When Starwood Capital’s Barry Sternlicht found himself drawn to the energy sector a little over a decade ago, the US energy landscape was substantially different to how it is today. Yet choices made at the time have proven both successful and resilient enough to withstand the dramatic shifts that are ongoing and re-shaping the sector.
“Our chairman, Barry Sternlicht, was very attracted to the locational aspects of essential energy infrastructure – power generation and transmission projects – in the US,” Starwood Energy’s senior managing director and co-head Brad Nordholm recalls, as he explains how a leading real estate investor, Starwood Capital, decided to branch out into the energy sector.
Sternlicht saw some interesting parallels between energy and real estate and decided to invest personally in two essential energy infrastructure projects. The first was the Neptune Regional Transmission System, a 65-mile submarine power transmission cable connecting New Jersey and Long Island, New York. The second was a portfolio of natural gas-fired power plants.
“Based on his validation that the returns could be attractive on a risk-adjusted basis and that this was a growing area – and an opportunity to diversify from while at the same time complementing the real estate sector – we started Starwood Energy that following year,” Nordholm explains. That year was 2006, when he joined the firm.
From the outset, Starwood Energy focused on a specific segment of the energy value chain. Specifically, it has been investing in natural gas-fired power generation, renewable energy and transmission.
“The power sector is evolving rapidly, which is creating a significant opportunity for us,” Himanshu Saxena, also senior managing director and co-head of Starwood Energy, comments as we sit in a sunlit conference room at the firm’s new Greenwich, Connecticut headquarters. “The opportunity is to both acquire and develop new generation and transmission assets. The US is sorely in need of massive infrastructure upgrades and the power sector is a key part of that. However, you need specialist managers if you want to invest in the power space, given the complexities and dynamism of the sector.”
Nordholm picks up where Saxena leaves off, adding “we have a market design in the US, which in power – unlike some other parts of the energy value chain – provides for the opportunity to create very well-structured investments with long-term recurring cashflows.
“About two-thirds of what we’re doing right now involves late-stage development and construction of new power generation and transmission projects,” he continues. “And when we commit capital to those projects, we have secured a long-term, fixed revenue contract and you can’t say that about some other parts of the energy value chain.”
To date, Starwood Energy has completed transactions totalling approximately $4 billion in enterprise value, across all three of its target areas.
DOING THINGS DIFFERENTLY
Investing in projects in the late-stage development phase is one strategy that differentiates Starwood Energy from its competitors.
“We tend to work with third-party developers,” Saxena notes. “Time and time again a developer will come to us at a certain point in the development cycle and say: ‘Now, is the time I need a capital partner, a partner who understands what development is all about and that this effort could take a couple of months – or in some cases a couple of years – to complete.’”
Starwood looks at the value-add angle with every investment it commits to, whether it is developing a project or acquiring an operational asset. “We look at a project and we do not see what it is at that specific point in time, but what it can become if we invest the time and expertise in it,” Saxena comments.
Often, it’s more a matter of investing time rather than money. “We would selectively deploy capital in these projects. But the focus is not really on putting out a lot of money during the development stages in these deals, the focus is really taking on a development project and making it better by using our intellectual capital and our relationships,” Saxena says.
An example is Stephens Ranch, a two-phase wind project in Texas completed last May. Starwood Energy stepped in as the project was entering the last six months of development, taking over negotiations for all key contracts. Those included a turbine supply agreement with GE, financing agreements with the banks that would provide the tax equity and a long-term power purchase agreement that made the project financeable.
“In this case, where we came in during the final stages of development, we did not invest a whole lot of development capital. It was really our expertise that we were bringing to the table,” Saxena notes.
Expertise has been a focal point since the firm’s inception. According to Nordholm: “From the very beginning we’ve worked to develop a team of people who have experience in the energy industry, not just investment experience. We’ve done that so that we are able to move flexibly between power generation and transmission technologies that in any given year have the most advantage, are the most attractive.”
A team with deep expertise in the power and finance sectors combined with the size of investments Starwood targets also give the firm a competitive edge. “We are playing in that part of the value chain which is really not populated by a lot of investors,” Saxena comments. “We’re not a $300 million fund, we’re not a $10 billion fund. We’re sitting in that $1 billion to $1.5 billion range and there aren’t many players in that space.”
So far, Starwood Energy has raised two general opportunity funds. The first, Starwood Energy Infrastructure Fund I (SEIF I) closed on $483 million. The second vehicle, SEIF II, was more than double that amount, closing on $983 million in January 2014.
Having said that, however, the firm works closely with its investors, some of whom are large entities, offering them the option of co-investment. “On the one hand, we do deals sized anywhere between $50 million and $150 million; on the other hand, we can write cheques that are significantly bigger,” Saxena comments.
DEVELOPMENT VS ACQUISITION
To date, Starwood has worked on 14 development deals, of which only one incurred cost overruns. That is 95 percent of projects being delivered on time and under budget, what Saxena terms the “value-add” component Starwood brings to development projects.
