Building a better mousetrap

STEP INSIDE FIRST Reserve Corporation’s Greenwich, Connecticut headquarters and sooner or later you’re bound to spend time viewing the “wall of fame”: a large, central hallway whose walls are filled with images of rigs, turbines, drill pipes, refining equipment, ships, mines and other successful investments from the private equity firm’s 26 years of investing in the various facets of the energy sector.

Just off the hallway, in a large, sunny conference room you might bump into Mark Florian, the man First Reserve has hired to re-do its interior décor. His task is to add a collection of infrastructure assets to the wall.

For anyone familiar with the 23-year Goldman Sachs veteran’s past life, you will likely start thinking about the Indiana Toll Road or the Chicago Skyway, the two roads the Chicago native helped auction off to the private sector in back-to-back blockbuster infrastructure deals in 2004 and 2006.

But these days, if you ask him to describe what he’s up to, he is likely to smile and say he’s “building a better mousetrap”. It’s his friendly way of letting you know that he’s now done with auctions and toll roads and that he has other plans for filling up that wall: energy infrastructure assets.

Unlike toll roads, these are assets with little or no demand risk and a lot more certainty over cashflows. They’re not easy to find, but they’re out there. And if there’s any firm that can find them and incorporate them into its portfolio without going through what he calls “the fury and excitement of a public auction process”, he believes it is First Reserve. And First Reserve believes he’s the right man for the job: not in spite of but in no small part because of his toll road experience. Together, they’ve got big plans for the asset class.

NOT ‘ME TOO’

To get an idea of how Florian ended up at First Reserve, it’s important to note that he’s not a “me too” kind of guy. Just one example: he staunchly opposed early policy formulations within the US Congress for a national infrastructure bank because he thought they didn’t offer anything new to the market. “I thought it was just more of ‘me too’ capital that didn’t really solve a problem or add to the solution,” he says.

Cynics, of course, have said the same thing about private equity firms moving into infrastructure: isn’t it all just “me too” capital? Not First Reserve, says Florian: “Everything that we’re working on in this space is through some direct dialogue with a corporate partner where we’re creating something from scratch”, as opposed to participating in competitive auctions for assets. He admits that “sometimes it’s a little harder to create things in this way” but he believes it’s possible at First Reserve because the firm has a long history of sourcing deals through the team’s rolodexes. One indication of this: in April, First Reserve closed its 12th private equity energy fund on $9 billion, according to a press release.

In the private equity world, sourcing deals through rolodexes is often termed proprietary dealflow, and it’s even harder to find in infrastructure because so many of the assets are held by governments. “And, almost by definition, governments have to auction,” notes Florian.

But things are different in the energy infrastructure sector. “Most of the assets are controlled by private-sector participants, particularly in the United States,” he says. So if you’ve got the relationships, chances are you can get proprietary infrastructure dealflow.

First Reserve says that was already happening – except the firm wasn’t pocketing the results. “We were referring deals out and really giving deals away because we didn’t have the team,” says 19-year First Reserve veteran Cathleen Ellsworth. Since one of the things limited partners in private equity firms pay for is the general partners’ relationships, “the LPs paid for that dealflow already”, she says. And so, in 2007 the firm set about to action that dealflow for itself.

A year-long dialogue with Florian ensued. He describes 9 July, 2008 as “a day I’ll never forget”: fresh after completing six months of non-stop diligence and countless all-nighters for Goldman Sachs Infrastructure Partners’ ultimately unsuccessful bid for the Pennsylvania Turnpike, Florian told his coworkers at Goldman that, less than two years after making partner – itself one of the most exclusive clubs on Wall Street – he was heading to First Reserve to start an energy infrastructure team.

Why? More than anything else, he says he saw an opportunity to “try to create a different paradigm for investing in these types of assets”.

NEW PARADIGM

Energy infrastructure, he says, is a unique sweet spot for infrastructure investors because “a lot of the assets for infrastructure in energy actually don’t have demand elements to them”. Marrying that with the conviction that there is “an over-arching movement” toward the use of clean energy in the energy sector generally, he and his team have identified three sub-sectors they see as being rich with the right kind of infrastructure assets.

The first is power generation – both renewable and conventional power. This would include power plants such as wind farms and gas-fired generation stations. Florian thinks most of his investments in this category might fall into the renewable side thanks to the revenue-ensuring incentives being provided by some countries’ governments. “For example, in Spain there is a tariff for wind. If you build a wind farm in 2009, you know you have that tariff for the next 20 years and it’s adjusted by inflation. So how much more certainty do you want?” he asks.

The second is what he calls “contracted midstream” which consists of pipeline and storage facilities for the transport of commodities that have long-term, availability-based contracts attached to them. “[With] a lot of pipelines, you get paid on availability. So it’s not unlike the [private finance initiative] deals in the UK, where as long as the pipeline’s available, somebody’s paying for 40 percent of the capacity to be available for them.  It doesn’t even matter if anything passes through the pipe,” he says. “That is a very small slice, frankly, of a much bigger space.”

The third sub-sector consists of transmission and distribution assets that sit within regulated utilities. “The most interesting space for us there is transmission because there’s just so much need” he says.

