PFR: Could you talk a little bit about the team and what the focus is?
Onukwugha: Babson Capital’s private debt group manages over $18 billion with over $3.5 billion of that amount in the infrastructure and energy sector. We’ve invested in infrastructure and energy project debt for a very long time—over two decades—so we have a very strong and deep team of professionals that work in the space, and they have very strong, long-term relationships in the industry that we’ve built over a number of years. If you drill within the $3.5 billion in infrastructure debt assets, the majority of it is investment grade, which is where we have the biggest appetite from our clients.
PFR: Where in the energy space do you see the most opportunity moving forward?
Onukwugha: Most of the opportunities we see in the renewable energy space are utility scale solar and wind projects with supporting investment grade metrics. Also, the drivers have been there with a number of states and utilities looking to meet renewable energy requirements combined with the desire of participants in the market looking to take advantage of the related tax credits. Compared to combined cycle generation and transmission and distribution projects, we have found more value in the renewable space and that’s why a fair amount of the growth you see from us came from that space. We’ve also had growth and continue to see opportunity in Latin America in traditional power and transmission assets as well as renewables.
PFR: In terms of the renewables opportunities that you are looking at right now, are you seeing a broad spectrum: geothermal, biomass, wind, solar, or would you say it is clearly weighted toward one or the other?
Onukwugha: We are seeing transactions in all the spaces that you mention. From a risk-adjusted return perspective, solar and wind have offered the most relative value as far as investment grade opportunities with some in biomass and less so in geothermal – it’s tough to find investment grade opportunities in the latter two though.
PFR: It seems like there has been some decrease in utilities needing to meet state renewable portfolio standards because they are well on the way to meeting those goals, so I’m curious to know if you think renewables are going to be a large part of investment moving forward, or if the volatility around state policy and the production and investment tax credits will impact the work you do.
Onukwugha: We believe that renewables will continue to play a role in meeting energy needs going forward. Obviously, with the expiration of the investment tax credit, there will be some impact on new projects going forward, but we do expect renewables to remain a meaningful aspect of meeting our utility needs. From an investment perspective, we’re not solely reliant on renewables as a means of growth.
One of the things that I am charged with—and that is our real investment focus—is to determine where the best relative value debt investment opportunities are. When we look at the energy space, we are interested in ‘where can we find the best relative value for our client and how do we best work with sponsors and deal sources to find these opportunities?’ If it’s in combined cycle project, then that’s where we want to invest. We still believe renewables will play significant role going forward, but we are really seeking relative value—wherever it may be.
PFR: In terms of the type of debt structure or the type of investment you’re looking to make, could you talk a little about whether you prefer to be in the first lien, or whether you’re open to mezzanine. Where do you fall in the capital stack of a project?
Onukwugha: A significant amount of the assets we own are investment grade and at the top of the capital stack. That’s a result of where our clients want us to be and, quite frankly, it’s the area where we’ve seen the best relative value. But that said, we can and do play in mezzanine and other senior secured structures. Again, it’s all about relative value and we will play in the part of the capital structure where we see relative value.
I’ll give you an example: in the mezzanine space, when the power and energy team joined in 2012, we were expecting and looking for returns in the lower to mid-teens area. Over time, having spent some time in that space, it became increasingly clear to us that the kind of risk profiles we were seeing for those returns were not the kind of risk profiles we felt comfortable underwriting, so we had to adjust.
Our preference is to look for things in the mezzanine space with better risk-adjusted profiles consistent with what we think is prudent for our client. We’re looking mostly at opportunities in the fully contracted power space in the U.S., where there is very steady cash flow. We also look at partially contracted areas, but full merchant would have to be especially compelling from a risk-adjusted return standpoint for us to be interested. We also continue to explore fully contracted power deals in Latin America which offer additional return.
PFR: When the team joined and you began looking at the space, and it began to seem like the returns you expected were not going to be found, what factors do you think contributed to that? Was it the type of projects that are out there, was it competition from other lenders or is there something else?
Onukwugha: Having spent time in the space and having talked to many people in this space, I think you are right on. It is a combination of both. There’s clearly more money that has come in as folks look for extra return in a lower yield environment.
The overall yields in finance—not just in the energy space—are coming down, and as a result it is forcing some folks to chase -returns by going up on the risk curve. That is not something we are comfortable doing. We have seen those returns come in from where we thought they should be to levels where we don’t see them as being very good risk-adjusted returns. It’s a combination of more money coming into the asset class while more people are reaching for returns.
PFR: What are your goals in terms of investment over the next 12-18 months? Do you have a quota of projects or a certain amount you’re trying to lend?
