Opting for private equity or the public markets

Over the next five years, wind power capacity will increase by 146 GW, requiring investment of over EUR 180 billion ($277 billion), according to the Global Wind Energy Council. Where the money is to come from, with the world's financial markets still reeling from the US sub-prime lending crisis and the resulting credit crunch putting downward pressure on stock market prices, is the subject of much discussion in the world of wind power financing.

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Opinions are sharply divided on whether the wind development industry is best served by turning to the public markets for its finance or to the private equity sector. Meantime, utilities are moving into place on the inside track

opting for private equity or the Public markets

Over the next five years, wind power capacity will increase by 146 GW, requiring investment of over EUR 180 billion ($277 billion), according to the Global Wind Energy Council. Where the money is to come from, with the world's financial markets still reeling from the US sub-prime lending crisis and the resulting credit crunch putting downward pressure on stock market prices, is the subject of much discussion in the world of wind power financing.

By its capital intensive nature, wind project development puts huge demands on the cash flow and capital requirements. The best prices are paid for projects that are fully developed, to the point of being operational. That takes a lot of capital and puts considerable strain on the financial resources of project developers. To boost their capitalisation, developers can head for a public market listing or welcome an equity investor. Either option has its pros and cons.

Among the more high profile recent listings in the wind sector are those by Spain's Iberdrola Renovables and France-based EDF Energies Nouvelles (EDF EN), both owned by utilities. But even small developers have braved the public markets in preference to selling up, with French Theolia a recent typical example. Since Iberdrola's initial public offering (IPO) in December, however, public market investment has virtually dried up, reports New Energy Finance, an information provider based in London. It says that just $807 million (EUR 521 million) was raised in the new energy sector in the first quarter of 2008, down from $5.2 billion (EUR 3.36 billion) the previous year, though the solar sector accounted for much of that.

In the current nervous financial climate, investors are concerned that developers will not be able to build as much as had been expected. The credibility of project pipelines is paramount for keeping share prices up. It is "probably the single most crucial factor in determining whether a company can access the public markets or not," Vittorio Perona, of investment bank Dresdner Kleinwort Wasserstein, told delegates at the recent European Wind Energy Conference (EWEC) in Brussels.

More broadly, share prices are being affected by simple forces of supply and demand. Although the wind sector is generally under-represented in the public markets, investors do now have a greater choice of where to put their money. Perona points to the impact of Iberdrola's IPO on the price of EDF's wind project development arm, Energies Nouvelles (EDF EN). As the first green utility associated with a big, international utility, EDF EN was a "must-own" stock at its launch in November 2007 for anyone wanting exposure to the wind energy sector in Europe, he says. Since then the share price has fallen around 30%, not because of any bad news from EDF EN, but because investors were moving their money to Iberdrola.

With two more of the major utility players in the sector, Energias de Portugal (EDP) and the renewables division of Italy's Enel, also going public soon, Perona thinks it will be more difficult for mid-range companies to achieve a listing. "There will be more scrutiny of the pipeline and management," as investors become better informed, more selective and prepared to reject deals. Indeed, a number of IPOs have already been pulled in the face of a challenging market. In January, the Danish government put a halt to the sale of 20-30% of national utility Dong Energy, a significant investor in offshore wind, in the face of continuing market turmoil. EDP's book building this month will reveal if the market is ready for wind IPOs once more.

Volatile shares

The market flux means publicly listed wind equities are suffering significant volatility. While most grew in 2007 despite a fairly flat market, they have experienced negative growth since the beginning of this year, says Philippe de Weck, of Pictet Asset Management, which invests in publicly quoted clean energy companies. He was also speaking at the EWEC event. This volatility reflects the fact that public markets have problems valuing the wind industry, he maintains, particularly wind infrastructure. Most analysts use a discounted cash flow model, which gives very different results depending on the projections used. "During periods of market volatility, wind infrastructure experiences big shifts in share prices, which it shouldn't; it should be a stable business," asserts de Weck.

In one sense it should be stable because the attractions of wind for public equity investors have not changed. It is supported by regulatory regimes and targets and, as de Weck points out, wind is "the only game in town" for meeting Europe's 2020 renewables targets and state level renewables mandates in the US. "Regulation is driving long term growth in an economic environment where growth is hard to come by just now," he notes. Wind has the advantage of being a mature technology compared to other clean energies and investment in wind plant provides stable cash flows. The sector also spreads investment risk, being diversified as regards geography, equipment, markets and regulatory regimes.

Other risks, such as the long term ability of turbine manufacturers to lower costs and the reliability of new turbines coming onto the market remain. In addition, turbine shortages add to earnings volatility, which is more difficult to manage in the current financial climate.

Nevertheless, Perona believes the public market is still open for "quality transactions." De Weck agrees. "Companies with strong franchises and reasonable valuations will continue to find capital even in a difficult market," he says. Investors want businesses that are conservatively managed and can achieve their targets, he adds. Listed equipment manufacturers will experience "very strong growth," he believes. "Overall the industry is a real centre for growth in a slowing economy and the public markets are there to support it."

