A New Discipline for the Energy Transition

A new approach to underwriting scale-up risk can help institutional investors to tap middle market opportunities, says Eduardo Monteiro, Co-CIO at Victory Hill Capital Partners.

Barring the climate change sceptics, the notion that the energy transition needs more capital is arguably axiomatic. Changing weather patterns, natural disasters and rising temperatures are reported annually and clear for all to see. Meanwhile, the commitments from large developed market governments (with some notable exceptions) down to small corporates acknowledge the situation and, for the most part, demonstrate a desire and impetus to address it. In a nutshell, we see the problem and want to fix it, so what next?

Historically, much of the scale was driven by large solar and wind farm projects, financed and constructed by big institutional investors who have been paying high development premia to gain access to these projects. However, despite the eye-watering amounts being reported daily, there just aren’t enough investment opportunities of sufficient size to satisfy the huge amounts of dry powder in both traditional private equity and the more specialist infrastructure funds. There is a gap in the market and the way to close it is to highlight an area traditionally ignored by these investors, the middle market.

Below the radar

Much of the transition is currently being addressed in this mid-market space both in terms of new projects under development and innovative ways of applying existing technologies to address market needs. Promoting the middle market could unlock significant opportunities but this typically falls below the radar of those with the big institutional capital to deploy. In short, there is a clear disconnect between the types of projects large investors are actively seeking and the processes they use to identify and invest in these opportunities as they emerge.

We believe that this conundrum is largely one of risk management and resource allocation. Large projects involving proven technologies are easy to gauge even when factoring in levels of development risk. The risk /return assessment is based on a long track record of other similar deals and investments while the large amounts of capital can be deployed with small teams doing the investment analysis work.

The process to create more opportunities by fomenting middle-market initiatives is held back by the fact that too many highly attractive investment opportunities are either deemed too small for an infrastructure investment or are EBITDA negative for typical private equity growth strategies. Concomitantly, small specialist management teams that have developed a robust project pipeline or carved out an attractive niche in the energy market are often hesitant to hand over their business. They fear that new ownership may lack an understanding of their operations, the potential of their technology, and the nuances of scaling it effectively, potentially steering the company in an unintended direction.

Backing the innovators

What is needed is a new approach so that the investors become more comfortable underwriting scale-up risk, effectively backing teams who are allowed to remain in charge of their own businesses but are given scope to scale these companies over time. Effectively we need capital to flow to the smaller companies to allow them to create scale with smaller projects or with their innovative approach to project execution.

Flying below the radar of the big investors, the mid market is where the real progress is being made in the energy transition. For real progress, it needs to stay independent and incentivised. We need to give mid-market companies the capital to scale and grow their businesses without seeing the ownership stakes of their businesses watered down too far by large investors seeking access to their pipeline.

This is hugely disincentivising. Investors need to get more comfortable backing teams, rather than just asset portfolios. Investors will need to gain a better understanding of, and be prepared to back, successful specialist teams behind these projects, support their solutions and ensure they stay incentivised to continue to scale. In other words, we need to develop the idea of ‘growth infra’.

First mover advantage

Getting the capital through to this layer of development while keeping these specialist managers independent and incentivised will unlock significant opportunities and attract further capital as these businesses scale. Our experience suggests however that while there is an acceptance within institutional circles of the potential of this type of model, there is a reluctance to be first. The approach seems less ‘early bird catches the worm’ and more ‘the second mouse getting the cheese’.

If we are to create an ecosystem that can really facilitate the energy transition at scale and speed, we need this new model of ‘growth infra’ to become mainstream. The potential is huge, but someone will need to be brave enough to be first. Or at least, for the barriers that exist in today’s infrastructure investing mindset to fall away. Both hold the keys to the solution, the question is who will be the first to move?

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