one thing that makes you run the other way or is there something else?
MR. GARDNER: I would rather see a couple of good lead projects with work completed, rather than 10 or 15 projects that we basically would discount and not view as real. Having evaluated a lot of projects and teams, you can judge quickly whether a team has looked in the mirror and assessed its capabilities. The company may have a strong and charismatic leader, but the leader has not surrounded himself or herself with people who have been through a project financing and someone else who has good construction management skills. You need a comprehensive and well-rounded team. That is the most important thing we look for. If a team lacks the skills to take a project all the way not only to financing but also through to COD, then that is a fatal flaw for us, unless we can bring someone in to enhance the team.
MR. MARTIN: Ricardo Diaz, where are equity yields for the two different technologies in which you are investing — wind and solar PV?
MR. DIAZ: We look for a long-term IRR for an investor over the life of the deal in the mid-teens for wind and in the low teens for solar PV. However, our strategy is to plan on an exit within a year after the project is completed. The yields I mentioned are what we think a long-term investor will want. Since we are coming in at a far riskier stage during development, we would be looking for a higher return on our capital. These are pre-tax numbers.
MR. MARTIN: Let me switch gears and pull Pat Eilers into this discussion. Madison Dearborn is interested mainly in buying whole companies rather than one-off projects. Are you interested in buying less than the entire company, and if so, do you insist on a controlling interest?
MR. EILERS: We are open to both. We do the full companies as well as minority investments. In the minority investments, though, we would look for certain negative control provisions that would give us seats on the board or at least a requirement for our consent for major corporate actions.
The only thing I would connect the dots to the prior conversation is that we have a wind development company, we are looking at solar development companies and we are doing transmission, but the premise is that the company has a pipeline of good projects that will be able to attract capital, some in construction, perhaps even some already built. When we look at a corporate investment opportunity, we go down to the project level and start with the question whether the company can attract the project-level debt required to make the model work. So even though we don’t do one-off projects, we analyze individual projects to decide whether we want to invest at the corporate level.
MR. MARTIN: Your wind company, First Wind, is what I would call mid-tier. I am guessing that if that is the model, then you are not keen on true start-up companies, ones that may have just emerged from venture capital. Is that fair?
MR. EILERS: It depends on whether we can get comfortable. We look at companies that have no operating assets, but if the anchor project has the right components in place, such as a power purchase agreement, perhaps a commitment from the US Department of Energy for a federal loan guarantee, an EPC contract with a respectable contracting firm, and the company just needs the equity, and we are convinced that the company can build on time and on budget and get the performance it expects out of the asset, then we consider those types of opportunities as well.
MR. MARTIN: If you buy the company, how is the ongoing development pipeline funded? Do you fund it through capital contributions or is the company in the same boat as before, having to seek other capital?
MR. EILERS: No, we fund through capital contributions at the corporate level. If you think about how development work is done, it requires 100% equity during development. As you get to construction, you pull in the construction loan, and sometimes we are able to recycle some of the equity and, ultimately, when you get to permanent financing of the project, there will be a permanent share of equity that will remain invested at the project level. The equity that is freed up will go back into the corporation and be used to develop other projects.
Selling Part of the Company
MR. MARTIN: How do you determine the price you are prepared to pay for a company? Do you typically pay the developer something to buy an interest or do you just undertake to contribute capital to fund ongoing activities?
MR. EILERS: We will commit capital to fund a business plan, and there is always a management carry or percentage ownership that the developer retains in the company. Sometimes the developer takes out cash, but we prefer not to do that. We don’t think it aligns interests well. We prefer to see the management team have skin in the game alongside us. Sometimes we will put our capital in at the project level, as we did with the Kaheawa project that First Wind developed in Hawaii, where we invested alongside a local developer who started the project and retained an interest. We will do individual project financings, and do equity participations with local partners, just as you were discussing earlier. Madison Dearborn does it as part of what is otherwise a corporate investment opportunity.
MR. MARTIN: You addressed part of this already, but what makes a company attractive, especially a start-up that comes to you seeking financial backing?
MR. EILERS: I think a couple of things that Scott Gardner touched on as well. First, the management team is very important. Is the management team credible? Has it done this before? Is it trying to do too much, as in where the company has four different types of renewable opportunities it is pursuing. That doesn’t interest us. We are interested in a management team with realistic expectations, and then we take a close look at the project to assess the likelihood the project will be built.
MR. GARDNER: It is important to distinguish between multi-technology companies, like an independent power company that owns different projects with different technologies, and the kinds of developers and smaller companies who come to us seeking development capital. For smaller companies, a targeted focus is essential. We had somebody approach us recently about a project that was going to produce ethanol, electricity and one other product. Maybe they were also going to have wind turbines on site. That was all within one project. They felt the dispersed focus was helpful because it represents diversification. Our response was just the opposite. What it represents is multiple offtake risks. If the project relies on all of the offtake being there and all of the resource being there for the various components, if you lose one of them, then you have lost the basis for a viable project. We think in terms of the downside and what happens when things go wrong. Having more bells and whistles and more integration is a negative rather than a positive.
