Energy infrastructure funds have emerged as a class of funds that offer investors the potential for long-term stable returns, as well as downside protection through the asset class’s inflation-hedging characteristics. An energy infrastructure fund’s value drivers are different from the conventional buyout-focused fund, and this has led some energy infrastructure fund sponsors to seek flexibility around conventional fund covenants relating to concentration risk and the fund’s term that can impact investments in unexpected ways. This article provides a brief introduction to energy infrastructure funds and uses examples to illustrate how conventional private equity fund limitations can impact an energy infrastructure investment. It also provides practical suggestions for reducing those impacts through flexible fund agreements that align investor goals with the fund’s asset development and hold strategy.

Defining Energy Infrastructure and the Return Profile

Many institutional investors seek exposure to the energy sector through two different, and sometimes overlapping types of funds: (i) natural resources funds, which traditionally invest in companies that develop and produce oil and gas or other minerals and target returns (net of management fees and carried interest) of approximately 15-25% and (ii) infrastructure funds, which generally develop and/or own real assets expected to generate stable, long-term cash flows and target returns for investors ranging from approximately 10-15%.[1]  Numerous funds are hybrids of these two classes, and their targeted returns may reflect a blend of the two comparable return targets.

The investment focus of infrastructure funds varies greatly fund-to-fund, but can include, with respect to energy assets:

• midstream oil and gas businesses having either non-regulated returns (e.g., gathering and processing assets or intrastate crude oil pipeline systems) or regulated returns (such as interstate pipeline systems regulated by the Federal Energy Regulatory Commission);
• conventional or renewable power generation or power transmission businesses; and
• terminal and port assets used for hydrocarbon or petrochemical storage, blending and import/export. 

Outside of traditional energy infrastructure, infrastructure funds may, depending upon their focus, invest in real assets such as toll roads, water desalination facilities, residential gas and water systems, ports, bridges, airports or waste to energy. 

Unlike a traditional buyout-focused private equity sponsor, which acquires operating businesses with relatively established earnings, energy infrastructure sponsors often fund growth-oriented businesses or projects. A target business could be in need of capital to (i) develop an energy project by obtaining permits, land rights and key project agreements (the so called “development phase”), (ii) fund the construction of a project that has completed key development milestones or (iii) allow historical owners to delever the business or sell down their interests. Sponsors that invest at the development or construction stage of a project expect higher returns on their invested capital relative to post-construction capital to compensate them for the risk entailed in the development of the asset. In turn, post-construction capital for a “de-risked” business must compete against more conventional financing sources and may have a lower risk adjusted return. Further, like other kinds of private equity, an infrastructure fund sponsor based in the U.S. typically aligns its profit motive with the portfolio company management team, as well as its investors, through carried interest. Accordingly, one theme across fund-sponsored infrastructure investments is the trade-off between, on the one hand, stability of the investor’s return, which is protected through the covenant package in the fund’s partnership agreement, and on the other hand, the possibility of higher returns for the investor, as well as the sponsor and portfolio company management team (through carried interest at the fund and company levels, respectively), as a result of increased development or construction stage risk.

Scenario One – Managing Concentration Risk for a Major Construction Project

Private equity funds limit their exposure to any one particular portfolio company often referred to as concentration risk, by restricting the maximum amount of capital that may be invested in a company relative to all capital commitments to the fund. Generally, if a fund sponsor seeks to exceed the concentration limit defined in its fund agreement, either the advisory committee of the fund or some percentage of investors must approve that change, which can take time and resources. By planning ahead in the fund agreement for energy infrastructure investments, the fund sponsor may obtain the flexibility to avoid this traditional approval process in special situations.

Unlike buyout fund investment, where the target business is already cash flowing and may have assets that can be disposed of post-acquisition to generate a return of the fund’s capital (thereby reducing concentration risk), an energy infrastructure investment, particularly in a pre-construction project such as a gas processing facility, requires capital funding contingencies for special situations like cost-overruns or project delays. If the fund’s capital commitments are ultimately drawn for those contingencies (perhaps because the portfolio company has weak remedies for liquidated damages against an engineering, procurement and construction firm), this further concentrates the fund’s investment. To counterbalance concentration covenants for a major capital project, a fund sponsor may seek flexibility to invest a greater percentage of its committed capital in a portfolio company if the sponsor determines that the upsized concentration will last for a temporary period, such as 12-18 months. This period might be temporary because the fund extends a bridge financing to the portfolio company immediately prior to a large construction financing. The construction financing would repay the bridge financing from the fund, with the returned proceeds to the fund being again credited towards unfunded capital commitments.

Further, if the construction project is financed with third party debt financing, it is possible, depending upon the balance sheet of the portfolio company, that the lender will seek a guarantee from the fund for some portion of the debt financing. This application of fund-level guarantees is different from the typical application of a fund’s guaranteeing indemnity obligations or break-up fees upon a portfolio company divestment. Before agreeing to such a guarantee, the fund would evaluate other alternatives, such as an equity funding commitment letter or other credit assurance products such as letters of credit. One consideration of the fund would be the contingent concentration risk posed by the guarantee, as well as any specially negotiated limitations on the extent to which a fund may guarantee the indebtedness of a portfolio company. Thus, it is critical at the outset of marketing a fund to understand the fund’s view of project financing its portfolio investments in order to appropriately negotiate guarantee limitations, and to understand any such limitations in the fund agreement before a portfolio company begins negotiating debt terms with a third party lender.

