How to avoid ‘penny squeezing’

Question: what do power generation firm GenPower, oilfield services provider Schlumberger and liquid storage firm Vopak have in common? Answer: all are joint venture industrial partners with private equity firm First Reserve, the Greenwich, Connecticut-based energy specialist.

In fact, according to First Reserve’s London-based director John Barry, around a third of the firm’s private equity portfolio is made up of industrial partnerships like these. No coincidence then that the first deal completed from First Reserve’s energy infrastructure fund (its debut foray into the infrastructure space which it closed in May this year on just over $1.2 billion) was a joint venture with US solar photovoltaic developer SunEdison.

First Reserve managing director and infrastructure group head Mark Florian, who is based in Greenwich, Connecticut, explains why the firm is such a fan of the industrial partnership approach. “It allows you to negotiate with the owner of the asset rather than having to get into auction processes, and we feel we can craft such investments to minimise our risk and make sure we achieve a stable return. A joint venture partner has a strong incentive to make the deal a success and not squeeze every penny out of us, so there is good alignment.”

Crowded space

The quote above – or something like it – may well have been part of the pitch to would-be investors during First Reserve’s 15 months on the fundraising trail. Not least because one of the key things about the firm’s industrial partnership strategy was that it provided the firm with something different to talk about in a crowded fundraising space – something which surely helped it land within its target range of $1 billion to $1.5 billion during a period in which limited partners were being extremely selective about which funds to back.

This ability to differentiate itself was a key factor in Barry’s decision to join the firm in 2008 from 3i, where he had been instrumental in the formation of that firm’s infrastructure business in 2004 and the following year oversaw its £150 million (€170 million; $244 million) investment in I2, a £450 million Private Finance Initiative (PFI) joint venture with Barclays Private Equity and SG Corporate & Investment Banking.

Reflecting on his move, Barry says: “I spoke to Mark [Florian] and we had a similar ambition. Infrastructure investing had gone from a few players to a lot of players and it was hard to see differentiation. People were often buying businesses through auction processes. At First Reserve you had an energy focus, a long history [having been formed in 1983] and a proprietary deal flow [Barry says 92 percent of assets on the firm’s books arose from this prized source] and a preference for industrial partnerships.”

But while partnerships may distinguish you from the crowd, they are not immune from difficulties. Anecdotally, private equity firms have long predicted that doing deals alongside strategic partners would become commonplace – and yet few private equity deals have actually been done on that basis. Barry concedes that achieving alignment of interest can be challenging. “Some people have ended up bearing the scars of a lack of alignment [within such arrangements] and you do have to work hard to make these partnerships work. Deals can take 18 to 20 months’ lead time and you may end up rejecting two or three things that you look at together. But ultimately we believe they should deliver better value.”

Barry points out that, with many infrastructure assets, “operational decisions are fairly limited” and this allows greater confidence that interests will be genuinely aligned (simply because there is less scope for differences).

Florian acknowledges the difficulties that can arise in private equity scenarios: “When I was at Goldman Sachs [where he headed the Public Sector and Infrastructure Investment Banking Group prior to joining First Reserve in 2008] I did a lot of work unwinding private equity joint ventures with corporates that had been unsuccessful.” Many of these failures, he adds, were because the joint venture partners had failed to give sufficient consideration to their exit plan – “alignment at the back end” as he describes it.

He thinks First Reserve is better placed than most to avoid the pitfalls because of the knowledge and relationships it has built up over the last 28 years. In building the infrastructure team to a current size of 15 investment professionals (with two appointments planned, to take the final number to 17), emphasis has been placed on hiring experienced industry veterans who will already know potential partners inside out. For example, Philip Burkhardt, a Greenwich-based asset manager and 30-year power industry veteran, previously ran a portfolio of operational wind and solar facilities for General Electric Company.

Florian says the firm’s dealings with SunEdison were informative with respect to the insights it has into potential partners: “SunEdison thought they could maybe work with infrastructure funds, but they weren’t sure. They had a pitch book in which the first 40 pages said ‘here’s why we’re a good investment and you should be interested in us’. The last five pages were about how they could work together with someone. We said we didn’t need the first 40 pages. We already knew the business extremely well. We could focus purely on trying to create something that worked for both of us.”

The subsequent joint venture involves First Reserve buying solar assets from SunEdison once they become operational. By monetising its assets in this way, SunEdison is able to free up capital to continue developing further assets. One example of this occurred in October last year when SunEdison sold to the joint venture the 70-megawatt Rovigo power plant in north-east Italy. Altogether, the joint venture now has around 120 megawatts of operational capacity.

All deals are partnerships

Asked whether the infrastructure fund is likely to replicate the private equity portfolio with around a third of deals based on industrial partnerships, Florian says: “I think it may even be more. Investing capital is competitive and it’s a strategy that we believe gives us an edge. Virtually all the deals we’re working on right now are some kind of partnership.”

Therefore, it shouldn’t be too long before First Reserve’s roster of strategic partners lengthens. Ultimately, the strategy will be judged on whether it delivers to investors what it has promised. But First Reserve at least has a boast few other infrastructure investors can match: it doesn’t just have contacts within many of the world’s most influential energy companies; it also has every-day working relationships with them.