Huffpost Business
THE BLOG

Featuring fresh takes and real-time analysis from HuffPost's signature lineup of contributors

Peter Gardett Headshot

Shadow Banks Go Long Energy Projects

Posted: Updated:

Hundreds of millions of dollars have been committed to solar and wind projects in recent weeks, and while the end of the year often brings with it a spate of deals to avoid upcoming changes in tax policy, that money is coming from a new and different source.

The rush of dealmaking in the final weeks of 2011 has been striking after a relatively slow year in fundraising for energy deals of any kind, but even more surprising have been the players: private equity firms and hedge funds.

Private equity firms and hedge funds are part of what is often referred to as the "shadow banking system," a collection of financial players that do not take deposits and operate outside the traditional regulatory formats of large banks. They have grown in scale and importance in recent decades despite occasional problems like the failure of Long Term Capital Management, and amid increased regulation and constricted lending by traditional banks, these members of the shadow banking system are playing an increasingly important role in the energy business.

The Players Change

The timing of the recent deals overlapped a rush of headlines outlining new regulatory threats to traditional bank lending for comparatively risky projects.

The Commodity Futures Trading Commission released new rules designed to improve the transparency of energy hedging activity but also potentially reducing trading volume in markets banks use to hedge project financing risk. The Federal Reserve indicated its intention to boost capital requirements to comply with increasingly strict Basel III international banking rules that will leave banks desperate to cut leverage and conserve capital where they can. And the largest US banks began to signal their intent to declare themselves as SIFIs (systemically important financial institutions), which would limit their ability to lend and act as counterparties but would guarantee them eased access to cheap government financing.

Banks' diminished appetite for project financing risk or lending to troubled sectors are reflected in the kinds of deals their private equity brethren picked up in recent days. The new deals announced at the end of this year include KKR's investment in a quartet of Recurrent Energy Solar projects, Terra Firma's purchase of wind energy assets and South Korean private equity funds in California's Stion solar manufacturing firm.

The largest private equity firms and hedge funds may need to register as SIFIs, but so far they have resisted pressure to limit their activities. They may be joined, both as partners and competitors, by discreet sovereign wealth funds and state-owned international energy companies, both of which have made significant investments in the US energy sector in recent years.

The Game Remains The Same

The financial world often views hedge fund and private equity players as "cowboy" institutions, keen to juice returns to investors and owners through leveraged financing, strategic reorganizations and tax-advantaged trades. The traditional view of the shadow banking system is one of fast moves and quick profitable exits, both approaches ill suited to the heavily regulated and politically sensitive but stable and potentially lucrative energy sector.

The shift in KKR's approach to the energy sector in the past few years demonstrates a new approach by private equity as they adjust to their new scale and focus on reliability of returns - a traditional banker's approach - rather than asset appreciation. KKR purchased the massive and diversified utility TXU five years ago for $45 billion, and while that deal's final outcome is still up for judgement, the firm has repeatedly had to dial back expectations as its plans for boosting value came up against a host of political, regulatory and economic challenges.

Last week's investment in Recurrent was made by KKR's infrastructure fund, a pool of money dedicated more to steady returns from transparent and comprehensible credit risks better suited to energy sector investing.

The money to be made in energy infrastructure is usually patient money, despite the appeal of fast returns from energy trading or oil-and-gas wildcatting. As shadow bankers learn new ways of evaluating energy investments, they will also bring with them new kinds of portfolio pressures and analysis as they knock on energy company doors. They have the potential (and increasingly the capital) to upend longstanding corporate relationships and alliances between major energy companies and major banks.

The reputation of private equity and hedge fund groups for short-termism and rapacity can make it difficult for stakeholders to swallow the idea of their taking larger positions in US energy infrastructure ownership. But with as much as $4 trillion needed to shore up crumbling infrastructure and avoid blackouts in the coming twenty years, the industry needs all the private capital it can attract.

If energy companies and new investor types can learn from each other, a virtuous cycle could result marked by steady returns on capital and revived national infrastructure. But get ready to navigate a bumpy, educational road while we get there.

See more from Peter Gardett and other AOL Energy editors here.