Florian draws a line in the sand between these and other infrastructure sub-sectors like ports. These, he points out, are fine investments with their own virtues, but their activity volumes are linked to GDP growth. That can introduce elements of trade and international demand risk that are hard to control or offset.

The same goes for energy assets. He’ll pass on opportunities where an energy-linked investment, such as an oilfield services company or an oil rig, involves demand risks, price risks, commodity risks or depletion risks. “In terms of infrastructure-style investing, those aren’t the types of risks that one should take,” he says.

As a result, the First Reserve approach to infrastructure investing is remarkably simple: invest in assets that you can de-risk as much as possible. With this in mind, he has already started looking at opportunities.

This philosophy extends to some greenfield, or new construction, projects. Florian believes “there are different shades of green” within greenfiels. Some – like right of way acquisition and permitting risk – he would not touch, while others are more manageable. For example, if First Reserve can get a contract from an engineering, procurement and construction that says, “I will guarantee the price and the timing of delivery” for a wind farm, then, says Florian, “that to us is something that could fit infrastructure investing”. “We generally want to have everything either contracted or regulated so that there’s a lot of certainty with regard to the revenue line”, he adds.

He also wants to acquire assets that he and his team can have a good handle on operationally. Toward that end, Florian is building out his team with professionals strong on operational expertise, especially in power generation.

Growth could be quick. His group is currently eight strong, but he says “we’ll have 15-20 people as part of our team a year from now”. He’ll be looking to hire from some premier houses too, as he has already done: his top people include Credit Suisse utilities banker Chris Hearn and John Barry, one of the founders of 3i’s infrastructure business, based in Greenwich and London, respectively.

LEARNING BY VIEWING

The benefit of bringing in outsiders, of course, is the particular experience they bring to the team. Florian admits he was not an energy specialist while at Goldman (nor really a toll road expert for that matter; he chuckles as he points out: “I didn’t do toll roads for 23 years” while at Goldman). Instead, he was more of a generalist, working on every type of infrastructure asset from ports and waste to lotteries.

“I think there’s a lot of lessons learned in terms of the mistakes of the past that can be applied not only to transportation-related investing but also energy,” he says.

How does one apply lessons from ports to energy? “I can remember one specific circumstance where folks were thinking about port assets and the fact that trade with China had driven 8 percent compounded growth in container traffic going into West Coast ports for the last 20 years. And that’s really striking – 8 percent compounded for the last 20 years? So we’ll be conservative and we’ll only assume 3 percent growth for the next 20 years. We’ve found just in the last year that paradigm doesn’t really work,” he says.

Indeed, July marked the 25th straight month of declining year-on-year container trade volumes at US ports, according to the National Retail Federation’s and IHS Global Insight’s Port Tracker report. First Reserve will avoid making investments along the same assumptions.

What about toll roads? With the draw of easily available debt pre-credit crisis, many toll road investors worldwide didn’t just overleverage assets at the outset: they also assumed that they would be able to “releverage,” or increase leverage over time. Releveraging proved to be the kiss of death for many of their base case returns once debt markets dried up because, all of a sudden, a myriad of assumptions about the kind of debt they could get in the future turned out to be invalid.

“We’re not going to rely on a debt take-out and all the assumptions related with how much and what’s the rate going to be and what’s the term going to be,” says Florian. This comes despite the fact that he could still probably do so if he wanted to. “For most of the assets that we’re focused on, there actually is a pretty good availability of debt,” he says.

Given today’s lean debt environment, would First Reserve potentially buy an asset all-equity? “Absolutely,” he says, adding that “to the extent that we put in 100 percent equity and we can borrow 30, 40, 50 percent of it later on, that’s just an upside, but it’s not going to be our base case.”

Leverage, ironically, was a big part of the reason why some of the auction processes he advised on turned out so well for the governments that sponsored them – but resulted in headaches for some of the buyers.

“Folks talk about some of the ills of the past and how could we do it better now. I think some of those ills were actually driven because people were stretching and trying to win in auction situations,” he says.

“How can you win the auction?” he asks. “Well, there are three things you can do. You can put more leverage on it. You can cut your equity returns. Or you can be more aggressive in terms of how the asset is going to perform over time. Any one of those three levers can help you stretch a little bit more, to pay a little bit more to hopefully win the assets.”

At First Reserve he hopes to avoid all three pressures by sticking to proprietary dealflow.

NOTHING TO WINE ABOUT

But it would be a mistake to think that Florian is turning his back on his Goldman past. “There is probably nothing like the fury and excitement of a public auction process,” he says with a noticeable hint of nostalgia in his voice.

He still fondly recalls opening up the envelopes containing the final bids for the Indiana Toll Road with Governor Mitch Daniels. “We found this conference room where nobody could find us and we had three envelopes on the table – and this happened with the Skyway too – where my respective client was nice enough to ask: ‘well, which one should we open up first?’” And in each case they found more money on offer than any of them had ever imagined.

And therein he finds an answer to the only question that stumped him during our two-hour meeting: how does one of his favorite hobbies – collecting and enjoying wine – illuminate investing in infrastructure? Opening up the bids was a little bit like opening up a good bottle of wine he says – “particularly when it goes well”. Then he pauses and adds: “It doesn’t always go well.”

But if all does go well at his new home, it may only be a matter of time before he’ll be hanging some new artwork up in his office in Greenwich.