There is little doubt the dynamics resulting from the ‘shale revolution’ have created numerous investment opportunities within the energy infrastructure sector. A vast amount of capital investment is required in order to transport, process and store these newly produced hydrocarbons. Given these dynamics, investors seeking to deploy capital into midstream assets must think critically about the role of various vehicles available to access the space.
Private capital can play a meaningful role in certain areas of the energy infrastructure build out across North America, but it is not always the best option. This is clear when you examine two main areas of investment opportunity: increased use of existing infrastructure and new development of midstream assets.
Existing energy infrastructure
Existing midstream infrastructure assets including pipelines and storage are critical to the domestic energy landscape. As such, they represent an intriguing investment opportunity, and the increase in oil and gas production throughout the U.S. should certainly help to boost their overall income profile.
However, given the stable, consistent operating income of these assets through medium-to-long term contracts, private capital is not necessarily the best source of funding. They are far more suitable for public Master Limited Partnerships (MLPs)—yield-oriented, publicly traded partnerships that distribute the bulk of their operating income in the form of quarterly cash distributions. Similar to REITs, MLPs are also tax-advantaged entities as they are flow-through structures. Private equity, in contrast, carries a higher cost of capital, making it less ideal (and more difficult) to acquire these yield-oriented midstream assets in the current environment.
Developing new midstream assets
This segment of the shale revolution is a much better fit for private capital to play a meaningful role, as these development projects are associated with a higher cost of capital given the attendant risks of permitting, developing, marketing and constructing a new asset. In addition, during the development stage there is little-to-no operating cash flow, making it less attractive to midstream MLP vehicles seeking to obtain a consistent cash yield. Once these projects are developed and operating, private equity managers should seek to exit to lower cost of capital investment vehicles that are seeking a long-term, stable cash flow profile.
The development of new midstream assets requires extensive operational expertise given the varying risks associated with this process – thus resulting in an opportunity-rich environment for skilled operators with patient, long-term private capital to deploy. In addition, the lack of cash flow generation during this period is a profile private equity managers can account for as they are not required to distribute cash flow on an ongoing basis. Given these dynamics, private capital fits nicely targeting this defined ‘inefficiency’ in the development phase of the value creation process.
A shifting landscape
However, neither of the pictures painted above are quite that simple. As the upstream oil and gas production base has shifted (and will likely continue to shift) across various regions of the U.S., certain energy infrastructure assets—both those with an established operational history and newly constructed assets— will likely be less utilized over time.
This occurs whenever producers see opportunity to shift their capital expenditure dollars towards lower marginal cost basins. Thus, certain midstream assets will become less essential and therefore unable to capitalize on the attractive sector dynamics. Therefore, not only is private capital not appropriate for these midstream assets, they are not an attractive prospect for any new investment.
From a portfolio perspective, it is important to consider that both private equity and public MLPs can play a complementary role given the varying return drivers and investment profiles (capital appreciation vs. yield). Given the higher cost of capital associated with private equity, fund managers should not be targeting the same assets as those with a more liquid, low cost capital base.
Skilled operators with patient private capital can be a meaningful component in the development phase of assets rather than targeting operating assets and competing directly with public, lower cost-of-capital vehicles. As the sector continues to evolve, it will be important to monitor the evolution of the investable universe and ensure private capital is deployed appropriately within the context of a broader portfolio.
Jim Gasperoni is a Partner at FLAG Capital Management and oversees FLAG’s Global Real Assets program.
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