Originally posted on pv Magazine USA.

In this #Solar100 interview, Richard Matsui, Founder and CEO of kWh Analytics, speaks with Ray Shem, CFO at Pine Gate Renewables.

In Greek mythology, Cassandra was gifted by the god Apollo the ability to see the future. She was also cursed to utter prophesies that were true but no one believed—until it was too late.

Today, Ray Shem’s understanding of real estate finance cycle and the solar industry lends itself to sharp analysis of solar’s evolution. In this interview, Shem provides a clear framework for understanding the sponsor equity market and describes a future solar market in which new entrants displace or acquire many of the current incumbents, reshaping the competitive dynamic of the entire industry.

Ray Shem is a solar soothsayer and this month’s featured #Solar100 thought leader.

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FROM HISTORY TO REAL ESTATE TO RENEWABLES

Richard Matsui: I saw that you have your BA in history from Yale and your MBA from University of North Carolina. What drew you to renewable energy and how did you begin working at Pine Gate Renewables?

Ray Shem: When I graduated from college, I originally thought I wanted to be an attorney. I was randomly assigned to the real estate practice group, and after a year, decided I wanted to work on the principal side of things. Real estate was booming around that time, so I left the law firm to work for a startup real estate developer in D.C. flipping houses in the revitalizing parts of DC. Then I went to Chapel Hill for their real estate program.

After I graduated from UNC in 2008, I took a job working for a medium-sized regional developer based in Charlotte. Two months later, Wachovia was basically bought for a dollar, Lehman failed, and I ended up selling condos for two years—fun. It was actually terrible, but it was formative in terms of gaining experience failing and needing to be creative to move units. After a few years, I ended up running capital markets and acquisitions, raising project debt and equity.

Zoe Hanes, who worked at FLS Energy at the time, was my neighbor and recruited me to go into solar.  I started off doing project finance at FLS, including tax credit equity and project debt, underwriting new investment opportunities, and developing the corporate finance strategy. That’s how I got into this industry.

Richard Matsui: Having witnessed firsthand a full economic cycle in real estate, what lessons do you apply in solar?

Ray Shem: It makes me pretty risk-averse. My biggest lesson was the importance of asset quality. Quality is especially important when things get rough. In 2009, if you had great real estate, you could always move it. Yes, it would sell at a discount, but you could sell it. Bad real estate didn’t move at all. It was just frozen out.

Solar is a little different because of the secular trend of cost reduction. Construction costs are down and the cost of capital is falling. It’s a big tailwind that mitigates some of the volatility. People have made aggressive bets on the cost curve continuing to fall, and to date they’ve been right. Even under the burden of the module tariffs, we’re seeing modules trading at pre-tariff levels. So, there’s still some room there. A development asset that looks bad today may look good in a year.

A FRAMEWORK FOR THE SPONSOR EQUITY MARKET

Richard Matsui: You have an interesting framework you use to describe the sponsor equity market. Can you outline it here?

Ray Shem: I see the world bifurcated into three different types of sponsors: early stage developers, aggregators, and long-term owners.

Early stage developers tend to be hyper-local and in the right place at the right time. You see it in Minnesota, in Massachusetts, South Carolina, and other states. Legislation changes, policies move, and all of a sudden, a bunch of homegrown developers pop into place.

You then have aggregators, folks that have some degree of development experience and can crawl into a deal and understand the risks associated with it. Aggregators have access to larger pools of capital, including tax equity, debt, and some form of sponsor equity. These developers aggregate projects, typically in the “distributed utility” segment, though we’ve also seen this with some C&I as well. These developers create value by aggregating portfolios to a scale that can successfully attract capital from large tax equity and debt providers in the market.

And then you have long-term capital: the infrastructure funds, pension funds, and insurers that want to be long-term owners of these relatively low-risk infrastructure assets.

Aggregators play a role in market-making. In our work, we see a lot of small projects that make sense from an economic perspective. But the scale of those individual projects is too small and requires someone to aggregate them into a portfolio to fit an investor who wants to write a $50 million check.