MR. MARTIN: Pat Eilers, most private equity funds plan to hold and then shed assets. I don’t know what your time horizon is, but many are five to seven years. What is your time horizon, and isn’t this fairly disruptive to a developer to contemplate that he will have new owners within a short time period?
MR. EILERS: We have 10-year funds with an additional three years at our own discretion to extend each fund. We have been in a five- to 10-year hold on average. We fund a company’s business plan over about a five-year period and then look ultimately to take the company public or sell down our position through secondary offerings, bringing in additional and hopefully lower-cost equity. There are times when a larger, strategic player acquires a company. That case probably goes to your point of being more disruptive from a management standpoint, but if we have done our job right, we have given the management team enough equity participation that any sense of disruption is offset by the investment returned.
MR. MARTIN: So you view yourself as providing a long landing strip like an airport for people to launch these businesses. Ten years is a long time.
MR. EILERS: That’s one way to put it.
MR. MARTIN: Scott Gardner, any other thoughts on potential disruption? What is your typical hold period?
MR. GARDNER: We look at holding for three to seven years.
We usually look to get through construction, which may be two years, and then have one to three years to stabilize the operating business, and then it’s time for us to exit and let the company replace us with cheaper capital during the lower-risk operating period.
Technologies of Interest
MR. MARTIN: Ricardo Diaz, you said Grupo Santander is interested in investing in two types of projects — wind and solar PV. Are you also interested in solar thermal?
MR. DIAZ: Yes. We have a strong pipeline of projects right now in southern Europe. We think the main market for concentrating solar power in 2010 will be Spain. We are very interested in exporting our expertise with both European industrial players and project financiers to the CSP market in the United States. The standard size for CSP could be around 50 megawatts, compared to 20 megawatts for PV. There are potential economies of scale not only in equipment cost, but also in financing.
MR. MARTIN: What about distributed solar companies, the ones that put solar panels on rooftops?
MR. DIAZ: Yes, we are interested in investing in such companies as well, as long as the size is attractive enough. Our equity investment must be a minimum of $5 to $10 million. So as long as these distributed generators set up a portfolio of different opportunities with an equity investment at least that size, we are interested. My only caveat is that we have some experience here in Europe with rooftops, and it is more difficult in such transactions to put term debt in place. If we are able to make it bankable, we are interested.
MR. MARTIN: Pat Eilers, are there other technologies besides wind, solar, geothermal and biomass that that you are watching — for example, wave, other forms of ocean energy or offshore wind? Are these technologies mature to enough to attract your attention?
MR. EILERS: Tidal energy is still too early stage for us. We are spending a lot of time on offshore wind. We have a minority interest through First Wind in a company called Deepwater, which has projects under development off Rhode Island and New York.
MR. MARTIN: Scott Gardner, are there other technologies besides the big four renewables that you think are ripe for investment?
MR. GARDNER: Yes. We have done very little in wind and solar because the project equity returns are not high enough for a private equity fund. A lot of the risks have been stamped out of those sectors. That’s a good thing for developers, because it means less risk and access to cheaper sources of capital like bank debt. That doesn’t mean that private equity funds have no role in the sector; there are still opportunities to build new companies. We have several platform companies focused on different sectors, even if for some of them, the underlying projects may not ultimately be things we invest in. They are what we call growth equity opportunities. They include a start-up geothermal developer, a waste-to-energy developer and a fairly significant investment in a biofuels company we helped found called Fulcrum BioEnergy. Fulcrum converts municipal solid waste into liquid fuels through plasma gasification and Fischer-Tropsch conversion.
MR. MARTIN: So you are willing to take risks.
MR. GARDNER: Yes, but we are past the R&D phase. In the case of something like Fulcrum, I would describe it as technology integration or scale-up risk because each of those technologies has been separately proven. Plasma gasification is used regularly to create gas in things like medical wastes. Fischer-Tropsch has been used for decades in South Africa to convert coal to liquid fuel.
MR. MARTIN: Scott Gardner, what is the best way for a developer to get in the door to make his or her case to you?
MR. GARDNER: We have a portal on our web site for people with business plans. We probably would prefer people just to contact us directly and send introductory information without a lot of volume, so we can make a judgment about whether it’s a fit. Let me give an example. I am looking at the area of waste heat recovery and industrial efficiency. It is an area that fits our mandate because it is carbon neutral. What we do in a sector like that is form a thesis around what we think is the right technology or the right approach to the business, and then we look for companies that are active in the sector. We often approach them. We are less likely to be turned on by a company who approaches us for money in a sector in which we have not already formed a thesis.
MR. MARTIN: Pat Eilers, what is the best way to get your attention at Madison Dearborn?
MR. EILERS: Go to our website and then just call us.
MR. MARTIN: Ricardo Diaz, same thing at Santander?
MR. DIAZ: We like preliminary information by e-mail, and we follow up by the phone after that