By the mid-2000s, First Reserve, a private equity firm which had been investing in the energy sector for more than two decades, would increasingly come across investments that, while attractive, did not fit with its existing buyout fund model. Whereas its existing funds had an investment horizon of three to seven years and targeted returns above 20 percent, there were other investment opportunities with a longer life span of 10 to 15 years that would generate significant amounts of cash which could then be distributed as dividends.
First Reserve recognised that a new asset class was emerging and began exploring ways of investing in it, making the most of the knowledge, expertise and relationships the firm had cultivated as an investor in the energy sector since 1983.
Around the same time, Mark Florian, then an executive at Goldman Sachs and now a managing director and head of infrastructure funds at First Reserve, was already active in the infrastructure space. Having started a career that would last 23 years with the Wall Street investment bank, his background included public finance, structuring municipal bond offerings for highways, roads and water systems; as well as mergers and acquisitions. That combination of experience proved helpful when Florian participated in the Chicago Skyway deal, which in 2003 was sold for $1.8 billion – one of the first sizeable privatisations in the US.
“At the time, I talked to the guy who ran the investment bank and said ‘I think there’s a business here. There are all these people in Australia and Canada and Europe that are executing these interesting infrastructure investments and transactions,’” Florian recounts.
That conversation was later followed by the creation of the Public Sector and Infrastructure (PSI) group which Florian helped establish. PSI provided both debt and equity for infrastructure in the US and abroad. He also sat on the investment committee for Goldman Sachs Infrastructure Partners, a $6.5 billion fund.
“The one thing I noticed was that a lot of the investment opportunities the firm was seeing were through auctions. If you won in an auction process then by definition you had paid the highest price, you took the most risk and you had the most aggressive assumptions. Not always what you want to have happen,” Florian notes.
Around that time, the dialogue with First Reserve began.
“What was so intriguing for me was to come to a place where you could create negotiated investments; really try to be value-add to companies but at the same time value-add to our investors and if we could figure out a way to do that together, using all of this energy knowledge, all these relationships – that could be something special and something different in the infrastructure space,” he comments.
A NEW CHAPTER
The dialogue resulted in Florian joining the firm in 2008 to head its first infrastructure fund, which closed on $1.23 billion in May 2011.
Since then, the firm has finished raising a second infrastructure vehicle – First Reserve Energy Infrastructure Fund II (FREIF II) – which closed on its hard cap of $2.5 billion in June 2014.
The infrastructure funds account for about $4 billion of the firm’s total assets under management, which as of September 30, 2014, stood at $21.2 billion. A team of 20 investment professionals are dedicated to infrastructure, representing approximately one-third of the firm’s investment staff.
“We’re a smaller part of the business, but we’re also a newer part of the business. And we’re still growing,” Florian comments.
Both FREIF I and FREIF II have a 15-year investment horizon and focus on contracted power, midstream, utilities and other contracted assets.
That fourth category is a relatively new one for First Reserve. An example is PetroFirst Infrastructure Partners, a joint venture First Reserve formed in June 2014 with Petrofac, a services provider to the oil and gas industry listed on the London Stock Exchange.
The first transaction under the agreement was First Reserve’s acquisition of 80 percent of three of Petrofac’s deployed and contracted floating production facilities for an initial consideration of approximately $450 million. Petrofac retains the remaining 20 percent of the assets through its holding company Petrofac FPSO Holding.
“In the energy sector, there are a lot of heavy equipment and other infrastructure assets that primarily serve the oil and gas industry, which often come with long-term contracts. These assets typically have very large and strong counterparties for these contracts, which are US dollar-denominated and have operational risks that we can control,” Florian says, explaining why First Reserve sees this as an area with strong growth potential.
Midstream is another area Florian acknowledges is “a very, very important part of what we do”. Indeed, the firm’s most recent transaction before our interview was the acquisition of Navigator Energy, a midstream services company developing a project that includes 250 miles of crude gathering pipeline and 140 miles of transportation mainline.
Considering that midstream features so prominently in First Reserve’s investment strategy, one can’t help but wonder how the price of oil, which the day before our interview had fallen below $50 per barrel for the first time in six years, affects the firm’s investments.
“In the case of our energy infrastructure funds, it [a lower oil price] doesn’t really affect our portfolio because we don’t have that commodity price exposure. With the exception of midstream assets where you have pipelines that are transporting oil and gas, and where you may see less volumes of growth over time,” he explains.
“We have minimum volume guarantees on the amount of revenues that we get from those portfolio investments and so they’re very safe investments. But the opportunity to grow your pipeline system or expand it may slow,” he continues.
An example is Caliber Midstream, one of 10 companies in First Reserve’s infrastructure portfolio. First Reserve created Caliber Midstream as a joint venture – in fact, almost every company in the firm’s portfolio is a result of some form of partnership – with Triangle Petroleum, to serve oil and natural gas producers in North Dakota’s Williston Basin, which includes the Bakken shale play.
“Triangle Petroleum owns acreage and they were going to produce oil and gas. But the oil and the water required to develop these wells were going to be transported by truck. By putting in a pipeline system with them, we saved them $3 to $4 a barrel of oil equivalent because it was cheaper. It was also environmentally better since you got all the trucks off the road and therefore [they] were not burning diesel. Also it was much more efficient,” Florian states, noting that pipelines can operate even if there are three feet of snow on the ground, which in North Dakota, is not uncommon.
“So that was the benefit for our partner. For us, we got 15-year take-or-pay contracts that got us returns very much in fitting with the risk/return profile of our fund.”
While locking in prices for a period of 15 years helps shield First Reserve’s investments from the volatility of oil prices, the same does not apply for other investors in the energy infrastructure sector. Here too Florian sees opportunity.