Finally, an infrastructure fund sponsor may consider investing in a project or facility that is closely related to or located near another investment, and this could create concentration questions among investors. For example, a sponsor might seek to invest in and develop two different businesses at the same shoreside terminal, such as a petrochemical storage business, but also a crude oil blending, storage and distillation business. If these businesses have unique management teams, strategies and expected capitalization, then a sponsor would not necessarily want its investments in both businesses consolidated for purposes of a concentration test under its partnership agreement. Indeed, if the sponsor understands that the economics of a particular business are strong at a given location based on another analogous investment at or near that location, then the sponsor and the investors should theoretically be aligned in exploiting that knowledge. One strategy for addressing, on the front end, concentration issues in the context of a terminal or site is for the sponsor, while marketing the fund, to specifically explain in the private placement memorandum the relevant investment opportunities associated with the overall terminal or site where various businesses may be developed. If investors agree to invest on the basis of a “project by project” concentration test, then the sponsor may avoid a time consuming approval processes in the future.

Scenario Two – Holding onto Mature, Income-Producing Assets

A typical private equity fund could have an initial term of 10 years from the final closing, with the fund sponsor having the option to extend the fund’s term for 1-3 years. During this term, investors expect the fund sponsor to maximize and realize the time value of its portfolio investments. This term, however, is significantly shorter than the economic useful life of most energy infrastructure assets, including revenue producing agreements associated with the physical assets. For example, a fund could invest in a company that raises project financing for an interstate pipeline system on the basis of securing firm service capacity agreements with customers having fifteen year tenors. At the end of the fund’s 10 year term (plus any extensions), there could be one or more large investors in the fund, such as a governmental employee pension investor, which would prefer to continue holding the securities in the underlying cash flowing portfolio company rather than having the fund sponsor liquidate the portfolio company, potentially during a sub-optimal market cycle.

In this scenario, there are several alternatives which could allow fund investors to remain beneficiaries of the investment. First, the portfolio company could seek an initial public offering of its equity securities. If successful (and following expiration of relevant lock-up periods), the fund could make a distribution in kind of publicly traded securities of the portfolio company to those certain investors electing to receive them (and for those investors not making such an election, the sponsor would liquidate a number of securities necessary to make an equivalent distribution in cash to such non-electing investors). The main problem with this solution, however, is that only a select few portfolio companies, even among those with stable, cash-flowing assets, have a substantial enough business and characteristics to successfully access public capital markets. In addition, the internal allocation policies of these investors may have differing treatment for private versus public investments.

A second alternative would be for the fund to offer its investors, at the end of the fund’s term, liquidity or the option to remain in the long hold portfolio company, perhaps structured through a parallel vehicle outside the fund (thereby allowing the fund to liquidate). The portfolio company would have to raise additional capital, either from third parties or continuing investors (or both), to fund the redemption of non-electing investors who want liquidity. The potential issues with this strategy include (among others) the risk that a capital raise is not successful enough to fund the redemption of the non-electing investors. Further, an investment bank would have to value the business for purposes of the new capital raise, which could create a conflict between the new investors and the continuing investors, particularly as it relates to the degree of dilution that the continuing investors are required to take. This conflict could potentially be mitigated by third party participation in the capital round. It is also important to note that investors electing to exit will seek an optimal tax structure, and though it is beyond the scope of this article, consideration will be given to whether a redemption transaction, relative to a sale of partnership interests, maximizes the amount of capital gain relative to ordinary income recognized by the exiting investor.

A third alternative is to structure, outside the fund, a separate investment vehicle that co-invests alongside the fund in portfolio companies with energy infrastructure assets that have long, stable cash flows, such as an interstate pipeline system or gas storage terminal. Although the separate investment vehicle would co-invest alongside the fund, it would have an extended term (i.e., 20 years), and could potentially exit the relevant portfolio companies at the end of the useful life of the underlying assets, rather than at the conclusion of the fund’s term. The fund sponsor would have to decide what rights and obligations this vehicle would have upon an exit by the fund from an investment. One approach is for the separate vehicle to have a passive investment thesis, and for this vehicle’s investments in a portfolio company to be subject to a drag-along covenant in favor of the fund which allows the fund to sell 100% of the equity of the portfolio company. A different, more active approach would be for the vehicle to have a right to match a third party buyer’s offer and acquire a company for its long-hold strategy. Ultimately, investors in the separate vehicle will have views on and will influence the preferred approach. The investor’s economic terms in this vehicle are not necessarily the same as the fund’s economic terms – for example, investors may ask for lower management fees given the long term nature of the separate vehicle. Other potential issues that could arise include (i) the allocation of partnership expenses between the fund and the vehicle (which would generally be allocated on a pro rata basis by reference to the size of the fund and vehicle’s relative investments) and (iii) how investment opportunities are allocated as between the fund, the vehicle, and even other fund investors who do not participate in the vehicle but which seek co-investment participation in certain fund investments.

Conclusion

As the population of funds focused on energy infrastructure grows, fund sponsors must compete for investors. This competition can drive some fund sponsors to adopt conventional fund documents that function very similarly to a buyout fund’s agreement. While this strategy is not unreasonable, it can lead to a fund agreement that does not address the unique situations that an energy infrastructure fund encounters, and may require more management of investor relations after the closing, and potentially at the end of the fund’s life, than the sponsor or the investor anticipated. With careful scenario planning during the marketing stage of a fund, it is possible to solve for some of these endgame scenarios and potentially distinguish the sponsor to investors as seasoned and thoughtful about the realities of energy infrastructure investments.