“I just can’t underscore this kind of value-add enough,” Nordholm stresses. “A lot of times people are inclined to think: ‘Oh, I’ll get a project completely developed and I’ll go to my capital source and it will close.’ That is not where Starwood operates; that’s not where we are at our best. We’re at our best when it’s not just a need for capital, but this technical expertise and willingness to work for months and sometimes years to make a project come together.”
While the business model differs based on whether the investment is developing a project as opposed to acquiring an operational asset, the value-add angle remains constant. “When we look at buying an operating asset, we are looking at how we can make it better,” Saxena explains. “And making it better comes in many different flavours.”
That includes operational improvements, negotiating and securing long-term power purchase agreements or improving the financial structure. But regardless of where the opportunity for improvement lies, the key is finding the right asset.
“On any given day, there are probably $10 billion plus worth of assets for sale,” Saxena remarks. “We look at that huge list of projects and say: ‘Which is that one project where we can make a difference?’” A recent example was the Quail Run Energy Center, a 550MW natural gas-fired power plant in Odessa, Texas, which Starwood acquired for an undisclosed amount in February 2015.
While Starwood’s focus has not faltered from natural gas, renewables and transmission, the firm has started to take a serious look at energy storage.
“The story with electrical storage and specifically battery storage is that prices are coming down, the technology is now proven and scalable,” Nordholm points out. “It’s gone from being more of a novelty to something that is very quickly becoming mainstream. We do think that it’s something that, at the very least, deserves close watching, but it will probably be a significant investment opportunity.”
One obvious benefit of battery storage is that it can help resolve renewable sources’ intermittency issues, but the benefits and effects of this technology are much more far-reaching than that.
“If you have a transmission line in the Los Angeles Basin that is at full capacity between 5pm and 7pm during the summer months because everyone is turning on their air conditioners, one alternative is to build a new transmission line which may cost billions. Another alternative is to have battery storage that can be used to release energy during peak demand,” Nordholm comments.
“And it’s not just transmission,” Saxena interjects. “If you have a local problem you can either build a natural gas-fired power plant in the Los Angeles basin – or you can install a battery. There are many who think energy storage could actually compete head on with gas-fired power plants at some point.”
Energy storage is not the only development shaping today’s energy markets. The shale revolution, the demise of coal and a more environmentally-conscious culture all play a major role. But according to Saxena, the low price of natural gas is the single-most important driver in what he calls “a period of transformation.”
Nordholm agrees. “Himanshu talked about the transformation and growth that’s under way. It’s really massive,” he says, adding that conservatively $300 billion to $400 billion of investment will be needed over the next 10 years to support the shift from coal to either natural gas or renewables as well as the transmission networks that will be required.
Speaking of coal, President Barack Obama’s Clean Power Plan, which seeks a 32 percent reduction in carbon emissions from power plants by 2030, naturally comes up during the conversation. As does the question of whether the lawsuits brought by at least 27 states to block the new regulations will prevent or slow down the retirement of coal plants.
“I think the Clean Power Plan would have accelerated the inevitable,” Saxena comments. “Whether or not you have a price on carbon, what you’re seeing in most markets is the price of a delivered electron from a coal plant is actually higher than that from a gas-fired power plant. So it really comes down to basic economics,” he says. “The coal plants simply cannot compete with gas in certain markets and we see this play out in valuations. In some recent transactions the valuation of some coal plants was essentially zero.”
The picture Saxena paints is particularly true for the US, a key geographic region for Starwood, along with Canada and potentially Mexico. In markets like Europe for instance, the situation is very different, with coal being cheaper than natural gas. As Saxena points out, “natural gas has become a local commodity, while coal remains a global commodity”.
But with natural gas prices so low in the US will renewables be able to compete?
“That’s an interesting question because while gas prices are going down, renewable technologies are getting better,” Saxena says, offering an example of wind turbines becoming bigger, with more capacity and improved efficiency. “What this means is that manufacturers are finding ways to reduce the levelised cost of electricity from wind turbines,” he notes. The same is happening on the solar side, he adds.
In addition to the lower costs of solar equipment, Nordholm also points to distributed and residential solar power. “It is one of the fastest-growing applications of renewable energy and we can confidently predict that it’s going to continue on a very rapid growth curve for years, if not decades,” he says.
With talk of the future, the question of where Starwood expects to find opportunities in the next 18 to 24 months inevitably follows.
“Right now we have a situation that we haven’t seen since 2009, where certain public independent power producers, including yieldcos, are trading at values below private market valuations,” Nordholm states. “That means there will be additional acquisition opportunities.”
Other opportunities will come from the need for more storage and transmission resources as well as ultimately more natural gas-fired power generation to address grid congestion to fill the void left behind by retired coal plants.
“The policies and capabilities that we established 10 years ago and our ability to move between technologies really positions us very well for this shifting commodity environment and this changing environmental regulatory context that we’re experiencing,” Nordholm asserts.
“We see a lot of opportunity in the next 12 to 24 months. Maybe we’ve never seen more.”