“In the energy infrastructure space there are obviously a lot of companies that do have exposure to commodity prices. And when you have a 50 percent decrease in the price of oil, some companies are going to be constrained in terms of the capital expenditures they can make and they’re looking for financing to continue to grow their business,” Florian points out.
For companies whose access to capital markets – whether for debt or equity – isn’t as attractive as it might have been six months ago, First Reserve is a good alternative, he says. “We’re long-term investors and we can help them achieve their goals without having to worry about the fickle nature of capital markets.”
THE RESILIENCE OF RENEWABLES
One area that Florian doesn’t expect to be affected by lower oil prices is renewable energy.
“Oil is really a transportation tool. It’s what we use to fuel our cars and trucks. It’s not really used in the production of electricity. The oil markets don’t affect the power markets, therefore they really don’t affect renewable power,” he comments.
As mentioned before, contracted power – including both conventional and renewable – falls within First Reserve’s infrastructure mandate.
The firm has two renewable energy companies in its portfolio. One is SunEdison Reserve, a joint venture created in partnership with SunEdison, the development division of MEMC Electronic Materials, a manufacturer of solar panels and equipment. SunEdison Reserve, which First Reserve owns, has a portfolio of 21 facilities in Europe and North America with over 255 megawatts (MW) of generation capacity.
While almost all of First Reserve’s portfolio companies are joint ventures, each model operates differently. In some cases, the firm will create separate management teams, while in other instances the joint venture partner will keep its team in place.
SunEdison Reserve falls under the latter category. “SunEdison is very, very good at operating these plants. We didn’t feel like we needed to create a separate management team and so we signed long-term operating agreements with SunEdison to manage the day-to-day operations of the plants,” Florian says.
“They’ve done a fantastic job and they’re a great partner,” he continues, adding that these long-term operating agreements have also locked in the cost of operating expenses for 20 years, helping First Reserve achieve its goal of controlling operating expenses in addition to generating stable revenue streams over long periods of time.
Renovalia Reserve is another renewable energy company in First Reserve’s portfolio. A joint venture with Spanish renewable energy firm Renovalia, Renovalia Reserve was formed in December 2011 to own and operate onshore wind farms. The portfolio currently consists of six projects in Spain, one in Hungary and two in Mexico, with approximately 500MW of capacity.
The Mexican wind farms are in Oaxaca, which according to Florian, has some of the best wind resource in the world. “The air actually wants to move from the warm water in the Caribbean to the cold water in the Pacific; so there’s this natural draw.”
That attribute, combined with high, local power prices and wind energy becoming more efficient has made this renewable energy source cheaper than buying off the grid.
As a result, US retailer Walmart and Bimbo, a large bakery company, have signed 15-plus-year contracts with Renovalia Reserve. “It’s actually the first time we saw utility-scale wind farms be cheaper than the local grid,” Florian remarks.
Asked whether renewables will be a segment of the industry First Reserve will continue to train its sights on, Florian responds: “We definitely see renewable activity in Europe but less of it.” Part of the reason for that is that Europe has already made significant progress towards reaching the European Commission’s goal of 20 percent of power produced to be generated from renewable sources by 2020. Another reason is the gradual disappearance of feed-in tariffs which effectively created a subsidy and incentivisation.
Florian sees robust activity in the US, but that market too has its own set of challenges, or more precisely one challenge: that of uncertainty. A most recent example is the Tax Increase Prevention Act of 2014, which Congress passed in mid-December retroactively re-instating the production tax credit only for 2014, essentially giving wind developers a two-week window to start a new project.
“Frankly, I’m hoping that the competitiveness of renewables will continue to get better and better so government subsidies and involvement is unnecessary,” he says, noting how this would take away some of the risk for investors.
Despite the uncertainty, however, wind is competitive in many regions of the country. “Turbines have gotten bigger and more efficient; costs have come down. Under those circumstances, projects can stand on their own and we’re starting to see that. You might be able to get power prices of let’s say $35 per MWh – that’s pretty competitive power in most of this country and you can achieve that by putting up a wind farm in Texas or Oklahoma or parts of the Great Plains, right now,” he says.
But the US’ appeal for investment in energy infrastructure is not limited to the wind sector as far as First Reserve and Florian are concerned.
THE PURSUIT OF OPPORTUNITY
“There’s a lot of opportunity in the United States still – even with lower oil prices,” he asserts. “Aside from midstream, a lot of coal-fired facilities will be replaced and it’s going to be primarily with renewables and natural gas.”
“The US is a big country and a big economy with lots going on in midstream and power so the US will continue to be a key market for us,” he adds.
Mexico is another key market First Reserve expects to remain focused on in the near- to medium-term.
“As I mentioned before, we contracted with Walmart and Bimbo as off-takers, but the CFE [Comisión Federal de Electricidad], which controls the grid and power in Mexico, is really facilitating that. They’re providing the transmission and other key services,” he explains.
Reform of the Mexican energy sector is what enabled Renovalia Reserve to invest in the Oaxaca wind farms, according to Florian.
“This energy reform is going to allow a lot more external ownership of pipelines, power plants, all different kinds of assets that could fit our infrastructure funds very well,” he says. “So, I’d say the US and Mexico are really interesting right now but it constantly changes too with new opportunities arising around the world.”
While opportunities may shift from region to region, First Reserve’s approach remains constant – create value for the companies with which it partners as well as value for its investors by capitalising on its energy “DNA”.
“The thing that’s been wonderful is that that was the concept and it’s played out in terms of the investments that we’ve done and our strategy going forward is still the same – no changes. We’re focused on that model,” Florian concludes.