New trends

Publication August 9, 2018

Chadbourne, now part of Norton Rose Fulbright, has hosted an annual energy and finance conference each year since the mid-1980s. The conference is attended by top executives at project developers, banks, private equity funds and tax equity shops. The 29th annual conference was at Lake George in New York in June.

The second session this year was a wide-ranging discussion about new trends in the market with the investment banker or banker equivalent of a panel of journalists on the Sunday morning talk shows. The following is an edited transcript.

The panelists are Ted Brandt, CEO of Marathon Capital, Ralph Cho, co-head of power and infrastructure in North America for Investec, Jonathan Kim, managing director and head of infrastructure finance for Natixis, Jim King, managing director and head of project finance and infrastructure for CIBC Capital Markets, and John Plaster, managing director and head of alternative energy at Barclays. The moderator is Ben Koenigsberg with Norton Rose Fulbright in New York.

MR. KOENIGSBERG: Jim King, what are the biggest risks currently in the market?

MR. KING: The two biggest risks developers face today in contracted renewables projects are transmission and rising interest rates.

Of those two, transmission is probably the one about which we worry the most while our clients appear to be more worried lately about interest rate risk. A lot of them are buying interest rate hedges to cover the period between signing the power purchase agreement and starting construction.

In other parts of our business, like infrastructure, that risk is less of a concern because it effectively gets passed through in a lot of those contracts.

There are various ways to hedge. Straight interest-rate hedges are sometimes backstopped by a balance sheet. In other cases, we are doing deal-contingent hedges where banks take risk on a non-recourse basis that projects will come to fruition.

(For more information about deal-contingent hedges, see “Deal-contingent hedges” in the October 2017 NewsWire.)

MR. CHO: In our bank deals where the interest rate floats, we require at least a minimum of 75% of the interest payments to be hedged through the maturity of the loan. Some of our clients, especially in the residential rooftop solar sector, are locking in all 100%, and they do not necessarily stop at maturity. They hedge through the full amortization of the loan, meaning the hedge also covers the expected refinancing period. Their customer revenue streams are locked in for 20 years.

If interest rates are higher than where you started, the hedge will be in the money when the debt is refinanced, which is not a bad position. Some developers have been getting paid out on these swaps. They seem like a good idea today given the upward trend in rates.

MR. KOENIGSBERG: I had lunch with a developer a couple weeks ago who said many developers focus on getting a power purchase agreement in place without focusing on the risk that the deal may become uneconomic if borrowing costs go up by 200 basis points by the time the project is built, so this is a critical thing to think about in the current rate environment.

Let’s move to another topic. Ted Brandt and John Plaster, there has been a lot of interest in buying projects this year. What are you seeing in the M&A market?

M&A

MR. BRANDT: We are seeing an influx that is probably stronger than any year since 2006 or 2007 of satchels full of euros by European companies wanting to get established in the United States. That has been a huge, huge driver. These are big, well-capitalized companies that see the United States as a higher growth market with a better interest rate environment than they have at home.

The other trend is developers are selling down to passive institutional investors, like pension funds and sovereign wealth funds, and this is bringing more permanent, less expensive capital into the market. It allows the more expensive capital to rotate back out. It has been a really positive trend.

MR. PLASTER: I agree with Ted. Another interesting and positive new trend for the sector is a rise in environmental social governance or socially conscious investing that is driving more money into renewable energy.

We have been hearing lately from large investment funds that have not invested in renewable energy, but who are hearing from their limited partners that this is an area of interest, and they want to know how to get involved.

In terms of deal flow, it is helpful to the think of the market as arrayed along a spectrum, starting with asset-only deals. The middle column is partnership deals, and then there are full-platform sale deals. Asset-only is relatively straightforward. A number of investors want to partner in some form.

We have been busy on full-platform sales. Two that we worked on recently were the sale of sPower to AES and Aimco and the sale of EverPower.

AES and Aimco wanted to buy the whole company, and they bought it 50-50. They are very excited about deploying capital and developing more assets. I think it has been a very successful deal for them.

On EverPower, we had two different buyers, and, in fact, Ted and I worked on it together. He represented Innogy, which bought the development platform and Blackrock bought the assets. I think for any full platform deal it is important to consider the possibility of selling separate pieces.

Finally, there has been a huge amount of activity in the yield co space. The sponsor positions have changed hands. That could be good over time for the development community.

MR. KOENIGSBERG: Europeans and Asians have been coming into the US market. What have been their main concerns once they get here?

MR. BRANDT: Talking to the Germans about US tax reform at the end of last year was a riot. Their response was, “You live in a very crazy country.”

Many Europeans believe that we are going through a period of temporary insanity and that, in the long run, we will figure out that the earth is warming.