Dirty laundry

Others argue, however, that raising money on the public market is not the best option for developers and infrastructure owners, particularly at the moment. One of the main reasons is that a company needs "a very strong growth story" to launch an IPO, says Mortimer Menzel of Augusta, a merchant bank. Other factors are the current high cost of capital and the "short-termism" enforced by stock market reporting regulations, which tie management to a quarterly timeframe. As Joseph Slamm of Hudson Clean Energy Partners, a US private equity firm, puts it, listed companies "have to air their dirty laundry and this can be a large, double-edged sword."

"It is also very difficult for developers to manage investors' expectations," Menzel adds. Even the slightest bad news can lead them to sell their shares. Or they can be swayed by external factors, sometimes only indirectly related, all of which makes for a volatile share price. Faced with the current market, listed companies which have still not turned a profit will find it particularly hard as investors and lenders seek to minimise risk.

Longer term

Private equity investors, on the other hand, tend to take a longer term view, typically two to five years, and to be very clear about how and when they will exit their position. "Good private equity is about value enhancement, such as management skills, which means well thought out projects," says Tom Murley, head of renewable energy investments at London-based institutional investor HgCapital. In his view the aim of private equity is to "seek returns for investors that give a superior return or a better risk-adjustment to that available investing in a public bond fund or a listed public equity." To this extent, the investment is just the beginning of the process, says Slamm, whose company has a very hands-on approach to maximising the potential of the target company. The downside is that the owners have to be prepared to surrender control or share it with the private equity partner.

Another benefit of private markets, however, is that when they are working properly they can build up competitive pressure during the investment process, which drives up prices for the company seeking funds. Slamm argues that some inexperienced investors coming into the market have been driving up asset values and turbine prices too far. It needs seasoned investors working with seasoned management teams to arrive at a fair valuation, he says, pointing to the way some developers talk up their pipeline of projects. "Bragawatts" are not megawatts.

Experienced private equity investors are also "smarter investors," he believes. He points out that it was the private equity sector which devised ways for a broad swathe of tax equity investors in the US to offset their tax bills by leveraging the federal production tax credit on wind energy investment.

Menzel also cites evidence that in the current market the cost of capital seems to be better for developers in the private market. The cost of equity in the public markets stands at just over 9% on average, whereas the internal rate of return (IRR) for private equity investors is just 7-10% for onshore projects, whereas in 2002-03 it was close to 20%.

This means that developers are getting a good price for onshore assets in the private market because investors are accepting such a low IRR, Menzel explains. The IRR for offshore projects remains at 18-22%, giving investors willing to shoulder the extra risk twice the return over onshore.

For all these reasons, Menzel argues that many companies quoted on European stock markets "probably should not be and perhaps won't remain public for long." Slamm notes that private equity buyouts are beginning to take place, particularly in the European markets but also in the US. "You don't take a company public just on the basis of growth and earnings expectations," he asserts.

More equity about

Private equity may also be getting more plentiful. New and diverse equity investors are appearing in the wind space alongside the pension and infrastructure funds which have traditionally competed for wind assets against utility investors, says Andrew Donovan of London's Lexicon Partners, a corporate finance advisory firm. Australian retail funds are entering the market, he says. Donovan wonders whether petro-dollars and sovereign wealth funds, particularly from the Middle East and Asia, will join in. The bond markets, too, might start to feel more comfortable with the wind industry, though he considers this more likely in the offshore sector where the size of the investment makes it worth their while.

James Knight from merchant bank Augusta estimates there is now about $7 billion (EUR 4.5 billion) of institutional equity wanting to invest in the renewables sector. While he believes the "smarter money" is willing to wait to get the right returns, the sector is increasingly recognised for its "attractive investment features, such as yields and good credit risk against government offtake agreements."

Knight also points to the ever-widening group of investors, which today number some 200 "credible major financial and strategic investors who are willing and interested in investing in wind across Europe." These are broadly split into around 120 institutional equity investors, 20-30 hedge and investment funds and 30-40 strategic investors, representing a massive increase over the last five-to-six years and a sign of the growth and increasing maturity of the market. While strategic investors have been in the market a long time, he notes that more and bigger players, such as E.ON, fellow German utility RWE, and Britain's International Power, are now moving into the space.

Utility competition

Some argue, however, that the role of private equity in wind will be short lived and that the end-play for the sector will be a "utility-type game", given the capital requirements of the industry and the need for grid integration. The utilities "need scale, have big balance sheets and can secure long term contracts," argues de Weck. They benefit from lower costs of capital than private equity and can also benefit from the whole value chain.

Knight counters that private equity still offers an attractive alternative to utilities. Utilities are generally not interested in small scale investments and are not comfortable with the inherent risk of the supply being outside their control. Private equity is also more willing to embrace new technologies, development risk and buy-and-build strategies for smaller wind plant. It also tends to offer more flexibility, ranging from total control to co-management, and does things the utilities cannot, such as "consolidating and creating assets and development platforms, technology rollups and tailored financial solutions for developers' needs." In order to develop a competitive advantage, private equity funds are specialising, too. This might be geographically, or with regard to the type of investment structure and the scale of the investment.

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