Into the Un-‘Known'

It’s not what you don’t know that gets you in trouble. It’s what you ‘know’ …that just ain’t so.

Though unconfirmed, this quote is often attributed to Mark Twain. Regardless of the source, there is a lot of wisdom in this old saying. We are weary of the unknown yet embrace what we feel as “known” without question.

The problem is, what we “know” is inherently biased by short-term signals. In contrast, optimal decision-making involves incorporating but modulating short-term indicators while marrying those with longer-term observations in order to inform our view of the future. As private market investors with a long-term horizon, we should be better at this than most. However, even the most rationale long-term investor can’t help being influenced by what we observe in the short-term, especially when those observations are echoed and repeated by nearly all market participant.

We are seeing some of this today in private real assets. I wrote previously in Catching the Wave about the strong macro themes driving infrastructure investment over the last several years. We continue to see those same themes attracting capital today. Indeed, it seems that nearly every infrastructure investor has been investing behind three key themes: Electrification, digitization and logistics. On the real estate side, we are hearing more generalist funds shifting to “only targeting” industrial and multi-family properties. Traditional energy, you say? No way. Invest in office, retail and hospitality? Are you trying to lose money!? There is a market consensus today that these assets have no future based on a reasonably short (albeit bumpy) recent past.

Mark Twain also famously said “The reports of my death have been greatly exaggerated.” So, with that in mind, what do we “know” that may not be so, and where are we potentially missing contrarian opportunities?

We’ve written extensively about the capital needs required to effectuate the energy transition. Over $4 trillion of capital is projected to be required to meet those goals. McKinsey recently put that number as high as $9 trillion. Not surprisingly, private investors have lined up to raise capital pools targeted specifically at this opportunity set.

Energy Transition-Oriented Funds in the Market
Shown as a multiple of 2006 in Hamilton Lane Proprietary Fund Database

Although the future looks electric, are investors potentially missing some warning signs on renewable assets? And, conversely, are there attractive investment aspects of traditional energy that are being overlooked?

Let’s look at a couple of things. First, with significant capital going to fund renewable generation, we are seeing higher degrees of renewable penetration in power markets across the U.S. But, with higher degrees of penetration, we are also seeing higher levels of curtailment on renewable resources. The graph below illustrates this in the California Independent System Operator (CAISO) market. By the end of 2021, roughly 23% of the power generated in CAISO came from wind and solar generation as this market has made great progress in moving toward renewable energy goals. But, while wind and solar penetration have increased, so has curtailment of these power generation resources in the CAISO market. Curtailment means to reduce the output of a renewable resource below what it can produce, potentially indicating over-built resource capacity in a specific type of generation. This introduces certain risks to developers and owners of these assets. Significant upfront capital costs are required to develop utility scale solar and wind resources. These upfront capital costs are undertaken based on expectations of future power prices and resource utilization. Depending on the payment schemes in the market, high degrees of curtailment can be indicative of an overbuilt market and one in which an owner needs to lower their expectations around both power prices and resource utilization.

Penetration of Wind & Solar (rhs) vs. Curtailed Energy (LHS)

We also see valuation risk increasing for renewable assets, as well as the execution risk investors seem to be willing to take today on renewable project development pipelines. Look at the chart below:

TEV/EBITDA

You can see that EBITDA multiples for renewable energy companies are near all-time highs, with multiples hovering between 35-40x. In contrast, traditional energy companies are trading at 5-7x EBITDA. A multiple of 35-40x assumes significant future growth in the platform — growth that may be difficult to achieve given transmission and distribution constraints.

We are also noting some aggressive underwriting assumptions for renewable assets and perhaps overly aggressive projections about the retirements of some traditional energy assets in certain power markets.  For example, consider the table below, which summarizes some of the underwriting assumptions we’ve seen versus what we feel are more realistic expectations around asset useful lives.

Why does this matter? Private investment tends to lean into markets where there is a strong belief of pending asset retirements that will require capacity substitutions from renewable resources. In addition, if useful lives are over-estimated on renewables relative to the actual capex requirements to build and maintain those assets, the risk of capital destruction increases.

At the same time we are seeing an increased risk in some of the renewable generation assets, we may also be missing opportunities in traditional energy. With improving commodity prices and capital discipline, the E&P sector saw record free cash flow and strong free cash flow margins last year. That strength is continuing into 2022. And whereas producers have historically increased capex with higher commodity prices, they are now showing much more discipline in their capital spending programs. This capital discipline is expected to be a permanent change to their business models, as E&P companies have heard from shareholders that they need to live within cash flow and remain selective about new development programs.

Leveraged Free Cash Flow Margin
LTM, Median Across Selected Peer Sets

S&P E&P Selected Cash Flow
Per Share

S&P 1500 Oil & Gas E&P (Sub-Index) Capex vs. Oil Prices
2004-2021; Average WTI Price ($bbl) by Quarter vs. Capex (Rebased)

In making some of these comparisons, we put together the table below. As noted, there are some similarities we are seeing in renewables today relative to the shale revolution we saw years ago — namely, aggressive capital inflows, loosening underwriting standards and an apparent unwillingness to distinguish between resource grade.

On the flip side, we see limited capital interest in traditional energy assets despite high distributable cash flows, disciplined capex decision making and attractive entry valuations. Most of the lack of institutional capital interest in the traditional energy space is attributed to ESG concerns related to the future viability of these asset types. These concerns are warranted, but as we have previously noted, we believe energy transitions take time and that traditional sources of energy will continue to make up the bulk of global energy needs for the foreseeable future. After a few very difficult years of capital raising, we are seeing some capital start to flow back into the traditional energy space, which is being reflected in share price performance relative to clean energy alternatives.

Growth of $100
1/2/2014 - 2/24/2021

All of this is not to say that we should stop investing in renewables or reverse progress in the energy transition. It is to highlight though that despite strong macro tailwinds, investing is never without risk and we see elevated risk in the renewable sector today as evidenced by high entry price multiples, aggressive underwriting assumptions, increased asset curtailment and potentially unmanageable constraints related to interconnection, transmission and distribution.

When we hear themes repeated and see the majority of market participants pursuing similar themes, it becomes much easier for us to accept those observations as known fact. Those “knowns” then become the basis for future decision-making and we may inadvertently create self-reinforcing feedback loops that lead us to screen out observations that we deem inconsistent with our own set of facts. As a result, we only see opportunities that look and feel like what we want to see, and although data may be telling us that we need to reevaluate what we “know,” it becomes increasingly difficult to shift our frame of reference.