However, a secular shift is underway. As the mystique around tax equity financing continues to fall away and the tax credit itself steps down, I think you will start to see pressure on the aggregator as a business model. Early stage developers, by deploying high-risk dollars and pushing policy that creates markets, will continue to create and capture value. In the aggregate, they will be fine. But the pie shared by aggregators and long-term owners will increasingly see the value migrate towards longer-term owners.

WHAT HAPPENS TO THE ‘FOR SALE’ SIGNS

Richard Matsui: It feels like half of the aggregators in the industry today have a “For Sale” sign in the window. Where do these firms end up?

Ray Shem: It’s a big question. Ultimately, I see two directions:

Some aggregators will begin to increasingly pivot to in-house greenfield development and become early stage developers.

Some aggregators will go in the other direction and sell themselves to long-term owners. The sale of sPower to AES and Aimco a few years back is a classic example of this.  As a result, some of the aggregators are likely trying to position themselves for this kind of exit. The key question is, “How well are they trading?” I know there are a couple out in the market, but I don’t know how those processes are going.

Richard Matsui: I think we, as an industry, are all holding our breath to see the results. Valuation will be the key question. When the purchase price is ultimately paid, that sum will represent the value of the assets on book plus the platform itself.

Ray Shem: Yes, and “platform value” can be an elusive thing. When we were at FLS, we thought we could clearly articulate the case for an acquirer to value the platform itself, and it proved to be somewhat illusory. A lot of value ended up being driven by assets on book.

Richard Matsui: Are you hearing that “platform value” is getting more value than what is has historically?

Ray Shem: I think it is an opaque, illiquid market. Without hard data points or trades that I’m thinking about in particular, my bet is that some platforms are getting value. I think those are probably platforms that had big pipelines, and that is probably where the value ultimately gets attributed. If I were managing low-cost money looking for a home in infrastructure assets, I would also be focused on pipelines, and then making sure that the team was in place that could translate that pipeline into investment opportunities. What I would expect to see is buyers first look at the pipeline, and then they lean into the bid, based on their confidence in the team.

THE COMING SHAKEOUT

Richard Matsui: Let’s talk about the long-term owners. It seems the category can perhaps be divided into two different groups: strategic and financial. From the strategic side, you have companies like BP and Shell buying Lightsource and Silicon Ranch. One of our own investors is ENGIE, which has acquired SoCore and Infinity Renewables. There are several other active strategics. They generally seem to follow a consistent logic—they want to own the businesses that will build the future energy system. From my perspective, strategic acquisitions appear to be motivated by a desire to internalize the talent and institutional capability, even as assets drive the valuation. But what about the financial long-term owners, like Capital Dynamics or New Energy Solar? Will they be using a different playbook?

Ray Shem: That’s a good distinction to draw. It probably depends on the source of money. Strategics are far more likely to look at a platform transaction. If you’re New Energy Solar, you’re not going to go back to your shareholders and say, “Hey, guess what? I just bought a company.” That’s probably not in the mandate.

I can see the aggregator firms bifurcating. Some aggregators will be acquired by strategics. Other aggregators will likely develop deep relationships with cheap, passive capital—the third group.

Richard Matsui: This introduces an interesting dynamic. If aggregators continue to get acquired, or start to develop exclusive relationships, or become early stage developers, then it could suddenly become difficult for a long-term owner to source projects. Even if they do have a competitive cost of capital.

Ray Shem: Yes. All of this boils back down to the scarcity of projects. It’s the linchpin. In a world where aggregators fade away, an important question becomes, “Can the small early-stage developers and the large pension funds find a way to do deals, even without the middleman?” As corporate PPAs continue to grow, we are already seeing a need for higher capital requirements for developers to strike those deals, which favors larger players.

I don’t have a background in conventional energy, so I am going out on a limb here, but I see two structural features about solar that dis-favor the strategics. Historically, conventional energy assets required a high degree of sophistication in energy markets. While some larger solar assets are management intensive, solar assets in general are a lot more of a pure-play financial investment: You have a long-term contract, you have merchant curves, and other factors that end up informing the value. The advantage of being a strategic is somewhat blunted vis-à-vis solar.