They are not used to the complex subsidy regimes that we have or tax equity, but at the end of the day, they believe that onshore and offshore wind, solar and battery storage are the future. Some of them also believe very much in gas.

They take a long-run perspective and look at the rest of it as just noise.

MR. PLASTER: It is hard for international parties to understand the subsidies in the US market through the tax code. Another challenge is the amount of regulation in our market. There are federal rules, and then each state also has rules. If you are not an expert in the US power market, it can be really daunting. Once you start digging in, you realize how little you actually know.

We see a lot of interest coming out of Asia now into the US renewable market, both from Japan and Korea. The motivations are strategic and financial. It is just starting. We are going to see more investment from some Asian strategics in the US market.

MR. KOENIGSBERG: Is most of the investment in projects at the start or end of construction? Has the market moved up the risk curve?

MR. BRANDT: There is liquidity at all stages. You could sell the development rights to a good project with transmission rights that does not have a power contract. There is a market for that. There is a market for projects that are just starting construction. There is a market for operating projects. The discount rates are generally lower for the latter couple of categories than the former.

It usually starts with a potential buyer asking what capabilities the developer has. Does it have the resources to see the project through to completion? Does it have the wind turbines? What is the strategy around solar equipment, given the tariffs on such equipment? Still, there is massive liquidity.

MR. KING: Not too long ago, a developer could earn a premium by waiting to sell until a project reached commercial operation. You see people selling at the start of construction today because developers do not see much, if any, uplift by keeping the project until commercial operation.

PJM capacity auction

MR. KOENIGSBERG: Next topic. Ralph Cho, people were pretty surprised by the prices that came out of the latest capacity auction in PJM. They were up 83% this year. Last year, prices fell 25%. To what do you attribute the swing, and what will be the impact?

MR. CHO: The prices were a lot higher than most of the lending universe expected. Bankers are definitely feeling pretty good. I see three themes emerging.

Number one is that low energy prices are affecting bid strategy. The bidders are all acting rationally.

Number two is we did not see a lot of new builds last year, and that clearly showed up in the numbers. I read that only one new-build bid into and cleared the PJM market. I think that was Hilltop.

The third thing for me is there is a continuing string of coal plant retirements, the biggest one recently being First Energy, and that has to have been factored in.

The prices had to be bittersweet from the standpoint of power plant owners. If the prices had been 80 to 100, they would have felt pretty good. But at 140, you can expect a lot of new competition to crowd into the market. There are a lot of projects that had stalled or were put on hold that may be ramping up again.

As for lenders, the high capacity price means that borrowers are likely to want to reprice or restructure existing deals.

MR. KOENIGSBERG: These are results for one year. For a rush to restructure, don’t you have to believe this is a trend?

MR. CHO: No, I get that. It is one data point. But there is so much equity capital on the sidelines right now, and this is a positive development. It will give investors a reason to put money to work.

MR. KIM: If you look over a longer time period, we had one bad year the year before and one good year now. If you are going to put money to work in a five- to seven-year financing, you have to consider whether the average price supports the thesis that these projects are financeable. It does. You might have a bump in the road or you might have some smooth riding for a while, but in the end, it comes down to averaging and taking a long-term view.

MR. CHO: We were flat lining $75 to $76 out into the future, so this certainly creates some uplift on some of our deals.

Offshore wind

MR. KOENIGSBERG: Let’s move to offshore wind, given that we have Jonathan Kim, who has been active in Europe with Natixis. There were two very significant announcements that were made on May 23, where Massachusetts announced an 800-megawatt award to Vineyard Wind, which is a joint venture between Copenhagen Infrastructure Partners and Avangrid, and then there was a 400-megawatt award in Rhode Island to Deepwater.

Jonathan, is it your sense that this is the start of what will be a really big industry in the United States?

MR. KIM: I think it will have a ripple effect on the broader market. For example, we were in the market for a New England peaker, which is going to close next week, and we took a positive view on that peaker because of what is happening with offshore wind. If you are old enough to remember, peakers used to be needed to fill in during weather-related events, but now they are used for filling in around intermittent renewable energy.

Offshore is happening. PPAs are being awarded. We are positioning ourselves to take advantage of it, but we are also looking out more broadly at the effect that it will have on different asset classes in different locations.

MR. CHO: We have not seen much offshore wind here in North America, but in Europe offshore wind financings are hot. A lot of the banks that play here also play in Europe. The sector is so active in Europe that offshore wind deals reprice and refinance during construction. The pricing has fallen as low as LIBOR plus 160 basis points.

MR. KIM: There are certain things about the US that are unique, like . . . .

MR. BRANDT: . . . the Jones Act.

