Originally posted in Greentech Media. In this #Solar100 interview, Richard Matsui, Founder and CEO of kWh Analytics, speaks with Brad Bauer, Co-Founder and Partner of Lacuna Sustainable Investments.

As one of the first investors in the U.S. solar market, Brad Bauer’s led teams to “boldly go where no one has gone before.” In his fifteen years working in renewables, Bauer co-founded one of the industry's first private "YieldCos", raised nearly a billion dollars for one of solar's brightest burning stars, and started a new company built on the lessons learned from the last one.

In this #Solar100 interview, Bauer discusses lessons learned from Cypress Creek, the evolving market structure of the solar industry, and the future of development capital.

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STARTING IN RENEWABLES

Richard Matsui: You majored in political science and economics, got your JD, then started your career at KPMG focusing on M&A. When did you first decide to work in renewables?

Brad Bauer: I actually started out working at a law firm in Boston then tagged along with my then-girlfriend now wife when she finished school and started practicing in San Francisco. I wasn’t enamored with practicing law—it certainly wasn’t something I wanted to do for the rest of my life. So I joined KPMG, one of the Big Four accounting firms and was admitted to the partnership a few years later.

KPMG was a really incredible place, as it gave me the opportunity to build a proactive practice focused on increasing project returns and corporate profitability and afforded me the opportunity to work with large company CFOs and Board directors at a really young age. I realized what I enjoyed most about my work was the creativity required to advise sponsors and investors on project based transactions. I didn’t work on any solar projects at KPMG but was involved in what were, at the time, some good-sized wind transactions. I left KPMG thinking solar had many of the attributes that made wind attractive and thought I’d have a chance to use what I’d learned and the relationships I’d built in solar.

After leaving KPMG I co-founded MP2 Capital, which was one of the first equity investors in U.S. solar assets. There I had the opportunity to partner with Mark Lerdal, a brilliant lawyer and executive, not to mention a great person and Jeffrey Glavan. We weathered the global financial crisis and developed a good sized portfolio of operating assets that we sold-off in a piecemeal fashion throughout 2014 and 2015.

Following that, I took a year off before joining Cypress Creek Renewables, where I was the Chief Capital Markets Officer and a member of the Board of Directors. While there we raised $450 million of corporate debt and another $300 million of equity.

I left Cypress last summer and formed Lacuna Sustainable Investments with Patrick McConnell and David Riester. We closed our fund in March of this year.

 

CYPRESS CREEK: THE THESIS, THE WHIPSAW, AND THE LESSONS LEARNED

Richard Matsui: I’d love to hear your experience of Cypress Creek, starting with the early days of the startup and its thesis.

Brad Bauer: What made Cypress unique was the identified opportunity to build solar at scale, quickly. We sold MP2 Capital because we didn’t see a path to scale without a great deal of third-party capital and resulting loss of control. Cypress, on the other hand, invested in a nascent market that evolved into a fantastic market, and used the resulting development investments as collateral for its initial corporate facility. As the development investments matured the company was able to borrow more money, which fueled additional investment. The market, of course, was North Carolina, where the combination of the public utility commission’s implementation of PURPA, the North Carolina state tax credit, the federal tax credit, and to a more limited extent, the state RPS and property tax abatement, created the market. In many ways, North Carolina was the perfect opportunity, not only did you have the financial characteristics just mentioned but you also had plenty of inexpensive land, clear interconnection and entitlement processes and reasonable labor costs. The speed at which equipment prices dropped didn’t hurt either.

All this allowed Cypress to acquire, build, and finance a large number amount of assets in a short period of time. It was uniquely exciting and yet unsustainable opportunity, with an unbelievably talented group of people motivated to do great things. 

Richard Matsui: As Cypress grew its headcount to 400+ people, everyone in the industry was talking about Cypress. Invariably the conversation would involve some version of, “Wow, that is incredibly aggressive growth,” followed immediately by, “But the team there is really strong.” I’m not a project developer myself so I can’t assess development skill, but I do closely observe reputations. Despite having such a strong team, things didn’t go to plan. What happened? 

Brad Bauer: Ultimately, Cypress developing at scale outside of North Carolina, while managing the growing cost structure, was problematic. And saying Cypress was a pure greenfield developer is a bit of a misnomer. While there was some early-stage development at work, Cypress had access to capital (corporate and project level) and went out and acquired projects from local developers at a pace and volume tacked to maximum use of available capital. The sheer number of acquisitions and the resulting need to move a large number of small projects through the system led the company to build an army of people focused on all aspects of design, engineering, construction and financing. And for a time, it worked when the market was lucrative and conditions relatively static. Unfortunately, value is ultimately determined at the company, rather than project level, and if your cost of production exceeds the value of what you have produced, well, that’s not a good thing.

