Think about the last time you had a power outage. It probably didn’t last more than a couple of hours; if it did, it likely made the local news.
The dependence of millions on reliable electric power is a recipe for stable, consistent returns. And by some estimates, upwards of $2 trillion of capital investment will pour into North American power utilities over the next 20 years. Your wealthier clients can participate in this investment through direct ownership of power plants. But don’t fret: good options still exist for those who don’t have the means to buy direct.
It used to be that only institutional players could buy into power plants directly. But individual accredited investors are now able to participate, says John Walker, managing director at Kensington Capital Partners in Toronto. He’s been in the power business for 40 years.
“We’re going after a very small segment of the power sector: asset enterprise value under $50 million,” says Walker. “Most of the big [pension] funds are going after stuff that’s $100-million minimum investment.”
Walker buys stakes in the physical assets. “We’re not buying companies; we’re buying power plants. Usually they are run by a company that has a slew of plants and we buy 35% or 50% of them. In one case we own it 100%, so we actually manage the power plant ourselves.”
Why do these companies let him in? It’s difficult for a small company to raise capital on the venture exchange. So when they need capital to expand, they come to people like him. In one case, he’s buying from a fund that, by mandate, must unload its assets by a certain date to provide investors with promised liquidity.
The plants Walker buys have power purchase agreements. “The provincial-owned utility has signed a contract with us to buy our power on a take-or-pay basis for 20 or 25 years. That means we have a guaranteed purchaser for our power.”
And there are no maximums: whatever the plant produces must be purchased or the buyer pays a penalty.
Walker’s fund currently has interests in 10 plants in Alberta and B.C. He targets facilities that produce 24 hours a day, seven days a week. There are many ways to crank that power out; here’s a sampling of Walker’s preferred methods.
- Heat recovery: Pipelines across the country give off a lot of hot air. “I like to buy plants where we’re grabbing the hot air and running it through a heat exchanger filled with butane, which is lighter fluid. We heat up the [butane], it turns into a gas and turns a turbine, and we generate electricity.”
- Geothermal: This method involves drilling up to two miles into the earth, for example. “You come across really hot water that’s almost volcanic in nature, pump it to the surface [and] wring it through the same heat exchanger as in [the] heat recovery [method].” The water then gets pumped back down into the earth to be reheated. As with heat recovery, the geothermal method capitalizes on a by-product of unrelated extraction efforts. Walker figures out where to drill by examining old mining records. “Every time somebody drills a hole to find gold or copper or nickel, they have to take temperature readings. And if they hit water they have to record [that]. So 20 years ago, people were drilling for gold and they didn’t find it, but hit a geyser. […] Fast-forward 20 years, we go back [in] and find the hot water is still there. So we drill another hole 10 feet away using new technology, and we now have a 35-megawatt plant sitting on top of it.”
- Energy storage: This method uses batteries, flywheels or compressed air to generate electricity.
Walker also likes wind and solar, “but we haven’t seen anything that’s 24/7 yet.” So, at least for now, they don’t appear in the fund.
Potential investments go through what Walker calls due diligence-plus. “You not only have to look at the technology, engineering and design of the power plant, you also have to look at the land it sits on,” he says, to ensure there are no environmental risks, such as hazardous leaks that may have occurred during the plant’s construction.
In-house experts do most of these assessments, though external consultants are brought in for specialized tasks. “If it’s a technology we’re not up to speed on, we study it [ourselves] or hire an independent [consultant] to look at it. A year ago, we knew nothing about energy storage; today we know a lot.”
Lawyers comb over every clause of purchase agreements. They also examine the regulatory environment for the plant’s method of power generation, as not all jurisdictions are equally friendly to all methods of generating electricity. Walker has a long background in plant operations, so he takes the lead on examining plant operators’ track records.
The biggest risk to any plant is fire, he says. “So, I insure the hell out of my power plants. I insure them for repairs, replacement, and for the distributions to our investors for the period that the plant would have to be rebuilt.”
Buy and hold
You can’t flip a power plant as you would stock, so clients should see direct plays like Walker’s as long-term investments. There’s a minimum three-year holding period; if clients want out before then, there’s a 5% penalty. After three years, they can leave.
To provide liquidity for exiting investors, 10% of the fund is in North American infrastructure stocks. But Walker says exits are few and far between. “We’ve only had three or four people get out,” he says, adding it’s typically because of a divorce or debt issues, which demand immediate liquidity. The management fee is 1% plus 10% of distributions. The target net return is 8% to 10%. Quarterly distributions are lower in the fund’s first couple of years because that’s when managers are deploying investor capital. After that, return variability is largely a function of how long production can go uninterrupted. Inevitably, operations go offline periodically for routine maintenance, and that means no electricity to sell.
Since the fund is structured as a limited partnership, every year investors get Form T5013 – Statement of Partnership Income, which shows distributions they earned. Government tax incentives for clean energy production mean part or all of the fund’s distributions can be tax-sheltered for upwards of 10 to 12 years.
