Counting the cost of capital

It’s hard not to see the downsizing of Terra Firma’s much-vaunted renewable energy infrastructure fund as a capitulation to the realities of today’s renewables market.

When the Guy Hands-led private equity firm started marketing the fund two years ago, it presented it as a $2 billion vehicle targeting 15 percent returns from investments in OECD-based renewable assets that, shall we say, needed work. Not distressed assets – just stressed, was the message coming from Terra Firma.

At last year’s Infrastructure Investor conference in Berlin, the firm argued there were a number of assets out there in less than ideal shape – assets that could be improved to generate the kinds of returns Terra Firma had in mind. They were just much less visible than their healthier counterparts.

But two years later, Terra Firma has downsized its renewables fund from $2 billion to $500 million and cut its returns target to 10 percent. Which is another way of saying that it won’t be focusing on large-scale deals anymore and that it no longer believes it can extract high returns from OECD-based renewable assets.

In a way, the writing was on the wall since late last year, when Canadian pension PSP Investments was on the cusp of becoming the fund’s $1 billion cornerstone investor.

The clincher hinged on Terra Firma’s ability to close a $400 million first deal. When that didn’t happen, PSP withdrew its support, as first reported by The Wall Street Journal.

It seems unlikely that Terra Firma wouldn’t be able to source a large-scale renewables deal. However, it does seem likely that it couldn’t source a large renewables deal in late 2014 paying the sort of mid-teens returns the fund was originally targeting. So Terra Firma’s downsizing is, essentially, a tale of cost of capital. Big institutional investors like PSP – not to mention yieldcos fuelled by cheap public money – have no qualms netting 6-8 percent from their operational renewable investments. Which is why returns have compressed so dramatically in the operating renewables space over the last two years.

This raises a larger, older question: can you earn private equity-like returns from what are essentially infrastructure assets? The answer seems to be that you can, but it’s getting harder to do it consistently. Just look at some of the oddball investments in funeral homes and cooking oil firms done not by private equity firms, but by infrastructure strategies managed by Antin and EQT Infrastructure.

Which, in turn, prompts a different question: why is a private equity firm like Terra Firma sticking to raising what now looks very much like a plain vanilla renewable infrastructure fund? And committing $100 million of its own money to boot.

The answer can only be speculative, but it might be tied to the overall health of the Terra Firma fundraising brand. Put simply, the firm hasn’t raised blind-pool capital since its third buyout fund in 2007, which, together with Fund II, held its infamous EMI deal.

Since then, and in addition to the renewables fund, it’s made noises about raising a fourth buyout fund and, most recently, seemed to eschew fund structures altogether with its announcement that it has €1 billion to invest on a deal-by-deal basis.

Yet Terra Firma is a bona-fide clean energy heavyweight, with 1.7GW of assets and a star investment in Infinis. If there’s a sector where it should be able to raise money, clean energy is it.