MR. KIM: Yes, the Jones Act. We still have to have tax equity, which does not exist in Europe. There are more strenuous protests here about offshore wind. So there are challenges here that are quite extensive.

Then you have the classic problem of the supply chain. Europe has a full supply chain to serve the offshore market. It does not exist yet in the US. Offshore commands a premium in the US. Lenders and investors are “risk on” for almost any spread at this point.

MR. KOENIGSBERG: Talk about the supply chain, because you just alluded to it with the Jones Act. You cannot use European ships here for installing turbines unless you rebuild them. Bringing ships from overseas is expensive. It is complicated to comply with the Jones Act.

MR. KIM: We will leave it to you guys to figure that one out. But, no, that is an important aspect. Deepwater finessed it, but Block Island was only five turbines. How do you do an 800-megawatt project? That will be a big challenge.

MR. BRANDT: If everything that we are hearing about a GE 12-megawatt offshore turbine is for real, it will be huge development from a cost standpoint. Most of the cost of these projects is in the towers and the installation.

The Jones Act forces you to use oil and gas techniques, much like you would in deepwater drilling.

The Europeans think that they have everything down. Time will tell who is right. There is a Hatfield-McCoy type of rivalry going on across this industry.

MR. KOENIGSBERG: How much expansion will there have to be in the offshore wind sector in the US before the consolidation starts?

MR. PLASTER: I think it will take a little more time.

MR. BRANDT: There is no shortage of capital. Deepwater is not a big investment-grade company, but it has plenty of capital. On the other hand, if somebody writes a big enough check, the private equity fund owners will sell.

MR. PLASTER: I agree. There has been a lot of consolidation in the wind sector already. Some of the larger independent developers have been acquired. We see a lot of strategics interested.

MR. BRANDT: You are talking about onshore wind?

MR. PLASTER: Yes. Some of the larger US strategics have not been enamored with the risk profile of offshore. I think they will stay on the sidelines for a while, and the companies that have done offshore wind in Europe will take the lead initially in the US. Over time, these are really large capital-intensive projects, and I think you will see some consolidation.

MR. KIM: One of the concerns I have about offshore wind is it may play out the same way LNG did. We will have massive, big dollars coming out for financing. It will have a run and, at some point, the rush will stop because there is only so much offshore resource that the developers can tap.

The challenge of offshore is so huge. The barrier to entry is much higher. The projects are much more complex. There is also political resistance in certain parts of the country to offshore wind. I do not think we will see all three US coasts, including the Gulf, lined with wind turbines.

Offshore wind will have its time and, because of that, the financings will be massive, but on the M&A side, there will be only a finite amount of supply that you can trade.

MR. BRANDT: There are only eight or 10 companies.

MR. KIM: Exactly. So how long is that going to last before people say, “We have hit the end already.”

MR. PLASTER: We should see the same M&A pattern that has emerged in Europe, which is there are sell downs of these assets. A large company develops a project. Then it operates the project long enough to establish a track record. Then the project is sold to a buyer with a lower cost of capital and development capital gets recycled into another project. There will probably be an interesting M&A angle, bringing in more passive capital for stakes in existing offshore wind farms.

MR. BRANDT: The optimists believe that there will be 5,000 megawatts of offshore wind PPAs handed out. The pessimists think that maybe the number will be closer to 1,200 megawatts, which is where the market is now.

It will probably land somewhere in the middle. The M&A market usually does not heat up until people have a better feel for what the cards look like.

Cost of capital

MR. KOENIGSBERG: Next topic. Jim King, panelists at industry conferences this year have been talking about how tight the spreads are in the debt market above LIBOR. Some construction debt is being bid at 100 basis points. Some sponsors are asking for even lower margins. How long do you see this continuing? Do you see the liquidity being soaked up in a few giant LNG and offshore wind deals?

MR. KING: All of the markets are incredibly liquid. It is not just the debt market. It is not just the bank market. Debt spreads have come in. Equity yields have come in as well.

We don’t see that trend reversing any time soon. If there is any pressure, it remains downward pressure.

As for the big LNG deals taking liquidity out of the market, we have committed $500 million this year to LNG transactions, and that number will likely increase by about 50% by the time the year ends.

We do not see numbers in this range having a significant impact on liquidity. There are a lot of big transactions in the market or coming to market, not just in the LNG space, and we have not seen any sign in the bank market that there is insufficient liquidity to bank those transactions.

MR. CHO: We are still seeing margin compression this year. However, there are signs that it is getting close to the bottom . . .

MR. KIM: You can’t go much lower, Ralph.

MR. CHO: Exactly. Some of the capital that we have been seeing come into the market, especially from Asia, is starting to tap out. Some of the potential investments are no longer making sense for these investors.

