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Energy Transition Funding Needs New Approach From Private Equity

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Bloomberg Law

Last year was challenging for private equity sponsors as they faced increased fundraising competition, decreased M&A activity limiting exits, and polarized debates over environmental, social, and governance.

From a deployment perspective, recent climate, infrastructure, and geopolitical policies such as the Inflation Reduction Act are reshaping the investment landscape. This has created a new asset class broadly classified as energy transition or net zero investments, climate and sustainability solutions, and other similar labels.

Sponsors should consider investment strategy, fund life, and structuring flexibility when raising funds intended for investments in this space.

Investment Strategy

When defining their investment strategy, at one end of the spectrum, certain sponsors have elected to retain discretion—making investments that the sponsor believes have positive climate impact. Others have favored a more detailed approach listing various types of assets such as utility-scale solar, distributed solar, and green hydrogen.

While the first approach may be somewhat preferable to sponsors—depending on the degree to which their belief must be substantiated—a more discretionary mandate is likely available only to sponsors with more established track records and greater market leverage.

The alternative approach has the advantage of identifying and pre-baking approval for investments in assets that are less obviously part of the space. These include cyber-security assets for power grids, small modular nuclear reactors, agriculture and forestry, water infrastructure and purification, tax credit and voluntary carbon offsets brokerages, data analytics, and much more.

Such an approach may also avoid potential future overlapping of mandates with other funds of the sponsor, most notably in the case of infrastructure funds.

Fund Life

Investments in this new asset class are often backed by government incentives such as grants, loans, tax credits, and guaranteed return on equity. Often such incentives sunset by a specific date or when a milestone is achieved.

If sponsors wish to capitalize on them—and offer a potentially more attractive targeted internal rate of return in their fundraising (which currently range from 12% to 25% gross IRR)—they may want to consider the expected duration of the incentives when determining the fund life (which currently range from 10 to 15 years without taking into account unilateral and approved extensions).

Other considerations relate to the very nature of the underlying assets and type of investments. For example, while transmission assets are typically prized and crucial to any energy transition effort, they often require patient capital largely due to permitting delays and various community outreach efforts. A longer fund life would avert the need to request fund extensions or continuations—or even prematurely liquidate the applicable asset.

Another consideration is the often greenfield nature of such investments, which may require longer investment periods (currently ranging four to six years) as development milestones are met or delayed. This issue may have direct financial implications to the extent a portion of sponsor management fees are calculated based on unfunded commitments.

Structuring Flexibility

If sponsors wish to make use of the various government incentives to enhance fund performance, it may be helpful to tailor opt-out terms, co-investment rights, and tax structuring terms to preserve the ability to do so. This is particularly relevant when certain investors aren’t able to benefit from certain government incentives.

For example, the tax-and-climate law makes a cash refund, or direct pay option, available in lieu of taxes deemed paid to tax-exempt entities. Such benefit is currently subject to structuring restrictions—the direct pay option isn’t available to such entities if they invest through a partnership or S corporation, for instance.

As sponsors often have state pension funds and other tax-exempt entities as part of their investor base, it will be important to preserve structuring flexibility at the investment stage.

Outlook

Given the novelty of the climate-related investment space, asset-based considerations may provide useful guidance to sponsors as they determine their new fund offering terms and the basis for deviating from any of prior fund terms as needed.

A bespoke offering supported by a differentiated investment strategy may be a winning factor that indicates superior subject matter expertise in an increasingly competitive fundraising environment.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Martha Kammoun is partner in Simpson Thacher’s energy and infrastructure practice.

Jonathan Goldstein is partner in Simpson Thacher’s tax department.

Jaclyn Starr is partner in Simpson Thacher’s private funds practice.

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