The board dynamic was tough as the equity chose growth over value creation, the lenders took a laissez faire approach based on their underwriting of asset values and both decided to ignore the reality that the North Carolina market was unique and unlikely replicable elsewhere. As it turned out, the North Carolina market changed for the worse, new markets did not develop, asset valuations were overly optimistic and the company could not keep up with the constant need for capital. As a result, the company’s lenders became the equity and have spent the past couple years in the market looking for answers.

Cypress’s cost structure wasn’t that of a successful developer. It was structured more along the lines of a manufacturer with disparate groups tasked with moving a large number of small projects through design, engineering, construction and financing. Definitely not the sort of lean, value creation focus one sees in a successful developer. While we did raise some preferred equity late in the life-cycle, for most of its existing the company was funded almost entirely with debt, and a lot of it. To service the debt, it had to maintain a constant velocity and volume of projects that would generate a projected value. Overly optimistic assumptions as to development timelines, MWs or project values create massive problems when you have high SG&A and quarterly interest obligations.  If the sale market slows, a market doesn’t materialize or financing assumptions decline, the only way to meet your fixed and variable cost demands is to raise additional capital.  As these things occurred, the company  needed more, and more, and more money. But absent  profits or value creation this became an uphill battle. Development takes time and valuation is dynamic. So if you’re not able to build as many assets as you thought as quickly as you thought, and they don’t have as much value as you thought, it’s a whipsaw. You’re in trouble. 

Richard Matsui: You seem to be pointing out two sides of the same coin—the aggression is what enabled Cypress to have that scale of impact, but it also created some structural challenges. When you take a step back, what lessons do you draw from that?  Because in the end it’s not as simple as, “Don’t be aggressive,” right? 

Brad Bauer: Absolutely. Lesson number one: Profitability, value creation, and liquidity are absolutely necessary for long-term success.  If you’re not profitable or if you’re not creating value you are not going to have access to the cash you need for very long, And without it you are not going to survive.  

Lesson number two: Even a great culture needs a strategy. Cypress had an incredible group of extraordinary professionals focused on doing great things. A really great culture.

Lesson number three: Just because someone is willing to loan you money doesn’t mean you should take it.

Lesson number four: Owning assets isn’t for everyone.  If you think it is for you, you need to know what you’re trying to accomplish. Why do you want to own the asset? Can you afford to own the asset? What are you going to do with the asset? Are you the best, cheapest, owner of the asset? Is ownership the highest and best use of you limited resources?

Lesson number five: People who don’t prepare for a rainy day just haven’t been around solar long enough. This goes to capital structure. Make sure you are capitalized such that you can thrive in good times and survive the rocky ones. And choose the right partners.

Ultimately, you’ve got to focus on your “bottom line”; take actions consistent with your short and long-term goals; make sure if you take other people’s money you have a good use for it; and prepare for the inevitable cloudy day so you can get to the other side.

Richard Matsui: I’m reminded of a previous Solar100 interview with Ed Feo, in which he said that having a fixed annual MW target is a fundamental mistake for a development business, simply because markets change constantly. How do you think about that?

Brad Bauer: I agree. It comes down to capital structure. If you are capitalized with debt, the die is cast. You need to build X MW at Y margin in order to meet SG&A and capital obligations. If the markets change, you are in trouble. If you can’t meet your capital obligations, you are in trouble. That’s the challenge. People love the idea of preserving equity upside but often fail to recognize how it impacts risk.  It is hard to get off the debt treadmill . A capital raise feels great, but investors and lenders expect returns of and returns on capital and if you are not creating value in excess of these amounts all you are doing is making money for others.

Richard Matsui: Related, you’d written about choosing development capital paths, and I thought this line was really well put: “Alas, conservatism and prudence are not the first two words that come to mind when one considers developers, so the growth treadmill is common.”

MARKET STRUCTURE EVOLUTION

Richard Matsui: I’m intensely interested in theories of how the market structure of our industry will evolve, and so I really enjoyed the 3-part series your firm published on the future of development capital. Clear thinking is hard to come by. Can you outline that thesis?

Brad Bauer: In a sentence, it is that your choice of how you capitalize your company and assets ultimately dictates the actions you need to take. Developers frequently take the road that offers the greatest possible upside, but don’t think about how capital structure creates risk in achieving that upside. In that paper, we posit that anytime you take somebody else’s money, you’re giving up something. And you have to understand what it is that you’re giving up and how that impacts you personally. Which I think Dave, who wrote the article, does a great job of laying out.

Development is an incredibly cash-intensive business, and when you’re short on cash it ultimately takes away opportunities. So you really have to be thinking about capitalization at all times. There is no one right answer by any stretch of the imagination, but there are a few answers:

1.      Self-financing, if you can do that, is absolutely fantastic, but you have to have a lot of conviction or you need to have a heck of a lot of money.

2.      For developers trying to raise cash at the corporate level, you have to have a heck of a good thesis and you have to have a market that you can “exploit” and not have bigger dreams of going outside that market at the outset.