“At the end of 15 years,” Walker adds, “we’ll probably go back to investors and say, ‘We can sell this to a pension fund, securitize it on the stock exchange or sell to a strategic investor.’ ”
Active and accessible
Clients who want active utilities exposure but aren’t accredited can go the mutual fund route. Izabel Flis, a research analyst at Franklin Bissett Investment Management in Calgary, helps mutual fund managers separate good picks from bad. She uses bottom-up analysis to determine intrinsic value. Here’s how that approach works in the utilities space.
One important variable impacting intrinsic value is the nature and quality of a power company’s assets. “Hydro [facilities] can operate over a hundred years and they’re the lowest-cost operating facility, while wind has a life of [about] 25-30 years.” A shorter shelf life detracts from the intrinsic value calculation.
Hydro also has advantages over coal. Flis is concerned, for instance, about the impact carbon tax policy will have on the long-term profitability of coal-based power.
Another variable is whether the company has purchase contracts. If so, what’s their remaining life? Are the power prices stipulated in the contract indexed to inflation? “Things like this enable you to assess the quality of the cash flows and [brings] visibility to the cash-flow stream,” says Flis.
Facilities that don’t have contracts are called merchant assets. “You’re selling right into the spot market, and that has a lot more volatility associated with it—you’re not protected over the long term.”
The strategic importance of the asset to the region it serves is critical. Say the facility is serving a remote area, and is nearing the end of a 40-year contract. “It’s going to run through its contract, but beyond that I’m not sure there’s any residual value,” says Flis. For instance, a competitor may have emerged, reducing the company’s leverage during contract-extension negotiations.
Contrast this to facilities that are integrated into the power grid of a densely populated metropolitan area. This creates a dependence that translates into a barrier to entry for potential competitors. “Beyond the initial contract value, there’s a lot of value left because everybody relies on you,” says Flis.
She also wants companies to demonstrate prudent capital allocation. “Has management pursued truly value-creati[ng] organic or M&A growth? Or has there been value destruction associated with those types of moves? We don’t like to see significantly levered balance sheets and high pay-out ratios with big growth ambitions. That’s not a good combination.”
Apples to apples
These and other considerations help Flis calculate discounted cash flow (DCF), the metric Flis uses for intrinsic value. Since the process yielding DCF can be applied to all companies within and across sectors, it allows for true apples-to-apples comparisons. If the stock is trading below its intrinsic value, it’s a potential candidate for investment.
Determining intrinsic value is an ongoing process, notes Flis, because that value can change. It can drop if management starts making poor capital allocation decisions, for instance. “We adjust our intrinsic value according to new developments for each company; it’s a very fluid, dynamic process.”
Some clients don’t have the means for private plays, and may prefer a purely passive approach. No problem, says Peter Guay, portfolio manager at PWL Capital in Montreal.
Utilities-specific ETFs still capture the sector’s key benefits, he says. “Utilities as a group behave differently than the rest of the stock market from a risk-return point of view over the long run. They are generally less correlated with the broader market, providing a diversification benefit at the asset class level.”
In a 60% equities, 40% income portfolio, Guay devotes 10% of the fixed-income allocation to utilities (3% to 4%), REITs (3% to 4%) and high-yield bonds (3% to 4%).
“You can essentially look at that 10% as the portfolio of alternatives—particularly the real estate and utilities. They’re more like real asset-based investments, similar to what the pension funds are doing when they buy infrastructure and real estate directly. It’s an attempt to recreate that as well as we can for the retail side.” Guay typically uses Canada-based vehicles for the utilities piece. He likes the iShares S&P/TSX Capped Utilities Index ETF and BMO Equal Weight Utilities Index ETF. “They are similar in that they target the power producers, electric utilities and renewable energy.”
He’s not concerned about overlap between utilities-specific ETF exposure and the utilities component of the broad TSX ETF that makes up a portion of clients’ Canadian equity exposure. That overlap is less than 0.2%, so “it ends up being almost negligible.”
U.S. tax concerns
Some of Guay’s clients with large non-registered accounts file taxes with the IRS. In these cases, he typically uses U.S.-based ETFs for utilities and other exposures in the taxable account. Guay notes that while it’s fine for these clients to hold Canada-based ETFs in their RRSPs, they shouldn’t park these vehicles in non-registered accounts or TFSAs.
The reason: Passive Foreign Investment Company (PFIC) rules, which subject gains on most Canadian mutual funds and ETFs to U.S. tax. There are also special filing requirements, which are onerous and costly. And though some fund companies are helping with the paperwork, “it’s still a burden for U.S. tax filers,” says Guay.
More U.S.-based exposure means more currency exposure. “But if you’re a long-term investor, the currency [issue] will essentially come to a wash over the long run. You sacrifice your targeted currency exposure for less tax burden and less tax compliance work when you’re filing your U.S. tax returns. For a lot of U.S. taxpayers, the benefits outweigh the costs of the currency risk.”