Finding creative ways to maximize cash flow is one of the primary goals of a private equity firm and its portfolio companies. Strategies tend to fall into one of two categories: encouraging new growth with new products, new markets, or new employees; or reducing unnecessary costs — like limiting overhead or eliminating excessive expenses.
To help reduce these unnecessary expenses, some investors and lenders have begun to offer energy efficiency financing, “the strategy of providing capital to commercial properties to upgrade their energy efficiency,” explained Eric Starr, a Partner at CapX Partners. “Once the retrofit has occurred, the lender will take a percentage of the saved capital until the investment has been returned. After the lender has collected its money back, the building owner gets all of the savings.”
The numbers behind energy efficiency financing should appeal to any investor. “The vast majority of commercial buildings that have not gone through an energy audit or upgrade are becoming increasingly inefficient everyday,” explained Starr. In a report published in 2009, McKinsey learned that more than 100 million buildings are eligible for such retrofits, and “if executed at scale, a holistic approach would yield gross energy savings worth more than $1.2 trillion.” While these numbers refer to both commercial and residential properties, the takeaway is still significant.
However, there are hurdles to overcome. According to a recent Guardian article, many investors are wary of the size of an individual project: “Banks untroubled by investing billions in mortgage-backed securities were wary of investing millions in energy retrofits. After all, each deal requires bankers’ time, so — from that perspective — smaller deals come with diminishing returns. And the energy efficiency industry wasn’t prepared to supply enough projects to be bundled into a bigger, bankable deal.”
This niche opening lends itself to middle market and lower-middle market lenders and investors. If the energy efficiency projects are not large enough in size to interest many bulge brackets, smaller lenders and investors may be able to broaden their investment thesis — or shift it — to better accommodate the growing market.
Processes & Insurance
Starr explained that the process of providing energy efficiency financing involves several parties and several stages of analysis. The process starts with “engineering firms that can determine how much energy conservation measures can save a building. Once they determine the energy situation, they can provide customers with recommendations that can be implemented to significantly reduce consumption through energy efficiency upgrades — anything from lightbulbs to a new power source. Engineers can then determine how much a retrofit would save the building.”
With the potential upfront cost and long-term savings estimated, the project is evaluated through two separate lenses. “The first is the actual engineering of the project, which is reviewed by engineering partners to help see the project through insurance underwriting for performance guarantees,” explained Starr. “The second perspective is in determining the cost of the project. We look at the guaranteed savings of the project to determine how much capital we can provide to finance the project.”
To further mitigate risk, Starr encourages the utilization of external insurance firms to guarantee the savings. Starr explained that by working with an insurance company, it “will insure a certain amount of savings, which takes significant risk off the table.” With the insurance in place, the “primary concern is whether or not the customer will be inhabiting the building for the entire term of the loan,” explained Starr. “There are no savings if nobody is in the building. As such, we do some pretty standard underwriting of the owner, to make certain he won’t go bankrupt over the term of the loan.”
From a portfolio company perspective, energy efficiency financing could be a worthwhile investment. Not only would it reduce unwanted energy expenses, but it could help boost the value of the business — especially when it comes time for an exit. The loan can help increase your EBITDA by reducing fixed costs, making the business worthy of a higher valuation at the close of your 5-7 year window.
Plus, It Does Good
In addition to the financial opportunities presented by energy efficiency model, there are added benefits from an environmental perspective. “Not only is this a large and underserved market, but by providing capital to allow these properties to become more energy efficient, we would reduce the draw on the energy grid, reduce the amount of carbon emission, and reduce need for foreign oil,” explained Starr. “At the end of the day, we are trying to improve buildings and make them more efficient.”