3.      Selling to larger developers can be a great situation, though it’s fraught with challenges because everybody is competing for capital. That inevitably creates a project hierarchy, and capital flows to the highest and best opportunities. And once your project is in somebody else’s pool, you’ve lost control over it.

4.      Raising project level development capital is challenging and costly, but it does allow for some of the benefits of both self-financing and corporate-level financing. It allows you to control your own destiny to a greater extent.

Richard Matsui: The article raised an interesting analogy with tech, real estate, and pharma: in other industries you see the emergence of early stage, true equity risk capital. Equity capital is able to take on that risk, despite the unique complexities to each of those asset classes. Why has 3rd party development equity been so scarce for our industry? I understand why it took a while for tech VC to emerge, but power plant development has existed for a long time. 

Brad Bauer: I think it comes down to the risk adjusted return potential and the effort required to source, diligence and monetize the investments.  When you think about an early stage technology or biotech investment, there is often an established market for the investment and a single investment can carry an entire fund.  There’s effectively unlimited upside to those investments because of the nature of what’s being produced.

In contrast, solar and storage development investments are pretty complicated and painful to invest in; it’s niche work with a lot of documents and models. There’s binary risk. The check sizes are pretty small. It’s a tough space to deploy large amounts of money, and there is a limitation on the upside potential of the investments. Along these lines it is not difficult to imagine owners and developers looking to Solar Revenue Puts as a means of eliminating downside risks, which would, in-turn, improve risk-adjusted returns for investors and decrease capital costs for developers.

Marketplace dynamics also change rapidly. As off-take contract terms get shorter and shorter, investors are who want to deploy money into the U.S. solar market are being forced to take more and more merchant risk, which will create winners and losers. 

Richard Matsui: I think the “low-upside, high-downside” observation is very astute; I haven’t heard it before. On merchant risk, I’ve been astounded by how quickly equity went from taking zero merchant risk to accepting the highest merchant curve it can find. One would have to assume the next logical step will be for investors to accept Ventyx at 3x.

Over the past three years there has been a strong shift towards the tie-ups between developers and the long-term asset owners. The asset owner’s motivation is clear: access to deal-flow. But it’s less clear to me why developers have taken this path. BlackRock with Distributed Solar Development, Capital Dynamics with Sol Systems, Osaka Gas with SolAmerica. What changed on the developer’s side?

Brad Bauer: Fundamentally, it’s a need for capital. Development pipelines are a very thirsty plant: they need a lot of cash at the outset, and even more cash as they mature. Most developers don’t have the cash to handle the magnitude of investment required to support PPA deposits, hedge deposits, and interconnection deposits on a project or portfolio basis. Further, as we’ve discussed, there are so many variables to juggle while developing solar. Locking in perhaps the biggest one—buyer pricing assumptions—even if it is not the top of the market, can be very attractive.

Richard Matsui: Does solar development become more or less fragmented over time? What I find fascinating about your post is that while it’s become less fragmented recently, it would appear that you think there will be more.

Brad Bauer: Large developers that can create a great deal of “product” for long-term investors are incredibly attractive. However, development is primarily local, and large national developers are hard-pressed to make that work. We’ve all seen this play out over the last 10 years.

The entrepreneurial nature of developers is that they generally want to be small shops. Developers want to take as much risk as they can—preferably with other people’s money—and taking project-level capital creates that opportunity. As the projects move toward NTP, the check sizes become larger and larger, and at that point in time you hope to be able to find the right long-term owner, as opposed to having that middle step along the way where it goes from local developer who created the opportunity, who sells it to the larger developer who takes their cut, and then it is ultimately sold to the right long-term owner. If the developer can skip that middle step there’s more money in the deal for them. 

Richard Matsui: If your thesis is correct and third-party development capital continues to grow in share, what are the second order effects that you anticipate? For example, do you see more “Cypress Creeks”, development platforms-turned-asset owners, emerging?

Brad Bauer: A successful development business must be good at managing capital and risk. As companies grow and attempt to capture more and more of the value chain, the necessary focus is often lost. So the core question has to be whether vertically integrated developer/IPPs can be as efficient and disciplined as necessary to be successful. Can they determine how best to allocate finite resources in a manner that allows them to be profitable and create equity value. It is hard to think of an example of a large developer that has gotten this right in the solar space.  The pages of solar magazines are filled with people who had aspirations of greatness but were unable to make it happen. Energy markets in the U.S. are fragmented, ebb and flow with public policy, and it is tough for large organizations to manage this dynamic. In contrast, smaller organizations that are nimble, quick, and have access to capital are often better positioned for success.

It is certainly possible that policies, economics, or costs will change in a way that large national developers and IPPs will have an advantage, just as it is possible that efficient organizations will grow out of new markets. But I think the former is going to take some time and the latter seems rather unlikely. So my money’s on the smaller nimble shops who pursue the right opportunities, pick the right partners and have the capital necessary to turn ideas and opportunities into projects.