Green is good for Hg(3)

The prudent private equity firm is always wary of ‘bandwagon investing’ – the compulsion to invest in ‘hot’ sectors, just because everyone else is.

But the industry remains opportunistic at heart. If it can find good businesses in growth sectors, where the underlying market conditions are favourable, it will always be interested. And in 2007, that will mean a lot of growth capital and buyout firms taking a look at renewable energy.

“We're seeing a wall of money flowing into the clean energy industry,” says Michael Liebreich, chief executive of research company New Energy Finance in London. His firm has calculated that overall investment in the sector was up 43 percent in 2006 to $70.9 billion (€54.8 billion) in 2006.

Liebreich is cautiously optimistic that this year will be even bigger. “2007 will be a critical year for the clean energy industry. The future is there for the industry to lose.”

Investors are flooding into renewables because the underlying conditions have never been more favourable. Recent trends in the energy sector such as rising demand, volatile commodity prices, dwindling reserves and concerns about the security of supply are forcing mankind to seek out both short- and long-term alternatives.

At the same time, the problem of climate change has rocketed up the political agenda. Businesses, politicians and consumers are falling over themselves to reduce their carbon footprint.

In other words, moving away from the long-standing reliance on fossil fuels has become both an economic and political necessity – which is why governments across the globe are actively promoting renewable energy. The European Union wants to double the proportion of renewable energy it uses to 12 percent by 2010 – just three years from now. Even China, now the world's greediest consumer of energy, has introduced a renewable energy law that could mean it spending about $200 billion on the sector by 2020.

So the market is growing. But there are plenty of pitfalls for private equity firms hoping to cash in.

“You need to be cautious,” says one investor at a large European pension fund. “These opportunities often rely on new technologies, so you are exposed to a high degree of technology risk.”

A fund of funds investor adds: These are not like normal buyouts. The return profile is different, the businesses are often at a much earlier stage and the industries tend to be very fragmented. You need to know what youre doing in order to make money.” He suspects that some investors who move in now may find this out to their detriment.

Of course, the best way to avoid jumping on a bandwagon is to be several years ahead of it, which is what HgCapital, a UK mid-market firm with offices in London, Frankfurt and Amsterdam, seems to have achieved. In 2004, Hg decided that renewables would be the next big thing in the energy sector, and set about building a team to exploit the opportunity. Three years later, the four-strong team is well placed to do so, having just closed a €600 million dedicated fund – the largest ever raised to target the sector in Europe.

Hg's initial research – at a time when very few firms were looking at the sector – led it to the conclusion that the opportunity was there, even if it did not sit well with Hg's typical mid-market buyout model. Ian Armitage, chief executive of Hg, says: “The profile of returns from these investments is different to buyouts, and is attractive to a different type of investor. For renewables, the returns are lower, but volatility and risk are lower too.”

Since the personnel requirements were also different (the sector would clearly require specialist project finance skills), Hg decided the best approach was to start from scratch and build a new team, recruiting wind energy specialist Tom Murley from Allianz to run it.

educating the market
But it was not plain sailing for the wind expert. Since investments could not be made from Hg's existing buyout fund, his new team had no money to spend. And in 2004, investors were still sceptical about renewables. “A few years ago, people's reaction tended to be: ‘This stuff doesn't really work, does it?’ Murley recalls.

Hg, on the other hand, was more confident. “The technology become more and more cost-effective – the cost of producing renewable power was becoming competitive,” says Armitage. So instead it persuaded some of its most loyal limited partners to finance the team in the short term. This would allow it to build a track record prior to formal fundraising.

The team made its first investment just nine months later, spending £21.6 million to buy Tir Mostyn, a 21.25MW wind farm in Wales. A few months later, Hg started premarketing the energy fund. But not everyone was convinced. “It was hard going to begin with – some people thought we were a bit ahead of time,” Armitage admits.

One problem, says Murley, was that investors weren't sure how to categorise the fund – Hg was a buyout firm, but the return characteristics of the renewables fund would be more in line with an infrastructure fund. Hg would not comment on return expectations, but infrastructure funds typically target a return of about 11 to 15 percent.

However, two further wind farm investments in Ireland and in France, plus a joint venture with Wind Direct, provided more proof that the team could turn good research into good deals. Investors quickly started to come round, as interest in the sector continued to grow. “By the end, it was more a question of differentiating our strategy,” says Murley. Sources close to the fundraising said the €300 million fund was ultimately over-subscribed, with Hg receiving commitments from half of the investors targeted.

All five of the team's investments to date have been in wind energy. Murley believes wind will continue to dominate the renewables sector for the next few years, since it remains the most cost-effective method of production. “We think about 65 to 70 percent of investments made from the fund will be in wind.” It is also the fastest to build, which will help in countries like China that are desperate for quick results.

Other areas are also under consideration, and as PEI went to press Hg was about to announce its first biomass investment.

So are there any dark clouds on the horizon for renewables? Murley believes that a high-profile failure could be the biggest threat to the burgeoning sector. He cites the case of Kenetech, a big US wind turbine maker that went bust in 1996. “That set the industry back a decade in the US,” he says. And today's investors are by no means guaranteed to succeed either: not every company in the sector will be a winner, as the relatively poor performance of some clean technology firms on London's Alternative Investment Market suggests.

Clearly opportunities will be rife in the sector in the coming years, and there is every chance that opportunistic investors will be attracted to the sector and come unstuck. However, there should also be great returns for those that get it right – and Hg seems well positioned to perform. As Murley says: “We've built a team, we have a clear strategy, we've done the research and we're already doing the deals.”

Hg's renewables division will remain unproven until it has shown it can deliver on its promise to investors. But if the sector does fulfil its potential in Europe, the firm is likely to be one step ahead of the bandwagon.