The second factor is the highly local nature of solar development. Small utility-scale projects continue to proliferate, nationwide. Community solar uniquely enables a near-retail compensation for near-utility scale cost structure. Succeeding in that market is a hyper-local question—Who can get the zoning? Is the policy regime in place? Who can sign on this offtake? Who can get their foot in the door before the local program closes? Those scenarios don’t necessarily play to the benefit of large, national strategics. It will be interesting to see ultimately where that lands. 

PREDICTIONS

Richard Matsui: You are very familiar with the aggregator business model, so it’s fascinating to hear you describe the secular headwinds there. Does the decline of aggregators and the rise of strategics and financial long-term owners represent the natural “end state” for our industry? I’m reminded of that Francis Fukuyama title—is this “The End of History”? 

Ray Shem: [Laughs]. Not necessarily. There’s still a fundamental gap here. If you have 4% equity capital, you need to deploy it in increments of hundreds of millions of dollars. There is an inherent mismatch between cheapest source of capital and what projects are available. From what I’ve seen, average project size in utility-scale is actually decreasing, even as these large long-term owners require bigger deals. Here’s the challenge: if I’m a local developer, I need to find someone with a few million dollars to finance my project. If I go out and raise that from friends and family, I’m not doing it at four percent. The aggregator has historically done that work. The question is, “Is this model the future of solar development?” If so, you could argue that there’s a permanent role for working capital to aggregate portfolios to a scale that can attract cheap capital.

Richard Matsui: I see. Is your hypothesis that that the aggregator role will still be needed, but it will be fulfilled by strategics that have vertically integrated down into the aggregator function? And that large, standalone aggregators will be increasingly rare, or even cease to exist in the future?

Ray Shem: Overall, I do see increasing pressure on the aggregator business model. At the end of the day, it comes down to competitiveness. Who will be more competitive: The strategic that has a reasonably cheap source of capital and has the operating businesses that can operate a distributed fleet of small utility-scale farms? Or the financial investors that may have the cheapest capital, but does require an aggregator intermediary? You could argue that the most efficient market will be the latter, where aggregators and financial investors are competing vigorously for every project. And vertical integration doesn’t benefit a strategic that much because the requirements to operate a solar farm isn’t high.

Richard Matsui: That makes sense. But sometimes, the market does not reach an efficient end-state. If I’m a strategic with an aggressive growth target in solar that I need to hit, I have to get my capital moving and start acquiring. Especially if I start seeing bigger aggregators getting snapped up, I’m going to start feeling very anxious that I might be the only one left without a date for the prom.

Ray Shem: Exactly. I think that will definitely happen. In fact, we’re seeing it now—for example, Orsted with Deepwater Wind. We are starting to see strategics insist, “I need to have a renewable energy platform.”

Richard Matsui: Yes. And if those strategics lock up dealflow by acquiring many of the bigger aggregators, it would seem to put the financial investors in a tight spot. Or perhaps new aggregators would simply emerge. We are in interesting times.

To wrap up, can you give me a non-consensus bet that you think is going to play out over the next couple of years?

Ray Shem: I live in Asheville, North Carolina, so I think every perspective I have is probably a non-consensus perspective.

If you’re a carpenter, every problem is a nail and every solution needs a hammer. So, my background is real estate. I think ultimately what you’re going to see in the marketplace is a lot of diversity—because of the diversity of the underlying assets. You’ve got everything from residential, small C&I, small utility scale, all the way up to massive 500 MW plants. I think you could make an argument that there will permanently be a diversity of players in the marketplace. I don’t necessarily think that this market will run to a singular end state, where all projects are fiercely competed for equally by all players. I do think there will be a lot of heterogeneity in terms of the marketplace and in terms of small, nimble developers taking advantage. I think you will continue to see some aggregators, though I do see added pressure on that business model. But if you build relationships and you can add value to those development relationships, there’s probably a niche for that. I think the strategics are just getting started here. The diversity of business models that we see today will reduce, but you’re still going to see a lot of diversity.

We haven’t hit the end of history yet.