Friday Letter: Terra Firma’s downsized fund is a tale of cost of capital

Cheap yieldco and direct investor money has compressed yields and again raised an age-old question: are private equity strategies really appropriate in the renewable infrastructure space?


It's hard not to see the downsizing of Terra Firma's much-vaunted renewable energy infrastructure fund as a capitulation to the realities of today's renewables market.

When the Guy Hands-led private equity firm started marketing the fund two years ago, it presented it as a $2 billion vehicle targeting 15 percent returns from investments in OECD-based renewable assets that, shall we say, needed work. Not distressed assets – just stressed, was the message coming out of Terra Firma headquarters.

At a conference in Berlin last year hosted by Private Equity International 's sister title Infrastructure Investor , Terra Firma argued that there were a significant number of assets out there in less than ideal shape – assets that could be improved to generate the kinds of returns Terra Firma had in mind. They were just much less visible than their healthier counterparts.

But two years later, Terra Firma has downsized its renewables fund from $2 billion to $500 million and cut its returns target to 10 percent. Which is another way of saying that it won't be focusing on large-scale deals anymore and that it no longer believes it can extract high returns from OECD-based renewable assets.

In a way, the writing has been on the wall since late last year, when Canadian pension PSP Investments was on the cusp of becoming the fund's $1 billion cornerstone investor. The clincher hinged on Terra Firma's ability to close a $400 million first deal. When that didn't happen, PSP withdrew its support, as first reported by The Wall Street Journal .

It seems highly unlikely that Terra Firma wouldn't be able to source a large-scale renewables deal. But it does seem highly likely that it couldn't source a large renewables deal in late 2014 paying the sort of mid-teens returns the fund was originally targeting.  PSP moved on and formed a renewables platform with Santander and Ontario Teachers'.

So Terra Firma's downsizing is, essentially, a tale of cost of capital. Big institutional investors like PSP – not to mention yieldcos fuelled by cheap public money – have no qualms netting 6 to 8 percent from their operational renewable investments. Which is why returns have compressed so dramatically in the operating renewables space over the last two years.

This raises a larger, older question: can you earn private equity-like returns from what are essentially infrastructure assets? The answer seems to be that you can, but it's getting increasingly harder to do so consistently. Just look at some of the oddball investments in funeral homes and cooking oil firms done not by private equity firms, but by infrastructure strategies managed by Antin and EQT Infrastructure.

Terra Firma, in raising what now looks very much like a plain vanilla renewable infrastructure fund, appears to be pursuing the kind of multi-asset class model that has become popular among alternative investment managers generally. It hasn't raised any commingled capital since its third buyout fund in 2007, which, together with Fund II, held its infamous EMI deal. Forming an infrastructure vehicle could be part of a strategy of staying in the business of raising blind-pool funds and, as a bona-fide clean energy heavyweight, with 1.7GW of assets and a star investment in Infinis, clean energy is certainly a sector where it makes sense for it to raise money.