by  John McDonaldJustin Boose, Adam Kobos and Vaughn Morrison

Introduction

The emerging trend of energy private equity (“EPE”) funds is revolutionizing the renewable energy field, as renewable energy joins leveraged buyouts, venture capital and hedge funds as asset classes that institutional investors and high net worth investors are using to deploy their capital in a diversified manner, with the added “social good” of investing in a sustainable energy future. Sophisticated energy sponsors are increasingly eschewing the traditional project finance structure, in which capital stacks are created for each deal, in favor of a private equity fund structure in which committed capital is deployed by the sponsor in accordance with a specified investment strategy.  From the sponsors’ perspective, the goal is the “holy grail” of all private equity sponsors – permanent capital.  This trend can be seen as further evidence of renewable energy maturing as an asset class within the larger investment world.  Since this trend is so new, the terms of EPE funds vary tremendously.  However, some common terms are summarized below.

Committed Capital 

EPE funds typically employ a traditional private equity fund structure in which LP investors sign subscription agreements requiring them to make capital contributions in response to capital calls issued from time to time by the sponsor to fund investments made by the fund in accordance with an agreed-upon investment strategy.  This contrasts with the traditional project finance structure in which the sponsor creates a project company for each investment and then sources investors to provide equity capital for that investment (which is analogous to the “fundless sponsor” model used by some emerging private equity sponsors).  U.S. renewable energy “tax equity” investments are predominantly done utilizing the traditional project finance structure, rather than a committed capital structure.

Investment Strategy 

EPE funds are typically focused on investments in a particular sector  – renewable energy, waste-to-value, etc. – and consent of a majority-in-interest of the LP investors (or, less frequently, limited partner advisory committee (“LPAC”)) is required for the EPE fund to make investments that deviate from that investment strategy.

Carried Interest and Management Fees

Carried interest and management fees in EPE funds vary significantly based upon relative negotiating strength of the parties, which is often a function of the sponsor’s track record and the sophistication of the LP investors.  However, we have seen a number of EPE funds employing the traditional “2&20” private equity fund structure, in which the sponsor receives a 2% management fee on committed capital (stepping down to apply to invested capital once it is deployed), along with a 20% “carried interest” share of the profits on investments made by the fund.

Distribution Structure

There is considerable variance across EPE funds with respect to distributions, but many employ a traditional private equity distribution structure in which the LP investors receive back their invested capital, plus a preferred return on that invested capital, and any remaining profits are divided between the LP investors and the sponsor in accordance with the traditional 80/20 “carried interest” split ratio.  In EPE funds, there is sometimes (but not always) the “disappearing pref” structure in which, once the LP investors receive back their invested capital plus the preferred return, there is a “catch up” so that the sponsor ultimately receives the agreed-upon 80/20 split of the fund’s total profits.  Sometimes the fund economics are structured to mirror the traditional project finance waterfall structure by providing for the profit split among the sponsor and the LP investors to occur on an investment-by-investment basis (with a “clawback” to the extent that it results in the sponsor receiving proceeds in excess of agreed-upon 80/20 profit split).  However, sometimes the 80/20 carried interest split of profits occurs on an aggregate basis across all investments made by the fund, deferred until liquidation of the last investment made by the fund, consistent with the approach commonly used by European private equity funds.

Fundraising Period

EPE funds typically employ the traditional private equity fundraising structure in which an initial closing occurs and subsequent closings occur over 6-18 months thereafter in which additional LP investors commit their capital to the fund.  However, for EPE funds making “tax equity” renewable energy investments, it is often not possible, due to tax law limitations relating to pass-through of the tax credits flowing from the underlying investments, to use a fundraising structure in which there are subsequent closings in which new LP investors retroactively participate in investments made with capital provided by initial closing LP investors.  As a result, that type of EPE fund typically has one closing, in which all of the LP investors commit to invest their capital.

Investment Period and Fund Term

In EPE funds that provide capital to construct renewable energy facilities that will, upon completion, be sold to long-term investors, the fund’s investment period often follows the approach customarily used in private equity funds in which there is a stated investment period, following by a realization/liquidation period and defined total fund life.  However, the investment period can vary considerably for EPE funds making other types of renewable energy investments, including those that invest in completed projects.

Conclusion 

In conclusion, there can be no doubt that renewable energy transaction structures are evolving as sponsors move away from the traditional project finance model of constructing a capital stack for each project, which they view as inefficient and wasteful, toward a committed capital structure in which LP investors have a streamlined way to deploy capital across a portfolio of renewable energy assets selected utilizing a specified investment strategy.  This trend could help transform the way in which renewable energy projects are financed and lead to further growth in the use of renewable energy.  Please don’t hesitate to contact the authors with any questions that you may have concerning EPE funds.