We have heard that the pricing on short-term construction loans is going as low as LIBOR plus 75 basis points. Fully-contracted deals are still at 125 basis points over, even on back-levered loans.

Quasi-merchant deals have now come in as well. We are seeing such deals at 275 over. We have a deal in the market at LIBOR plus 275 because the sponsor did not want to pay any more than that. My view is rates cannot go much lower.

MR. KING: This is a very active market with a lot of liquidity. You see developers doing some pretty smart things to boost their returns.

Banks are doing similar things. We would love for the pricing to move back up. I am sure the equity sponsors in the room would like for the yields to move back up as well.

MR. KIM: It is the new European and Asian investors coming into the market that is driving the spreads down. If the financings were coming solely from institutions that have US branches or US operations, then I think the spreads would be much wider.

We are seeing investors that you have not heard of before from the Middle East, from Europe, from Asia, and it is because the potential returns in their own markets are so horrible that 1% sounds great.

As long as the global interest rates are relatively low or flat, I think the spreads are going to stay this way. The turning point will be an event where rates rise in Asia or Europe. Money then will be taken out of the US or the Americas and redeployed outside the US. That is when we will see the liquidity start to drop.

MR. KOENIGSBERG: So it is not just US rates, but global rates.

MR. KIM: Yes. We have to be mindful that it is global rates now. It is not just what the US Federal Reserve doing.

MR. KING: But we also know one thing that changes spreads on the debt and equity side is difficult deals. So notwithstanding that there is a lot of liquidity in the bank market, there are some deals that are struggling, including underwritten transactions. That tends to force people to take another look at how the market is behaving. It is early. Some of those deals are in the market now.

MR. KOENIGSBERG: Maybe some renewables deals with merchant tails is a category.

MR. PLASTER: Let’s also not lose sight of how the future rate increases that the US Fed has signaled will occur this fall and into next year are starting to have a ripple effect through the currency markets. They add to exchange rate volatility and put stress on emerging markets. Some investors had moved to those markets as returns got tighter in the US.

MR. BRANDT: Inflation risk also has to be considered. We are seeing investors for the first time in 10 years start asking what their real rates of return are after subtracting projected inflation. They are worried that US inflation will increase given the massive borrowing by the US government to finance its growing deficits and given the tight labor market.

Institutional investors, like pension funds, have been moving money into this sector. It is fixed-income money — it is not equity money — and for the first time, we are hearing institutional investors ask whether the returns are high enough.

That is as bullish a sign as one can get. It is not happening in the bank markets, but we are seeing it in the equity markets.

CFIUS

MR. KOENIGSBERG: Let’s turn to audience questions.

MR. HESSE: Balduin Hesse, CEO of Frontier Renewables. You mentioned acquisitions and interest in the US by new European and Asian investors. Have you seen any increase in CFIUS approval risk? We run into that as a condition precedent in some of our project asset sales, which can take 90 days, maybe even longer. Given the current administration, is there a new risk about CFIUS, whereas maybe previously it was a rubber-stamp process?

MR. PLASTER: Absolutely. We have evaluated CFIUS risk on deals for a while, but we believe the threshold has gotten higher, particularly around Chinese inbound investment. In some deals, we have seen potential buyers hire counsel and evaluate the likelihood of getting CFIUS approval before spending time and money on an M&A process.

MR. BRANDT: I would add that there are also significant delays in the CFIUS reviews. It used to be a 90-day process. Now we are hearing about extensions on almost every request, so that it is becoming a four- or five-month process even for buyers from Scandinavian and other European countries where there seems little risk of the transaction ultimately being rejected.

MR. CIRINCIONE: Guy Cirincione with Siemens Financial. Jim King, you mentioned pre-start hedges that clients are doing with you. What is the logic for that hedge? Are you hedging to what you think will be the financial close of the construction financing? Are you hedging way beyond that period? Are you picking an estimated amount of debt to hedge?

MR. KING: We are pre-hedging the expected term loan portion of those transactions, and the hedge is not very different than the hedge that would be executed at financial closing. It is just being put in place earlier. It is the expected term loan quantum, and there is an assumed start date.

If the actual start date moves, then there are mechanisms in the hedge to account for that. For example, if the closing date is delayed a month or two, then there is an incremental cost associated with that. That is generally how the structures work.

MR. MARTIN: Let me ask Ted Brandt a question. Tell us the current discount rate for winning bidders in auctions of projects.

MR. CHO: Tell us all your secrets.

MR. BRANDT: I don’t think that they have changed dramatically for individual project bids and even the 80 basis points increase in the 10-year treasuries has not changed it that much. We are still seeing solar selling at 6.5% to 7.5% on an unleveraged 35-year after-tax basis, and wind is 8% to 9.5% on a 30-year unleveraged after-tax basis.


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