Onukwugha: That is a good question. Really, we want to continue to build on the momentum that we have from last year. The power space is still very attractive from a risk-return standpoint. The attributes we like in that space is still there—long duration, often underpinned by strong regulatory environments and contracted power purchase agreements.
When you look at what we’ve done to date, you see we really are very committed to the space. I can tell you that when I look at the professionals we have in the private group, four of the last six newest hires are people who are really experienced in the power and energy space. The idea is to hire people to best serve our clients.
PFR: What’s been most surprising to you about this sector?
Onukwugha: The biggest surprise for us has been how quickly some of the returns and return expectations have come in, and just how much money has come in that space.
The challenge for us is trying to do what we do best—which is create long-term financing solutions that work for everyone. We want to add value by providing long-term funds to clients that need it and returns that work for investors. Just chasing yield for our investment clients is not the answer.
We are a solutions provider, a long-term player in this space and again, we don’t want to try to market time our investments. In all the private market areas that we’ve been in, we have been a consistent participant through cycles -. Our job, and what we do best, is to find where the best relative value and risk adjusted returns are in all market cycles, not just when returns are attractive. And those opportunities are always there for players who want to be in the asset class over the long term.
We are deliberate when we get into an asset class. We build slowly because we want to stay in the market for a long time. I think by being a consistent, reliable player, we and our clients reap the benefits.
PFR: You’ve mentioned the long-term characteristic of your investments. I was hoping you’d be able to tell me an average tenor on an investment that you would make.
Onukwugha: The average tenor would depend on the asset itself. For example, let’s say it is a solar project that has the typical lifespan of 18-19 years. For something like that, we would be looking at doing something that fully amortizes with an average life of 11-12 years with a final maturity within the 15-18 year timeframe. These are often long-dated deals with relatively stable cash flows. Our clients like this, as longer tenor debt is useful for asset-liability matching and project finance deals have performed well, providing a good risk/return balance.
PFR: Shifting south, what sort of opportunities do you see there in Latin America?
Onukwugha: We do see a fair amount of opportunities out there, given the growing economies in the region and power and utility assets are essential to support continued growth. Being able to provide a reliable source of power goes a long way in helping a nation move from under-developed to more developed. We’ve seen the number of investment grade countries in South America increase over time as economies have improved along with the standards of living. Meeting their energy challenges has played a huge role in that effort.
Sponsors, or most of the clients we work with, see a great opportunity in that region to, again, meet this growing demand for power. We currently are working with a large Spanish company that has been very active in that region, and we have done some transactions with them in that space covering wires and transmission lines. There is a huge, huge build out that is going on in that area, so the outlook for our clients is very strong.
PFR: Are you looking at Brazil, Chile, and Mexico, which are the countries most people are looking at or are there others?
Onukwugha: You mentioned the ones that we are looking at – also Peru, Uruguay, Costa Rica, and Panama are all possibilities. We see good opportunities there. It is those nations that we have seen overtime their ratings move to investment grade territory. There is a fair amount of build-out taking place in those areas, and the risk-return attributes are attractive to us.
PFR: How would a transaction differ for a project in Latin America from a similar one in the U.S?
Onukwugha: Obviously, due diligence is very important and working with a local player or sponsor is helpful. We do a lot of checks to get comfortable in new areas and thorough due diligence is something that’s critical. We have a very long term investment horizon and most of these assets are long dated assets so you have to be able to form a long-term outlook. To be active on a long-term horizon, due diligence is key, because very often you don’t have the ability to get in and get out given the illiquidity of both project finance investments and private debt.
One of the easiest ways to lose money, is to try to market-time your investment so we are very careful and deliberate when we get into something. Take Brazil, or even Chile, as an example: the due diligence involves getting very comfortable with not just the country, but the credit rating issues in the country. For example, currency effects at the sovereign level can flow through to a project investment if there’s a government offtaker supporting the project. At Babson Capital, we have the benefit of being able to talk to the issue area experts in the Emerging Markets team that the firm recently added. They’re a great resource that we’ve been able to leverage and increase our geographic scope for project finance investing.
We like getting extremely comfortable with the sponsor group that we are entering into the transaction with, and making sure that the investment supports critical infrastructure assets underpinned by a monopoly characteristic. By the time we are done with diligence, when we go in there long term, in that space, in that country, we have done enough due diligence so that when the next transaction comes along, to the extent we can, we just pick back up on it and proceed. There is a lot of legal work and due diligence that we do before we go into Latin America countries.
In the U.S., obviously we do significant due diligence as well. Again, and I’ve heard someone put it this way, we take a somewhat “forensic approach” to our due diligence process because we are very deliberate and we want to be in the deals long-term.
